Investment markets and key developments over the past week
- Share markets continued to recover from their recent falls helped by good earnings news in the US, better-than-expected economic data in Europe, China and Japan and as the European Central Bank (ECB) started up its quantitative easing program with indications that it might be widened. Global and Australian share markets have roughly recovered half the fall they saw in the correction, with the Australian share market also being helped by investors taking advantage of 6% grossed up dividend yields. Over the last week US shares rose 4.1%, European shares rose 2.7%, Japanese shares rose 5.2% and Australian shares rose 2.7%. Bond yields were mixed, as were commodity prices with oil down but metals up, and the Australian dollar was little changed.
- Events in Canada provided a reminder of the terror threat posed to countries participating in the efforts to combat IS. (A colleague has pointed out that the term ‘Islamic State’ should be avoided in referring to the Insurgent Savagery currently threatening Iraq, Syria and beyond as it defames one of the world’s great religions – he’s right, so I won’t). Terrorist attacks are horrible in terms of their human consequences and there is no doubt that IS-related terrorist attacks in western countries will be taken badly initially by share markets, as we saw with the 1.5% dip in Canadian shares after the attack in Ottawa. But the experience with various Al-Qaeda-related attacks last decade is worth recalling: after an initial negative impact share markets bounced back as it was clear that there would not be a major economic impact and it seemed the effect on markets weakened as the terror threat continued. It only took just over a month for the US share market to recover from its 12% post 9/11 slump and it took the UK share market one day to bounce back from its 1.3% fall on the day of the July 2005 London bombings.
- The wall of worry (global growth, deflation risks, the end to the third round of quantitative easing (QE3) in the US, the IS terror threat, Hong Kong protests, Ukraine, Ebola, etc.) remains for investors, but there were some positives in the last week: manufacturing conditions purchasing managers’ indices (PMIs) unexpectedly rose in the Eurozone, Japan and China; the ECB has now started its quantitative easing program and appears to be thinking about expanding it to include corporate bonds which would allay any concerns that it may not be big enough to have a meaningful impact; and Nigeria was declared Ebola-free after earlier being seen as the next country at risk in Africa – if they can contain it the West also should be able to.
- The results from the ECB’s Asset Quality Review and stress tests of Eurozone banks were slightly better than feared. The ECB found that 25 of 130 Eurozone banks had inadequate capital at the end of 2013, but once 2014 capital raisings are allowed for this fell to 13 banks (with four of these in Italy). The required capital raising of €9.5 billion to be carried out over the next six to nine months looks manageable given that much more has been raised already this year and does not imply a big burden on public finances. Just as occurred with the US Federal Reserve’s (Fed) stress test of US banks in 2009, it could prove to be a watershed event that helps restore confidence in Eurozone banks and clears the way for more bank lending and better take-up of the ECB’s cheap targeted long-term refinancing operations funding in December. The key remains though for Eurozone policy makers to do more to boost spending and demand for credit.
Major global economic events and implications
- US economic data was mostly favourable. While the Markit manufacturing conditions PMI cooled it remains strong at 56.2, jobless claims continue to trend down, leading indicators rose and home sales are trending up. What’s more, continued low consumer price index inflation of just 1.7% leaves the Fed with plenty of flexibility on interest rates.
- Of greater interest for investors, September quarter earnings continue to impress. So far 208 S&P 500 companies have reported of which 79% have beaten earnings expectations and 61% have beaten on sales. Earnings growth looks like it is coming in around 10%, compared to market expectations for a 6% gain.
- The Eurozone saw some good news on the economic front with unexpected gains, albeit modest, in manufacturing and composite business conditions PMIs for October. This suggests that growth continues. That said, it’s still slow and with the risk of deflation the ECB will need to ramp up its quantitative easing program.
- Japan’s manufacturing PMI rose suggesting the recovery from the sales tax hike earlier this year is continuing.
- Chinese data remains relatively steady. September quarter gross domestic product (GDP) growth came in at 7.3% yearon- year (yoy), down from 7.5% in the June quarter but slightly stronger than expected. While retail sales slowed to 11.6% this was probably due to lower inflation and growth in industrial production accelerated to 8%. Growth in investment was little changed with slower property investment being offset by strength in manufacturing and infrastructure. Meanwhile, the flash HSBC PMI for October improved slightly. While the property sector will remain a drag on growth, various mini-stimulus measures already announced and likely more to come should be enough to see growth this year come in “around 7.5%”. No boom, but not bust either.
