Key events of the past week and implications

  • Global share and bond markets got a lift over the past week as, first Larry Summers dropped out of the race to replace Ben Bernanke as US Federal Reserve (Fed) chair, reducing fears of a more bearish Fed. Then the Fed surprised markets by maintaining its asset purchase program at US$85 billion a month. However, some of the gains were retraced later in the week, as it became clear that tapering is still ahead and as US budget and debt ceiling negotiations loom.
  • While the Fed may have confused investors, it clearly became concerned by the combination of mixed data recently, the rapid back-up in bond and mortgage rates, the approaching government funding and debt ceiling debate and a concern that the leadership transition at the Fed may give its forward guidance less credence. As a result, it elected not to taper. The key message from the Fed is very supportive of growth. It won’t risk a premature tightening in financial conditions, via a big bond sell off, and tapering won’t commence until there is more confidence that its expectations for 3% growth in 2014 and 3.25% growth in 2015 are on track. The downside though is that the Fed has just delayed the inevitable, and arguably an opportunity for a smooth reduction in quantitative easing has been lost, with more volatility a likely consequence. Although it’s hard to see a move before the Fed’s December meeting, the reality is that every Fed meeting going forward will now be “live” in terms of a possible commencement to tapering.
  • The decision by Larry Summers to withdraw from the race to run the Fed, and the re-elevation of current Fed viceChair Janet Yellen as the favourite, has substantially boosted confidence that the Fed will continue with its current growth supportive approach. There is a fair way to go yet, but at least the other alternatives are perhaps perceived to be a bit less uncertain than Summers.
  • The week ahead will open in Europe with reaction to the German election, which saw a resounding victory for Chancellor Merkel, with the only uncertainty remaining whether she and her party will govern in their own right, or with a coalition. This is good news for the Eurozone, as it means that German support will continue, but arguably with fewer delays now that the election is out of the way. This is positive for the Euro and Eurozone shares.

Major global economic events and implications

  • US economic data released over the last week indicated that tapering has just been delayed and is still ahead of us. Industrial production showed a nice gain and regional manufacturing surveys point to further improvement ahead. The NAHB home builders’ survey also held at a high level and existing home sales rose solidly, suggesting that the softness seen in housing starts and permits is temporary. One thing is clear though, which is that inflation remains benign at just 1.5% year on year in August. This gives the Fed plenty of flexibility.
  • August Eurozone inflation remained benign at 1.3% year on year and European Central Bank (ECB) officials remain rightly dovish.
  • Chinese house prices continued to rise in August, but the authorities seem less concerned about it of late – perhaps realising that the only real solution is to address supply-side constraints.
  • While the pressure on India has faded a bit this month, with the Fed’s non-taper decision helping, its outlook remains problematic with inflation increasing again in August despite soft growth. A surprise interest rate hike from the Reserve Bank of India will further dampen the growth outlook for India.

Australian economic events and implications

  • It was a quiet week in Australia, with the minutes from the last Reserve Bank of Australia (RBA) Board meeting being the main focus. Two key points emerged. First, the explicit easing bias is back after being absent yet again from the post meeting statement earlier in the month. While the RBA has reiterated that any move is not imminent, declining mining investment, restrained non-mining investment, soft consumer spending, rising unemployment, the bounce back in the A$ and benign inflation indicate the risks are still tilted towards another rate cut. Second, the RBA looks to be getting a little bit more concerned about the risk of a new housing bubble – even though RBA Assistant Governor, Malcolm Edey, and Board member, John Edwards, pointed out it’s not one yet. However, the Board have been briefed on RBNZ moves to limit high loan/valuation ratio loans and Board members agree it’s important for banks to maintain prudent lending standards and to monitor trends in property gearing in self-managed super funds. I must admit, I am not a fan of old fashioned/back to the past "macro prudential controls" because they just distort the financial system. But, a direct move to limit home lending growth (such as raising the capital banks are required to put aside for home lending) is preferable to raising interest rates if the property upturn is getting too hot. So far, it’s not too hot (housing credit is running at just 4.7% annually, versus 21% in 2003), but it’s worth keeping an eye on.
  • Meanwhile, the downgrading of WA's credit rating to AA+ by Standard and Poors highlights how some Australian governments have squandered the mining boom. After a massive boom, WA should have minimal debt and big budget surpluses, but unfortunately that’s not the case. More broadly, it highlights risks for the new Federal Government if it doesn't maintain the path back to surplus. Privatisation should be back on the agenda big time as it is the quickest way to get public debt down. At the same time, that it will help keep super funds invested in Australia and put public assets into private hands, where they can be managed far more efficiently.

Major market moves

  • Share markets had a solid week as investors celebrated good news from the Fed, despite gains being pared on Friday. US shares gained 1.3%. Eurozone shares rose 1.9%, Japanese shares rose 2.5% and Australian shares were up 1.1%.
  • Commodity prices were also buoyed by the continuation of QE3 at its current pace, but ended mixed. The A$ rose, but ended off its highs.
  • Bond yields fell sharply in the US and were down slightly elsewhere on the back of the dovish Fed news.

What to watch over the next week?

  • Monday is PMI day with preliminary business conditions PMIs being released in China, Europe and the US. All are expected to show a continued trend improvement consistent with improving global growth prospects.
  • In the US, expect further gains in house prices (Tuesday) and rises in new home sales (Wednesday) and pending home sales (Thursday) after falls in July. Durable goods orders (Wednesday) are also likely to see a bounce after a fall in July, consistent with a broad recovery in business investment.
  • The focus is now turning to Congressional negotiations regarding a new Budget (required by October 1) and an increase in the debt ceiling (required by mid-October). Expect the usual cantankerous argy bargy between both sides of politics to cause bouts of financial market nervousness, ahead of the usual last minute deal. With the US budget deficit having fallen to 4% of GDP (from a 2010 peak of above 10%) it will be harder for the Republicans to push too hard, without risking alienating the public, which they probably don’t want to do ahead of mid-term elections next year.
  • Along with Eurozone PMI's for September, the German IFO index (Tuesday) is expected to show a further improvement. Confidence indicators will also be released Friday and will likely show further gains.
  • Japanese inflation data (Friday) is expected to show further evidence that deflationary pressures are fading.
  • In Australia, the RBA's financial stability review (Wednesday) is expected to show that Australia's financial system remains sound, with banks seeing improvement in asset performance and funding, business balance sheets in good shape and households exercising prudence. However, the RBA is likely to reiterate the need for banks to maintain "prudent lending standards" and that it is keeping an eye on the increase in property gearing in self-managed super funds. August job vacancies (Thursday) are likely to have remained soft.

Outlook for markets

  • Shares are still at risk of hitting a speed bump in the month ahead as we go through the seasonally weak September/October period with potential triggers being the budget and debt ceiling negotiations in the US, and a return of Fed taper fears.
  • However, any pullback is likely to be just another bull market correction, which should be seen as a buying opportunity, as the broad trend in shares remains up. Valuations remain reasonable, monetary conditions are set to remain easy, and profits are likely to improve next year as global and Australian growth picks up. So, by year end we see further upside in global and Australian shares, with gains continuing next year.
  • Government bond yields are falling after having risen too far too fast, but are likely to resume a gradual upwards trend, as it becomes clear that the global economy is picking up momentum and as Fed tapering comes back into focus. Low yields and an unwinding of years of massive inflows into bond funds point to poor sovereign bond returns ahead.
  • The short covering rally in the A$ was given a boost by the Fed’s decision not to taper, but the downtrend is likely to resume once extreme shorts have been squeezed out, tapering comes back into focus and as the RBA retains an easing bias.

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