Investment markets and key developments over the past week

Share markets had a good week driven by a strong quantitative easing (QE) program from the European Central Bank (ECB) along with good US data. This saw US shares gain 1.6%, Eurozone shares surge 5.5% and Japanese and Australian shares both up 3.8%. Chinese shares fell 0.7% though being hit earlier by a crackdown on margin trading. Bond yields fell sharply in peripheral Europe on the back of the ECB’s bond buying program which also pushed the Euro lower. The $A fell below $US0.80 for the first time since 2009 on increased expectations for an RBA rate cut. Oil and copper continued to fall.

The QE announcement from the ECB was well above expectations. Key elements of the ECB’s QE program are: €60bn/month in debt purchases involving both public and private debt out to September 2016 or until inflation is back on track; 80% of sovereign debt buying to be by national central banks but the remainder by the ECB resulting in partial loss sharing across Europe; and the Targeted Longer Term Refinancing Operation (TLTRO) cheap lending program sweetened by removal of a fee. While the low level of loss sharing on public bond purchases is a dampener this was necessary to get German support and in any case is more than offset by the sheer size of the program. The ECB is now set to expand its balance sheet well beyond the 2012 level or €1trillion of QE that President Draghi last year implied was the objective.

Source: Bloomberg, AMP Capital

With public debt now included there is little doubt that this can be achieved. And the open ended nature of the program, ie until inflation gets back closer to target, puts it on a par with the Fed’s successful QE3 program. As in the US, it is expected to work by boosting inflation expectations, displacing investors from low risk assets into higher risk assets and so boosting the availability of capital and asset values, helping support bank lending and via a lower than otherwise euro.

In short, the ECB’s move gets the thumbs up. The scale and open ended nature of the QE program provides significant confidence that Eurozone deflation will not be sustained and that growth will get back to a firmer footing. This is good news for the global economy. So it’s no surprise shares rallied and it makes sense to continue overweighting Eurozone shares.

For Australia, the ECB’s move is good news as it should help global economic growth and particularly China given that the Eurozone is its largest export market. While it is likely to reinforce demand for Australia’s higher yielding and highly rated government bonds, coming on the back of a surprise interest rate cut by Canada it highlights that global deflationary forces remain intense and require further monetary easing and so Reserve Bank of Australia (RBA) rate cut expectations have been given a further boost.

As expected the IMF followed the World Bank in revising down it global growth forecasts, but this tells us nothing new. The IMF’s 3.5% growth forecast for 2015 is now in line with our own expectation. What is perhaps most interesting in the IMF’s outlook is that in 2016 it sees growth in India exceeding that in China. Such a cross-over underlines how India will become increasingly important for investors.

Finally, the passing of Saudi Arabia’s King Abdullah is unlikely to change the outlook for oil prices with new King Salman likely to maintain current production levels as the country seeks to regain its long term market share.

Major global economic events and implications

US economic data was mostly favourable with solid housing data. The January manufacturing Purchasing Managers Index (PMI) fell slightly but remains solid. US December quarter earnings are okay with 77% beating on earnings and 51% beating on sales but it’s still early days and there have been some high profile disappointments.

Eurozone PMIs improved in January adding, along with the ECB’s move, to confidence that growth will improve.

In Japan there were no surprises from the Bank of Japan (BoJ). However, further easing is likely. Given the falling Euro versus the Yen, the BoJ is effectively in an easing battle with the ECB – which is a good thing overall given the soft conditions in both countries.

China has slowed, but in a controlled manner and only to a more sustainable pace. December quarter GDP growth was in fact a little bit better than expected and resulted in 2014 growth of 7.4% which is in line with the Government’s target. Growth in industrial production also perked up and retail sales growth remained robust. The January flash PMI also suggests that growth remains reasonable. But given the risks flowing from the property downturn and falling inflation, further interest rate cuts are likely from the People’s Bank of China (PBOC) and this should help ensure that growth this year comes in around 7%.

China’s move to slow margin trading was understandable. But with Chinese shares still relatively cheap and the economy stabilising it’s unlikely to mean the end of the bull market.

Australian economic events and implications

In Australia, the decline in inflationary pressures was highlighted by weakness in the TD Securities/MI Inflation Gauge. This is pointing to a sharp fall in official inflation.