Australian economic events and implications
- Benign inflation supports the case for rates to remain low. The September quarter saw a broad-based fall in inflation with headline inflation falling to 2.3% yoy. While price rises in government-related sectors remain the main driving force of inflation, inflation in market-related sectors fell to just 1.8% yoy. The September quarter saw price weakness in areas like clothing (- 2.7% yoy), furnishings and household equipment and services (+0.4% yoy), transport (+0.2% yoy) and communications (- 1.8% yoy). Subdued wages growth and falling commodity prices suggest that inflation will remain. So no pressure for a rate hike here. The message from the minutes from the last Reserve Bank of Australia (RBA) Board meeting and various speeches from RBA officials remains unchanged: rates are on hold, the Australian dollar remains too high and measures to slow bank loans to investors are being considered by the RBA and Australian Prudential Regulation Authority.
What to watch over the next week?
- In the US, all eyes will be on the Fed (Wednesday) which is expected to end the final US$15 billion of QE3 it is doing each month. There is a chance that the fall in US inflation expectations will prompt the Fed to just taper by US$10 billion leaving quantitative easing alive at US$5 billion a month. However, in the absence of more bad global news or market turmoil ahead of the meeting we would only attach a 40% probability to this. That said, the Fed is likely to restate that a “considerable time” is expected to elapse before it starts to raise interest rates and indicate that it will allow for the impact of softer global growth, the impact of a stronger US dollar in holding US inflation down and the recent fall in inflation expectations which will likely serve to reinforce market expectations that the first Fed rate hike won’t come until late 2015. It may also indicate that it will ramp up quantitative easing again if needed.
- Meanwhile September quarter US GDP data (Thursday) is likely to show that growth slipped back to a 2.9% pace, which is good but not booming after just 1.3% growth in the first half. Expect reasonable growth in pending home sales (Monday) and durable goods orders (Tuesday) along with solid consumer confidence (also Tuesday). Labour cost data will be released Thursday and the Fed’s preferred inflation indicator (Friday) is likely to remain around 1.5% yoy, leaving plenty of scope for the Fed to keep rates down. More than 100 US S&P 500 companies will report September quarter earnings.
- In Japan, industrial production for September (Wednesday) will be watched for a rebound after August weakness and data for household spending, unemployment and inflation will be released Friday.
- China’s official manufacturing conditions PMI for October (1 November) will likely be little changed.
- In Australia, expect trade prices (Thursday) to show a further decline in the terms of trade, September quarter producer price inflation (Friday) to remain benign and private credit growth (also Friday) to remain moderate. The main focus in the credit stats will be on housing credit, in particular whether growth credit to investors in housing shows any signs of moderating given RBA concerns.
Outlook for markets
- Our assessment remains that the roughly 10% top to bottom fall in share markets seen from September highs to recent lows represents a correction and not the start of a new bear market. A retest of the lows cannot be ruled out but the cyclical bull market most likely remains intact. The correction pushed share valuations well into cheap territory, the global growth outlook remains for ok growth (‘not too hot, but not too cold’), monetary conditions globally and in Australia look like they will remain very easy with Europe and Japan filling the quantitative easing gap that will be left by the US and US rate hikes looking even further away and investor sentiment remains very bearish which is positive from a contrarian perspective. October is often a month where market falls come to an end ahead of a Santa Claus rally into year-end and I expect to see the same happen this year. The start-up of ECB quantitative easing, getting the ECB’s bank stress tests out of the way and US mid-term elections on 4 November which are likely to see the Republicans take both the House and the Senate are likely to help.
- Low bond yields will likely mean soft medium-term returns from government bonds. That said, in a world of too much saving, spare capacity and low inflation it’s hard to get too bearish on bonds.
- To its recent low of US$0.8640 the Australian dollar fell a bit too far too fast (just as the US dollar has risen too far to fast), so a short covering bounce has been underway and could go further. That said the broad trend in the Australian dollar is likely to remain down reflecting soft commodity prices, the likelihood the Fed hikes interest rates before the RBA and the relatively high cost base in Australia. Expect to see it fall to around US$0.80 in the next year or so.
Click here for full article: Weekly Report ~ 24 October 2014