Investment markets and key developments over the past week
While the bond sell off initially continued into the last week it showed signs of stabilising with yields falling later in the week and this helped shares a bit. In fact, while Eurozone share fell 1.2%, US shares rose 0.3% to a new record closing high, Australian and Japanese shares both rose 1.8% and Chinese shares rose 2.4%. Meanwhile, the $US continued to fall on some soft US data and this saw most commodity prices edge higher and the $A push back above $US0.80, which must be a concern for the RBA.
Have we seen the end of the bond sell off? In the short term it’s too early to say that the bond sell-off is over as positions that built up on the back of deflation fears earlier this year could continue to unwind. However, bond yields are unlikely to back-up too far for several reasons and we may have already seen the worst. First, in Europe - which is the epicentre of the bond sell-off – the European Central Bank (ECB) bond buying program has a long way to go with ECB President Draghi reminding the market that “we will implement in full our (quantitative easing) purchase program”. In fact the ECB is likely to appreciate the fact that it can now buy bonds on more attractive yields and that there seems to be plenty of investors willing to now sell them to it. Second, global growth remains below trend and underlying inflation remains very low. Finally, flowing on from this, central banks are unlikely to ratify the back-up in bond yields with sharp rate hikes like occurred in the 1994 bond crash. Soft data in the US if anything is pushing out the timing of the Fed's first rate hike (again), rate hikes are not even on the horizon in Europe, Japan and Australia and in China rates are set to fall a lot further. So while it’s hard to be bullish on bonds - because yields remain very low pointing to low medium term returns - it’s hard to be too bearish either as the world remains awash in savings and spare capacity.
Similarly, the pull-back in shares could have further to run if bond yields remain under short term pressure and as we proceed through a seasonally weak part of the year for shares. However, our view remains that in the absence of unambiguous and broad based share market overvaluation, investor euphoria in favour of shares and excessively tight monetary conditions that will drive bond yields rapidly higher or slow growth significantly, what we are seeing in shares is more likely to be a correction rather than the start of a new bear market. Corrections are quite normal and healthy for shares in that they help prevent markets from overheating and provide opportunities for investors. In anticipation of a correction in bonds and shares we have been running a higher than normal cash allocation and see recent moves as setting up investment opportunities.
In Australia, the Federal Government's Budget was a far a more boring and moderate affair than last year's austerity debacle. Reflecting this, it’s likely to have a positive impact on confidence. The big positives are increased child care assistance and a tax cut & instant tax write-off for capital spending items up to $20,000 for small business. Both the child care and small business packages look to have been received very well and the tax write-off looks like providing a boost for retailers, car sales and capital goods providers. It would be dangerous to overstate the upside as the various "spending measures" are being fully offset by savings, including the decision not proceed with the proposed Paid Parental Leave Scheme (PPL). However, the child care and small business measures look like generating a bigger bang for the buck than the expensive PPL would have. At the very least, this budget looks like providing a boost to confidence in contrast to last year's confidence zapper. However, the downside is that the Government is still seeking to have the Senate pass many of last year's savings so there could be another fight with the Senate, the revenue assumptions being based on a return to 3.5% growth from 2017-18 look at risk and the return to surplus looks as distant as ever.
Major global economic events and implications
US data was mixed, but on balance suggests a soft start to June quarter growth. On the positive side small business optimism rose but remains below the highs of a few months ago, job openings remained solid, the quit-rate improved and unemployment claims fell to around a 15-year low. Against this, retail sales and industrial production disappointed in April and consumer confidence fell sharply in May indicating the soft patch in consumer spending seen since late last year is yet to pass. What’s more, a New York regional manufacturing index rose only slightly in May. At the same time, the strong $US is continuing to bear down on import prices and inflation. There is still no reason for the Fed to hurry in raising interest rates, and the timing of the first move looks like it could slip beyond September.
