Key events of the past week and implications

  • The past week was dominated yet again by the ongoing soap opera around when the US Federal Reserve will start to taper their bond purchasing program. While news that tapering will likely commence in coming months should hardly surprise anyone it still creates a bit of nervousness. This saw higher bond yields and volatility in share markets which, along with capital raisings, saw the Australian share market fall. However, US shares made a new record high on Friday as improving economic data provided confidence the economy will withstand the expected slowing in monetary stimulus.
  • The basic message from the Minutes from the Fed’s last meeting and various Fed officials including Chairman Bernanke is that: the timing of the start to tapering remains dependent on improved confidence regarding the growth outlook; that if economic conditions improve as the Fed expects it could start in coming months (i.e. December out to March) and that the Fed is working on strengthening its forward guidance to stress that interest rates will remain low for longer to offset the negative impact on bond yields of cutting back bond purchases. While our base case is for tapering to start early in the New Year as opposed to in December, in reality it’s too close to call and if the November payroll report due in two weeks is strong, the odds will clearly favour a December taper, particularly if US politicians reach a budget deal by the December 13 deadline.
  • While the prospect of tapering will likely continue to cause periodic concern in financial markets, we remain of the view that it won’t stop the rising trend in share markets. First, it will only occur because the Fed is more confident the US recovery is sustainable. In other words ‘mission accomplished’, and that’s surely a good thing. Second, tapering is not the same as tightening as it will just mean a gradual reduction in the amount of asset purchases (maybe from $US85 billion a month to $US75 billion a month initially). Third, the Fed will likely couple the start of tapering with a move to further push out expectations for the first rate hike. Finally, by the time tapering happens it will be well and truly factored into most markets unlike when it was first talked about in May.
  • While the Fed is debating when to taper it should be noted that the advanced world is set to have easy or even easier monetary policy for a long time. Bernanke has stressed that tapering does not mean interest rates will rise anytime soon. Moreover, both the European Central Bank and Bank of Japan are on alert to provide more monetary stimulus, not less. This provides a reasonably supportive back drop to investment markets.
  • US shares are at new record highs with the US’ Dow Jones Industrial Average above 16,000 and S&P 500 above 1800, but is it a bubble? No. US profits are also at a record high which means the forward Price-to-Earnings ratio on US shares at around 15 times is not unreasonable and is well below the previous record highs for the market of October 2007 and March 2000. Shares are actually still cheap if allowance is made for the very low interest rate environment we are in.
  • Comments in a speech by Reserve Bank of Australia Governor Stevens that he is open minded on foreign exchange intervention to lower the Australian dollar combined with ongoing taper talk in the US helped push the $A lower. But it doesn't look like the RBA is even close to undertaking intervention as Steven’s speech extolled the benefits of the free float. He was also not sure by how much the $A is overvalued and pointed out that intervention is not costless. The mere threat of intervention though helps strengthen the jawboning the RBA is trying to use to push the $A lower. My view remains that the broad trend in the $A is down and this will ultimately see it fall back to around $US0.80 in the years ahead.
  • The debt ceiling noise continued in Australia but it’s a non-event for investors. Does the Federal Government’s debt ceiling need to be raised? Yes, as the current $300 billion ceiling will be reached next month. Will it be raised? Yes, both sides of politics agree on this. Does it matter if it’s raised to $400 billion or $500 billion? No, as it will take three years or so to reach the $400 billion level and once that’s reached it will just be raised again anyway.

Major global economic events and implications

  • US economic data points to a possible pickup in economic growth. Retail sales were solid in October despite the government shutdown, the Markit Manufacturing Purchasing Managers’ Index (PMI) rose to a solid 54.3 in November, unemployment claims fell sharply, job openings rose to a five-year high and weekly mortgage applications had a nice bounce. Existing home sales fell again in October but this may have been due to delayed processing due to the shutdown. Meanwhile inflation remains benign, which of course gives the Fed plenty of flexibility.
  • While German business conditions indicators improved, the composite Eurozone business conditions PMI disappointed, falling slightly in November, due a fall in the services PMI even though the manufacturing PMI rose slightly. The composite is still well up from its lows, but still points to a slow recovery. It highlights the need for more ECB stimulus, which it seems to be considering.
  • In China, the reaction to the detailed Plenum reforms was positive. HSBC's flash manufacturing PMI fell slightly in November but remains in a very mild rising trend and points to growth remaining around the 7.5% level, so all ok.

