Key events of the past week and implications

  • US Federal Reserve (Fed) taper fears dominated over the past week resulting in volatile share markets. Some emerging share markets were hard hit as taper fears combined with worries about the economic outlook in countries like India, Indonesia and Brazil concerned investors. Renewed concerns about Italy and Greece also weighed in Europe. However, improved business conditions indicators (or purchasing managers’ index, PMI) in China, the US and Europe provided underlying support and signalled the global economic recovery was on track. In Australia, the minutes from the last Reserve Bank of Australia (RBA) Board meeting made it clear that it retains an inclination to cut interest rates again, albeit more likely on the other side of the election, and as long as nottoo-good/not-too-bad profits continue to flow.
  • The minutes from the Fed’s last meeting did nothing to change our base case view that it will start tapering or slowing its monetary stimulus at its September 17-18 meeting, but it’s far from a done deal with minutes reiterating that it is contingent on improving economic conditions and Fed officials at a central bank conference providing differing views as to timing. Given recent mixed economic data, the first move could be just a reduction in monthly asset purchases from $85 billion to $75 billion and it may be positioned as a “one off” for the time being. Importantly, the Fed is likely to try and use aggressive forward guidance to make it clear that it won’t be raising interest rates anytime soon and thereby contain the upwards pressure on bond yields. Taper fears could continue to weigh on investors in the near term but are unlikely to derail the broad upward trend in share markets.
  • In Europe, fears about Greece and Italy reared their heads again. In Greece, another bailout package is likely, but it’s likely to be relatively small and unlikely to be a major problem. The threat of Berlusconi’s party leaving the coalition government in Italy is probably a bigger threat but may still settle down and the European Central Bank’s “whatever it takes” commitment to preserve the euro is likely to continue to keep any contagion across Europe to a minimum.
  • Asian and emerging market assets came back under pressure over the last week. Fed taper fears are clearly not helping to the extent they are partly driving a flow of capital back to the US, but the broader malaise affecting the emerging world relates to the slower pace of growth in China along with inflation and current account problems (notably in India, Indonesia and Brazil). Underpinning all of this has been a lack of structural reforms. Our broad assessment is that the period of strong relative performance by emerging markets we saw last decade is over and the problems we are now seeing in the emerging world are indicative of this.
  • Meanwhile, in Australia, the minutes from the Reserve Bank’s last meeting made it clear that it still retains a bias to cut interest rates further. It’s also clear that the RBA sees the Australian dollar as being critically important in terms of the outlook for interest rates and by singling it out is continuing to try and “jawbone” it lower. It is understandable that the RBA won’t want to do anything at its September meeting as it’s just four days before the election, but I suspect that unless the Australian dollar (A$) falls sharply or Australian economic data picks up quickly, the RBA will cut rates by another 0.25% in either October or more likely in November.
  • Finally, it is worth noting that the Reserve Bank of New Zealand’s move to limit high loan to valuation mortgage loans to 10% of banks’ new residential loans to control the property market without having to raise interest rates is a possible guide to what the RBA could do if our property market got too hot at a time when the rest of the economy is still subdued. The downside to such an approach though is that it mainly hits first home buyers, not trade-up buyers.

Major global economic events and implications

  • US economic data was mostly solid with a very strong gain in existing home sales, a further increase in home prices, an uptick in its manufacturing PMI (to a solid 53.9), an increase in a leading index and trend in jobless claims remaining low. However, a very sharp fall in new home sales raised concerns about the impact of rising bond yields and mortgage rates on the housing recovery. However, given the strength in surveys of homebuilders this could just be an aberration.
  • Eurozone business conditions PMIs and consumer confidence rose again by more than expected, continuing the uptrend that began about a year ago. The composite PMI at 51.7 points to a continuing economic recovery.
  • Chinese economic news was also good with the HSBC manufacturing PMI for August rising back above the 50 level, which is consistent with growth remaining around the 7-7.5% level. No boom, but no bust either!

