Key events of the past week and implications

  • The past week was relatively quiet, with the approaching deadline to avert a US government shutdown weighing on US shares, while Australian shares managed their seventh straight week of gains, reaching a new 5 year high.
  • We are now coming up to crunch time in the US for Congressional negotiations regarding government funding and the debt ceiling, and this is causing investor nervousness. A new funding resolution needs to be agreed by Tuesday to avoid a government shutdown and the debt ceiling needs to be raised by mid-to-late October to avoid a partial US government default. However, we have seen this movie before in 2011, with the fiscal cliff then, and after the usual nerve-wracking political brinkmanship some sort of deal is likely. With the US budget deficit having fallen to 4% of GDP (from a 2010 peak of above 10%) it’s harder for the Republicans to push too hard, without risking a crisis that just alienates the public, which they probably don’t want to do ahead of mid-term elections next year. So, the most likely outcome is that budget funding will be agreed at the last minute, to avert a shutdown in the week ahead. However, the risk of a short shutdown has increased, as some Republicans seem keen to use the budget battle to curtail “Obamacare” (ie the new Affordable Healthcare program). The debt ceiling negotiations are perhaps the bigger risk, as President Obama is so far refusing to negotiate, with the Republicans thinking that he will in the end. So, both sides could end up playing a game of chicken, with the risk of a miscalculation. But here, again the most likely outcome is a last minute deal. However, it could get quite uncertain in the interim, which could unnerve share market investors. It’s interesting to note, though that past US government shutdowns (there were 17 between 1976 and 1996) have had a mixed impact on markets. In fact, the 32 day shutdown over late 1995 to early 1996, actually saw US shares gain 0.5%.
  • With the dust settling from the German elections, the focus is now on Chancellor Merkel's negotiations to form a coalition with the Social Democrat Party. Coalition governments are the norm in Germany, so there is nothing to be alarmed about. A coalition with the SDP (or even the Greens) probably makes it easier at the margin for Merkel to agree to support peripheral Eurozone countries. Don't expect a big change though. The failure of the Anti-Euro Alternative for Germany party to even gain a place in parliament highlights that Germans are happy with the Euro, and the stronger than expected support for Merkel in the elections highlights that they are happy with the way she has been dealing with things. So basically, expect more of the same.

Major global economic events and implications

  • US data was somewhat mixed, certainly not enough to raise market expectations for Fed tapering next month. Consumer confidence fell in September, as did the Markit manufacturing conditions PMI and pending home sales. Against this, durable goods orders for August remain consistent with a recovery in business investment, house prices continue to rise, new home sales rose strongly in August, new mortgage applications rose again and jobless claims fell. Personal income and spending in August rose in line with expectations.
  • US June quarter data highlighted the deleveraging that has occurred in the US. Total credit has fallen to 330% of GDP, from a 2009 peak of 362%, and this has largely been driven by sharp falls in the ratio of household debt to GDP (to 78% from a peak of 95%) and financial sector debt (to 84% from a peak of 119%). But even the public debt to GDP ratio has slowed to a crawl, and even fell slightly last quarter from a peak of 90% of GDP, thanks largely to reduced budget deficits. So, the argument that the US has made no progress in reducing debt, is nonsense. Household wealth is also up strongly, providing strong support to consumer spending.
  • Eurozone business conditions PMIs and confidence readings confirmed that the recovery in Europe is continuing. Credit growth remains poor though, highlighting that the recovery is still gradual.
  • Japanese inflation of 0.9% year on year in August adds to confidence that deflation is ending, but it needs to broaden out, as inflation ex-food and energy is still -0.1% year on year.
  • China’s HSBC manufacturing PMI rose more than expected, confirming that the soft patch in economic growth through the first half of the year is over.

