Investment markets and key developments over the past week

Shares have had a volatile start to the year, first falling sharply, then rebounding before coming off again in the US and Europe on Friday. It seems shares were left with a bit of a “hangover” from the Santa Claus rally through the second half of December and so worries about the fall in oil prices, Greece and Europe along with weak US wages growth and uncertainty about the ECB have led to a volatile ride at the start of the year. Over the last week US shares fell 0.6%, Eurozone shares fell 3.1% and Japanese shares fell 1.5% but Australian shares rose 0.5% and Chinese shares gained 1.6%. Of these markets, only Australian and Chinese shares are up year to date. Bond yields are generally down year to date reflecting expectations that the falling oil price will weigh on inflation. Oil and metal prices have continued to fall, with the global oil price falling below $US50/barrel for the first time since 2009. However, the $A is up slightly on expectations that weak US wages growth will delay Fed monetary tightening.

The period ahead sees more event risk regarding the impact on energy producers from falling oil prices, Greece and the Eurozone and the Fed’s gradual move towards a rate hike. Looking at each of these:

  • The oil price collapse is a big negative for energy producers and its reasonable to expect some sort of blow up there, but its unlikely to cause major systemic problems globally or in Australia and more broadly the stimulatory impact of the 50% fall in oil prices over the last year on global and Australian growth (likely to be around 0.7%) is expected to ultimately dominate.
  • Uncertainty about a Grexit (Greek exit) from the Euro has returned ahead of Greece’s January 25th election with left wing Syriza leading in the polls. This uncertainty could linger for a while yet, particularly if the election does not result in a government as occurred in May 2012, necessitating another vote. However, a Grexit is not the threat it was several years ago: while Syriza is ahead its lead is small and it will be unlikely to get enough support to govern on its own; secondly its anti-Euro rhetoric has been toned down as it realises that most Greeks want to stay in the Euro suggesting if it does win it would ultimately seek a deal with the Troika (the ECB, Eurozone and IMF that now own 80% of Greek debt); other peripheral countries (Portugal, Ireland, Spain) are now in much better shape and hence are less vulnerable to any contagion that may flow from a Grexit; and finally the defence mechanisms in Europe are now far stronger with a strong bailout fund, a banking union and a far more aggressive ECB committed to doing “whatever it takes” to preserve the Euro.
  • The broader issue in Europe is deflation with headline inflation going negative in December and growth indicators remaining soft. Fortunately, the ECB looks set to widen its quantitative easing program with a letter from President Draghi indicating that it may include sovereign bond buying. However, uncertainty is intense with reports that an ECB staff briefing only focussed on a €500bn program causing some consternation as it would be below market expectations. However, it would be wrong to read too much into this as some reports also suggest open ended QE was considered in the briefing and, even if it is just €500bn initially, Draghi could indicate that it will be extended if needed. Quite clearly investors are nervous ahead of the ECB’s January 22 meeting, but I think it likely that the ECB will deliver a decent quantitative easing program.
  • The Fed is likely to confirm at is January 28 meeting that it will remain patient in moving to raise interest rates and that it will be dependent on further improvement in the US economy providing confidence that inflation will eventually rise back to target. Our base case is for a June rate hike, but soft December wages growth clearly indicates that the risks are skewed towards a later tightening.

While we see each of these “events” turning out ok, they all nevertheless have the potential to create short term turbulence in markets.

Major global economic events and implications

US data releases basically indicate that the US economy is solid. US jobs related indicators are robust highlighted by a stronger than expected gain in December jobs and unemployment falling to 5.6%, house prices are clearly rising again and the various ISM and PMI business conditions indicators for December remain strong. But its worth noting that the latter are all off their highs of several months ago indicating that the US economy is not taking off. And average wage earnings fell 0.2% in December taking annual wage growth down to just 1.7%. This along with low inflation readings provides plenty of scope for the Fed to remain patient on rates.

In Europe, the much anticipated slide into deflation has arrived with the December CPI coming in at -0.2% year on year thanks to the slump in energy prices. Core inflation is running at just 0.8% year on year. This combined with continued soft indicators regarding growth (softish December PMIs, a fall in German factory orders, etc) maintains pressure for more aggressive ECB quantitative easing.

Chinese December business conditions PMIs continue to paint a confusing picture with manufacturing PMIs softening a bit (albeit stuck in the same range they have been for the past few years) but services PMIs rising slightly. The overall picture remains one of growth around 7-7.5%. However, with inflation likely to fall further as lower commodity prices feed through and to support growth more stimulus is likely this year with the PBOC expected to cut its benchmark lending rate to 4.5%. Reports that Government has sped up RMB7trn (or $A1.4trn) of infrastructure spending are positive but likely massively exaggerate the amount of new spending as most of it would have been occurring anyway.

Australian economic events and implications

Australian data releases started the year on a reasonable note with a fall in the manufacturing and construction conditions PMI but stronger services sector conditions, a rise in building approvals to record levels highlighting that the housing recovery is continuing, continued decent trend growth in retail sales and a lower than expected trade deficit. However, in terms of the latter while export volumes appear to be growing nicely a worsening in the trade deficit is expected as the fall in commodity prices feeds through with a lag. Meanwhile, home prices continue to trend up in December but momentum slowed in 2014 as a whole compared to 2013.

What to watch over the next week?

In the US, expect to see solid December retail sales growth (Wednesday), strong January manufacturing conditions in the New York and Philadelphia regional surveys but benign producer and consumer price inflation readings for December (due Thursday and Friday respectively). In fact, plunging energy prices are expected to push CPI inflation to just 0.8% year on year and core inflation is likely to remain low at 1.7% year on year. All of which should leave the Fed with plenty of scope to remain patient on interest rates.

The December quarter profit reporting season will kick off in the US with companies such as Alcoa, JP Morgan and Intel due to report. Consensus expectations are for just 2% growth in profits over the year to the December quarter, but this is likely to yet again prove too conservative with a final outcome likely to be closer to 6-7%.

In the Europe the focus will be on European Court of Justice’s opinion (Wednesday) on the ECB’s Outright Monetary Transaction sovereign bond buying program. So far the OMT has not had to be implemented but an unexpected negative Court opinion on the ECB’s ability to buy sovereign bonds could impact its quantitative easing plans to be announced on January 22nd forcing it down a weaker path of having individual country central banks conduct any bond buying.

Chinese export and import data (Tuesday) are expected to show a slight improvement for December as is money supply growth but growth in total credit is likely to have continued to slow.

In Australia, expect to a small gain in housing finance (Monday), but only a 5000 gain in jobs leaving the unemployment rate stuck at 6.3% (Thursday). Data for ANZ job ads (Monday) and ABS job vacancies (Wednesday) will also be released.

Outlook for markets

Uncertainties associated with the plunge in oil prices and the impact on energy producers, the Greek election and Europe 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 the reality of low bond yields are good; economic growth is continuing; and monetary policy is set to remain easy with further easing likely in Europe, Japan, China and Australia and only a gradual tightening cycle in the US. As a result 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.

Very low bond yields point to a soft return potential from sovereign bonds, but it’s hard to get too bearish on bonds 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.