Key events of the past week and implications

  • The past week saw share markets gain but indications from the US Federal Reserve (Fed) that it has left open the possibility of a December start to tapering its monetary stimulus program weighed on US shares relative to other share markets. Talk of a December taper also boosted the US dollar and US bond yields.
  • There was no surprise that the Fed decided to make no changes to monetary policy but some were surprised that it was not more dovish. The Fed's post meeting statement logically removed reference to tighter financial conditions because they have eased since the September meeting and retained expectations for stronger growth ahead which suggests it has left open the option of a December tapering. Against this though, the Fed acknowledged softer housing data and clearly remains in ‘wait and see’ mode, looking for clearer evidence that the recovery will be sustained. In other words, the commencement of tapering remains data dependent. Our assessment is that tapering is unlikely until the March 2014 meeting, as growth won't pick up fast enough to justify a December taper and fiscal uncertainties in January and February will prevent a move at the January Fed meeting. Nevertheless, it will be an ongoing guessing game and source of volatility for investors. But even if tapering does start earlier it won’t be a bad thing because it will only mean that US growth is stronger.
  • In Australia, Reserve Bank of Australia (RBA) Governor Stevens reiterated a number of views. In particular, he’s not too concerned yet about the pick-up in house prices with credit growth remaining contained, but banks need to maintain prudent lending standards and buyers need to maintain reasonable return expectations; and secondly, the A$ will likely be materially lower in the future. There’s a bit of RBA jawboning on both views but I find it hard to disagree on either.

Major global economic events and implications

  • US economic data broadly supported the Fed's decision to hold back on tapering just yet, with soft readings for pending home sales, manufacturing production, consumer confidence and the ADP's private employment survey. However, there were some positive signs with retail sales (ex-autos) holding up well, house prices continuing to rise while the Institute of Supply management’s (ISM) Manufacturing Conditions index rose slightly in October. Moreover, while consumer confidence fell sharply in October on the back of the shutdown, it’s likely to rebound as more frequent confidence measures have, given lower mortgage rates and gasoline prices together with rising house and share prices. Finally, inflation readings remain benign, providing plenty of flexibility for the Fed.
  • The news on the earnings front remains positive in the US, with consensus earnings estimates for the September quarter now rising to 4.1%, up from 2% a few weeks back. So far, 75% of the 368 S&P 500 companies that have reported so far have exceeded earnings expectations, with 53% exceeding sales expectations.
  • There was more good news out of Europe, with Spain emerging from recession, economic sentiment continuing to rise and the European Central Bank’s (ECB) September quarter bank lending survey showing an easing in bank lending standards and demand for mortgages returning. Meanwhile, very low inflation of just 0.7% year on year in October provides plenty of scope for further ECB easing.
  • The news out of Japan was also favourable, with unemployment falling, the ratio of new jobs to applicants rising, household spending up strongly, industrial production rebounding solidly with indications that a further sharp rise is likely in October, and the manufacturing Purchasing Manager’s Index (PMI) rising to its highest since May 2010. The Japanese recovery looks to be continuing and so no surprise that the Bank of Japan left monetary policy unchanged.
  • China's official PMI rose to its highest level in 18 months, pointing to solid growth and the Peoples Bank of China (PBOC) resumed injecting liquidity into the money market, which saw some lessening in fears of another liquidity crunch.
  • The Reserve Bank of India, while easing short term liquidity conditions, highlighted the problem facing several emerging markets at present by raising its official interest rates and revising down its growth forecasts but revising up its inflation forecasts. Indonesia and Brazil face similar problems as years of capital inflows and success have led to a slowing in the economic reform process. Emerging markets need to be treated on an individual basis now - they are no longer the universal buy of a decade back.

