Investment markets and key developments over the past week

The past week has seen most share markets gain as the US dollar stabilised, most commodity prices including oil gained helping resources shares and US economic data was reasonably solid. While Japanese shares lost 1.1%, US shares gained 2.8%, Eurozone shares rose 0.7%, Australian shares gained 2% and Chinese shares rose 1.4%. After a shaky start it looks like the seasonal Santa Claus rally may have kicked in for shares. Bond yields were flat to up. The US dollar fell slightly and this enabled the Australian dollar to rise back above US$0.72.

Spain’s unclear election result and leftward lurch has hurt Spanish shares and bonds, but Spain is not Greece. The big surprise in the Spanish election was that the reformist Citizens Party did not do so well and this, combined with the loss of seats by the centre right governing People’s Party, means that the two do not have enough seats to form a coalition government. But nor does the centre left Socialist party with the radical left antiestablishment Podemos (which is a bit like Greece’s Syriza). Either a centrist coalition needs to be formed with the People’s Party and the Socialists or a new election will have to occur, probably around March. The outcome is likely to be a loss of reform momentum and short-term uncertainty. However, Spain is not a Greece. First, 65% of the electorate voted for pro-euro parties so a ‘Spexit’ is not on the agenda! Second, Podemos got only 21% of the vote leaving it a long way from being able to govern unlike Syriza in Greece which got around 35% at this year’s Greek elections. Finally, unlike in Greece much of the heavy lifting on reforms has already been done in Spain. So while a period of uncertainty is likely a Greek-style existential crisis regarding the euro is unlikely – the euro is actually up since the Spanish election.

Are the problems in some US mutual funds that invest in junk bonds just the tip of the iceberg, presaging another financial crisis? There is clearly a risk here with rapidly expanded US energy debt now at risk due to the plunge in oil prices and the risk that some investors not used to the risk of corporate debt may panic. So investors need to be alert to the risks around this issue. But there are several reasons not to be alarmed and specifically why this is very different to the circumstances preceding and surrounding the global financial crisis. First, some of the funds freezing redemptions had very concentrated investments in risky and illiquid bonds and so may reflect special cases. Second, the problems late last decade that led to the global financial crisis came after an extended period of US Federal Reserve monetary tightening which we haven’t see this time around. Third, US bank lending to energy sector is a small fraction of total bank assets (around 2-3%) in contrast to housing-related lending which was at the centre of the global financial crisis and the credit problems at the time (remember sub-prime debt). Finally, as my colleague Keith Poore in New Zealand points out, the US household sector is a huge beneficiary of falling energy prices whereas it suffered big time from the loss of wealth and financial distress that flowed from collapsing home prices at the time of the global financial crisis.

Major global economic events and implications

US economic data was mostly good. While durable goods orders for November were on the soft side and existing home sales plunged in response to slower property closings due to regulatory changes, consumer spending in November was solid, consumer confidence edged higher, new home sales rose and September quarter gross domestic product growth was little changed at 2% annualised with strong growth in private demand. Meanwhile, inflation as measured by the core private consumption deflator remains stuck at 1.3% year-on-year in November which is well below the US Federal Reserve’s 2% target and supports the case for rate hikes to be gradual.

Japanese economic data was mixed with disappointing household spending and a slight rise in unemployment, but gains in the jobs-to-applicants ratio and housing starts and a rise in core inflation back to 0.9% year-on-year.

More economic stimulus on the way for China in 2016, with the Central Economic Work Conference signalling: more fiscal easing; “prudent” monetary policy which if 2015’s “prudent” is any guide means more People’s Bank of China easing; and measures to lower costs for companies and reduce the housing inventory. With Chinese real interest rates still too high for small and medium businesses we expect the central bank’s benchmark interest rate to be cut towards 3%. The required reserve ratio for banks is still too high for an environment where the People’s Bank of China is no longer looking to sterilise capital inflows and is likely to fall to around 10% over the next few years.

Australian economic events and implications

Nothing much happened on the economic data front in Australia – although Christmas shopping seemed frantic… then again it always does, so I wouldn’t read too much into that!

What to watch over the next two weeks?

In the US, the focus will likely be on the minutes from the US Federal Reserve’s last meeting (6 January), which are likely to reinforce the message that future interest rate hikes will be dependent on actual and expected progress towards meeting the US Federal Reserve’s inflation objective and that they are likely to be gradual, and December’s jobs report (8 January). Expect December payroll employment to have increased by another 200,000, unemployment to remain at 5% and wages growth to rise to around 2.8% year-on-year. In other data releases, expect further gains in home prices and a rise in consumer confidence (29 December), a solid gain in pending home sales (30 December), a slight improvement in the Institute for Supply Management manufacturing conditions index (5 January) and continued strength in the Institute for Supply Management non-manufacturing conditions index (January 6). Apart from all this, the main event will be 8 January which will be Elvis’ 81st birthday.

In the Eurozone, expect December core inflation (5 January) to have remained low at around 0.9% year-on-year and unemployment in November (7 January) to fall slightly to 10.6% from 10.7%. Money supply and credit data (30 December) will be watched for a further improvement in momentum.

In Japan, November industrial production data (28 December) and the Nikkei manufacturing conditions purchasing managers’ index (4 January) will be released.

China’s official manufacturing conditions purchasing managers’ index (1 January) and the Caixin purchasing managers’ index (4 January) are both expected to show modest improvements.

In Australia, expect credit data (31 December) to show continued moderate growth with an ongoing slowdown in lending to property investors, Core Logic/RP Data home price data for December (4 January) to provide further evidence that the Sydney and Melbourne property boom is slowing, November trade deficit to show a slight improvement, building approvals to fall (both 7 January) and November retail sales (8 January) to show a 0.4% gain.

Outlook for markets

Shares are likely to see their traditional Santa Claus rally over the Christmas/New Year period as investors take advantage of improved valuations, monetary conditions remain easy and new issuance dries up into year-end. However, worries about the US Federal Reserve and a rising US dollar possibly weighing on commodity prices and emerging countries may mean that volatility will remain high.

For 2016, our key themes are as follows:

  • The combination of OK global growth, still low inflation and easy money remains positive for growth assets. But ongoing emerging market uncertainties combined with US Federal Reserve rate hikes and geopolitical flare ups are likely to cause volatility.
  • Global shares are likely to trend higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth.
  • For shares we favour Europe (which is still unambiguously cheap and seeing continued monetary easing), Japan (which will see continued monetary easing) and China (which will also see more monetary easing) over the US (which may be constrained by the US Federal Reserve and relatively high profit margins) and emerging markets generally (which remain cheap but suffer from structural problems).
  • Australian shares are likely to improve as the drag from slumping resources profits abates, interest rates remain low and growth rebalances away from resources. But they will probably continue to lag global shares as the commodity price headwind remains. Expect the ASX 200 to rise to around 5700 by the end of 2016.
  • Commodity prices may see a bounce from very oversold conditions and as the US dollar stabilises or slows, but excess supply for many commodities is expected to see them remain in a long-term downtrend.
  • Very low bond yields point to a soft return potential from sovereign bonds, but it’s hard to get too bearish in a world of too much saving, spare capacity and low inflation.
  • Commercial property and infrastructure are likely to continue benefiting from the ongoing search by investors for yield.
  • National capital city residential property price gains are expected to slow to around 3-4%, as the heat comes out of the Sydney and Melbourne markets. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.
  • Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the Reserve Bank of Australia expected to cut the cash rate to 1.75%.
  • The downtrend in the Australian dollar is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the Australian dollar undertakes its usual undershoot of fair value. Expect a fall to around US$0.60.