Investment markets and key developments over the past week
Shares generally rose over the past week with gains helped by better US earnings reports, a further gain in the oil price, better Eurozone data and some optimism regarding Greece. US shares rose 3%, European shares rose 1.5% and Australian shares surged 4.2%. However, Japanese shares lost 0.2% and Chinese shares remained in correction mode falling 4.2%. Oil and metals rose from oversold levels with the former helped by a further reduction in the US oil rig count. The iron ore price is still drifting down though. Bond yields generally reversed some of the years’ sharp falls, with a very strong rise in US bond yields on the back of strong US jobs data. The $A rose slightly.
Australian shares have been a star performer, having surpassed my (too optimistic) target for last year and my target for this year to now be up 7.6% year to date, which is up there with European shares. Clearly the combination of lower interest rates boosting yield plays, the lower $A boosting earnings and a stabilisation in oil and commodity prices helping resources stocks are having a big impact. While Australian shares are now looking a bit overbought in the short term (with the forward PE pushing above 15 times compared to a long term average around 14 times) and could see a correction or consolidation, the broad trend is likely to remain up.
Expect further easing from the RBA. The RBA did what it should and cut rates to a new record low of 2.25%. This was justified by sub-par growth, low confidence readings, benign inflation and a still too high Australian dollar. The main risk flowing from the latest rate cut is the additional boost it will provide to the property market, but the RBA clearly believes that this is an issue for APRA. Downwards revisions to the RBA’s growth forecasts and to its inflation forecasts in its quarterly Statement on Monetary Policy, along with the need to maintain downwards pressure on the value of the $A in the face of ongoing global monetary easing, are consistent with another 0.25% rate cut in the months ahead. In fact, the RBA’s downwardly revised growth and inflation forecasts have already baked in further monetary easing as they are built on the assumption that the cash rate moves down in line with current market pricing for at least one more cut. So if the RBA does not cut again, at least in line with market expectations, then the implication is that it will take even longer to return the economy to decent economic growth. So we expect the cash rate to soon fall to 2%, with the risks skewed to a dip below this later in the year.
China also eased monetary policy with the People’s Bank of China cutting the required reserve ratio of banks by 0.5% to 19.5%, freeing up RMB600bn for lending. Coming after a rate cut last November, the Chinese authorities are clearly moving to support growth and with China no longer accumulating foreign exchange reserves it can afford to lower the banks’ required reserves. More rate cuts and reserve ratio reductions are likely, with the bench mark lending rate likely to fall to around 4.5% (from 5.6% currently.
In Europe, the argy bargy is now well underway regarding Greece, with the ECB upping the pressure on the Greek Government to reach an interim agreement on its funding program by ending the ability of Greek banks to access cheap ECB funding using junk debt as collateral. This means that it will be harder for the Greek Government to fund itself once the current EU/IMF/ECB funding program ends at the end of the month by issuing short term debt to Greek banks which the latter would purchase using funding from the ECB. Greek banks can still get funding from the Greek central bank but this is a more expensive and the ECB has the power to turn this access off too. So the pressure on the Greek Government to reach a deal has increased immensely as no deal could mean no funding from the end of February and potentially a run on the banks (which may come sooner). There has been a welcome softening in the Greek stance with Syriza dropping demands for a debt write down in favour of lower rates and longer maturities, but the two sides are still a long way apart. However, the ECB move could trigger a resolution quicker than previously thought. Our base case remains that a deal will be reached (although I must admit it’s a difficult call) but that even if Greece doesn’t agree and heads for a Grexit, the risk to the rest of the Eurozone is manageable as the peripheral countries are now in better shape and defence mechanisms are stronger. In terms of the latter it’s noteworthy that Italian and Spanish bond yields remain at record lows.
