Investment markets and key developments over the past week
Share markets had a rough week with uncertainty about the Fed, profit taking in US tech stocks, nervousness ahead of the coming US March quarter profit reporting season, worries about Saudi air strikes on Yemen and uncertainty about Greece all weighing at various points. US shares fell 2.2%, Eurozone shares fell 1.3%, Japanese shares lost 1.4% and Australian shares fell 0.9%. Chinese shares managed to gain 2%, though they were helped by expectations for further monetary easing. Bond yields rose slightly, but a slight fall in the $US saw oil and gold prices up and the $A break briefly above $US0.78 before it ended down slightly for the week.
Should we worry about the conflict in Yemen? The short answer is no. It seems every time there is a conflict somewhere in the Middle East there are fears of a disruption to oil supplies and a wider conflagration and so oil prices spike and investors worry. The Saudi airstrikes against Iranian backed Shia insurgents in Yemen is no exception. Yemen produces hardly any oil (just 125,000 barrels a day) but it borders the Bab el-Mandeb strait which sees nearly 5% of global oil production pass through daily and so some fear this may be disrupted and more generally that the conflict in Yemen will lead to a broader Saudi (Sunni)/Iranian (Shia) conflict. Of course lots of things could happen regarding Yemen and there could be a further short term spike in oil prices. However, Yemen probably won’t cause a major problem as Saudi Arabia is unlikely to want to get involved in Yemen on the ground and its best hope to limit Iranian influence in the Middle East is to ensure oil prices stay low so it will likely act against any significant oil price spike by increasing oil production. So Yemen is likely to be just another distraction.
Major global economic events and implications
US data provided something for Fed hawks and doves. On the hawkish side were strong readings for home sales and the March Markit manufacturing and service conditions PMIs, along with a fall in jobless claims and stronger than expected consumer sentiment. However, on the dovish side there was another soft reading for durable goods orders, possibly reflecting the dampening impact of the strong $US. Core CPI inflation was a bit higher than expected, possibly providing confidence that inflationary pressures may be bottoming, but it’s too early to read too much into this. The overall impression remains that the Fed is on track to raise interest rates this year, but it’s a more likely to occur in September rather than June. Comments by Fed Chair Yellen imply that she expects to raise interest rates this year and that increases will likely be gradual offered nothing new.
Eurozone data continues to impress with further gains in manufacturing and services conditions PMIs pushing the composite business conditions indicator to its highest since May 2011 and a continuing pick up in money supply and bank lending. This is all backed by stronger business confidence readings in Germany, France and Belgium and a further gain in Eurozone consumer confidence. Eurozone shares remain very attractive.
While Eurozone and US PMIs were solid, the Japanese PMI unexpectedly fell. However, other Japanese data wasn’t bad with stronger than expected household spending, a slight fall in unemployment, a rise in the ratio of new jobs to applicants to a 23 year high and stronger small business confidence. Underlying inflation remains too low though at around 0.3% year on year if the impact of the sales tax hike is excluded. The Bank of Japan looks like it will need to do more, which will lead to another leg-down in the yen.
China's March flash manufacturing PMI also unexpectedly fell. It remains in the same 48 to 52 range it’s been stuck in for the last four years now, so no reason to get to concerned, but it does reinforce the view that Chinese economic growth has started the year on a soft note and that more monetary easing is needed. Expect the People's Bank of China to cut their 12 month benchmark lending rate to around 4% this year, from 5.35% currently. The overall impression is that global growth is continuing but it remains just below trend and uneven as highlighted by the various PMI's.
Australian economic events and implications
The Australian financial system is strong, but with some risks. The RBA's six monthly Financial Stability Review (FSR) characterised the Australian financial system as performing strongly with relatively low risks regarding household sector finances generally and corporate lending. However, it did express ongoing concern regarding residential property prices and investor lending in the biggest cities and highlighted risks around commercial property reinforcing the need for banks to maintain lending standards. Since RBA Board members were briefed on the latest FSR at the last board meeting. and yet the RBA still expressed an easing bias at that meeting, it does not alter our expectations for a further interest rate cut in the months ahead to support the broader economy. Rather it continues to fall to the prudential regulator, APRA, to ensure that bank lending standards are maintained.
Regarding commercial property, yes yields have been falling as values have gone up relative to rents, but it’s worth noting that the gap between bond yields and commercial property yields remains well above where it was prior to the GFC and is actually very high by historical standards. You can't say the same thing about residential property yields though!
On the political front, the NSW Liberal/National Government’s re-election means that its proposed “poles and wires” “privatisation” plan will likely go ahead which will help fund a $20 billion infrastructure spending program. NSW will become the only state participating to any significant degree in the Federal Government's infrastructure asset recycling program. The only uncertainty is whether it will be passed by the state’s upper house, where the NSW Government looks like having to negotiate with smaller parties but here the prospects have improved.
What to watch over the next week?
In the US, the main focus is likely to be on the March manufacturing conditions ISM (Wednesday) which is likely to show a modest improvement after the weather affected February result and March employment data (Friday) which is likely to show a strong 250,000 gain in jobs and unemployment remaining unchanged at 5.5%. Meanwhile, the Fed's preferred inflation measure, i.e. the core private consumption deflator (Monday) will likely show that inflation remains benign and data for pending home sales (also Monday), home prices and consumer confidence (both Tuesday) and the trade balance (Thursday) will also be released.
Eurozone inflation data for March (Tuesday) will likely show that deflationary pressures are bottoming with energy prices (at least for now) and that unemployment (also Tuesday) is continuing to trend down, albeit only gradually. Economic confidence measures (Monday) will also be watched to see if they confirm the gradual improvement evident in PMIs. Greece is also due to provide details (probably on Monday) on how it will fulfil its reform commitments as a precursor to funding being released. The reaction of Eurozone finance ministers to Greek commitments will clearly be watched closely given Greece’s rapidly approaching need for new funding to be disbursed.
Japan's February industrial production data (Monday) and March quarter Tankan business survey (Wednesday) will be watched for continuing signs of recovery after last year’s sales tax hike inspired recession.
China's March official manufacturing conditions PMI (Wednesday) will likely drift a bit lower as foreshadowed by the HSBC flash PMI that has already been released, providing a further sign that more monetary easing is needed in China.
In Australia, expect continued investor housing driven growth in private credit data and solid HIA new home sales figures (both Tuesday), a 2% pullback in building approvals from the record high seen in January and further modest growth in March RP Data home prices (both Wednesday) driven mainly by Sydney and a further deterioration in the trade balance (Thursday) driven by lower commodity prices. The AIG's manufacturing conditions PMI and data on job vacancies will also be released.
Outlook for markets
At some point this year shares are likely to see a decent correction with the anticipation of the Fed’s first interest rate hike likely to provide the trigger. However, 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.
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 last Fed meeting helped trigger a short covering rally in the $A (and in the Yen and Euro). However, so far it’s been fairly weak. More broadly, the 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.