Key events of the past week and implications

  • Shares continued to trend higher over the past week helped by dovish central bank comments and good news from the US and Europe in particular. Perhaps the biggest event though was a further leg down in the Australian dollar to US$0.89 on the back of comments from the Reserve Bank of Australia (RBA) and news of a further deterioration in the budget outlook.
  • In Australia, despite little change in the economy since the May budget, the Government’s economic statement showed a surprising A$33 billion deterioration to the budget outlook over the next four years as a result of weaker economic growth and revenue assumptions and new spending commitments being only partly offset by savings. The latter included an increase in tobacco excise, a bank deposit levy, public sector savings and delayed foreign aid payments. The good news is that the savings don’t kick in for two years by which time the economy should be better able to withstand them and a projected surplus is maintained for 2016-17. The bad news is that the budget blow out is much worse than feared; uncertainty has increased yet again as to when we will get back to surplus. Our public finances after the biggest boom in our history should be in much better shape and the deteriorating budget outlook may only add to fears of an aggressive post election fiscal tightening regardless of who wins. In terms of the latter, while the latest budget tightening doesn’t commence until 2015-16 and even then is only modest at just 0.2% of gross domestic product (GDP), the continuous deterioration and uncertainty regarding the budget outlook combined with fears that more aggressive tightening is on the cards post the election is likely to further undermine business and consumer confidence. The implication is that more pressure is being placed on the RBA to support growth via interest rate cuts. While the consensus is for the cash rate to bottom out at 2.5% (following a cut on Tuesday), the odds are starting to favour a cut to 2% by year end. The deteriorating fiscal outlook also highlights the need for the Australian dollar (A$) to fall towards US$0.80.
  • In the US, the basic message from the US Federal Reserve (Fed) was little changed: tapering of its quantitative easing program will only commence when the economy strengthens and interest rates will remain low for a long time. However, the Fed’s post meeting statement injected a more dovish tone with a downgrade in its characterisation of economic growth from “moderate” to “modest” and concerns about the rise in mortgage rates and low inflation. Overall this, along with softer than expected jobs growth in July, suggests that if tapering starts in September it could be a relatively modest one-off move or that it may be pushed out to later in the year. For tapering to commence, employment growth needs to be running around 200,000 jobs a month and economic growth needs to pick up to a 3% plus pace. In this context, the disappointing jobs growth for July of 162,000 with downwards revisions to previous months should be seen as “just right” in that the jobs market is not weak enough to threaten economic recovery, but not strong enough to further fuel Fed tapering fears.

Major global economic events and implications

  • Forward looking US data was positive. The June quarter GDP data confirmed that the first half has been soft and jobs growth was softer than expected in July. However, growth is likely to pick up in the current half as the impact of tax hikes and sequester spending cuts fade and a strong rebound in the Institute of Supply Management (ISM) manufacturing conditions index adds to confidence that this will occur. Unemployment claims have now fallen to their lowest since January 2008 and strong gains in house prices are providing a strong boost to household wealth.
  • The improving US economic outlook is backed up by the June quarter profit results. To date, of the 391 S&P 500 companies to have reported, 74% have surprised on the upside for earnings and 56% for sales revenue. Continued profit strength is good for shares and good for jobs and business investment.
  • Eurozone economic confidence readings rose, adding to evidence economic growth will return in the current half year. The European Central Bank (ECB) left monetary policy unchanged and ECB President Draghi’s comments remain dovish.
  • Japanese economic data was mixed with weak data for household spending, industrial production and manufacturing purchasing managers’ index (PMI). However, manufacturers expect a strong rebound in production in July, the trend in the PMI is still up strongly, and jobs data and housing starts were stronger.
  • In China, the official PMI defied the fall recorded in the flash HSBC PMI and actually rose slightly. The official PMI is probably the more reliable but taking an average of the two would suggest a gradual moderation in growth. Meanwhile, Chinese authorities continue to provide assurance that growth will be held above its bottom line of 7%, while at the same time indicating a big stimulus program is unlikely.