Australian economic events and implications

  • Australian economic data provided further evidence that interest rate cuts are working. To be sure, export and import prices for goods point to a further decline in the terms of trade and credit growth remains subdued, with housing credit up only 4.8% year on year which is a long way from bubble territory. However, new home sales rose 6.4% in September to their highest level since June 2011, building approvals rose a whopping 14% in September, home prices continue to rise strongly and are now up 7.9% year on year according to RP data and the AIG’s manufacturing PMI rose to its highest since July 2010. Rising new home sales and building approvals augur well for housing construction ahead, the rise in house prices is providing a strong boost to household wealth which is positive for spending and the continuing rise in the PMI suggests its more than just an election bounce. Finally, earnings results from the ANZ Bank and National Australia Bank highlight that Australia's banks remain in good shape.
  • Rising bank fixed rate mortgage rates reflect the back up in bond yields this year but also suggest that the best time to lock in low fixed rate deals may have passed and that the next move in the RBA's cash rate and hence variable mortgage rates will likely be up - although I suspect not till September/October next year.

Major market moves

  • Share markets rose despite the possibility of the Fed tapering at its December meeting which weighed on US shares. US shares rose 0.1%, Eurozone shares gained 0.6%, Japanese shares rose 0.8% and the Australian share market gained 0.5% which took it above 5,400 for the first time in over five years.
  • Commodity prices were mixed, with metal prices up but a stronger US$ weighed on oil and gold. Renewed Fed taper talk and the RBA’s reiteration of its expectations for a lower A$ weighed on the local currency.
  • Bond yields were mixed - up in Australia and the US, but mostly down in Europe.

What to watch over the next week?

  • In the US, employment data (Friday) for October will likely show the depressing impact of the partial Government shutdown on the economy, with payroll growth likely to have slowed to 130,000 and the unemployment rate increasing to 7.3%. The impact is likely to have been temporary though, with a bounce in jobs growth expected in November. Going by the ISM manufacturing index survey for October, the ISM non-manufacturing conditions index (Tuesday) is likely to be little changed and consumer sentiment data (Friday) for November are likely to show a bounce back. Soft growth in consumption and business investment is likely to have seen September quarter GDP growth slow to an annualised pace of 2.2% from 2.5% in the June quarter.
  • Final PMI readings for the Eurozone (Wednesday) are likely confirm the slight setback seen in the flash estimates. Both the ECB and Bank of England are likely to leave monetary policy unchanged (Thursday), although the ECB may make reference to bank liquidity injections (LTRO) to boost bank lending.
  • Chinese data for October is expected to be consistent with solid growth. Look for a pick up in export growth (Friday) after September's 0.3% fall, steady to slightly softer growth in industrial production, retail sales and fixed asset investment (Saturday) and benign underlying inflation (also Saturday).
  • On Saturday, the Third Plenum of the Chinese Communist Party will get underway. These occur every five years but given this is the first under the new leadership, an aggressive reform agenda is widely expected to be announced.
  • In Australia, the RBA is expected to leave interest rates on hold on Tuesday. Economic indicators since the last meeting have been consistent with a stabilisation in growth, with housing indicators and confidence readings actually pointing to stronger conditions over the year ahead. On top of this, September quarter inflation was a little bit higher than expected. The RBA's quarterly Statement of Monetary Policy (Friday) is expected to signal a degree of confidence that interest rate cuts are helping non-mining economic activity. Our view remains that interest rates have bottomed but a rate hike is unlikely until around September/October next year.
  • On the data front in Australia, expected a 0.4% rise in September retail sales, a solid 2% gain in September quarter house prices (both Monday) and October labour force data (Thursday) to show a modest 5,000 jobs gain and rise in unemployment to 5.7% after the surprise fall in September. Trade data will also be released Wednesday. Profit results will also be released for Westpac (Monday) and Commonwealth Bank (Tuesday).

Outlook for markets

  • While shares are vulnerable to a correction or pause after recent strong gains, particularly if talk of an earlier Fed tapering gathers pace, the trend is likely to remain up as 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. Australian shares are on track to hit 5,500 or even higher by year end, with a little help from a Santa rally.
  • Government bond yields are likely to resume a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering eventually comes back into focus either later this year or early next. Low yields and an unwinding of years of massive inflows point to poor sovereign bond returns ahead.
  • Expect the A$ to be buffeted in the short term between signs that Australian interest rates have bottomed and growth is stabilising in China together with periodic talk of Fed tapering. The medium term trend in the A$ is likely to remain down.

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