Investment markets and key developments over the past week
Share markets have had a good week reflecting good news regarding Greece, better-than-expected Chinese economic data, the nuclear agreement with Iran and benign comments from US Federal Reserve chair Janet Yellen. US shares rose 2.4%, Eurozone shares gained 3.9%, Japanese shares rose 4.4% and Chinese shares gained 2.1%. Australian shares rose 3.2% with the still-falling Australian dollar also helping the profit outlook. Bond yields fell, but with sharp falls in peripheral Eurozone countries as Grexit risk continues to recede. The US dollar continued to drift higher with the perception that the US Federal Reserve is still on track to hike rates later this year (now that global risks have faded a bit) and this saw the Australian dollar, euro and yen fall. Commodity prices remained weak including oil on the back of the agreement with Iran.
The Chinese share market continued its recovery, helped by rumours that the China Securities Finance Corporation has up to RMB3 trillion (or A$652 billion) with which to buy shares if needed. The proportion of Chinese shares in trading halts has now fallen to 23%, from a high of around 40%.
The problem with going on holidays. It seems that whenever I go on leave (like three weeks ago) share markets take a tumble but to get them back up again all I have to do is return to work. Well maybe not quite, but it certainly feels that way!
Grexit off! - at least for now. Agreement was finally reached between Greece and its creditors on a path towards a new three-year bailout program. Greece has met its commitment to pass various reforms through its parliament, the deal has already been approved by several Eurozone parliaments including Germany and Finland, €7 billion in bridging finance has been arranged for Greece to make its near-term debt payments and the European Central Bank has increased its liquidity assistance for Greek banks. The next step is to agree the details of the three-year program and this is not without risk, particularly given the unstable political environment in Greece with the government having to rely on opposition parties for support and also given the International Monetary Fund’s view that Greece's debt needs to be put on a sustainable footing upfront. Given that the Greek economy will likely get worse before it gets better and debt relief is still a way off (after program reviews) another rebellion by Greece - reopening the prospect of a Grexit - remains a risk. But in the short term, Greece is likely to fade as an issue.
The key for investors to bear in mind though is that the risk of contagion flowing from Greece to other Eurozone countries is now substantially reduced compared to several years ago - with other vulnerable countries now in much better shape and defence mechanisms much stronger. Through the recent turmoil the highest Italian and Spanish 10-year bond yields got to was just 2.4%, a fraction of the 7% plus seen in 2011-12.
More oil to hit an already oversupplied oil market. Agreement was also reached between Iran and the US to curb the former's nuclear program and remove sanctions. Assuming it is finalised, this is good news, in particular to the extent that it will see a boost to global oil supply ultimately of around 1% per annum, providing another dampener on the world oil price. Over the last year world oil production expanded 3.1 million barrels per day, but demand only rose by 1.4 million barrels per day. It will also potentially open Iran up as a major investment destination. The potential negative to keep an eye on though is that a less constrained Iran may intensify the ‘cold war’ between Sunni Saudi Arabia and Shia Iran in the Middle East (intensifying proxy wars in the region) that has arisen as US influence in the region has diminished.
In a broader sense - the events of the last few weeks with Greece, China's share market turmoil and the Iran deal - provide a reminder that the world is still being subject to deflationary shocks which are serving to keep economic growth uneven and constrained and ensuring that monetary conditions need to remain easy. Consistent with this the International Monetary Fund (and other forecasters) is continuing to do the same as over the last few years in revising down current year global growth forecasts (to 3.3% for this year) but anticipating an improvement in the New Year (which will probably also get revised down again in time). The Bank of Canada's latest 0.25% rate cut taking its cash rate to just 0.5% on the back of weaker growth forecasts reinforces all this. For investors it means continued low (and in some cases lower interest rates) and an environment characterised by an ongoing ‘search for yield’.
Major global economic events and implications
US economic data was a mixed bag. While data for housing starts and permits, industrial production and the New York regional manufacturing conditions survey improved more than expected, June retail sales disappointed, the Philadelphia regional manufacturing conditions survey fell, small business confidence fell and consumer confidence slipped (but probably due to all the noise around Greece and China). Inflation readings were also mixed with producer prices up a bit more than expected but import prices remaining weak and consumer prices in line with expections. So while US Federal Reserve Chair Janet Yellen is still expecting to raise interest rates later this year, it’s dependent on a further improvement in growth coming through and while the September US Federal Reserve meeting is ‘live’ for a hike it looks only 50/50 at this stage.