Source: ABS, TD Securities/MI, AMP Capital

Meanwhile, consumer sentiment rose in January but given the sharp fall in petrol prices and better news on jobs the gain was modest leaving confidence well below its long term average.

While a February rate cut is unlikely, soft consumer confidence and weakening inflation support our view that the RBA will cut rates again. Canada’s move to cut interest rates in the face of the oil price slump arguably adds to the case for an RBA cut because Australia has had a similar hit to its national income from lower commodity prices.

What to watch over the next week?

In the US, the Fed (Wednesday) is expected to reaffirm that it will remain patient in terms of when it will first start to raise interest rates and that it will be data dependent. While recent US economic and labour market data has been favourable it will be interesting to see how the Fed interprets the recent fall in core inflation. Our base case remains that the first hike will be in June, but with the risk of a delay.

Meanwhile, on the data front in the US expect gains in December durable goods orders, new home sales, house prices and consumer confidence (all due Tuesday) and pending home sales (Thursday). December quarter GDP (Friday) is expected to rise at a solid 3% annualised pace and the December quarter Employment Cost Index (also Friday) will likely also show continued modest growth.

In Europe, the main focus will be on the outcome of the Greek election (January 25). Polls point to a “win” by left wing Syriza, but if wins it will be weeks or months before the outcome in terms of a Greek exit (Grexit) from the Euro will be known. First, Syriza may not have a majority so a coalition Government will need to be formed (in 2012 this required two elections). Second, a period of negotiation with the Troika of the IMF, EU and ECB will then commence. Syriza is no longer seeking to leave the Euro as it knows 70% of Greeks want to stay. But to stay it will have to reach agreement with the Troika on its budget and reform program and to do this it will have to compromise. The pressure to do this will be immense because to not compromise will see Trioka funding withdrawn resulting in even worse austerity and ECB support for Greek banks removed. So I expect a deal to be struck. And finally, if there is no agreement and Greece does leave the Euro, the threat of contagion to peripheral countries is far less than it was in 2012 as Portugal, Ireland and Spain are now in much better shape and the defence mechanisms in Europe are far stronger with a strong bailout fund, a banking union and an aggressive ECB.

Meanwhile, European economic confidence indicators will be watched for further signs of stabilisation (Thursday) and the January CPI (Friday) is likely to show further modest deflation.

Japanese economic activity data is expected to show further signs of improvement but inflation is likely to have slowed reflecting lower fuel prices (all due Friday).

In Australia, expect the December quarter inflation rate (Wednesday) to have fallen below target leaving plenty of scope for another RBA rate cut. A 7% slump in petrol prices is likely to have resulted in inflation of just 0.1% quarter on quarter or 1.6% year on year. Underlying inflation is also expected to be relatively weak at just 0.5% quarter on quarter or 2.1% year on year. Both headline and underlying inflation are expected to come in below RBA expectations.

Meanwhile the NAB business survey (Tuesday), trade prices (Thursday), producer prices & credit (Friday) will be released.

Outlook for markets

Uncertainties associated with the plunge in oil prices and the impact on energy producers, the January 25th Greek election and the Fed’s move towards a rate hike could result in a volatile first half in share markets with the risk of a 10-15% correction at some point along the way.

However, the broad trend in shares is likely to remain up as: valuations, particularly against bonds are good; economic growth is continuing; and monetary policy is set to remain easy with further easing in Europe, Japan, China and Australia and only a gradual tightening in the US. As such share markets are likely to see another year of reasonable returns.

The Australian share market is likely to do better than in 2014 as growth continues to rebalance away from resources helped by low interest rates and the fall in the $A. However, it will probably continue to lag global shares as commodity prices remain in a long term downtrend. Expect the ASX 200 to rise to around 5700 by end 2015.

Commodity prices may see a bounce from very oversold conditions, but excess supply for many commodities is expected to see them remain in a long term downtrend.

Low bond yields point to soft medium term returns from sovereign bonds, but it’s hard to get too bearish in a world of too much saving, spare capacity & low inflation.

The downtrend in the $A is likely to continue as the $US trends up and reflecting the long term downtrend in commodity prices and Australia’s relatively high cost base. Expect a fall to around $US0.75. However, the $A is likely to be little changed against the Yen and Euro.

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.