Australian economic events and implications

  • The RBA's Financial Stability Review was generally positive, with banks and businesses perceived to be in good financial shape, while households generally remain cautious, with little financial stress. Four things stood out though. First, the RBA appears to see the increase in bank dividends and high payout ratios as being consistent with Australian banks having capital ratios ahead of minimum requirements. Second, the RBA is reminding banks to maintain prudent lending standards. Third, while it does not appear to be alarmed by the hotting up of the residential property market, it has started down a path of “jawboning” by warning buyers to have realistic price growth expectations. Finally, it has signalled it has concerns regarding recent changes to self-managed super fund rules which allow them to gear into property, potentially making SMSF funds a vehicle for property speculation. However, this relates more to commercial property, as this comprises 77% of SMSF direct property holdings.
  • It was a light week on the data front in Australia, with only job vacancies being released. While they rose 3.1% over the 3 months to August they are still down 20% year on year and indicate ongoing labour market softness.

Major market moves

  • Shares were mixed with the US budget debate not helping. US shares fell 1.1%, Eurozone shares fell 0.5% and some Asian markets fell, but Japanese shares rose 0.1% and Australian shares gained 0.6%.
  • Commodity prices mostly fell and the $A moved down a bit.
  • Bond yields generally fell amid mixed US data and as the US budget impasse boosted safe haven demand. They rose in Italy as political uncertainty continued regarding Berlusconi’s party’s support for the Government.

What to watch over the next week?

  • In the US, apart from the budget negotiations, the main focus will be on the ISM manufacturing and services conditions indicators (due Tuesday and Thursday), which are likely to show that business conditions remain at solid levels. Attention will also be on employment data (due Friday) which is expected to show a gain of 180,000 jobs in September, with the unemployment rate holding at around 7.3%. Robust ISM indicators, and stronger than expected jobs growth, would likely boost speculation of a start to tapering when the Fed meets at the end of the month. A speech by Ben Bernanke on Wednesday will also be looked at for clues on this front.
  • In Europe, the ECB is expected to leave monetary policy unchanged when it meets Wednesday, with ECB President, Mario Draghi, expected to reiterate that it retains an easing bias.
  • Japanese industrial production data for August (Monday) is expected to show a sharp rebound after July weakness, and the Tankan business survey (Tuesday) is expected to show further improvement. Friday's Bank of Japan meeting is expected to see no change in monetary policy, with the recovery currently on track.
  • In China, the official manufacturing conditions PMI for September (Tuesday) is expected to confirm the improvement in conditions already reported by the flash HSBC PMI.
  • In Australia, the Reserve Bank (Tuesday) is expected to leave the cash rate unchanged at 2.5%. While the minutes from its last meeting indicated a clear easing bias, it has also reiterated that if there is to be another easing, it’s not imminent. While the $A has had a bit of a bounce since the September meeting, highlighting the case for another cut, working in the other direction are the continuing improvements in housing related indicators and the election related boost to consumer and business confidence. To help push the $A lower though, it would make sense for the RBA to reintroduce an explicit easing bias into its post-meeting statement, rather than risk confusing the market yet again, as to whether it has one or not.
  • On the data front, in Australia expect credit growth (Monday) to have remained modest, but with some signs of a pick-up in growth in housing credit, continued strength in house prices and a 0.3% gain in August retail sales (both Tuesday). Also expect a rebound in August new home sales, but a slight fall back in building approvals after a huge bounce in July (both due Wednesday). Data for the trade balance and AIG PMIs will also be released.

Outlook for markets

  • Shares are at risk of hitting a speed bump in the month ahead, reflecting seasonal weakness and the threats posed by the US budget and debt ceiling negotiations, 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. Australian shares look they could hit 5500 by year end, with a little help from a Santa rally.
  • Government bond yields are falling, after having risen too far too fast, but are likely to resume a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering comes back into focus. Low yields and an unwinding of years of massive inflows point to poor sovereign bond returns ahead.
  • The downtrend in the $A is likely to resume once extreme shorts have been squeezed out, as tapering comes back into focus, and as the RBA retains an easing bias.

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