Investment markets and key developments over the past week
The past week saw the rebound in shares and other risk assets continue. US shares rose 2.8%, Eurozone shares gained 4.7%, Japanese shares rose 6.8%, Chinese shares gained 3.5% and the Australian share market put on 3.9%. Bond yields were mixed in core countries but fell in peripheral Europe, oil moved a bit higher along with other commodity prices as did the A$. The rebound in risk assets has been supported by a number of factors. First, a speech by ECB President Mario Draghi was dovish and reassuring indicating the ECB is watching the impact of financial turmoil on banks closely and "will not hesitate to act". Expect more QE and cheap bank funding from the ECB.
Second, Russia and various OPEC oil producers agreed to cap oil production at current levels. They need to do more but it's a step in the right direction and the oil price continues to look like it's trying to build a base.
Third, PBOC Governor Zhou's comments left the impression that without a major surge in the value of the US$, a sharp fall in the value of the Renminbi against the US$ is unlikely. In fact with the US$ drifting off lately the Renminbi has been rising, with no sign of recession.
Fourth, US manufacturing production data has been looking healthier, the overall flow of US March quarter data so far points to reasonable GDP growth and January inflation readings point to a bit of increased pricing power.
Finally, after falling hard share markets had become oversold and several had fallen to technical support levels.
With periodic sharp bounces in shares normal in bear markets it’s premature to say that the current rebound means the bottom has been seen. But if we are right and recession is avoided then there is a good chance that either we have or may have come close to the bottom.
The recent success in presidential primaries of populist candidates Donald Trump (Republican) and Bernie Sanders (Democrat) raise the concern that this year’s US presidential election will result in a less business friendly president. This is certainly a risk and would only add to market nervousness. However, there is still a long way to go in the primaries so hopefully more centrist candidates like Hilary Clinton or Marco Rubio will prevail and even if a populist does get up centrist dominance of the broad rump of Republicans and Democrats in Congress (with Republicans likely controlling both houses) should limit the power of the president to enact extreme or less business friendly policies.
The debate over negative gearing in Australia has reached fever pitch. My views on this are as follows: 1) negative gearing is not to blame for expensive Australian housing – it’s due to a lack of supply; 2) negative gearing does not reflect a distortion in the tax system but as the Treasury has pointed out reflects a basic feature of the tax system that allows deductions for expenses incurred in earning income; 3) if we are going to restrict access to negative gearing it makes more sense to limit the dollar value of negative gearing concessions per tax payer rather than force all investors into new housing as this could avoid making it harder for first home buyers to get a new home and avoid complications around when a new property becomes an old property for tax purposes; 4) the capital gains tax discount is the real distortion in the tax system as it enables capital gains to be taxed at half the rate of regular income; 5) limiting access to negative gearing to just new property will also affect investment in other assets like shares and commercial property – is this something we really want?; 7) curtailing negative gearing and the capital gains tax discount needs to be offset by income tax cuts as the Australian tax system is already highly progressive with just 17% of workers providing around 63% of the income tax revenue provided to Canberra. Cutting back on concessions without cutting tax rates will only see this rise acting as a further disincentive to work effort which is the last thing Australian needs now.
Major global economic events and implications
US economic news was mostly okay. Housing starts and home builder conditions were down slightly but this may be weather related with permits to build new homes little changed. Meanwhile, manufacturing conditions were slightly less negative according to a couple of regional surveys, industrial production rose nicely in January and jobless claims continue to fall. Meanwhile, January inflation data showed a pick-up in core inflation suggesting improved pricing power and that the US is not following Japan into deflation. The minutes from the US Federal Reserve’s (Fed) last meeting simply reiterated that it’s aware of the risks flowing from tighter financial conditions and so a March hike looks very unlikely, with the US money market attaching just a 6% chance.
Japanese December quarter GDP contracted again, highlighting that Japan is still yet to escape the pattern of on and off again recessions it’s been having since the 1990s.
Chinese trade data was poor in January but this may be due to distortions associated with the floating Lunar New Year and disguised capital flows. And against this money supply and credit growth was much stronger than expected for January – perhaps a bit too strong with the PBOC announcing increased reserve requirements for some banks as a precaution to make sure lending growth does not get out of hand. While inflation rose in January, this was mainly food related with non-food inflation remaining low at 1.2% year on year. Meanwhile, despite the PBOC fine-tuning bank reserve ratios, policy stimulus measures are continuing to flow including a cut to property transaction taxes for mostly mid and small cities.
