Investment markets and key developments over the past week
Shares have got off to a rather bad start for the year, triggered by many of the same worries seen last year: a fall in Chinese shares and the value of the renminbi, which in turn has triggered renewed worries about the Chinese economy; the weaker renminbi triggering more commodity price weakness and fears of an emerging market crisis; some soft US manufacturing data; and geopolitical risks, this time regarding tensions between Saudi Arabia and Iran, and an H bomb test in North Korea. Consequently all share markets have seen sharp declines so far this year (with US shares -6%, Eurozone shares -7.2%, Japanese shares -7.0%, Chinese shares -9.7% and Australian shares -5.8%). Commodity prices are down further with the oil price falling to its lowest since 2009. Bonds have rallied with safe haven buying.
The poor start to the year clearly warns that global growth concerns remain, that commodity prices are still under downwards pressure and that volatility in investment markets will likely remain high. However, it is worth putting these developments in some perspective:
- The latest fall in Chinese shares may have a bit further to go but looks to have been exaggerated and driven more by fears and regulatory issues around the share market and currency rather than a renewed deterioration in economic indicators. While the Caixin business conditions PMIs were weaker in the last week, official PMIs for December were stronger. The main drivers were rather around worries concerning new share supply, following the scheduled end to a ban on selling by major shareholders, a new share market circuit breaker that commenced on Monday, which appears to have added to market volatility rather than calmed it down (because the 7% threshold for a market fall to trigger a shutdown was too tight and encouraged investors to bring forward selling in an effort to beat the shutdown) and a continuing depreciation of the renminbi.
- Looking at each of these: Chinese regulators have since announced a restrictive limit on the size of stakes that major investors can sell; the circuit breaker has now been suspended after the experience of the last week; and after a 6% plus depreciation in the value of the renminbi since July the People’s Bank of China is now likely to step up efforts to try and stabilise it again much as it did through September and October. The depreciation of the renminbi is the key issue at present as its decline is helping fuel upwards pressure on the $US, adding to weakness in oil and other commodity prices and keeping alive fears of some sort of emerging market crisis. Fortunately, Friday did see some stability return to the Chinese share market and currency but it needs to be sustained.
- While the US ISM manufacturing index has been softer lately and is a concern, most US data points to stable underlying growth of around 2% or so. This includes employment in the US which rose by a much stronger than expected 292,000 in December.
- Signs that global growth remains fragile and constrained will have the effect of ensuring that global monetary policy remains easy this year, with the US Federal Reserve (the Fed) tightening likely to be very gradual, with maybe just two 0.25% rate hikes this year, Japan and Europe continuing with quantitative easing and China continuing to cut interest rates. The continuing global weakness also adds to the case for the RBA to cut interest rates again.
- The tensions between Sunni Saudi Arabia and Shia Iran have been building for a while and partly flow from the US’ shift in military focus away from the Middle East. However, while they will continue to show up in wars in the region, e.g. in Syria and Iraq, they are unlikely to result in outright direct conflict in a way that dramatically pushes up oil prices. In fact in the short term the tension ensures that OPEC will remain paralysed, with Saudi Arabia focused on maintaining high production to inflict pain on Iran and Iraq, which will serve to keep oil prices low (or lower) for now.
- North Korea’s H bomb test is a big concern, but there is some debate as to whether it was really an H bomb and it has already had three nuclear tests since 2006.
So overall, while it’s been a poor start to the year for equity markets and risks remain high in the short term our expectation remains for better returns this year than we saw in 2015 as share market valuations are reasonable, being cheap relative to bonds and bank deposits. Global monetary conditions are likely to remain very easy and this should in turn help ensure a rising trend in share markets, albeit with bouts of volatility along the way. While confidence in Chinese shares is being tested again, it’s worth noting that Chinese companies listed in Hong Kong provide particularly attractive long-term value, trading on forward PEs close to 6 times, less than half that of Australian shares.So overall, while it’s been a poor start to the year for equity markets and risks remain high in the short term our expectation remains for better returns this year than we saw in 2015 as share market valuations are reasonable, being cheap relative to bonds and bank deposits. Global monetary conditions are likely to remain very easy and this should in turn help ensure a rising trend in share markets, albeit with bouts of volatility along the way. While confidence in Chinese shares is being tested again, it’s worth noting that Chinese companies listed in Hong Kong provide particularly attractive long-term value, trading on forward PEs close to 6 times, less than half that of Australian shares.