Australian economic events and implications

  • The Minutes from the RBA Board’s last meeting added little that was new with the RBA seeing mounting evidence that the economy is responding to lower interest rates and continued benign inflation but noting again that the $A remains “uncomfortably high” and needs to fall. Once more it left open the door to another rate cut but our view remains that given the economy does seem to be responding to past rate cuts and that the full effect is not yet evident, the RBA will keep rates on hold ahead of the next move being a rate hike, but not until around September/October next year. It is clear from the Minutes though that the RBA is much more concerned about the high $A than rising house prices, which it sees as just the expected effect of low interest rates, all of which makes it clear that the risk is still on the downside for rates.
  • Australian economic data was light on with skilled vacancies down but looking like they are stabilising and marginal gains in leading economic indicators put together by Westpac and the Conference Board.

Major market moves

  • Share markets saw a bit of volatility on the back of taper talk, but US shares still ended with a 0.4% gain for the week and a new record high thanks to solid economic data. Eurozone shares were flat but Japanese shares gained 1.4% as the Yen fell and Chinese shares rose 1.8% on the back of the Plenum. By contrast Australian shares fell 1.2%, not helped by 14 capital raisings requiring about $3.5 billion to be raised.M
  • Apart from gold, commodity prices rose, but the $A was pushed lower by a combination of taper talk in the US and more jawboning from the RBA including talk of intervention in the foreign exchange market.
  • Bond yields rose virtually everywhere on the back of Fed taper talk.

What to watch over the next week?

  • In the US, expect a bounce in pending home sales (Monday) after softness in September and reasonably solid housing starts data (Tuesday) along with continued gains in house prices (also released Tuesday). Expect underlying durable goods orders and consumer sentiment (both Wednesday) to show a bounce. Post-Thanksgiving sales on “Black Friday” will be watched closely as a good indicator for how holiday spending will go.
  • Eurozone economic confidence data (Thursday) is likely to confirm that the economic recovery remains very gradual at this stage. Unemployment (Friday) is likely to have remained around 12.2% in October, and November inflation is likely to remain very low at around 0.8% year-on-year.
  • Japanese household spending, labour market data, industrial production and inflation data (all Friday) will be watched for further evidence that Abenomics is working.
  • In Australia, the focus will likely be on September quarter investment data (Thursday) including investment intentions. Business investment in the September quarter is at risk of a fall given a 4% gain in the June quarter and capex plans are likely to confirm that mining investment has peaked and that the outlook for non-mining investment remains weak, but it’s doubtful the investment outlook will have changed much since the last survey three months ago. Meanwhile, September construction data (Wednesday) will also contribute to expectations for September quarter GDP growth. Private credit (Friday) is likely to show continued slow growth.

Outlook for markets

  • Shares are at risk of a consolidation or mild correction phase after very strong gains from early October lows which have left them vulnerable. This appears to have already commenced in Australia with a rash of capital raisings not helping. However, this is likely to be just a pause ahead of the resumption of the rising trend as valuations are reasonable, monetary conditions are set to remain very easy, profits will improve next year as global and Australian growth picks up and there is still a lot of money sitting in cash and bond funds. The Australian share market remains on track to hit 5500 or even higher by year end, with a little help from a Santa rally.
  • Government bond yields are likely in a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering eventually occurs. Low yields and an unwinding of years of massive inflows point to poor sovereign bond returns ahead. However, dovish forward guidance from central banks is likely to help ensure the rising trend in yields remains gradual.
  • Expect the $A to be buffeted in the short term between signs Australian interest rates have bottomed and stable growth in China but talk of Fed tapering and RBA jawboning. The medium term trend in the $A is likely to remain down.

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