Investment markets and key developments over the past week
The past week has seen shares under pressure again, with worries about a US Federal Reserve rate hike next month driving the US dollar up, putting downwards pressure on commodity prices and reigniting worries about the emerging world and threatening US growth returned. While Japanese shares gained 1.7%, US shares lost 3.6%, Eurozone shares lost 3.1% and Chinese shares fell 2.3%. Resources shares led the way down as oil and iron ore prices head back towards their recent lows. As a result, Australian shares fell 3.1% taking them almost back to their September lows, even though global shares remain well above them. Despite the fall in commodity prices the Australian dollar actually rose, helped by stronger-than-expected Australian jobs data. Bond yields rose in Australia on the back of the jobs data but fell in the US, Japan and particularly Europe where talk of European Central Bank easing is weighing.
Events in Paris provide a terrible reminder of the terror threat posed to countries participating in the efforts to combat the ‘Islamic State’. Terrorist attacks are horrible in terms of their human consequences and my thoughts are with those affected. In terms of the impact on financial markets, there is no doubt that the attacks in Paris will contribute to short-term investor nervousness. But the experience with various Al-Qaeda related attacks last decade is worth recalling: after an initial negative impact share markets bounced back as it was clear that there would not be a major economic impact and it seemed the effect on markets weakened as the terror threat continued. It only took just over a month for the US share market to recover from its 12% post 9/11 slump and it took the UK share market one day to bounce back from its 1.4% fall on the day of the July 2005 London bombings.
Back to worries about a rising US dollar and its impact on US growth, commodities and the emerging world. With heightened expectations the US Federal Reserve will now raise interest rates in December, we are seeing a return to the worries of August and September that a stronger US dollar will weigh on commodities and accentuate the risk of a crisis in the emerging world and that this will all blow back and harm the US. If the US Federal Reserve is not careful this could see a re-run of September where the central bank is forced yet again to back down from its plans to raise US rates. To minimise the risk of such a re-run, key US Federal Reserve officials are trying to sound a bit more dovish, emphasising that the pace of hikes will be very gradual. This was particularly evident in a speech by New York Federal Reserve President Dudley, and is all aimed at damping down upwards pressure on the value of the US dollar. As the path of least resistance of the US dollar is up (as the US Federal Reserve moves to hike and other central banks such as the European Central Bank and the Bank of Japan continue to ease), expect more dovish talk of a gradual approach from the US Federal Reserve. Also bear in mind that the US dollar will be a big brake on how much the central bank will be able to tighten. So it’s worth keeping an eye on.
US shares still following the 2011 analogy. After a strong gain through October, the 2011 analogy now points to a pull-back through November. US Federal Reserve worries are likely to be a key driver of this. But once the central bank is out of the way, expect a decent rally into year-end as investors get more comfortable that the US Federal Reserve is not going to be aggressive and is allowing for the impact on the US dollar and global growth. Global share markets generally are likely to follow a similar pattern, but Australian shares will likely remain a relative underperformer as commodity price weakness continues to weigh.
Source: Bloomberg, AMP Capital
El Nino and the Australian economy – should we be worried? Indicators of the risk of a serious El Nino weather phenomenon have been getting more concerning. An El Nino sees trade winds that normally blow across the Pacific to the west (La Nina) weaken or reverse causing more rain in the east Pacific and less rain/drought in the west. It is commonly measured by the Southern Oscillation Index which measures sea surface pressures across the Pacific and it is nearing levels seen around the last major El Nino of 1997-98 and so warning of drought in Asia and the east coast of Australia, pointing to lower farm production and higher food prices. For Australia, the link from El Nino to farm production varies, e.g. farm production was little effected by the severe 1997-98 El Nino but was more affected by weaker El Nino’s last decade. See the next chart.
Source: ABS, AMP Capital
And swings in farm production don’t have the impact they used to on the economy as it is now only just 2% of gross domestic product. That said a severe El Nino drought-induced slump in Australian farm production at a time when growth is sub-par would not be good. For example, a 20% slump in farm production (as occurred in 1982-83) would knock around 0.45 percentage points off gross domestic product growth. While food prices may see some upwards pressure, the hit to growth would likely dominate the Reserve Bank of Australia’s thinking.
Major global economic events and implications
US data provided mixed signals. Jobs data remains solid with ultra-low jobless claims and strong job openings and a rise in consumer confidence. Against this though, retail sales remain soft with little sign of a boost from strong employment and the fall in gasoline prices, small business optimism is steady at a moderate level and producer and import prices fell more than expected in October. Rising US interest rates at time when Europe and Japan are still easing will only mean a rising US dollar which in turn will mean downwards pressure on US import prices and hence inflation making it harder for the US Federal Reserve in meeting its objective to get core inflation back to 2%. Market pricing for a December US Federal Reserve rate hike is now 64% (from 68% a week ago). While a December move is my base case, the combination of messy US data, renewed falls in commodity prices and global growth worries could still see another re-run of September where the US Federal Reserve chooses to delay again.