What about the January barometer? There is an old saying in relation to the US share market that “as goes January, so goes the year”. Sometimes this is narrowed down to the first five days of the year. This year the US S&P 500, with a fall of 6% for the first five days. is off to its worst start at least back to 1950. However, the track record of this barometer is rather mixed. In fact the hit rate of negative first five days going on to negative years for the US share market has been 45% since 1950 and just 29% since 1980.
Major global economic events and implications
While the US ISM manufacturing conditions index softened further in December, other data has been more favourable with the non-manufacturing conditions index remaining solid, gains in home prices, higher consumer confidence and labour market data remaining solid. The December jobs report was particularly positive, with payroll employment up much more than expected at 292,000 and employment in the prior two months being revised up, but increasing participation keeping the unemployment rate unchanged at 5% and wages growth coming in weaker than expected at 2.5% year on year. The strength in jobs tells us that the US economy remains solid, but rising labour market participation and soft wages growth gives the Fed plenty of breathing space on interest rates. Meanwhile, the minutes from the Fed’s last meeting reinforced the focus on “actual and expected inflation” moving closer to target when considering future rate hikes, so it’s hard to see the Fed being anything but gradual in raising rates as weak commodity prices will continue to constrain inflation. The next Fed hike is unlikely till March but this could be delayed if global growth concerns, market volatility and falling commodity prices continue.
Eurozone bank loans accelerated further in November, German factory orders gained more than expected in November and confidence readings rose to their highest since 2011 in December and are at levels consistent with reasonable economic growth.
Chinese economic data has been mixed with better December readings for the official manufacturing and non-manufacturing PMIs, but softer readings for the Caixin PMIs. Meanwhile, inflationary pressures remained low in December with non-food inflation of just 1.1% year-on-year and producer prices continuing to fall at the rate of 5.9% year-on-year, indicating there are no constraints to further monetary easing here.
Australian economic events and implications
Australian economic data releases over the last two weeks were mostly soft. November retail sales were solid and the trade deficit fell slightly, but remains high. Meanwhile, the services sector PMI softened significantly in December. Building approvals for November provided further evidence that the contribution to economic growth from home construction will slow this year. December home prices showed a further loss of momentum and lending to investors continued to slow in November. Our view remains that with global growth remaining fragile, commodity prices weak, mining investment still falling and housing’s contribution to growth set to slow that the RBA will have to cut interest rates further this year.
What to watch over the next week
In terms of recent market turmoil the key things to watch out for are stabilisation in the Chinese share market and currency. In the US, the main focus will be on the December quarter earnings reporting season, which will kick off on Monday with Alcoa
. The strong $US and weak oil prices are a drag, but as the consensus is for a 6% year-on-year decline in earnings there is a bit of scope for upside surprise. On the data front expect to see a modest 0.1% gain in December retail sales, a slight fall in industrial production and weak core producer price inflation (all Friday). Data for small business optimism and manufacturing conditions in the Philadelphia and New York regions will also be released.
In China, December data is likely to show continued strength in credit flows but ongoing softness in exports and imports (Wednesday).
In Australia, December jobs data (Thursday) is expected to show some reversal of the unbelievable 71,000 jobs surge seen in November. We expect a 10,000 decline in employment and unemployment to rise to 5.9% but the reality is that trying to pick the jobs numbers is a bit like forecasting a random number generator. November housing finance data (Friday) is likely to show a further decline in lending to investors.
Outlook for markets
Worries about China and the Fed are likely to drive continued volatility in the short term until some stability returns to the Renminbi and $US and hence in commodity prices. Beyond the short-term we still see shares trending higher, helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. But expect volatility to remain high.
Very low bond yields point to a soft medium-term return potential from sovereign bonds, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield.
National capital city residential property price gains are expected to slow to around 3% this year, 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 RBA expected to cut the cash rate to 1.75%.
The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes it’s usual undershoot of fair value. Expect a fall to around $US0.60 by year end.