Investment markets and key developments over the past week

Share markets bounced back over the last week, helped along by a combination of okay earnings news in the US and greater comfort around the Fed raising interest rates next month after the Fed minutes reiterated that the tightening process would be gradual and increasing expectations of further ECB easing. Over the week US shares gained 3.3% (their best weekly gain this year), Eurozone shares rose 2.8%, Japanese shares rose 1.4% and Chinese shares also rose 1.4%. Australian shares saw a particularly strong and broad based 4.1% gain for the week after managing to hold above their September lows on Monday. With Australian shares offering a 5% plus dividend yield it seems that “yield chasing/bargain hunters” may have returned to the market again. My 5,500 target for the ASX 200 by year end is starting to look a bit more achievable again! Partly reflecting more comfort around the Fed and the prospect of more easing in Europe, bond yields fell, particularly in Europe. While commodity prices remained under downwards pressure, the A$ was able to push higher.

Perhaps the big surprise for many over the past week was the short lived and muted reaction to the horrible events in Paris from late the previous week. Looking at past experience though, this is not very surprising at all. First, it’s worth recalling that parts of Europe have lived with terrorism in decades past, eg the IRA campaign regarding Northern Ireland, the ETA in Spain, the Red Army Faction in Germany, Red Brigades in Italy, etc. After a while many of these threats came to be seen as the norm. Secondly, the experience of the last decade or so has highlighted that terrorist attacks on soft targets like buildings and sports venues don’t really have much lasting economic impact. So while the 9/11 attacks had a big short term share market impact with US shares falling 12%, they had recovered in just over a month, the Bali and Madrid bombings had little impact and the impact on the UK share market of the London bombings of July 2005 was reversed the day after. So while the terror threat is negative for confidence, it would need to cause more damage to economic infrastructure to have a significant economic impact and hence a more lasting impact on financial markets.

In reality there was nothing really new from the US Federal Reserve (the Fed), but markets seem to be getting more relaxed about a December rate hike. The minutes from the Fed’s last meeting confirmed that the Fed expects to hike in December, but that it is dependent on there being no unanticipated shocks, good news regarding jobs and confidence that inflation will rise. So far, so good. They also reiterated that the path to higher rates will be gradual. That investment markets were able to take the reiteration that a rate hike is likely in December in their stride without a panicky sell off in shares, commodities and emerging currencies is a good sign. Global investors appear to be getting used to the idea of a Fed rate hike next month and may be starting to see it as a sign of strength, not weakness. The key is that Fed rate hikes are conditional on continuing economic improvement and that they will be gradual.

Expectations of more European Central Bank (ECB) easing are also helping investor confidence, as it means global monetary conditions will remain very easy. ECB President Mario Draghi added to expectations of further easing at its December 3 meeting by indicating “we will do what we must to raise inflation as quickly as possible.” This is likely to take the form of more quantitative easing and an even lower deposit rate. ECB easing, the weak Euro and slowly improving economic momentum are all reasons why Eurozone shares should do relatively well.

Australian petrol prices falling back to where they should be? Apart from a brief collapse in petrol prices earlier this year, Australian retail petrol prices generally haven’t come down anywhere near as much as the 60% plus decline in world oil prices adjusted for the fall in the A$ would suggest. However, petrol prices of around $1.117/litre at some service stations in Sydney and $1.08/litre in parts of Perth in the last few days are getting down to around to where they should be. Low petrol prices are clearly a source of support for consumer spending.

Major global economic events and implications

US data releases over the last week were mostly okay, consistent with growth continuing to run around the 2% pa average seen since the GFC. While manufacturing production rose in October, manufacturing conditions in the New York and Philadelphia regions improved slightly but remain soft into November. Housing starts fell in October but a still strong reading for the NAHB home builders’ index and a gain in permits to build homes points to continued strength in housing ahead. Jobless claims also remain very low, pointing to ongoing labour market strength. Meanwhile, consumer price inflation rose to 0.2% year on year as expected in October with core inflation unchanged at 1.9%. It’s hard to get too excited by any of this though.