Major global economic events and implications
US data was mixed with a softer manufacturing conditions ISM index for January, weaker than expected construction and personal spending data and a wider trade deficit, but a strong services conditions ISM and employment report. The January jobs report was unquestionably strong with payrolls up more than expected, previous months revised up and wages growth bouncing back. However, the bounce in wages just corrected a weak December and while there may be an improving trend it is still modest at this stage. So while the jobs report has swung the timing of the first Fed rate hike back to June, the risks are still that it could be delayed into the second half.
The tone to US December quarter earnings results has continued to improve over the last week. We are now two thirds done and 78% of companies have beaten on earnings, 56% have beaten on sales and earnings growth for the quarter has picked up to 4.5% from a low of 1.3% in mid-January.
Eurozone data continued the somewhat better tone seen lately with the services conditions PMI for January revised up resulting in solid gains in the overall composite PMI, retail sales growth at 2.8% year on year (or 3.4% in real terms given falling prices) running at its fastest since 2007 and stronger than expected German factory orders. Eurozone growth looks to be picking up and this was reflected in upwards revisions to European Commission’s growth forecasts for this year and next.
Chinese manufacturing and services conditions PMIs were all a bit softer in January, suggesting soft growth momentum at the start of the year. Fortunately, the PBOC is responding with further monetary easing.
Australian economic events and implications
Australian data was mixed with a fall in new home sales and building approvals, although both remain at solid levels, gains in business conditions PMIs, although only to softish levels, strong growth in retail sales volumes in the December quarter and a further narrowing in the trade deficit. Consumer spending and net exports are now likely to make solid contributions to December quarter GDP growth. Meanwhile, home prices saw solid gains in January according to RP Data. While APRA’s toughened stance towards home lending was announced in December, it’s too early to expect much impact.
What to watch over the next week?
In the US, January retail sales (Thursday) ex fuel should bounce back after softness in December helped by low gasoline prices and consumer sentiment (Friday) should hold around an 11 year high. Data on small business confidence will also be released. US December quarter earnings results will continue to flow as the reporting season starts to wrap up.
Eurozone GDP data for the December (Friday) is expected to show growth of 0.3% quarter on quarter representing a slight improvement from the prior two quarters.
China’s January inflation rate (Tuesday) is expected to slow to just 1% year on year reflecting weaker food prices and the flow through of soft commodity prices to non-food inflation. This combined with a steepening rate of decline in producer prices is likely to add to pressure for further monetary easing. Money supply and credit data will also be released.
In Australia, a speech by RBA Governor Stevens (Monday) and his Parliamentary testimony (Friday) may add a little colour around the RBA’s latest interest rate cut, but is unlikely to change our view of another rate cut to come. ANZ job ads data (Monday) will likely continue to show modest growth, January NAB survey business confidence (Tuesday) will likely remain subdued, December quarter house prices are likely to show growth of around 2% quarter on quarter, consumer confidence (Wednesday) may get a boost from the latest rate cut and fall in petrol prices, housing finance (Wednesday) should show a bounce but employment (Friday) will likely have fallen by 10,000 after several unbelievably strong months resulting in a back-up in unemployment to 6.2%.
The December half profit reporting season will also start to get underway in earnest with 30 major companies due to report including Cocklear, Stockland, Telstra and Rio. Consensus earnings growth expectations for this financial year have already been wound back to near zero, driven by an expected 28% drop in resource profits on the back of the slump in commodity prices. However, the rest of the market is a bit stronger with industrials expected to see growth (for the fourth year on a row) of around 10% and banks to see about 8% growth. Given the difficult economic conditions the risks are to the downside, but ongoing cost cutting and help from the lower $A should be two key positive themes.
Outlook for markets
Uncertainties associated with the impact on energy producers from the plunge in oil prices, negotiations with Greece 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.
Commodity prices have been seeing a bounce from very oversold conditions, with oil in particular looking like it may have built a short term base around $US45/barrel. However, 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 and deflation risk.
Short term gyrations aside, 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. We now expect a fall to around $US0.70, with the risk of an overshoot. However, the $A is likely to be little changed against the Yen and Euro.
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