Investment markets and key developments over the past week

Indications from the US Federal Reserve that it is not in a hurry to raise interest rates dominated financial markets over the past week with US shares (up 2.7%) receiving a strong boost and this flowing on to most major share markets (with Eurozone shares up 1.5% and Japanese shares up 1.6%), including Australian shares which rose 2.8% to their highest close since 2008. Chinese shares also surged 7.2% to their highest since 2008 on indications that the Chinese Government will do more to support growth. Bond yields generally declined. The Fed’s dovish commentary also saw the $US fall back and this saw the $A rise and most commodity prices rise.

The Fed may have dropped “patient” in terms of when it will raise interest rates, but it’s a long way from being “impatient” with very dovish commentary. Lower rates for longer is the key message. While a June rate hike is still a possibility, the downwards revision to the Fed’s growth and inflation forecasts, its reference to growth “moderating somewhat”, its requirement for further improvement in the labour market and reasonable confidence that inflation will move back to 2% and a cut in the median expectation (the so called “dot plot”) for the Fed Funds rate to 0.625% for year end from 1.125% all point to September as now being the new base case for the first Fed rate hike. It could be even later. What’s clear is that the Fed is well aware of the dampening impact of the stronger $US and is not going to risk de-railing the US economic recovery with a premature rate hike. It has clearly learned well the lessons of 1937 when premature tightening tipped the US economy back into recession/depression.

This is all positive for growth assets and bonds and may see a pause in the $US rally. That said, it’s worth bearing in mind that the Fed is still likely to start raising interest rates at some point this year and speculation around when this will occur will continue to cause occasional bouts of volatility in investment markets. However, regardless of when the Fed starts to hike, overall global monetary conditions will remain easy with Europe, Japan, China and Australia all set to ease further so shares are likely to remain in a rising trend.

Major global economic events and implications

US economic data was generally soft with weaker than expected industrial production, New York and Philadelphia regional manufacturing conditions, home building conditions and housing starts. This may partly reflect poor weather, with permits to build new homes actually up. It’s like déjà vu all over again though with the US economy going through a soft March quarter like it did early last year. While it’s likely to pass as it did a year ago, it does provide plenty of justification for the Fed to hold back from raising rates.

The Bank of Japan made no additional changes to its quantitative easing program. None was expected, but further easing is likely to be required at some point to help ensure that growth and inflation targets are met.

The threat from the Chinese property slump appears to be receding a bit. Chinese property prices are continuing to decline, but the monthly pace has slowed to around -0.4% from -1% around the middle of last year. While it’s too early to see much impact from recent monetary easing its probable that last year’s easing up on home ownership and mortgage restrictions may be helping. More broadly, Premier Li’s comments to the effect that growth needs to be supported in a reasonable range highlights that recent soft data may be approaching the Government’s comfort zone and that as a consequence further policy easing is likely. The prospect of more policy stimulus partly explains why the Chinese share market has taken off again, making new recovery highs.

Australian economic events and implications

The minutes from the last Reserve Bank of Australia (RBA) Board meeting signalled a clear bias towards cutting rates again. However, while another easing was considered at the last meeting it was clear that the Reserve was in no rush deciding to allow more time for the economy to adjust to the last cut and to await more data on the economy. This could well carry over to the April meeting meaning that the next cut may not come until May. A speech by Governor Stevens did nothing to alter the view that rates will fall further, but that the RBA is not in a hurry.

Meanwhile, the RBA can’t ignore the dovish commentary coming from the Fed. To the extent that a delay in commencing rate hikes by the Fed puts upwards pressure on the value of the $A, it will only increase the urgency for the RBA to cut rates again.

On the fiscal policy front, the Prime Minister’s foreshadowing of a “boring” May Budget suggests we may not see a re-run of last year’s confidence zapping battle over spending cuts. By the same token it begs the question of when the budget will be brought back under control and what will be done about the long term pressure on spending from the aging population.

Australian petrol prices remain much higher than justified. While world oil prices have been falling again, petrol prices have been going back the other way (pushing around $1.37/litre in parts of Sydney). Based on the normal relationship between the level of the Asian Tapis oil price in Australian dollars and average Australian petrol prices, petrol prices should be running around $1.10/litre right now.

What to watch over the next week?

In the US, expect existing and new home sales (due Monday and Tuesday respectively) to remain on the soft side thanks to poor weather, house prices (Tuesday) to show continued gains, the manufacturing PMI (Tuesday) and services PMI (Thursday) to remain solid and durable goods orders to show further gains. CPI inflation (Tuesday) is likely to have remained benign.

Eurozone business conditions PMIs (Tuesday) will likely show a further slight improvement.

Japanese data for employment, household spending and inflation will all be released Friday.

The Chinese manufacturing conditions PMI (Tuesday) may fall slightly after a couple of months of gains.

In Australia, the RBA’s six monthly Financial Stability Review (Wednesday) is expected to indicate that the Australian financial system remains in good shape, but highlight again the risks in the household sector associated with rapid house price gains. The NSW state election (March 28) will also be watched closely – if the current Government is returned with an upper house majority it will become the only state to significantly implement the Federal Government’s infrastructure asset recycling program.

Outlook for markets

The dovish message from the Fed may mean that any serious setback in shares will be delayed into the second half of the year. More broadly, the 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. Eurozone, Japanese and North Asian shares are likely to outperform.

Commodity prices could see a short covering rally helped by the Fed’s dovish comments which have helped push down the $US. However, excess supply 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 on bonds in a world of too much saving, spare capacity and deflation risk.

The dovish message from the Fed may have triggered a short covering rally in the $A (and in the Yen and Euro). However, the broad trend in the $A is likely to remain down as the Fed is still likely to raise rates this year whereas the RBA remains on track to cut and the long term trend in commodity prices remains down. We expect a fall to $US0.70 this year, and a probable overshoot into the $US0.60s in the years ahead.