Australian economic events and implications

  • In Australia, RBA Governor Stevens gave a relatively dovish speech highlighting that increased uncertainty domestically and structural forces globally are likely to hold interest rates down at relatively low levels, that recent inflation readings were no barrier to further rate cuts and that a further fall in the A$ would not be surprising.
  • Meanwhile Australian data releases were mixed. On the positive side, house prices rose another 1.6% in July according to RP Data (residential property data), taking their year-on-year gain to 4.9%, new home sales rose again in June, having risen now in eight of the last nine months and credit growth picked up albeit only very marginally. But against this, building approvals fell in June, the AIG’s manufacturing PMI fell and producer price inflation remained low.

Major market moves

  • Share markets rose on the back of good data releases and profit results in the US and Europe along with dovish indications from the Fed and ECB. Australian shares benefitted from the strong global lead along with dovish comments from RBA Governor Stevens. Over the week, US shares rose 1.1%, Eurozone shares 2.4%, Japanese shares 2.4% and Australian shares 1.5%.
  • Comments from the RBA along with better news from the US saw the A$ slide to around US$0.89.
  • Bond yields were mixed: up slightly in the US but down slightly in Europe and Australia.

What to watch over the next week?

  • In the US, the ISM non-manufacturing index (Monday) is expected to show a modest rise and the trade deficit (Tuesday) is expected to narrow slightly. A speech by Fed Chairman Bernanke on Wednesday will be watched for more clues regarding the start of tapering, although it is doubtful he will say anything new.
  • The Bank of Japan meets Thursday, but is unlikely to announce any changes to monetary policy.
  • The focus globally though, will likely be back on China with July export and import data (Thursday) likely to show continuing softness and data for industrial production, investment and retail sales (Friday) likely to have remained relatively subdued by Chinese standards. Inflation is expected to rise slightly to 2.8%.
  • In Australia, the RBA is expected to cut the cash rate to an historic low of 2.5% on Tuesday. Since the last RBA Board meeting, we have seen more weak readings for consumer and business confidence, a further rise in unemployment, benign inflation and more uncertainty regarding the outlook for China. With the economy still struggling and budget uncertainty escalating, more monetary stimulus is needed. This should ideally come in the form of both lower interest rates and a lower A$. Following a relatively dovish speech by Governor Stevens, the money market has priced in a 90% chance of a rate cut on Tuesday. The weekend announcement from the Government setting the Federal election for September 7 could cause the RBA to hold back the rate cut, but this would be dangerous as it would effectively mean delaying the rate cut till October, and may risk triggering a rebound in the A$. As a result we would see such a delay as being unlikely. The RBA will also release its Statement on Monetary Policy on Friday which is expected to retain a dovish tone.
  • On the data front, expect retail sales (Monday) to show continued modest growth, but with flat retail sales in the June quarter in real terms, June house prices (Tuesday) to show a 2% rebound after a flat March quarter, housing finance data (Wednesday) to show an ongoing rising trend and labour force data (Thursday) to show a 15,000 loss of jobs in July resulting in a rise in unemployment to 5.8%.
  • The June-half Australian profit reporting season will start to ramp up with 12 major companies due to report, including Cochlear, Downer, Rio and Telstra. Consensus estimates for 2012-13 earnings growth have slipped to a fall of 0.5% from +12% earlier this year, so a lot of bad news is already factored in. Resources profits 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 A$ are likely to be supports for the profit outlook going forward, with the fall in the A$ to date potentially boosting profits by around 4.5%.

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 should see further upside in international and Australian shares.
  • Sovereign bond yields still remain low and point to low medium-term returns.
  • With commodity prices in a downtrend and the Australian economy deteriorating versus the US, it’s likely the A$ will fall further. Given its overvaluation in terms of relative prices, expect the A$ to fall to US$0.80.

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