Investment markets and key developments over the past week

Shares got a strong boost from the European Central Bank (ECB) signalling further monetary easing ahead, additional monetary easing in China and some better earnings reports in the US. As a result, over the last week US shares rose 2.1%, Eurozone shares gained 4.5%, Japanese shares rose 2.9%, Chinese shares rose 0.6% and the Australian share market gained 1.6%. While bond yields rose a bit in the US, they were flat in Australia and fell sharply in the Eurozone on the prospect of more ECB quantitative easing. Commodity prices fell as the US$ rose & this drove a slight fall in the value of the A$.

The ECB looks to be replacing the US Federal Reserve (The Fed) as investors’ best friend. As expected the ECB left its quantitative easing program unchanged, but ECB President Draghi signalled further easing in December unless the risks to the outlook fade. While Eurozone growth is heading in the right direction, it’s still slow, with inflation a long way below target, as well as remaining vulnerable to weaker emerging market growth. Further easing is likely to take the form of an extension of its quantitative easing program beyond September next year and another cut in the rate of interest banks “receive” on deposits they have with the ECB. The ECB’s strong easing bias is very supportive of Eurozone shares, but because it puts downwards pressure on the value of the euro it adds to pressure on the Bank of Japan to ease further and on the Fed to further delay rate hikes.

The People’s Bank of China continued its pattern of easing monetary policy every two months with a 0.25% cut to its 12 month benchmark lending rate taking it to 4.35% (its sixth reduction since late last year) and another cut in banks’ required reserve ratios. The ongoing easing program is clearly aimed at supporting growth, and as such is a big positive. However with real borrowing rates for small and medium sized businesses remaining very high, more easing is likely. Expect another move in December. This easing is good news for Chinese shares, which are likely to continue their recovery. The move by the People’s Bank of China (PBOC) to abolish the ceiling on deposit rates is also a positive sign, as it signals ongoing economic reform despite recent economic and financial uncertainties.

There is still a way to go for the US to avoid another debt ceiling/shutdown crisis. The debt ceiling will be reached early next month and finance for spending is only approved out to December 11, but with former vice presidential candidate Paul Ryan looking like he will be the next House Speaker, the risk of a crisis is now quite low. Ryan is in favour of increasing the debt ceiling and understands the negative impact that would flow from a default or shutdown. There could still be some short term uncertainty though and there is some chance that the debt ceiling might be suspended into December until another spending deal is worked out with President Obama.

The moves by the CBA, NAB and ANZ to hike their variable mortgage rates, following Westpac, add further pressure on the RBA to cut its official cash rate to offset the flow on to households with mortgages. While the RBA looks like it doesn’t want to have to cut rates again, it won’t want to see households with a mortgage paying higher rates just now either given the risk this will pose to consumer spending at a time when economic growth is still weak. So we remain of the view the RBA should and ultimately will cut rates again to ensure that this does not happen. We have pencilled in a 0.25% rate cut at the November meeting, but the RBA may need more convincing and so there is a risk it could be delayed into early next year.

The next chart shows the relationship between variable mortgage rates and the RBA’s official cash rate. Clearly the gap between the two has been expanding since the GFC, supposedly due to “rising bank funding costs” as banks first had to rely more on bank deposits and now have to run higher capital ratios. The widening gap applies whether standard or discount variable rates are used. Because it’s borrowing rates that ultimately count for the economy rather than the cash rate, the RBA has had to compensate by cutting the cash rate more than would normally be the case in both the 2008-09 easing cycle and since 2011. Although the chart doesn’t show it, we expect the RBA to do the same this time around as well.

Source: AMP Capital. For illustration chart assumes cash rate stays at 2% in Nov

While the Australian economy is doing a lot better than many have feared, there are five reasons why the RBA will likely cut rates again: to stop big bank mortgage rate increases flowing to households with mortgages; the contribution to growth from home construction will likely peak next year; the non-mining capital spending outlook remains poor; El Nino related drought risks pose an additional threat to growth next year; and the A$ is at risk of drifting back higher if the Fed continues to delay rate hikes.

Major global economic events and implications

While there are concerns that US economic growth may be losing some momentum, the October Markit manufacturing conditions PMI showed a welcome improvement, and housing related indicators remain strong, with housing starts and existing home sales up solidly in September and further strength in the NAHB home builders’ conditions index pointing to more gains ahead. Home construction remains well below long term averages in the US, and with household formation rising, is likely to be a solid contributor to US growth going forward. Meanwhile US September quarter earnings results came in a bit better over the last week, with impressive results from Dow Chemical, McDonalds, eBay, Google and Amazon. Of the 35% of S&P 500 companies to have reported, so far 75% have beaten earnings expectations. Fortunately the big drags on US earnings from the collapse in the oil price and the surge in the US$ have faded.

