Key events of the past week and implications

  • While shares in the United States (US) and Japan consolidated the previous week’s gains, European, Asian and Australian shares had solid gains with the Australian share market decisively above the 5000 level.
  • Flash manufacturing purchasing manager indices (PMI) for July highlighted how much the world has changed. While they surprised on the upside in the US and the Eurozone they continue to surprise on the downside in China. This is consistent with a broader theme of improvement in advanced countries led by the US, Europe and Japan and disappointment in emerging economies. This goes a long way to explain why traditional international shares are up 16.0% year-to-date versus emerging market shares which are down 4.0% year-todate. This theme likely has a lot further to run.
  • Chinese authorities seem to be becoming a bit more concerned about growth in China, with Premier Li indicating that 7.0% is the lower limit for acceptable growth and that 7.5% remains the growth target for this year and Vice Premier Zhang indicating China “must adopt resolute measures" to expand demand. A further slowing in the HSBC flash PMI highlighted the risks and the authorities already seem to be moving with tax breaks for small business, measures to boost railway construction and help for exporters, including stabilising the exchange rate. Don't expect any big stimulus program though, rather just enough to stabilise growth around 7.5%.
  • US political risk looks to be rearing its head again with another battle looming over the need to increase the Federal debt ceiling by late October and early November amid indications that Republicans and President Obama are a long way apart. Experience tells us that ultimately a deal will be reached though.
  • Similarly, in the US the debate about who will replace Bernanke as Chairman of the Federal Reserve is hotting up with current Federal Reserve Vice Chairmen Janet Yellen and former Treasury Secretary Lawrence Summers the favourites. A transition to Yellen would be smoother as she has been a co-driver with Bernanke of current Fed policies. Summers might cause more uncertainty as his monetary policy views are less well known. He has supported stimulus in the past, and would be unlikely to get the job at the Fed if he was more hawkish. In any case the majority at the Fed is unlikely to support a radical change in policy direction. A letter from US Senators suggests Yellen may be easier to confirm.
  • Finally, indications that the Australian Federal budget is running A$20 billion worse than expected over the next four years, or A$5 billion per annum, points to further spending cuts and tax hikes whoever wins the election. Coming at a time when the economy is soft, this means added pressure on the Reserve Bank of Australia (RBA) to cut interest rates again and for the Australian dollar to fall further.

Major global economic events and implications

  • While US existing home sales unexpectedly fell this looks more like noise than a signal with new home sales up sharply and house prices continuing to rise. Moreover, after several months of soft readings the preliminary Markit PMI rose in July, consumer sentiment rose to a six year high and solid durable goods orders augur well for business investment.
  • The US June quarter profit reporting season continues to indicate that US companies are in good shape. At the half way mark 73.0% of results have come in better than expected in terms of bottom line earnings and 57.0% have exceeded revenue expectations, with the latter well up from the March quarter outcome of just 48.0%.
  • Eurozone economic indicators continue to improve with business conditions PMIs rising solidly again in July continuing the rising trend that has been underway for a year now. This combined with a bank lending survey pointing to improved credit demand and some easing in bank lending standards adds to confidence the Eurozone will return to growth through the current half. Consistent with this the German IFO index rose for the third month in a row, Italian consumer confidence rose to a 16 month high and Spanish unemployment fell. June quarter profit results are soft, but should improve if economic growth returns as expected.
  • Japanese deflationary pressures continued to fade in June with headline inflation turning positive and deflation in core prices continuing to recede. This adds to confidence that ‘Abenomics’ is working.

Australian economic events and implications

  • In Australia, the June quarter consumer price index (CPI) showed inflation remains benign. Headline inflation actually came in a bit weaker than expected at 0.4% quarter-on-quarter (qoq) or 2.4% year-on-year (yoy) and the underlying inflation measures showed an average gain of 0.6% qoq or again 2.4% yoy. A lack of pricing power in the economy was highlighted by the just 1.5% annual increase in the price of goods and services in the market sector of the economy (after excluding volatile items). The bottom line is that inflation is comfortably contained in the RBA's 2.0% to 3.0% inflation target range and while it does not guarantee a rate cut next month we think it will be enough to get the RBA over the line, particularly given the softness in data for retail sales and business conditions, the rise in unemployment and the weak news out of China that we have seen since the last RBA Board meeting. Another rate cut will also likely be needed to maintain downwards pressure on the Australian dollar.

