Key events of the past week and implications

  • The past week saw rising expectations that the US Federal Reserve (Fed) will start to taper its quantitative easing program in December, which weighed on most share markets, bonds and commodities and boosted the value of the US$ . However, a much stronger than expected payroll employment report provided confidence that the US economy is strong enough to handle tapering and as a result, US shares rose strongly on Friday.
  • The much stronger than expected rise in US payrolls of 204,000 in October, coupled with upwards revisions to earlier months indicates that the US jobs market may have been picking up pace in recent months and that the US Government shutdown in October had little impact . While unemployment rose to 7.3% from 7.2% as measured by the household employment survey, this was likely distorted by the shutdown and is probably best ignored in favour of the more reliable payroll report, which shows jobs growth averaging a respectable 202,000 a month over the last three months. The improvement in payroll growth combined with solid readings from the Institute of Supply Management’s (ISM) Manufacturing index will likely impress the Fed and as result, it’s now close to a 50/50 call as to whether the Fed starts to taper at its midDecember meeting or early in the new year. In this regard, the November jobs data due early December along with public comments in the week ahead by both Fed Chairman Bernanke and Vice Chair Yellen will be worth watching.
  • While the prospect of tapering has the potential to cause occasional concern in financial markets, its impact will likely be less than many fear. First, it will only occur because the Fed is more confident that the US recovery is stronger and sustainable. Second, tapering is not tightening as it will just mean a gradual reduction in the amount of asset purchases (maybe from US$85 billion a month to US$75 billion a month initially). Third, papers by Fed staffers released over the last week indicate that it’s highly likely the Fed will couple the start of tapering with a move to lower the unemployment threshold (currently 6.5%). Below this level, the Fed would consider raising interest rates to around 6% or 5.5% which suggests that the Fed Funds rate will remain near zero through to 2016 or maybe 2017. By doing this, the Fed will be able to limit or offset any upwards pressure on bond yields. Finally, by the time tapering happens it will have been well and truly factored in, unlike when it was first talked about in May.
  • In China, Premier Li reiterated that economic growth of 7 to 7.5%p.a was the minimum necessary to keep unemployment down, but that there is limited room for more stimulus and the focus is on structural reforms.
  • There were no surprises from the Reserve Bank of Australia (RBA) which left interest rates on hold, but its quarterly Statement on Monetary Policy was a bit more dovish than expected. While the RBA acknowledged that rate cuts are helping the economy, it has restated an explicit easing bias and revised down its growth forecasts. Key concerns held by the RBA are a more dramatic slowdown in mining investment, fiscal cutbacks and the still strong A$. These are real risks but just as the RBA was arguably too optimistic at the ‘top’ in 2011, there is now a risk that it is getting too pessimistic at the ‘bottom’. Our view remains that the RBA will leave the cash rate on hold ahead of eventual rate hikes starting around September/October 2014 but the near term risks are still on the downside.
  • On the A$, the RBA is clearly stepping up its efforts to influence further declines, noting that it’s “uncomfortably high” and will likely need to fall further. More efforts from the RBA to try and talk the A$ down are likely, but given that the board is clearly more concerned about its level than surging house prices, if talk fails it may resort to another rate cut.
  • The broad message from the Fed, the European Central Bank (ECB) and the RBA is that monetary conditions will remain loose, particularly with Fed tapering likely to be offset by very dovish forward guidance regarding interest rates. This, along with improving global growth prospects, provides a very favourable backdrop for equity markets.

Major global economic events and implications

  • US economic data was mostly positive, with much stronger than expected payroll growth, the ISM Non-Manufacturing Conditions index up in October, a leading index continuing to rise, September quarter Gross Domestic Product (GDP) growth much stronger than expected and a Fed survey pointing to a further easing in bank lending standards. There were however some soft areas, with continued weakness in mortgage applications and the upside surprise in GDP growth driven primarily by a 0.8% contribution to growth from inventories.
  • In Europe, the ECB rightly responded to the recent plunge in inflation by cutting its key interest rate to 0.25%. Actually, they should have done this years ago, but ‘better late than never’ and President Draghi’s forward guidance of low or even lower interest rates for an extended time should help keep bond yields down, adding to monetary stimulation. Economic data was positive, with the final services sector October Purchasing Managers’ Index (PMI) revised up slightly. German industrial production fell in September but rising factory orders point to gains ahead.
  • Chinese data for October pointed to continued solid growth, with growth in industrial production (+10.3%), retail sales (+13.3%) and fixed asset investment (+20.1%) coming in around September levels and export growth rebounding at the same time that inflation remains benign. Non-food inflation remained just 1.6%.

