Key events of the past week and implications

  • Positive global economic data was a mixed blessing over the last week as it combined with comments from various US Federal Reserve (Fed) officials adding to expectations that the Fed will start to slow or “taper” its quantitative easing program when it next meets in September and this in turn resulted in some volatility in financial markets, with share markets mostly a bit weaker.
  • In terms of Fed tapering our view is that while a September timing for the first move is now looking a bit more likely, it will only occur if economic indicators continue to improve and that it won’t signal that the first Fed interest rate hike is closer. As such, while taper fears are likely to continue to periodically weigh on markets in the run up to the Fed’s September meeting, to the extent it comes with stronger economic growth, it shouldn’t be a major problem for shares as any negative impact will likely be more than offset by stronger profit growth.
  • In Australia, the Reserve Bank of Australia (RBA) cut the official cash rate to a record low of 2.5% as widely expected and backed this up with a cut to its gross domestic product (GDP) growth forecast for this year to just 2.25%. What’s more, the RBA’s comments that the Australian dollar (A$) remains “high”, that there is “considerable uncertainty” about the economy rebalancing away from mining investment to other sources of growth and that the inflation outlook remains benign, leave the door open for further rate cuts. However, its failure to explicitly retain its previous comment that there was "scope for further easing" was disappointing in that such a statement helped maintain downwards pressure on the A$ without the RBA necessarily having to do anything. This partly goes to explain the bounce in the A$ over the last week. For the next few months, the RBA is likely to sit pat and a lot now depends on the A$. If it continues to fall with broadening signs of improvement in the economy then we have likely seen the low for interest rates, but if it remains around current levels or rises and there is little evidence of improvement in the economy then rates will likely fall to 2% over the next six months. An aggressive post election budget tightening would also increase the case for another rate cut. At the moment the risks are still skewed to the downside for official interest rates – not good news for those relying on income from bank deposits but good news for those with a mortgage.

Major global economic events and implications

  • In the US, the run of better-than-expected economic data continued with the Institute for Supply Management (ISM) non-manufacturing index rising solidly and better-than-expected trade data pointing to an upwards revision to June quarter GDP growth to around 2.5%. On top of this, the Fed’s latest bank survey pointed to a further easing in bank lending conditions, and increased demand for credit, the mortgage delinquency rate fell to its lowest in five years and unemployment claims remained low. The basic picture from the US is one of improving growth.
  • The US June quarter earnings reporting season continues to impress. It is now 90% done with 72% of companies surprising on the upside regarding earnings and 56% surprising positively on revenue.
  • There was also good news from the Eurozone with the final services purchasing managers’ index (PMI) for July coming in stronger than initially reported which took the composite PMI to 50.5, which is consistent with a return to economic growth.
  • Japan’s mixed run of data continued with softer-than-expected readings for some confidence measures but a further pick up in bank lending. Despite a mixed run of data recently and a back up in the value of the yen, the Bank of Japan left its ongoing monetary stimulus unchanged. For the Japanese share market to resume its uptrend though some combination of structural economic reforms and further monetary stimulus is likely required.
  • Chinese economic data for July mostly came in better than expected. Inflation remained low and growth in exports and imports returned to positive territory, industrial production expanded 9.7% year-on-year which was well up on 8.9% in June, electricity production accelerated, fixed asset investment remained solid and money supply growth and bank lending picked up. Overall, Chinese data remains consistent with a 7 to 7.5% growth rate for this year. No boom, but no bust either!
  • Another interest rate hike in Brazil, designed to cool inflation, provided a reminder of the less favourable growth/inflation trade-off now being seen in key emerging countries.

Australian economic events and implications

  • Australian economic data was a mixed bag. On the positive side, housing finance continues to trend up and house prices rose strongly in the June quarter. However, we are a long way from the renewed house price bubble many seem to fear. House prices are up 5.1% over the last year, but at a similar stage following the interest rate easing cycles that started in 1996, 2001 and 2008 they were showing annual growth of 7.7%, 18.9% and 18.8% respectively. What's more, housing credit is very weak compared to past cycles. Moreover, on the soft side retail sales were flat in June and in the June quarter as a whole in real terms, employment fell in July and another fall in job ads points to more labour market softness ahead. While unemployment was unchanged in July this reflected a fall in labour force participation. The basic message remains that while rate cuts have helped the housing sector there is as yet not a lot of evidence of a flow on to other parts of the economy. This is likely to occur over time, but in the meantime a further depreciation of the A$ is needed to boost sectors like manufacturing, tourism and higher education and the risks still point to further rate cuts.
  • The June-half Australian profit reporting season picked up pace. So far so good, with 42% of results having come in better than expected, which is just below the long-term average of 43%. But given that only 16 major companies have reported so far it’s too early to read much into this.

Major market moves

  • Shares were mostly down over the last week partly on the back of Fed taper fears. Japanese shares were the hardest hit falling 5.9% as that market continues to consolidate after its 80% rise over six months into May and the yen rose. US shares fell 1.1% and Australian shares fell 1.2%, but Eurozone shares gained 0.8%.
  • Commodity prices generally rose, helped by better-than-expected Chinese trade data and a weaker US dollar (US$). The combination of stronger commodity prices and the weakening of the RBA’s easing bias saw the A$ bounce back to US$0.92.
  • Bond yields were mostly little changed, but fell in Italy and Spain.

What to watch over the next week?

  • In the US, expect a 0.4% gain in retail sales (Tuesday) after a flat outcome in June, a 0.3% gain in industrial production (Thursday), continued strength in the home builders’ conditions index (Thursday) and solid gains in housing starts and permits (Friday). Manufacturing conditions, according to the New York and Philadelphia regional surveys, are likely to have remained solid and inflation is likely to have remained benign with signs that it may have bottomed – albeit at a low level.
  • In the Eurozone, the focus will be on preliminary June quarter GDP data (Wednesday) which is expected to show growth just ticking back into positive territory with a 0.1% gain, following six quarters in recession.
  • Japanese June quarter GDP data to be released Monday is expected to show that the economy has continued to recover solidly with a 0.9% gain following a 1% gain in the March quarter.
  • In Australia, the NAB business survey readings for business conditions and confidence in July (Tuesday) are likely to have remained weak but consumer confidence (Wednesday) may show a slight improvement after the latest interest rate cut. June quarter wages growth (Wednesday) is expected to have remained benign. The Treasury’s Pre Election Economic and Fiscal Outlook will also be published Tuesday and will be watched to see how it compares to the Government’s recent Economic Statement.
  • The June-half Australian profit reporting season will ramp up with 40 major companies due to report, including JB HiFi, Commonwealth Bank, Leightons, Worley Parsons, AMP and Wesfarmers. Consensus estimates for 2012-13 earnings growth have slipped to -0.5% from +12% earlier this year, so a lot of bad news is factored in. Resources profits may show signs of bottoming with a fall of 18%, 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, US debt ceiling negotiations, growth in China, the profit reporting season in Australia and the Australian election, have the potential to cause more volatility. However, the broad trend in shares is likely to remain up: valuations are no longer 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.
  • 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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