Investment markets and key developments over the past week

Shares had a good run over the last week helped by continued reasonable economic data, merger & acquisition (M&A) activity and confirmation from the US Federal Reserve (the Fed) that it’s more likely to raise interest rates in September than June. US shares rose 1.7%, Eurozone shares gained 3%, Japanese shares rose 2.4% and Australian shares gained 1.2%. Chinese shares continued to push higher gaining 4.4%, but shares in Hong Kong rose 7.9% and are now starting to play catch up driven by mainland Chinese investors. Bond yields were mixed – up in Australia and the US as the overreaction to the weak US payroll report was reversed, but flat to down in Europe. Metal prices were little changed, but oil rose 5% and while the $US moved up again the $A rose slightly in response to the RBA leaving interest rates on hold.

From China to Hong Kong. After Chinese mainland (or A shares) rocketed up 90% since mid-last year, Chinese residents are now taking advantage of the Shanghai-Hong Kong Connect arrangement (that enables investors on either stock exchange to buy shares in the other) to buy up relatively cheap Hong Kong shares. So far this month the Hong Kong share market is up 9.5% and H shares (ie mainland Chinese companies listed in HK) are up 13%. So the boom is spreading from mainland Chinese shares to Hong Kong. We think both have further to go but value is clearly better in Hong Kong with Hong Kong shares on a forward PE of 11.5 times, H shares on 8.3 times and mainland shares on 13.6 times.

Shell’s acquisition of BG coming on the back of a long list of deals in the US over the last year or so highlights that M&A- mania is clearly back. This is an inevitable result of companies being cashed up after strong profit gains and able to borrow very cheaply. It’s also showing up in rapidly rising dividends. M&A mania is often a sign of the sort of euphoria we see around major market tops, but other indicators are sending the opposite signal. For example individual investors are still pulling money out of equity funds in the US and believe it or not putting it into bond funds, which is not the sort of think you see at major share market tops. Likewise, investor sentiment measures are running around the middle of their normal ranges.

The Reserve Bank didn’t exactly surprise, but did disappoint, by leaving interest rates on hold yet again. It didn’t provide an explanation for not cutting – after all why should it! – so one can only guess. Maybe it wants more data including the March quarter CPI due later this month. Maybe it’s still worried about the property market. Or maybe it just wants to stretch the process out feeling it’s not yet ready to signal sub 2% interest rates but wants to retain an easing bias to keep downwards pressure on the $A and so had to keep the cash rate at 2.25% for now. Whatever the reason our assessment remains that the RBA will have to act on its easing bias as the blow to national income from the falling iron ore price has intensified, this along with a poor investment outlook is pointing to continued sub-par growth and ongoing spare capacity, inflation remains benign and the $A is still too high. A loss of momentum in investor housing lending is likely also providing the RBA with more flexibility. So we expect the cash rate to fall to 2% in May with a strong possibility rates will fall below that later this year.

Major global economic events and implications

US economic data was a bit light on but showed continued strength in the ISM non-manufacturing conditions index, another solid gain in job openings in February to their highest since 2001 and while jobless claims rose they are trending around very low levels. The job openings and claims data provides confidence that weak employment growth in March was more due to poor weather as opposed to a renewed fundamental deterioration in the economy. Meanwhile, the minutes from the Fed’s last meeting provided no surprises and simply confirmed the more dovish stance taken at that meeting. There is now plenty of acknowledgement from the Fed of the dampening role being played by the strong $US, which is evident in another broad based fall in import prices in March. While some at the Fed seem to still be leaning towards a first rate hike in June, the majority looks to be focussed on September.

Eurozone retail sales fell slightly in February but at 3% year on year are running at their strongest pace in around 10 years. Although Greece has yet to unlock funding from the Eurozone, it made a scheduled payment to the IMF and the issue continues to have little impact on the rest of Europe.

While the Bank of Japan left monetary policy unchanged, pressure for further easing is likely to mount in the months ahead as the boost to prices from the sales tax hike in April last year drops out of annual inflation data which will see headline inflation head back to around 0.5% year on year, i.e. well short of the 2% target. Meanwhile, a stronger than expected gain in the Eco Watchers confidence survey, further gains in machine tool orders and a continuing downtrend in Tokyo office vacancies suggest that modest economic growth is continuing.

Chinese inflation in March was a bit higher than expected, but at 1.4% year on year or 0.9% year on year excluding food it remains very low. Producer prices are also continuing to deflate being down 4.6% over the past year. This remains consistent with more monetary easing ahead.

While the Reserve Bank of India left interest rates on hold, the favourable economic environment in India was highlighted by solid and stronger than expected growth in industrial production in February.

Australian economic events and implications

Australian economic data was mixed with a stronger than expected gain in February retail sales, but a fall in ANZ job ads, a weaker services sector conditions PMI for March and a smaller than expected gain in housing finance in February coming on the back of a sharp fall in January. The latter may be a welcome sign for the Reserve Bank of Australia (RBA) as investor finance fell 3% and is showing signs of falling momentum. In fact, with investor housing credit at 10.1% over the year to February its quiet likely that the Australian Prudential Regulation Authority (APRA) has had a word with some lenders forcing them to slow down and this may explain the recent loss of momentum.

What to watch over the next week?

In the US, expect a solid rebound in retail sales (Tuesday) after a soft few months, a slight fall in industrial production (Wednesday), a rise in the NAHB home builder conditions survey (Wednesday), a 16% gain in housing starts (Thursday) and benign consumer price inflation (Friday) leaving plenty of flexibility for the Fed in terms of timing the first interest rate hike. The Fed’s Beige Book of anecdotal evidence along with manufacturing conditions surveys for the New York and Philadelphia regions will also be released.

US March quarter earnings results will start to flow in earnest and this could be a source of market volatility. Consensus expectations for a 5.8% fall in profits over the year to the March quarter may prove to be a bit too pessimistic but there is little doubt that the rise in the value of the $US will have hurt earnings, with around 25% of US earnings sourced in foreign currencies.

The ECB meets Wednesday but no change to monetary policy is expected. Based on recent economic indicators ECB President Draghi is likely to express confidence that its expanded quantitative easing program is working.

In China, March quarter GDP data (Wednesday) is likely to confirm a further slowing in economic growth to around 7% year on year (from 7.3% in the December quarter). Meanwhile, expect March data to show a fall back in export growth after an unbelievable 48% surge over the year to February, but some improvement in momentum for imports, industrial production, retail sales and fixed asset investment (with the last three all due Wednesday).

In Australia, expect business and consumer confidence to have remained subdued according to the NAB business survey (Tuesday) and the Westpac/Melbourne Institute Consumer Sentiment survey (Wednesday), housing starts (Wednesday) to show a decent gain confirming the strength in building approvals and jobs data (Thursday) to show a 10000 gain in employment and unemployment remaining unchanged at 6.3%.

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 a potential 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 US and Australian shares.

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 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.