Investment markets and key developments over the past week
Shares had a mixed week with mostly good economic data, but increasing nervousness regarding Greece and worries about a Middle East Respiratory Syndrome (MERS) outbreak in Korea weighing on some Asian markets. While US shares (+0.1%), Australian shares (+0.8%) and Chinese shares (+2.9%) rose, European shares (-0.2%) fell slightly as did Japanese shares and some other Asian markets. Bond yields mostly fell late in the week. Despite stronger US economic data, the US dollar fell slightly and this helped some commodities and the Australian dollar.
Chinese shares’ inclusion in MSCI benchmark indices on hold but inevitable. While some may have been disappointed by MSCI's decision not to include China A (or mainland) shares in its benchmark indices the logic was understandable as gaining exposure to Chinese shares for foreign investors is still a bit convoluted. That said it’s just a matter of time as China is steadily making foreign access easier. When it does occur it will boost global demand for Chinese shares from global “benchmark huggers” and more importantly will inject a more significant and much needed foreign institutional element into the Chinese share market helping to balance out speculative retail investors and making for a more stable market.
Its back - the RBA's clear easing bias, that is. If there was any doubt that the RBA retains an easing bias it was laid to rest by Governor Steven's comment that "we remain open to the possibility of further easing" and that "the economy could do with some more demand growth". Of course there were numerous qualifications around this - in particular the risks around low interest rates - but the clear message is that another rate cut is under serious consideration. I think it’s now more about narrowing the interest rate gap between us and the zero rates in the US, Europe and Japan to make sure the $A continues to come down, helping globally exposed sectors like tourism, higher education, manufacturing and agriculture combine with home construction and consumer spending to help fill the gap left by the end of the mining boom. The $A probably needs to fall into the $US0.60s. Whether there is another cut or not, the Governor pointed out "it will be quite some time before we can think about interest rates going back up" so get used to low rates for a long time yet. (Sorry Mum!).
RBNZ back peddling on rates. It now looks like NZ jumped the gun a bit on rate hikes and is now having to fall back into line by cutting rates as NZ export prices are falling. More RBNZ cuts are likely. So while the $A is likely to head lower over time against the $US, the $A/$NZ rate is on the way back up again.
Bank of Korea cutting rates too, largely in response to the threat that an outbreak of Middle East Respiratory Syndrome (MERS) is posing to consumer spending there. It seems we regularly have fears of new pandemic lately. Since 2003 there has been fears regarding SARS, bird flu, swine flu, Ebola and now MERs. The latter appears to have originated in Saudi Arabia from camels with the first reported cases in 2012, with cases being reported in over 20 countries with the Korean outbreak being the largest outside of Saudi Arabia. At this stage it’s hard to know how big a threat it is, but fear and the resultant reduction in travel and consumer spending could have a short term effect on economic activity like occurred in some Asian countries with SARS in 2003. But just bear in mind - we have seen all this before with SARS and Ebola last year. The panic around the outbreak could fade just as quickly as it has arisen as authorities swing into action and human behaviour changes. After all, MERS seems to have been reasonably well contained in other countries.
Greece nearing the end game. While there have been some positive signs of progress with Angela Merkel saying “where there’s a will there’s a way”, with the IMF leaving Brussels and indicating there are still major differences and EU leaders issuing ultimatums to Greece the ball is now clearly in Greece’s court to accept what is on offer or face the consequences. To avoid defaulting at end June a deal needs to be agreed soon so it can pass various country parliaments (which will be another source of uncertainty) in time. The June 18 Eurozone finance ministers’ meeting is the next deadline to watch. The pressure on Greece is now immense as recent turmoil has helped plunge it back into recession, which has hit tax revenue and likely eliminated its primary (ie ex interest payments) budget surplus. So even if it were to repudiate all its debts it will still have to undertake aggressive austerity. The problem for PM Tsipras is trying to get support for an agreement which is acceptable to both Greece’s creditors and to the rest of Syriza. Our base case remains that a deal will be agreed but the risks are high. So Greece is likely to remain a source of volatility. But even if Greece does end up leaving the Euro, the threat of contagion to other peripheral countries is low compared to the 2010-12 period as they are now in better shape and the ECB is now providing stronger support.