Australian economic events and implications
After several months of unbelievably strong jobs reports, employment surprised on the downside for January pushing unemployment back up to 6%.It’s dangerous to read too much into one month’s jobs data and the trend in the ABS jobs data and various other labour market indicators still suggest the jobs market is solid. However, our view remains that the Reserve Bank of Australia (RBA) will act on its easing bias in the months ahead with another rate cut, as growth remains sub-par and as a delay in Fed tightening puts upwards pressure on the A$. The RBA however is unlikely to move till May.
The Australian December half profits reporting season is now more than half done and overall results have continued to come in much better than feared. 53% of results have bettered expectations (against a norm of 44%), 69% have seen profits up on a year ago and 68% have raised their dividends relative to a year ago (against a norm of 62%). It’s tough out there for resources stocks but no more than expected. While they are cutting their dividends note that mining stocks are now less than 10% of the market (believe it or not RIO is just 1.5% of the market and BHP just 4.2%!). Meanwhile, most of the big banks are seeing reasonable results and stocks exposed to the Australian economy, led by housing and the consumer, are doing well. Company guidance has had a slight positive skew. The better than feared nature of the results to date has been reflected in 64% of stocks seeing their share price outperform the market the day results were released. Of course, there is still a way to go and good results have a habit of coming out early in the reporting season.
What to watch over the next week?
The G20 Finance Ministers meeting in Shanghai on Friday and Saturday will be watched for signs of global policy coordination. These meetings are normally little more than a talkfest resulting in platitudes, but in times of financial stress like the present they can play a helpful role. What’s needed now is a refocus on the “Brisbane Action Plan”, from the 2014 G20 meetings in Australia, designed to boost global growth and some degree of monetary policy coordination to avoid a situation where more monetary easing in Europe, Japan, etc, but not in the US just results in a renewed surge in the US$ taking us back to the same old problems (further commodity price declines, more pressure on emerging markets, etc).
In the US, the Markit manufacturing conditions PMI (Monday) and services PMI (Wednesday) will be watched to gauge the impact of recent financial volatility on business confidence. Expect the manufacturing PMI to stay around 52.5 and the services PMI to remain around 53.2. Meanwhile, durable goods orders (Thursday) are expected to show a slight bounce for January after the broad based softness seen in December. In other data expect to see a slight fall in consumer confidence, continued gains in home sales, a pullback in existing home sales (all Tuesday) and new home sales (Wednesday) and an improvement in January consumer spending (Friday). US December quarter GDP growth is likely to be revised down to 0.5% from 0.7% and the January core private consumption deflator will be released Friday.
Eurozone business conditions PMIs (Monday) and confidence readings (Thursday) will also be watched closely to assess the impact of market turmoil. January inflation readings (Thursday) are expected to remain low.
Japanese CPI data (Friday) is expected to show a slight slippage in core inflation to 0.7% year on year highlighting that inflation remains well away from the BoJ’s target.
In Australia, expect December quarter data to show that wages growth (Wednesday) remains low at 0.6% quarter on quarter or 2.3% year on year and that construction activity (also Wednesday) and business investment (Thursday) remain weak led by mining related engineering. Key to watch will be the capex intentions data where hopefully there will be some better news regarding non-mining investment.
The Australian December half profit reporting season will essentially wrap up in the week aheadwith 83 major companies reporting including QBE, BHP, Qantas, Wesfarmers, Woolworths and Harvey Norman.
Outlook for markets
Shares have seen a decent rebound from oversold levels which may have further to go. But with global growth worries remaining it’s still premature to say we have bottomed. Beyond the near term uncertainties, we still see shares trending higher this year helped by a combination of relatively attractive valuations compared to bonds, further global monetary easing and continuing moderate economic growth.
Very low bond yields point to a soft medium term return potential from sovereign bonds, but it’s hard to get bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation.
Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield. The further decline in bond yields will only add to this.
National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. 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%.
An ongoing delay in Fed tightening poses short term upside risks for the A$. However, the RBA appears to be becoming uncomfortable regarding the Australian dollar’s recent strength, with RBA Board member John Edward’s comment that he would be more comfortable with the A$ at US$0.65 possibly being the first sign of at least a renewed bout of RBA jawboning to get it lower, and which we believe will ultimately contribute to another RBA rate cut. As such, any short term strength in the A$ is unlikely to go too far, and the broad trend is likely to remain down as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the A$ undertakes its usual undershoot of fair value. We continue to expect a fall to around US$0.60 by year end.