US June quarter company earnings are doing it again. Each quarter market expectations for US profits get guided too low and the actual outcome ends up being better. The same seems to be happening for the June quarter results, where the consensus started with a -5.3% year on year decline, but after 72% of results to date have beaten expectations has already been revised up to -3.2%. It’s likely to end up slightly positive. So yes the strong US dollar is impacting but not as much as feared.
There were no surprises from the European Central Bank which left monetary policy unchanged, but signalled a preparedness to ease if there is an unwarranted tightening in monetary conditions. A fall in May industrial production in the Eurozone was disappointing, but the European Central Bank's latest bank survey revealed no tightening in lending conditions and improving credit demand, which is good news given the background of the Greek turmoil.
The Bank of Japan left monetary policy unchanged but nudged down its growth and inflation forecasts a bit. Further easing is still possible with inflation well below target.
Chinese economic data was all a bit stronger than expected, confirming earlier signs that growth had improved somewhat. June quarter gross domestic product growth held constant at 7% year-on-year, but improved on a quarterly basis from 1.4% to 1.7%. This was consistent with improved or better-than-expected June data for exports, imports, retail sales, industrial production, fixed asset investment, electricity consumption, money supply growth and credit. Property sales have also picked up. This suggests that policy easing is possibly starting to get some traction. That said, with consumer price inflation well below target and producer prices deflating at 4.8% year-on-year, real borrowing rates remain too high so further monetary easing is likely to be necessary.
Australian economic events and implications
Australian economic data remains all over the place with business confidence and conditions up according to the National Australia Bank survey and dwelling commencements at record highs but consumer confidence falling to last year's lows (with the noise around Greece and China not helping) and non-dwelling building starts falling sharply reflecting the capital expenditure slump. Continuing mixed and messy economic data in Australia highlights why another rate cut remains a 50/50 proposition. That said, having the lowest borrowing rates since the early 1950’s and the continuing plunge in the Australian dollar to now below $0.74 is certainly helping the economy through this tough patch.
What to watch over the next week?
Greece will remain in the spotlight with progress towards a new three-year bailout likely to be watched closely with a few fireworks along the way likely to be inevitable. But I suspect that Greece is on the way to becoming just background noise – at least for a while anyway.
On the data front, the release of global business conditions purchasing managers’ indices for July (Friday) will give a guide as to how global growth is progressing . The readings for June indicated that global growth remains uneven and slightly below trend, although this is not necessarily a bad thing as it means that inflation and interest rate pressures remain very low. The Chinese manufacturing purchasing managers’ index will be watched for a further slight gain after that seen in June and the US manufacturing purchasing managers’ index is likely to remain around 53.6. However, the main focus will be on the Eurozone purchasing managers’ indices to see if they held at the previous month’s reasonable levels despite all the turmoil around Greece.
In the US, expect to see a further gain in home prices and existing home sales (Wednesday) but a slight pullback in new home sales (Friday). The June quarter profit reporting season will also start to ramp up. The market consensus is for a 5.3% year-on-year fall in profits but as with last quarter this is likely to be too negative.
In Australia, headline inflation for the June quarter (Wednesday) is likely to show a rebound to 0.8% quarter-on-quarter or 1.7% year-on-year thanks to a roughly 12% spike in petrol prices and some flow-through of higher import prices due to the lower Australian dollar. Underlying inflation is likely to remain around 0.6% quarter-on-quarter or 2.3% year-on-year, but with the combination of significant spare capacity, record low wages growth and weak pricing power according to business surveys suggesting downwards pressure on inflation. While I see a 50/50 chance of another rate cut in the months ahead, June quarter inflation data is unlikely to be low enough to justify on its own an immediate Reserve Bank of Australia rate cut. On the interest rate front, the minutes from the last Reserve Bank of Australia Board meeting (Tuesday) probably won’t tell us anything new, but a speech by Reserve Bank of Australia Governor Glenn Stevens on Wednesday will be watched for any clues.
Outlook for markets
Most share markets have already seen the short-term correction that I had been a bit wary off. From their highs earlier this year to recent lows Chinese shares fell 32%, Asian shares 14%, Eurozone shares 13% and Australian shares 9% providing opportunities to increase exposure to such markets. Some volatility is likely to remain though as we are still going through a seasonally-weak period of the year for shares and a likely US Federal Reserve interest rate hike lies ahead for later this year.
But looking beyond the near term, the cyclical bull market in shares likely has further to go: 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 remain reasonable, despite current uncertainties . My year-end target for the ASX 200 remains 6000.
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 and 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 US Federal Reserve is likely to raise rates later this year whereas there is a 50/50 chance that the Reserve Bank of Australia will cut again and the long-term trend in commodity prices remains down. We expect a fall to US$0.70 by year-end, and a probable overshoot into the US$0.60’s in the years ahead.