Major global economic events and implications
US economic data provided further evidence that growth is picking up with retail sales up strongly in May and previous months revised up, consumer confidence up, small business optimism up, jobless claims remaining low, job openings up strongly in April even though the hiring and quits rate was down fractionally and mortgage applications to purchase up strongly. Meanwhile, May core producer price inflation remained benign at just 0.1% month on month and 0.6% year on year.
Japanese economic data was good with March quarter GDP growth revised up to a strong 1% quarter on quarter driven by strong investment, strong machinery orders in April indicating that the strength in investment may be continuing and further falls in bankruptcies and Tokyo office vacancy rates.
Chinese economic data for May provided signs of a stabilisation in growth after the soft patch early this year. Imports and fixed asset investment were weaker than expected, but growth in industrial production, consumer spending, exports, property sales and money supply improved and credit came in stronger than expected. At the same time though inflation was weaker than expected and producer prices are continuing to fall highlighting that monetary policy still remains way too tight, so further PBOC easing is still likely.
Australian economic events and implications
Australian economic data mostly surprised on the upside with a nice lift in business confidence, continued gains in housing finance and much stronger than expected jobs growth in May. However, against this consumer sentiment gave back all of its post Budget boost and the official jobs numbers look a bit too good to be true, particularly with employment growth accelerating even though GDP growth has been slowing.
The bottom line seems to be that while growth is not great, we aren’t seeing the collapse many doomsters keep talking about either. What we are seeing is the reversal of the two speed economy with last decades laggards (including Victoria and NSW) coming back to life. I just saw a report from JLL on “record leasing activity in the Melbourne CBD office market” - not exactly the sort of thing you would see in a recession.
On my ranking of the current performance of Australian states, Victoria and NSW rank number 1 and number 2.
What to watch over the next week?
In the US, the Federal Reserve Bank (the Fed) will be the big focus in the week ahead. The recent improvement in US economic indicators have come too late, and the labour market improvement is not yet strong enough, to bring on a rate hike at Wednesday's Fed meeting, but the Fed is likely to signal that it remains on track to hike rates later this year providing economic data continues to improve giving confidence that inflation will rise back to target. On the data front, expect modest gains in industrial production and the NAHB home builders’ conditions index (both Monday) and a slight fall back in May housing starts and permits (Tuesday) after very strong gains in April. May CPI inflation data (Thursday) is expected to show a 0.5% monthly gain in headline inflation on the back of higher gasoline prices, but the annual rate is likely to remain at zero. Core inflation is likely to show a 0.2% monthly gain with the annual rate falling back to 1.7%.
In Europe the focus will remain on Greece ahead of Thursday’s finance ministers’ meeting.
The minutes from the Reserve Bank of Australia’s (RBA) last Board meeting (Tuesday) will be looked at closely for guidance as to the extent of the RBA’s easing bias. Speeches by RBA officials Kent (Monday) and Debelle (Tuesday) will also be watched for any clues regarding the outlook for interest rates.
The Bank of Japan (Friday) is unlikely to make any additions to its quantitative easing program, although it may still need to do so in the months ahead in order to ensure it eventually meets its inflation target.
Outlook for markets
The combination of seasonal weakness and uncertainties around bond yields, Greece and the Fed mean that 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 the Australian ASX 200 index remains 6000. Australian shares ran too hard earlier this year and this set the market up for a correction that has been triggered by a combination of softer global markets, the back-up in bond yields weighing on high dividend payers and uncertainty around the Australian growth outlook. So far the market has had a correction of 8.5% and the resultant improvement in valuations and continued low rates and an eventual improvement in the growth outlook should set the scene for a renewed run up later 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. Central banks won’t ratify a bond crash like in 1994, by raising interest rates aggressively.
The broad trend in the Australian dollar remains down as the Fed is likely to raise rates later this year whereas there is a 50/50 chance that the RBA will cut again 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.