Australian economic events and implications

  • Australian employment data remains very weak, but it’s worth bearing in mind that the labour market is a lagging indicator. This is important now as a range of leading economic indicators are improving. This was certainly evident over the past week, with gains in retail sales, a 1.9% increase in house prices in the September quarter (+7.6% year-on-year), gains in the Australian Industry Group’s performance indicators for the services and construction sectors and indications the ANZ job ads index is starting to stabilise. With forward indicators improving, jobs growth is likely to improve next year, with the unemployment rate likely to peak around 6% before mid-year.

Major market moves

  • While news of solid jobs growth boosted US shares by 0.5% over the past week, Eurozone shares were flat, Japanese shares fell 0.8% and Australian shares slipped 0.2%, not helped by US taper talk.
  • Taper talk also saw the US$ push higher and this weighed on commodity prices and the A$, with the latter pushed down by more RBA 'jawboning' designed to push it lower and a weaker than expected jobs report.
  • Bond yields rose sharply on the back of increasing talk of a December start to tapering in the US.

What to watch over the next week?

  • In the US, a speech by Fed Chairman Ben Bernanke (Wednesday) and Janet Yellen’s confirmation hearing (Thursday) will be watched closely for clues as to whether the Fed will start to taper its quantitative easing program next month and whether it will cut the unemployment threshold for raising interest rates from 6.5% to 5.5% or 6%. On the data front, the US Government shutdown is expected to have constrained October’s industrial production (Friday) to only a 0.1% gain, but a post-shutdown bounce back in small business optimism (Tuesday) and the New York manufacturing conditions survey (Friday), are likely to point to stronger demand growth ahead. Data for the trade balance will also be released.
  • Eurozone GDP for the September quarter (Friday) is likely to show growth of around 0.2%.
  • Japanese September quarter GDP growth (Thursday) is expected to have slowed to 0.4% quarter-on-quarter after a couple of quarters around 1%. Leading indicators point to a rebound in the current quarter though.
  • In China, focus will be on the reaction to October’s economic data released over the weekend and the Third Plenum of the Chinese Communist Party which wraps up Tuesday. This Plenum - being the first under the new leadership - is widely expected to announce an aggressive reform agenda possibly covering the role of the state. Likely to be discussed are deregulation and privatisation, the financial system (with a faster move to opening up the capital account and deregulating interest rates), fiscal reform, land reform and household registration rules. The new Chinese President is regarded as politically conservative and an economic liberal and appears to have a lot of support. However, only a broad outline is likely so the lack of specifics may disappoint some.
  • In Australia, the National Australia Bank business survey (Tuesday) and Westpac’s consumer sentiment survey (Wednesday) will be watched to see whether the recovery in confidence evident over the last few months is sustained. Given more upbeat news flow and the rising share market and house prices, it’s likely that it will be. Housing finance data (Monday) is expected to show a bounce back after a fall in August and September quarter wages growth (Wednesday) is expected to remain soft at 2.9% year-on-year.

Outlook for markets

  • After solid gains from early October lows and with technical and sentiment indicators a bit stretched, a short term correction or consolidation in shares would not be surprising. Fed taper fears may be a trigger. However, the trend in shares is likely to remain up as valuations remain reasonable, monetary conditions are set to remain accommodative and profits are likely to improve next year as global and Australian growth picks up. Australian shares remain 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 be in a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering 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. However, dovish forward guidance from central banks is likely to ensure that the rising trend in yields remains very gradual.
  • Expect the A$ to be buffeted in the short term between signs that Australian rates have bottomed and stable growth in China, but also by talk of Fed tapering and RBA jawboning. The medium term trend is the A$ is likely to remain down.

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