Australian economic events and implications

  • It was a light week for Australian economic data. On the positive side, skilled vacancies rose in July after several months of falls, but the Westpac leading index was flat in June and motor vehicle sales fell.
  • We are now about 70% through the June-half profit reporting season. Results have been weak but not as bad as feared which partly explains why the Australian share market has held up well. 40% of companies have exceeded expectations, which is down from the February reporting season but not bad compared to the last few years; 66% of companies have seen their profits rise from a year ago; 62% of companies have increased their dividends from a year ago and only 12% have cut them; and while corporate outlook comments have been subdued, the fact they haven’t been too gloomy is a good sign. Consequently, we haven’t seen the earnings downgrades some had feared. Earnings expectations for 2012-13 are little changed at -0.5% (with resources earnings down by around 20% but with earnings for the rest of the market up by around 7%) and for 2013-14 earnings growth expectations remain around 13%. Reflecting the better-than-feared results, 54% of companies have seen their share price outperform the market on the day their results were released. Key themes are ongoing cost control and weak revenue growth but a prospective boost to profits from the lower A$ and for iron ore companies from a higher iron ore price.

Major market moves

  • Shares had a volatile and mixed week. US shares ended up 0.5% and Australian shares gained 0.2%, but Eurozone shares lost 0.7% and several Asian and emerging share markets fell.
  • Commodity prices were mostly softer and the combination of taper fears and the RBA’s renewed easing bias weighed on the A$.
  • Bond yields were flat to up as the rotation out of them continued, not helped by Fed taper fears.

What to watch over the next week?

  • In the US, expect to see ongoing modest trend growth in durable goods orders (Monday), house prices (Tuesday), pending home sales (Wednesday) and personal income and spending (Friday). June-quarter gross domestic product (GDP) growth (Thursday) is likely to be revised up to 2.2% annualised from the initially reported 1.7% thanks largely to stronger trade data. However, the back-up in mortgage rates may result in a slight fall back in consumer confidence (Wednesday).
  • In Japan, key consumer spending, labour market and industrial production data to be released Friday will be watched closely for signs Abenomics is working after a recent run of mixed data. However, inflation data is expected to show ongoing evidence that deflation is fading.
  • China's official manufacturing PMI (due September 1) is likely to edge higher adding to confidence that growth has stabilised around 7-7.5%.
  • In Australia, the focus will be on business investment data to be released Thursday for an indication as to how quickly mining investment is slowing and whether non-mining investment is picking up. Expect June-quarter capex data to show a 1.8% rebound after a sharp fall in the March quarter, but forward looking investment plans to remain subdued. June-quarter construction data (Tuesday) is also expected to show a bounce after March quarter softness. New home sales data (Thursday) is expected to show an ongoing recovery and growth in private credit (Friday) is likely to have remained modest but with more signs of having bottomed.
  • The Australian June-half earnings reporting season will wrap up with 40 major companies set to report, including Boart Longyear, Caltex, Flight Centre, Seven Group AGL, Woolworths, Qantas, Westfield, Harvey Norman and Virgin.

Outlook for markets

  • Shares are vulnerable to a further consolidation or correction over the next month or two with various events and risks that could cause volatility including the Fed’s September meeting where it may start to taper its monetary stimulus, US government funding and debt ceiling negotiations, the nomination of the next Fed chairperson, various imbalances in the emerging world, political instability in Italy and the election in Australia.
  • However, any pullback should be seen as a buying opportunity as the broad trend in shares is likely to remain up: valuations are not dirt cheap but they are not expensive either; monetary conditions will remain very easy with interest rate hikes a long way off in the US and in other developed countries and interest rates still at risk of falling 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 as yields gradually adjust higher in response to the improving global growth outlook. An unwinding of years of massive inflows into bond funds runs the risk of resulting in a more aggressive rise in bond yields and hence losses on sovereign bonds.
  • 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 $US0.80.

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