Investment markets and key developments over the past week
The past week has seen more volatility with shares initially falling then rallying into (and immediately after) the US Federal Reserve’s (Fed’s) decision to raise interest rates before then giving back some or all of their gains as commodity price weakness and global growth worries continued. This left share markets mixed for the week with Eurozone shares up 1.8%, Australian shares up 1.5% and Chinese shares up 4.2%, but US shares down 0.3% and Japanese shares down 1.3%. Japanese shares were dragged lower by disappointment that an enhancement to the Bank of Japan’s monetary easing program didn’t go further. Oil and gold prices fell, not helped by a rise in the value of the US dollar. The stronger US dollar saw the Australian dollar fall. Bond yields rose in the US but fell in Australia.
At last the Fed raises rates, but expect future moves to be gradual. The Fed's rate hike was hardly a surprise to anyone. It has been warning of such a move all year and markets have been in fear of it all year. There are four key points to note. First, the hike after seven years at zero is a vote of confidence in the US economy. Second, by starting to move ahead of inflation picking up the Fed is hoping to prolong the business cycle rather than end it. Third, future rate hikes are conditional on further improvement in the US economy, with the Fed's commentary highlighting a greater focus on achieving progress towards its inflation goal as a condition for further rate hikes. Fourth, future hikes are likely to be gradual as inflationary pressure remains low, probably more gradual than the Fed's "dot plot" projections for four 0.25% rate hikes next year. Finally, the Fed has indicated that it does not plan to start reversing its quantitative easing - the next big move - until interest rates get much closer to normal – so this is likely to be a 2017 issue at the earliest and when it does start it will probably just be with the Fed no longer rolling over maturing bonds on its balance sheet. With the Fed out of the way for now, monetary conditions likely to remain easy for a long time to come and the Fed not likely to do anything to upset the growth outlook, shares should see their normal Santa Claus rally into year-end. But as we have seen in the last few days it’s likely to be a bumpy ride.
But, how big a threat are the redemption freezes imposed by some US mutual funds that invest in junk bonds? There is clearly a risk here with energy debt at risk due to the continuing plunge in oil prices and the risk that some investors not used to the risk of corporate debt may panic. Against this, some of the funds freezing redemptions had very concentrated investments in risky and illiquid bonds, broader US corporate health is good and junk bond yields around 9% are attractive. In short, it’s an issue to keep an eye on - be alert but not alarmed.
The move by the US to remove its ban on oil exports will add to negative sentiment around oil. First, it will likely further close the gap between global and US oil prices (which is currently around $US2/barrel between Brent and US West Texas Intermediate). Second, it will reinforce Saudi Arabia’s disinclination to help balance the global oil market as it knows that it will just lose long term market share if it does. Finally, while it may not result in a further sharp fall in oil prices as the US is still a net oil importer, it will help cap upside in oil prices, to the extent that higher prices will drive stronger US production and potentially exports.
In Australia it was a case of another budget update, another deficit blowout. The Mid-Year Economic and Fiscal Outlook projects the four year deficit outlook to be a cumulative $26bn worse than projected at the time of the May Budget thanks to a combination of weaker commodity prices and lower economic growth. While this is only 0.5% or less of GDP a year, it’s still yet another deterioration pushing the return to surplus out by another year to now 2020-21. Given this slippage has been an ongoing phenomenon for several years now (see the next chart) it’s reasonable to ask whether we will ever get to surplus. This is particularly so given that history warns of an economic downturn sometime in the next five years and that the aging population will start making a return to surplus even harder next decade. While Australia’s public debt levels relative to GDP are modest by Japanese, US and European standards our ongoing failure to bring the deficit under control warns that we could find ourselves slipping into a debt problem. In the interest of avoiding this and providing flexibility to undertake fiscal stimulus through the next economic downturn it is imperative that our politicians find ways to stabilise revenue growth and limit spending.
Source: Australian Treasury, AMP Capital
Major global economic events and implications
US economic data was mixed with weak industrial production, a fall in the Markit manufacturing PMI for December (although it’s still well above the ISM) and weak readings for manufacturing conditions in the New York and Philadelphia regions, a slight fall in the NAHB's home builders' conditions index albeit to still strong levels but very strong gains in housing starts and permits, strong leading indicators and a larger than expected fall in jobless claims. US inflation rose in November on an annual basis but mostly due to low numbers a year ago dropping out.
Eurozone industrial production rose more than expected in October, and while business conditions PMI's slipped in November their continued strength points to improved growth ahead.
While the Bank of Japan enhanced its quantitative easing program to buy longer dated bonds and expand the purchase of ETFs by ¥300bn annually it’s a trivial move relative to the size of the current program. In fact, it may have backfired to the extent that it added to investor fears that the Bank of Japan is not really prepared to do more.
Chinese property prices continued to rise in November indicating that the gradual property market recovery is continuing.
Australian economic events and implications
Australian house prices were confirmed by the Australian Bureau of Statistics (ABS) as seeing solid gains in the September quarter – up 2% quarter-on-quarter of 10.7% year-on-year, led by Sydney and Melbourne. This is old news though as more recent private sector home price data series point to a sharp softening in recent months. Meanwhile, skilled vacancies rose further in November indicating that labour market strength may be continuing – albeit not quite as strong as recent ABS data suggests. The minutes from the Reserve Bank of Australia’s (RBA’s) last Board meeting offered nothing new – with the RBA reasonably positive on recent data but still retaining a mild easing bias. At this stage the RBA remains quite happy to “chill out” over the Christmas period, but our assessment remains that with the mining investment boom still unwinding, commodity prices still weak, the contribution from housing to growth starting to slow next year and inflation remaining very low that the RBA is still likely to ease again next year.
Oil prices at new lows yet petrol prices remain high – how come? As can be seen in the next chart the Asian Tapis oil price in Australian dollars has fallen well below its January low but Australian capital city petrol prices are averaging well above their January lows. Someone is making a higher margin.
Source: Bloomberg, AMP Capital
What to watch over the next week?
In the US, expect to see gains in home prices and existing home sales (Tuesday), but a downwards revision to September quarter GDP growth to 1.9% annualised from 2.1% (also Tuesday), the core private consumption deflator for November remaining low at 1.4% year-on-year, a slight fall back in durable goods orders after a strong rise in October and a gain in new home sales (all Wednesday).
In Europe, Spain's general election (Sunday) will be watched closely. Recent opinion polls show some increase in support for the left wing/anti-establishment Podemos party but the most likely outcome remains a coalition involving the ruling People's Party. Either way much of the heavy lifting on reforms has already been done in Spain. So a Greek-style existential crisis regarding the Euro is unlikely to be triggered.
Japanese data (Friday) is expected to show continued labour market strength, a slight improvement in household spending but still low inflation.
Outlook for markets
With the Fed out of the way for now, shares are likely to see their traditional year-end Santa Claus rally as investors take advantage of improved valuations, monetary conditions remain easy and new issuance dries up into year end. However, worries about a rising US dollar weighing on commodity prices and emerging countries mean that volatility will likely remain high.
More broadly the 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 should help see the global economic recovery continue. Our end-2015 target of 5500 for the ASX 200 may be a bit of a stretch, but we see it rising to 5700 by end 2016.
Low yields point to soft medium term government bond returns, although they remain a great portfolio diversifier.
The Australian dollar could continue to bounce around the $US0.70-0.73 level in the short term, but the broad trend 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 Australian dollar fall to $US0.60 in the next year or so.