Investment markets and key developments over the past week
The past week was dominated by worries about the US Federal Reserve (the Fed) hiking rates later this month against a background of mixed economic data and disappointment that the European Central Bank (ECB) did not ease by more. This saw sharp falls in Eurozone shares (-4.5% for the week) and falls in Japanese and Australian shares. However, a solid but not over the top jobs report in the US helped the US share market reverse its losses later in the week. Chinese shares gained 1.8%. The ECB’s smaller than expected increase in its quantitative easing program saw bond yields rise, again particularly in Europe, but by reducing upwards pressure on the $US for now it perversely provided commodity prices with a bit of support. Oil continued to slide though, as OPEC failed to cut production. The weaker $US along with stronger than expected GDP growth in Australia saw the $A gain.
ECB easing disappoints, but it’s still a further easing. The key moves by the ECB were to extend its €60 billion a month bond buying, or quantitative easing program, by another six months out to March 2017 and to cut its deposit rate by another 10 basis points taking it to -0.3%. The problem is that largely due to ultra-dovish comments by ECB President Mario Draghi over the last few months, markets were expecting more and this explains the negative reaction seen in share markets, the rise in bond yields and the bounce back in the value of the euro. As a result Draghi has arguably lost a bit of credibility in the short term. However, there is a danger in getting too carried away here. First, the ECB has still undertaken a very significant further easing with the quantitative easing program increasingly looking open ended until the ECB gets the pick-up in inflation that it wants. Second, it’s not that recent Eurozone economic data has been bad. In fact, data for bank lending, business conditions PMIs and confidence have all been quite good. Third, the ECB still has plenty of scope to do more. In fact, with Draghi known to look at share markets closely (he said a few years ago it was the first stat he looks at in the morning) and the value of the euro, he is likely to have been disappointed by the initial 3.6% fall in Eurozone shares and the 3% gain in the euro and is likely to push back with dovish commentary in the period ahead. Finally, the ECB’s more muted than expected easing so far has taken some of the pressure off the Fed by lowering the value of the $US, which may take a bit of the pressure off emerging markets and commodity prices. So overall, the initial negative reaction to the ECB’s easing looks to have been overly negative and likely to reverse in the months ahead. However, in the very short term, market volatility is likely to remain high ahead of the Fed’s December 16 meeting.
The Fed remains on track for a mid-December rate hike, but it’s likely to be a “dovish hike”. While some at the Fed are feeling nervous about the December meeting, the clear messages from Fed Chair Janet Yellen are that: the recent flow of information has been satisfying the conditions for a December hike; the hike when it comes will be a sign of how the US has recovered since the global financial crisis; and that subsequent rate hikes will likely be gradual and tied to progress in lifting inflation back towards the Fed’s target. Recent mixed US economic data, bouts of turmoil in share markets and ongoing weakness in commodity prices suggests a hike could still be delayed again but our base case (with 70% probability) is that the Fed will move on December 16 (taking the Fed funds rate to a range of 0.25-0.5%) and that the accompanying Fed commentary will be dovish, emphasising that it anticipates future hikes to be gradual.
November’s solid but not over the top US jobs report is consistent with a December 16 rate hike by the Fed. US payrolls increased by 211,000, which was pretty much in line with expectations, and wages growth is continuing to trend up, all of which supports the case for the Fed hiking this month. However, there is nothing in the report suggesting a more aggressive Fed going forward with a rise in the labour force participation rate supporting those at the Fed like Janet Yellen who still see spare capacity in the US labour market.
The Reserve Bank of Australia remained on hold as widely expected with Governor Steven’s justifiably pleased with the September quarter’s solid GDP growth. However, our assessment is that the economy will likely need more help next year as mining investment continues to fall, commodity price weakness continues to flow through and housing cools. As a result I see it as still likely that the RBA will have to act on its easing bias early in 2016 and cut the cash rate below 2%.
Iron ore price heading below $US40/tonne as the global oversupply of steel continues to hit. The past week has seen the iron ore price continue to fall to a new eight year low of $US40/tonne. Its near 80% plunge from its 2011 high has largely wiped out the price boom seen last decade. For Australia this means an ongoing loss of national income and a further blow out in the budget deficit as each $US1/tonne fall in the iron ore price knocks $A250 million off annual federal tax revenue, with the latter likely to be confirmed by another blow-out in deficit projections in the Mid-Year Economic and Fiscal Outlook due mid-December. Fortunately, a lower $A provides an offset, but it will need to resume falling. This is likely over the year ahead with the $A heading to around $US0.60.