Eurozone growth picked up to its fastest pace since 2011 in the March quarter. GDP growth was 0.4% quarter-on-quarter or 1% year-on-year, with the pick-up led by Spain and Greece. This occurred largely before the impact of quantitative easing which only started in March. A further acceleration in growth is likely ahead, but with inflation remaining well below target, it’s way too early to consider a premature end to the ECB’s QE program. Meanwhile, negotiations with Greece over a reform for funding deal continue to drag on, although people on both sides have indicated some progress.
Japan saw a further improvement in the Ecowatchers confidence survey and a sharp fall in bankruptcies both of which are positive for growth.
Weaker than expected Chinese economic indicators for April – retail sales, industrial production, fixed asset investment, money supply and credit – coming on the back of soft readings for trade and the HSBC PMI indicate that growth is still yet to pick up. With inflation remaining low, further policy easing is likely, with the benchmark 12-month lending rate likely to be cut to around 4% this year, from 5.1%.
Australian economic events and implications
Australian economic data was mixed. According to the NAB business survey confidence and conditions remain sub-par, and wages growth fell to the lowest level on record (since 1997) of just 2.3% over the year to the March quarter. Weak wages growth is bad for household income and indicates no inflation threat from this source. Against this, growth in housing finance for investors remains way too strong, highlighting the need for further APRA efforts to try and rein it in. The latter looks to be on the way with a speech by APRA Chairman Wayne Byres indicating it expects to see tougher lending standards evident in slower growth in investor lending through the second half of the year and, if not, lenders should expect more action by APRA. Maybe the RBNZ’s exploration of a more targeted approach to macro prudential controls (focussed on Auckland versus the rest of NZ) is worth looking into given the concentration of housing market strength in Sydney.
What to watch over the next week?
In the US, the minutes from the Fed’s last meeting are likely to confirm that while it’s not in a hurry to raise interest rates the decision will nevertheless be dependent on the flow of data regarding the state of the US economy. Meanwhile, on the data front, expect to see modest improvements in the NAHB home builders’ index (Monday), housing starts and permits (Tuesday), existing home sales (Thursday) and the Markit manufacturing conditions PMI (Friday). CPI inflation (Friday) is expected to remain low.
Eurozone business conditions PMIs (Thursday) are likely to show a modest rise after a slight pullback in April and progress on Greece will be watched for around the European leaders’ summit (Thursday).
Japanese March quarter GDP growth (Wednesday) is expected to be around 0.4% quarter on quarter, unchanged from the December quarter and the manufacturing PMI (Thursday) will hopefully show an improvement after a soft April reading. The Bank of Japan meets Friday but is unlikely to make any changes to monetary policy.
In China, the HSBC flash manufacturing conditions PMI (Thursday) is expect to show a modest improvement after weakness seen in April.
In Australia, the minutes from the RBA’s last meeting (Tuesday) will be watched for signs as to how strongly the Bank retains an easing bias. Meanwhile, the Westpac consumer confidence survey (Wednesday) is likely to show a positive reaction to the Federal Government’s Budget.
Outlook for markets
Given the uncertainties around the bond sell off, the Fed’s eventual move to tightening and Greece the next few months could remain volatile for shares. However, notwithstanding near term risks, the conditions for an end to the cyclical bull market in shares are still not in place: valuations against bonds remain good; economic growth is continuing at a not too cold but not too hot pace; and monetary conditions are set to remain easy. As such, share markets are likely to see another year of reasonable returns. My year-end target for Australian shares remains 6000. It’s just that the market got ahead of itself with the surge earlier this year.
Still low bond yields point to soft medium term returns from bonds, but it’s hard to get too bearish on bonds in a world of too much saving, spare capacity and deflation risk. Central banks won’t be ratifying a bond crash, like in 1994.
Despite the risk of a further short term bounce in the $A – possibly up to the 200 day moving average around $US0.83-84 - the broad trend is likely to remain down as the Fed is still likely to raise rates later this year whereas the RBA retains a mild easing bias (which is likely to turn into an easing if the $A doesn’t soon head back down) and the long term trend in commodity prices remains down. We expect a fall to $US0.70 by year-end, and a probable overshoot into the $US0.60s in the years ahead.