Major market moves

  • Shares were mixed with Japanese shares down 3.2% and US shares flat, but Europe up 0.7%, Asia up and Australian shares up 1.4%. Economic and profit news is supportive of US shares, but tapering fears linger.
  • Commodity prices were mixed, but the Australian dollar rose helped by a softer US dollar. Bond yields backed up a bit in the US, Germany and Australia.

What to watch over the next week?

  • In the US, June quarter gross domestic product (GDP) data (Wednesday) is likely to show a further slowing in growth to around 1.1% annualised, but confidence in the growth outlook is likely to be sustained by an uptick in the ISM manufacturing conditions index (Thursday) to 52.0 from 50.9 in June and solid payroll employment growth (Friday) of 185,000 which should see the unemployment rate fall back to 7.5% with both likely to indicate that the soft patch in GDP growth is temporary. Meanwhile, pending home sales (Monday) are expected to have slipped 1.0% after a surge in May, home prices (Tuesday) are expected to show further solid gains. US June quarter profits results will also continue to flow.
  • The Fed meets Wednesday and is likely to reiterate that while it is considering tapering its monetary stimulus later this year it is conditional on stronger economic growth coming through and that interest rate hikes are still a long-way off and may even consider adjusting its policy guidance to emphasise this. The Fed’s assessment of recent mixed data will clearly be watched as a guide to whether the start of tapering will be delayed beyond the September meeting, which was initially the consensus favourite as to when it would begin.
  • In the Eurozone, economic confidence indicators (Tuesday) are expected to show further improvement in line with that seen in PMIs. Expect the European Central Bank to leave monetary policy on hold at its meeting on Thursday.
  • In Japan, data for household spending, the labour market and industrial production (Tuesday) will be watched for further evidence that Abenomics is working.
  • In China, the official manufacturing PMI for July (Thursday) is likely to follow the HSBC PMI below the 50 level with a reading of 49.8 expected. Data for industrial profits will also be released.
  • In Australia, expect a 2.0% gain in June building approvals (Tuesday) to continue the rising trend and growth in private credit (Wednesday) to have remained modest. The AIG manufacturing PMI will also be released Thursday along with data for house prices, new home sales, export and import prices and producer prices. A speech by RBA Governor Stevens Tuesday will be watched for any clues on the interest rate outlook.
  • The focus in Australia will also start to shift to the company reporting season, with much nervousness given a string of recent downgrades on the back of the soft economy. However, consensus estimates for 2012- 2013 earnings growth have now slipped to a fall of 1.0% from +12.0% earlier this year, so a lot of bad news is already factored in. Profits in the resource sector may show signs of bottoming, but domestically exposed cyclicals are vulnerable to further weakness. On the positive side though, ongoing cost control and the fall in the Australian dollar are likely to be supportive for the profit outlook going forward, with the fall in the Australian dollar to date potentially boosting profits by around 3.0%.

Outlook for markets

  • We remain in a seasonally weak period of the year for shares and worries about the Fed tapering its monetary stimulus, the approaching US debt ceiling negotiations, growth in China, and the growth slowdown and profit reporting season in Australia have the potential to cause more volatility. However, the broad trend in shares is likely to remain up; valuations are reasonable; monetary conditions are likely to remain very easy with interest rate hikes a long way off in the US, Europe and Japan and rates still likely to fall further in Australia; and the gradually strengthening global growth outlook points to stronger profits ahead. So by year-end we see further upside in global and Australian shares.
  • Sovereign bond yields still remain low and point to low medium-term returns.
  • Very large speculative short positions continue to provide some support for the Australian dollar in the short term, but with commodity prices in a downtrend and the outlook for the Australian economy deteriorating relative to the US it is likely the Australian dollar will ultimately resume its downswing. Given its overvaluation in terms of relative prices, expect the Australian dollar to head towards US$0.80 over the next few years.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.