In Europe, there was more talk of European Central Bank easing in December. September quarter gross domestic product growth was a bit less than expected, but still okay, and industrial production fell again in September.
Japanese economic data was a bit better with a rise in current conditions according to the Eco Watchers survey and a decent rise in machinery orders in September. The underlying improvement in the Japanese economy is evident in a collapse in Tokyo’s office vacancy rate to 4.5% from 9.4% in 2012.
Chinese economic data was consistent with a stabilisation in growth, but no improvement. Export and import data fell more than expected in October and industrial production slowed a bit further but retail sales, car sales and investment picked up. Sales tax cuts for small vehicles are clearly helping and fiscal stimulus is evident in a 36% rise in fiscal expenditures against just an 8% gain in revenues over the 12 months to October. Credit data was weaker than expected but after adjusting for local government bond issuance still showed an acceleration in terms of annual growth rate. More stimulus is needed though and with non-food inflation of just 0.9% year-on-year and producer prices falling 5.9% year-on-year, there is plenty of scope for the People’s Bank of China to provide more monetary easing next month (on its easing every two months cycle). Finally, a surprise rise in China's foreign exchange reserves suggests the capital outflows that had been triggered by August's Renminbi devaluation have come to an end.
Australian economic events and implications
The past week has seen a run of mostly better Australian economic data, culminating in a blowout jobs report. Business conditions held above-average levels according to the latest National Australia Bank survey (although confidence is subdued), consumer confidence recovered to long-term average levels presumably helped again by the ‘Turnbull factor’ and jobs growth was unbelievably strong. While the October jobs report (+60,000 jobs in one month and unemployment back to 5.9%) was too good to be true, with a payback likely at some point, the underlying trend in jobs growth suggests that the economy is holding up reasonably well helped by a rebalancing away from Western Australia to the population rich states of New South Wales and Victoria. As a result a December rate cut is now looking very unlikely and we will need to see a run of softer data to get a rate cut early next year now. Meanwhile, housing finance data for September showed a further fall in lending to investors only partly offset by increased lending to owner occupiers.
What to watch over the next week?
While the G20 leaders’ summit in Turkey will no doubt generate lots of coverage, just bear in mind that such events rarely have any real market moving impact (those in the global financial crisis aside). Whatever happened to the 2% boost to global gross domestic product that was supposed to flow from last year’s summit?
In the US, the minutes from the last US Federal Reserve meeting (Wednesday) will no doubt be watched closely but they have been superseded by the strong October jobs report with the market still seeing a 64% probability of a hike by year-end. Meanwhile, expect inflation to remain benign at 0.1% year-on-year for headline and 1.8% year-on-year for core, industrial production to show a small gain, the National Association of Home Builders’ conditions index to remain strong at 64 (all Tuesday), housing starts to have fallen back a bit after surging in September but building permits to be stronger (both Wednesday).
The Bank of Japan meets Thursday and is still under some pressure to undertake further monetary easing. September quarter gross domestic product (Monday) is likely to fall 0.1% quarter-on-quarter.
In Australia, the minutes from the Reserve Bank of Australia’s last meeting are unlikely to add much given that its Statement on Monetary Policy was released a few days after. Meanwhile, expect the September quarter wage price index to show that wages growth remains very subdued at 2.2% year-on-year.
Outlook for markets
After the strong share market recovery through October, a pause or pullback was inevitable as US shares in particular became overbought, some complacency had crept back in and as worries about a US Federal Reserve-driven rise in the US dollar and its flow on to commodities and emerging market currencies re-emerge. This is now underway and looks like it will have further to go. In contrast to the September quarter though, there is likely to be less concern this time around about China.
But after a messy November, share markets are likely to see the normal ‘Santa Claus’ rally into year-end through the last two weeks of the year and the broad trend in shares is likely to remain up. Shares are cheap relative to bonds; monetary conditions are set to remain easy and the US Federal Reserve is unlikely to do anything to threaten global growth; and this in turn should help see the global economic recovery continue. While it looks distant at the moment, 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, although government bonds remain a great portfolio diversifier.
The broad trend in the Australian dollar remains down as the US Federal Reserve is likely to raise interest rates sometime in the next six months whereas the Reserve Bank of Australia is more likely to cut rates again than hike them and the trend in commodity prices remains down. This is expected to see the Australian dollar fall to US$0.60 in the next year or so.