Key events of the past week and implications

  • An avalanche of good news out of the US caused a volatile ride in share markets over the past week, initially pushing them down as the strong data was seen as adding to the probability of a December taper by the US Federal Reserve, but with the US share market rebounding sharply on Friday after a solid payroll report boosted confidence that the US economy is strong enough to withstand tapering. Australian shares missed out on the benefit of the Wall Street rally on Friday and have been hit relatively hard thanks to a combination of 17 capital raisings draining US$4.5 billion from the market, a few negative profit warnings and the high yield nature of the Australian market that leaves it more vulnerable to rising bond yields on the back of Fed taper talk.
  • The flow of good economic data in the US along with signs that renewed budget turmoil will be avoided next year is clearly adding to the case for the Fed to soon start slowing its quantitative easing program. However, it is still 50/50 as to whether they move at the 17-18 December meeting or will wait until early next year as both Bernanke and Yellen may prefer to see a bit more certainty that recent strength will be sustained. The uncertainty is likely to continue to cause a volatile ride in investment markets though over the next week or so.
  • However, volatility aside, I remain of the view that Fed tapering won’t stop the rising trend in share markets. First, it will only occur because the Fed is more confident the US recovery is sustainable. In other words mission accomplished. Better growth means better profits. Second, tapering is not tightening as it will just mean a gradual reduction in the amount of asset purchases (maybe from US$ 85 billion a month to US$ 75 billion a month initially). Third, the Fed will likely couple the start to 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. As such it could turn out to be a case of ‘sell on the rumour, buy on the fact’.
  • US budget talks seem to be progressing well with a good chance that a budget deal will be reached by the 13 December target that was set as part of the budget and debt ceiling deal agreed by Congress back in October. This looks likely to involve reduced ‘sequester’ spending cuts next year in return for long-term savings and should enable an agreement to be passed by Congress to head off another Government shutdown by the time current funding arrangements end on 15 January. Cooperation around a budget deal would also augur well for raising the debt ceiling again, which will likely be required again around March.
  • There were no surprises from the Reserve Bank of Australia (RBA) which left interest rates on hold for the fourth month in a row. While economic growth is subdued at +2.3% year-on-year this is line with the RBA’s own forecasts for 2.25% gross domestic product (GDP) growth this year and more importantly forward looking indicators are starting to look a bit healthier at the same time as the A$ has fallen back to around US$ 0.90. As a result the RBA is likely feeling reasonably comfortable. While the risks to rates are on the downside in the short term our view remains that the RBA will most likely leave the cash rate at 2.5% for at least the next 9 to 10 months as signs of improvement head off the need for more cuts, but still sub-par growth and the need to keep the A$ down dictate that rates remain low.
  • On the Australian political front, it was good to see the abolition of the debt ceiling. Like its US counterpart, the debt ceiling was really a silly construct with little value.
  • Are the woes at Qantas telling us anything alarming about the economy? I don’t think so as they mainly appear to reflect a capacity war and it is worth noting that airlines like Qantas are one of the few large caps to be adversely affected by a falling A$ – primarily because it means higher fuel costs and possibly also because it will mean less Australians travelling overseas.

Major global economic events and implications

  • US economic news was positive with strong data for payroll employment, consumer confidence, personal spending, the manufacturing ISM index, construction, auto sales and new home sales adding to confidence that growth is picking up. The November payroll report was particularly good news as jobs growth has now averaged +204,000 a month over the last four months, the job gains are broad based across sectors and unemployment is still trending down. September quarter GDP growth was also revised up to +3.6% annualised from the +2.8% initially reported. Of course it was not all rosy with the services ISM index falling slightly and mortgage applications sliding highlighting the risk to the housing recovery from rising mortgage rates. And the GDP revision was not as good as it looks with more than all of it coming from higher inventories and growth in final demand remaining soft. That said the overall picture is one of improvement in the US economy. While tapering is on the way it looks like it will go hand in hand with stronger growth which means stronger profits.
  • The final Eurozone composite purchasing manager index (PMI) showed a small fall relative to October, but with the level of the PMI still pointing to continued gradual growth in Europe. The European Central Bank (ECB) left monetary policy on hold as expected, but the message from President Draghi remains that the ECB stands ready to provide more stimulus if needed.

Australian economic events and implications

  • Australian economic growth remained subdued in the September quarter at the just below +2.5% annualised pace that has been in place for 18 months now. As is well known this reflects the combination of the mining slowdown occurring at a time when the rest of the economy was weak thanks to the lagged effect of excessively high interest rates. More timely and forward looking indicators released over the last week are looking more positive with strong building approvals, retail sales rising more than expected in October adding to confidence that consumer spending is starting to improve, house prices continuing to trend higher and the various PMIs produced by the AIG trending higher (albeit not in a straight line). As a result we remain of the view that growth will gradually accelerate to around a 3% pace through the course of next year.

Major market moves

  • It was a messy week for share markets as good US economic news added to taper fears only to see US shares rebound on Friday as solid payrolls provided confidence in the US growth outlook. This saw US shares have a flat week, but Eurozone shares fell -3.3%, Japanese shares fell -2.3% and Australian shares fell -2.5%. Australian shares are getting hit a bit harder than US shares given their higher weighting to high yield shares like banks and financials (which led falls over the past week), a raft of capital raisings which are draining around $4.5 billion from the market and a few profit warnings.
  • Oil and metals gained on the back of stronger growth data, but taper talk weighed on the A$.
  • Bond yields rose on the back of taper talk with the Australian ten year bond yield rising to a two year high.

What to watch over the next week?

  • In the US, the main focus will be on November retail sales (due Thursday) as a guide to how holiday shopping got underway post Thanksgiving. Retail sales are expected to gain +0.4%. Producer price inflation data (Friday) will also be released and is likely to be benign.
  • Chinese inflation data (Monday) is likely to show a fall to +3.1% on the back of lower food prices and benign non-food inflation. Data for industrial production, retail sales and fixed asset investment (Tuesday) is likely to have remained solid, albeit fractionally slower than in October. Lending data will also be released.
  • In Australia, expect ANZ job ads (Monday) to show further signs of bottoming, housing finance (Tuesday) to continue to trend higher and modest increases in the NAB's business confidence measure (Tuesday) and consumer confidence (Wednesday). Employment lags the cycle and November data (Thursday) is likely to have remained soft with a 5,000 gain not being enough to prevent a rise in unemployment to +5.8%. The Federal Government may also release its mid-year budget review which will likely show a further blowout in the budget deficit for this financial year to around A$50 billion as a result of the RBA recapitalisation and more revenue slippage.

Outlook for markets

  • The combination of Fed taper talk and excessively high short term sentiment readings regarding US and global shares suggest that the share market correction could have a bit further to run. Capital raisings are of course not helping in Australia. However, this is likely to be just a pause ahead of the resumption of the rising trend as share market 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. After a -6% fall since October highs, Australian banks are back to offering grossed up yields around +8% and so are starting to look pretty attractive again given that term deposit rates of around +3.5% to +4% are continuing to slide. Note that the first half of December is often flattish for shares with the Santa rally usually starting around Christmas and we expect the same to occur this time around. Next year the combination of stronger profits and low interest rates are likely to see the Australian ASX 200 push up to around 5,800.
  • 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 rates have bottomed but talk of Fed tapering and RBA jawboning. The medium term trend in the A$ is likely to remain down to US$ 0.80 though.

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