Japan’s economy contracted by 0.2% in the September quarter, marking the fourth technical recession in five years. Consumer spending was positive but business investment was a drag. The “stop go” economy is clearly maintaining pressure on the BoJ for further easing, even though it held steady at its regular meeting in the last week. It’s interesting though that while the Japanese economy continues to bounce in and out of recession some indicators are in very good shape, eg the jobs to applicants ratio is at its highest since 1992, Tokyo’s office vacancy rate is down sharply and Japan’s GDP deflator is at last in a clear rising trend for the first time since Japan’s multi decade malaise set in. So Abenomics has had a positive impact.

China’s home prices rose again in October led by Tier 1 cities. While there has been some slowing in momentum in the last few months this is a probably a good thing as a return to another boom bust property cycle would not be good.

Australian economic events and implications

Wages growth in Australia held at a record low of just 2.3% year on year in the September quarter, highlighting the lack of inflationary pressure from labour costs. Private wages growth fell to a new record low of 2.1%. Quite clearly the adjustment flowing from the end of the mining boom and associated weak demand in the economy is continuing to show up in weak wages growth. This in turn is helping protect employment and partly explains why jobs growth has been able to come in better than expected despite the slow rate of economic growth. So while weak wages growth is a dampener on its own for consumer spending, it’s partly offset by solid jobs growth.

Weak wages growth also means that inflationary pressures coming from the labour market remain weak, reinforcing the RBA’s easing bias which is predicated on the outlook for continuing low or benign inflation. The minutes from the last Reserve Bank of Australia (RBA) Board meeting didn’t really add anything new, but it does seem as if the hurdle to act on its easing bias is quite high at present.

What to watch over the next week?

In the US, data on manufacturing conditions, consumer confidence, durable goods orders, personal spending and the Fed’s preferred inflation measure will be watched in terms of their implications for the Fed’s decision regarding US interest rates next month. Expect the Markit manufacturing conditions PMI (Monday) to remain okay at around 54, consumer confidence (Tuesday) to improve, durable goods orders growth to bounce back after a soft September, personal spending to pick up slightly and the core private consumption deflator to remain low at around 1.3% year on year (all due Wednesday). In addition, expect to see a fall in existing home sales but a gain in new home sales, continued gains in home prices and September quarter GDP growth (Tuesday) to be revised up to 2% annualised (from 1.5%).

In the Eurozone, Markit’s business conditions PMIs (Monday) and economic confidence readings (Friday) are likely to remain consistent with continued moderate growth.

Japan’s manufacturing conditions PMI (Monday) is expected to remain okay at around 52.4 and labour market, household spending and inflation data will be released Friday.

In Australia, September quarter data for construction (Wednesday) and investment or capex (Thursday) will be inputs to market expectations for September quarter GDP growth and capex plans will be watched to see if there is any improvement in the outlook for non-mining investment. Expect to see dwelling investment contribute solidly to construction but the mining slump to continue to weigh on investment. The combination of low interest costs, the low A$ and slightly better confidence all point to a pick-up in non-mining investment but it has been slow in coming. A speech by RBA Governor Steven’s will be watched for any clues regarding the interest rate outlook.

Outlook for markets

While the run-up to the Fed’s interest rate setting meeting in mid-December could see more volatility in share markets, the positive response from markets over the last week to Fed news around a December rate hike suggests investors may be becoming less worried about it. The absence of one way bad news out of China or the emerging world may also be helping to keep investment markets more settled at present, in contrast to what we saw last quarter. As such any further near term correction in share markets could prove to be limited and the bias maybe starting to return to the upside again after a bit of a pullback in the early part of this month.

Looking further out, share markets are likely to see the normal “Santa Claus” rally into year-end, particularly in 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 Fed is unlikely to do anything to threaten global growth; and this in turn should help see the global economic recovery continue. 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.

While the A$ could still have a short term bounce up to around $US0.75, perhaps on expectations that the Fed will be gradual, the broad trend in the A$ is likely to remain down as the interest rate differential in favour of Australia is set to narrow and the trend in commodity prices remains down. This is expected to see the A$ fall to $US0.60 in the next year or so.