The ECB’s latest bank lending survey pointed to a further recovery in credit demand and easing in lending standards, which is a positive sign for growth, and business conditions PMIs also improved in October.

Chinese economic data was mixed, with September quarter GDP growth coming in slightly better than expected at 6.9% year-on-year, and retail sales growth showing a further improvement, but with industrial production and investment slowing further. GDP data, helped by strength in retail sales and services sector activity, suggest growth may be stabilising. Improving credit growth, a gain in the MNI China business sentiment index and further gains in home prices in September are consistent with a stabilisation in Chinese growth. Chinese hard landing risks appear to be receding but then again it’s hard to see a strong growth rebound either.

Australian economic events and implications

The minutes from the RBA’s last meeting confirmed that the RBA was content with current interest rate settings. However, with the big banks hiking mortgage rates resulting in a de facto monetary tightening, the minutes are dated. Economic data painted a mixed picture with another strong reading for skilled vacancies but a slight fall in weekly consumer confidence and a soft Westpac leading index.

What to watch over the next week?

Globally the focus will return to the Fed which meets on Wednesday, but is expected yet again to leave interest rates on hold. While financial markets have improved since the last meeting, US economic data has been mixed suggesting that underlying US growth may have slowed a touch and uncertainties regarding growth in emerging countries remain. It’s doubtful that conditions will have improved enough to warrant a first rate hike by the Fed's December meeting and the probability of such a move is now below 50%, but the Fed will likely signal that it remains hopeful of a move by year end.

On the data front in the US, expect September quarter GDP growth (Wednesday) to have slowed to 1.7% annualised from 3.9% in the June quarter. While the slowing is mainly due to negative contributions from inventories and trade, it will highlight the fragile and constrained nature of US growth at present. In terms of other data expect to see a fall back in new home sales (Monday), flat September core durable goods orders, a modest rise in home prices, a slight fall in consumer confidence (all due Tuesday), a rebound in pending home sales (Thursday) and continued softness in the core private consumption deflator and employment cost index (Friday). Meanwhile, US September quarter earnings results will continue to flow with over 100 S&P 500 companies reporting.

In the Eurozone, expect economic confidence to remain solid but inflation to have remained around zero (all Thursday).

The Bank of Japan meets Friday and may announce more easing. Meanwhile industrial production data will be released Thursday and data for inflation and jobs on Friday.

In China, the Fifth Plenum of the 18th Chinese Communist Party Congress (starting Monday) will be watched for a downwards revision in the growth target for the next five years from 7% to 6.5% and for further economic reforms.

In Australia the main focus will be September quarter inflation (Wednesday), which is expected to show a 0.6% quarter on quarter rise driven by higher prices for imported items including travel costs (from the lower $A), housing construction and tobacco, only partly offset by falls in petrol and electricity prices. However, inflation is likely to remain low, at 1.6% yoy, with underlying inflation measures remaining benign at 0.5% qoq and 2.4% yoy. September quarter goods exports prices (Thursday) are likely remain weak, pointing to a further terms of trade fall. September quarter producer price inflation is likely to remain low and credit growth (both Friday) is likely to show a further softening in lending to investors.

Outlook for markets

So far October is living up to its reputation as a “bear killer” month. While we could see a bit of a pause in November, markets are likely to see the normal “Santa Claus” rally into year end and the broad trend in shares is likely to remain up. Shares are cheap relative to bonds; monetary conditions remain easy; this in turn should help see the global economic recovery continue; and investor sentiment remains negative such that it’s actually positive from a contrarian perspective. As such, share markets have likely resumed a broad rising trend. We continue to see the ASX 200 rising to around 5500 by year end.

Low bond yields point to soft medium term returns from bonds, but sovereign bonds remain a great portfolio diversifier.

In the short term, the A$ could bounce a bit higher, particularly if the Fed continues to delay and if the Reserve Bank of Australia (RBA) fails to cut or signal a cut next month. However, the broad trend is likely to remain down as the Fed is still likely to raise interest rates sometime in the next six months, whereas the RBA is more likely to cut rates again, and the trend in commodity prices remains down. This is expected to see the A$ fall to US$0.60 in the next year or so.