Major global economic events and implications
US data was mixed, but still consistent with the Fed hiking interest rates on December 16. Data for pending home sales and a sharp fall in the ISM manufacturing conditions index were disappointing with the latter highlighting the pressure the US manufacturing sector is facing from the rise in the $US. However, the broader Markit manufacturing conditions PMI is holding up much better, services sector conditions PMIs remain stronger, although they have also slowed a bit, and labour market indicators remain strong including payroll employment.
Eurozone unemployment fell in October, but only to a still high 10.7% highlighting the extent of spare capacity in the Eurozone economy. This, along with a fall in core inflation to just 0.9% year-on-year in November, supports the case for the ECB’s additional monetary easing.
Japanese capital spending data accelerated much more than expected, pointing to an upwards revision to initial September quarter GDP data showing a contraction.
China’s manufacturing conditions PMIs provided mixed signals for November by moving in opposite directions, but remain soft. Services conditions PMIs remain reasonable.
Replace BRICs with ICs. The irrelevance of the BRICs concept was highlighted in the last week by September quarter Indian growth surprising on the upside to 7.4% year-on-year at a time when Brazil’s recession deepened with September quarter GDP down 4.5% year-on-year, which is deeper than its recession at the time of the global financial crisis. While at some point the bad news in Brazil will be “so bad that its good”, its plunging manufacturing conditions PMI to 43.8 at a time when President Dilma Rousseff is to be impeached suggest we aren’t at that point yet. With Russia also in a structural recession it remains a time to be selective when investing in emerging markets.
Australian economic events and implications
The rebound in September quarter GDP growth is good news and indicates the economy is continuing to find ways to sustain growth as other sectors help fill the gap left by mining investment and as the third and final stage of the resources boom drives stronger export volumes. However, before breaking out the champagne it’s worth noting that the 1.5 percentage point contribution to growth from net exports won’t be repeated this quarter, with the October trade balance already showing a renewed deterioration, and more importantly it masked very weak domestic demand. The risk for next year is that with mining investment still falling, demand in the economy could slow further as the contribution to growth from dwelling investment and wealth gains from rising home prices fades and as further bank mortgage rate hikes in response to increasing capital requirements cut into household spending power.
While retail sales growth was solid in October, the slowdown in the housing sector was clearly evident over the last week with Sydney’s auction clearance rate now around 2011-12 cycle lows, building approvals continuing to show signs of peaking, new home sales rolling over, lending to investors continuing to slow and home prices starting to soften. At the same time the TD Securities Inflation Gauge for November shows inflation being very weak.
But will home prices crash? Is this it? Sure the plunge in Core Logic RP Data home price series in November is quite dramatic, but it’s noteworthy that we have seen similar sharp falls before which have proven temporary and we may have seen a knee jerk reaction from buyers to recent bank rate hikes that may not prove lasting. Our assessment remains that the property cycle has now turned down but in the absence of generalised oversupply, a recession or a sharp rise in interest rates a house price crash is unlikely.
What to watch over the next week?
In the US, November retail sales (Friday) will give some guide as to how Christmas shopping has started out with a modest 0.3% gain expected. Consumer sentiment is expected to show a slight improvement and producer price inflation is expected to remain low (both Friday). Labour market indicators and small business confidence will also be released (Tuesday).
In Japan, business investment data points to the contraction seen in preliminary September quarter GDP data being revised to show a slight gain (Tuesday). So Japan's fourth recession in five years may get revised away.
Chinese data for November will be watched for further signs of improvement or at least stabilisation. Expect to see less negative export and import momentum (Tuesday), a pick-up in bank lending and credit flows (Thursday) but stable to marginally stronger growth in industrial production, retail sales and fixed asset investment (Saturday).
Australian jobs data for November (Thursday) is likely to show some reversal after the unbelievable strength recorded in October. Expect a 10,000 decline in employment and unemployment to rise to 6%. Housing finance commitments (Wednesday) are expected to show continued softness in lending to investors. The NAB business conditions and confidence indexes (Tuesday) and the Westpac consumer confidence survey (Wednesday) will also be released.
Outlook for markets
Share market volatility is likely to remain high in the run-up to the Fed’s interest rate setting meeting in mid-December. Providing the Fed undertakes a “dovish hike” as we expect, stressing that future moves will be gradual, then confidence is likely to return, allowing share markets to see the normal “Santa Claus” rally into year-end and the broad trend in shares 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. We continue to see the ASX 200 rising to around 5500 by year end.
Low yields point to soft medium term government bond returns, although they 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.