The past week saw major global share markets rebound on the back of good economic data, favourable earnings reports in the US and steps towards a de-escalation of the Ukraine crisis. US shares rose +2.7%, Eurozone shares gained +1% and the Australian share market rose +0.5%. Bond yields rose in the US.
However, they were mixed in Europe and fell slightly in Australia. Commodity prices were also mixed. The Australian dollar fell and talk of further easing in Europe weighed on the euro. March quarter gross domestic product (GDP) growth in China was not as bad as feared with the March quarter result likely representing the low point for growth this year.
A fall in property related investment saw GDP growth estimated at +7.4% year-on-year (yoy) and quarterly GDP growth at +1.4%, the lowest in two years. However, this is likely to be the low point for the year. For the last two years growth has picked up after a weak first quarter, momentum in industrial production, retail sales and electricity consumption already appear to have started to pick up in March and ongoing policy fine tuning is likely to help underpin growth as well. As such, Chinese growth remains on track to come in ‘around’ +7.5% this year. This should be positive for the Chinese share market which has a forward price-to-earnings ratio (PE) of 8.5 times and is priced for a hard landing and credit crunch. It is also likely to be supportive for Australian resources stocks.
Earnings reports in the US in the next few weeks are likely to be a source of support for shares. Earnings growth expectations for the March quarter were slashed from near +7% yoy in January to around +1% on the back of negative corporate guidance flowing partly from bad weather. However, expectations were cut so much that it has become easy for companies to beat expectations. It is early days yet with only 82 S&P 500 companies having reported, but so far so good with +71% of companies exceeding expectations.
The European Central Bank (ECB) wants the euro lower. ECB President Mario Draghi has offered his strongest comments yet that the rise in the euro will necessitate further monetary easing. While it is not clear that ECB quantitative easing is imminent it is clear the ECB is very focused on heading off deflation and will do what is necessary to achieve this goal. This, at a time when the US is tapering and heading towards eventual rate hikes next year, indicates that the euro is unlikely to rise in value and is likely to decline.
The crisis in Ukraine reached a dangerous phase in the past week. However, following talks on Thursday it looks like a diplomatic solution is on the way. This looks to involve a de-escalation of the armed situation in its eastern regions in return for a move to a federal structure in Ukraine. This is what Russia has been seeking as a federal structure will virtually guarantee that Ukraine will stay out of the European Union and North Atlantic Treaty Organisation (NATO). However, this result is far better than a civil war or broader conflict with Russia. While there is still a long way to go, there are now grounds to be confident that the risks around Ukraine are starting to recede.
Major global economic events and implications
The US economy looks to be gradually shaking off its winter chill. Only modest gains in the National Association of Home Buildings (NAHB’s) home builders’ conditions index. Housing starts rose but were disappointing. However, housing starts were revised higher in February and mortgage applications for purchase are trending up.
More significantly both retail sales and industrial production rose much more than expected in March suggesting that growth ended the March quarter on a strong note. The April Philadelphia Federal Reserve’s (Fed) manufacturing conditions index rose strongly and jobless claims continued to trend down. This is all consistent with the Fed’s Beige book which indicated signs of a rebound from bad weather. Meanwhile, inflation data remained benign and momentum appears to have bottomed. Comments by US Fed Chair Janet Yellen were mostly dovish, saying that there is more downside risk for inflation relative to the Fed’s target than upside. She also came across very clearly as a pragmatic policy maker focussed on the economic outlook rather than as an ultra dove.This adds to confidence that when the time comes the Fed will raise interest rates rather than let inflation get out of control – that point still looks to be a fair way off though. There was a downwards revision to core Eurozone inflation in March to +0.7% yoy from +0.8%. With headline inflation at just +1% yoy this adds to the case for further ECB easing.
Growth in India remains weak and an inflation rate of +8.3% yoy highlights the fundamental deterioration in its growth and inflation trade-off. This supports the need for significant economic reform. A likely change of government offers hope on this front, and helps explain why the Indian share market is around record highs, but it will not be smooth sailing and it will take several years for the benefits to show.
Australian economic events and implications
The minutes from the Reserve Bank of Australia’s (RBA) last meeting offered nothing new: The RBA sees further signs that low interest rates are helping the economy, sees the recent rise in the A$ as being unhelpful and continues to see a period of stability for interest rates. Our view remains that rates will be on hold for another four or five months after which rates will gradually start to rise as it becomes clear that economic growth is picking up and in order to put a lid on inflation and house price gains. An +8% rise in housing starts in the December quarter reflect the lagged response from last year’s rise in building approvals. With more to go, this tells us a housing construction boom is on the way which will be good news for rebalancing the economy, good for employment and ultimately provide some relief in terms of housing affordability.
What to watch over the next week?
It will be business conditions PMI day again on Wednesday, with the Chinese HSBC flash manufacturing PMI expected to show a slight improvement, the Eurozone PMIs likely to show further gains and a slight rise in the already strong US Markit manufacturing PMI. In the US, expect to see a further gain in house prices (Tuesday), a small fall in existing home sales (also Tuesday) based on already released pending home sales data, a bounce in new home sales (Wednesday) and an improvement in core durable goods orders (Thursday). Japanese inflation data (Friday) will likely show a further slight increase for March, with Tokyo inflation data for April expected to rise sharply on the back of the April 1 sales tax hike. In Australia, the March quarter inflation report (Wednesday) is of greater than usual importance because we have already seen two quarters in a row of higher than expected inflation and the December quarter release contributed to the RBA moving to a neutral bias on interest rates and dropping its jawboning on the A$.
The March quarter CPI should be a bit more benign with a quarterly rise of +0.6% for both the headline and underlying measures as seasonal increases in prices for health and education and higher petrol prices are likely to be offset by price falls in clothing and footwear, household equipment and recreation.
While annual rates of inflation will move up to +3% for headline and +2.8% for underlying inflation, this reflects the elevated inflation readings in the previous two quarters and the RBA is already forecasting a rise to +3.25% for headline inflation and a rise to +3% for underlying inflation in the June quarter. Therefore, unless inflation data is much worse than expected it is unlikely to change the RBA’s stance on interest rates.
Outlook for markets
While investors should allow for more volatility in share markets, with the likelihood of a -10% to -15% correction around mid-year in the third quarter, the broad trend in shares is likely to remain up.
Share market fundamentals remain favourable with reasonable valuations, improving earnings on the back of rising economic growth and easy monetary conditions helping to entice investors to switch out of cash and into shares. Any dip in share markets should be seen as a buying opportunity.
Our year-end target for the ASX 200 remains 5800. Bond yields are likely to resume their gradual rising trend and this combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits also continue to offer poor returns. With the A$ having come close to our short term target of US$0.95 and short positions now unwound, it is likely that the short covering rally is now largely over and that the broad downward trend of the A$ is likely to resume. Commodity prices remain relatively soft and the A$ is likely to revert to levels that offset Australia’s relatively high cost base.
Renewed RBA jawboning in the months ahead is also likely to weigh on the A$. Our medium term view remains that the A$ will fall to around US$0.80.