The news on the policy front out of Europe over the past week has been pretty quite. ECB officials have reaffirmed their determination to act and its clear the ECB has the support of the German Government.
- What ECB President Draghi has put on the table amounts to a major game changer for Europe in that it will effectively lever up the less than €500bn in the Euro-zone bailout funds to push Spanish and Italian bond yields down to more sustainable levels. All that has to happen is that Spain and Italy need to apply for support and sign a commitment to economic reforms and this of course is the remaining fly in the ointment as it may require a bit more pressure on their bond yields to convince them to apply given the blow to national pride. So there could still be bout of share market weakness to come out of Europe as we go through the August holiday period but the key is that help is on the way and so any weakness is likely to be a great buying opportunity.
- Chinese data was disappointing with production up “just” 9.2%, new bank lending slowing and exports up just 1%. Fortunately inflation fell to 1.8%, suggesting plenty of scope for policy easing. We expect another two 0.5% cuts in bank reserve ratios and two rate cuts in the next few months. However, the pace and quantum of easing is likely to remain modest compared to what investors would prefer. This means Chinese shares, commodity prices and resources stocks will ultimately be given a boost but could remain volatile in the next few months.
- There were no surprises from the Reserve Bank of Australia which left interest rates on hold. The RBA’s Statement on Monetary Policy made few substantive changes to its forecasts, reinforcing the impression it is comfortable with current interest rate levels balancing the more subdued global outlook with domestic growth around trend and inflation consistent with the target. Our assessment remains that with growth likely to slow a bit as the impact of Government handouts to households wears off, as unemployment rises slightly, as the $A remains strong and as inflation remains low the RBA will cut rates again, but it may not be for several months.
- The RBA’s Statement particularly highlighted that it is keeping a close eye on the strong $A as a risk, observing that part of its strength may reflect safe haven demand and that it may exert a more contractionary impact on the economy and inflation than historical relationships suggest. Our assessment for some time is that the $A is a lot more contractionary than the RBA has been allowing. At this stage the RBA may just be contemplating what to do rather than signalling imminent action. Given that the divergence in the $A from fundamentals is likely relatively modest, our assessment is that it is too early to contemplate intervention to push the $A down and we remain of the view that a better approach would be to cut interest rates further in order to take some of the pressure off the $A. Time will tell, but either move would be a dampener for the $A.
Major global economic releases and implications
- US data releases were positive. Consumer credit increased, job openings rose and weekly jobless claims fell, productivity growth picked up, a survey of bank lending officers showed a modest easing in lending standards and a pickup in demand for mortgages and better June trade data points to an upward revision to June quarter GDP growth to around 2%. With the US earnings reporting season now 90% complete the number of companies surprising on the upside has remained solid at around 68% and corporate guidance has become less negative.
- Euro-zone data stayed soft with falls in industrial production and German factory orders. June quarter earnings reports have seen 57% of companies better expectations which makes it a reasonably good reporting season.
- Japanese data was mixed with a fall in leading indicators and confidence, but gains in machine orders and bank lending. The Bank of Japan left monetary policy on hold leaving little hope it will meet its 1% inflation objective.
Australian economic releases and implications
- Australian data releases were mixed. Jobs growth was stronger than expected and housing finance had a rise suggesting rate cuts are starting to help. Against this it’s hard to describe the labour market as strong as jobs growth is not keeping up with growth in the working age population and leading labour market indicators remain soft. On top of this the AIG’s construction sector activity index weakened further in July. Meanwhile the TD/Melbourne Institute Inflation Gauge rose only marginally in July suggesting that the impact of the carbon tax on inflation has been much less than expected, so far at least. Underlying inflation remained very benign at 1.4% year on year. The bottom line is that mixed economic data and benign inflation are keeping the prospect of a further cut in interest rates alive even though the RBA is comfortable about current settings right now.
- The profit reporting season in Australia is off to a poor start with 34% of results so far coming in worse than expected and just 22% coming in better, against a norm of around 43%. The disappointment has been reflected in share price reactions with 65% of companies seeing their share prices fall relative to the market on the day they reported. Defensives are proving particularly vulnerable, having run hard their share prices are now vulnerable even when they deliver good earnings as was seen with Telstra. By contrast sold down cyclicals are prone to see their share prices surge if they can deliver in line or better results as we saw with Bradken.
Major market moves
- Share markets rose as investors took a more positive view of the ECB’s plan to buy bonds, US economic data was generally positive and expectations of Chinese easing strengthened. US shares rose 1.1%, European shares 1.6% and Australian shares 1.3%.
- Commodity prices rose & the $A was little changed despite weak Chinese data & fears of RBA intervention.
- Bond yields backed up in the US, Japan, Germany, the UK and Australia as safe haven demand abated.
What to watch over the week ahead?
- In the US, expect a modest bounce in retail sales (Tuesday), 0.5% growth in industrial production (Wednesday), an unchanged reading in a survey of home builders after a strong rise in July (Wednesday) and a slight fall in housing starts after a huge surge in June (Thursday).
- Euro-zone June quarter GDP (Tuesday) is expected to contract by 0.25% confirming an ongoing recession.
- In Australia expect sub-par readings in business conditions and confidence in the NAB survey (Tuesday), a modest rise in consumer sentiment and a 0.9% rise in June quarter wages (both Wednesday).
- The Australian June half profit reporting season will hot up with 45 major companies due to report including James Hardie, JB HiFi, Newcrest, CBA, AMP, ASX, Brambles, QBE and Wesfarmers. Results are expected to be weak on the back of falling commodity prices, the strong $A, cost pressures and poor domestic demand. The risks are on the downside to consensus expectations for a 1% fall in earnings for 2011-12. Resources stocks are likely to fare the worst with a 15% fall in profits under the weight of falling commodity prices at a time of cost pressures associated with massive investment programs. Financials and industrials will likely have modest positive profit growth of around 3 to 4%. Key things to watch are dividends and outlook statements with consensus expectations for 9% profit growth in 2012-13 likely to remain at risk.
Outlook for markets
- After a period of strong gains, shares have become a bit overbought and vulnerable to a short term setback on implementation delays for the ECB’s plan and worries about poor economic data in Europe, the US and China as we approach the seasonally weak month of September. However, with the ECB on the brink of a major game changer, the Fed set for further easing if needed, further easing likely in China and shares cheap we remain of the view that shares will be higher by year end. As such any weakness over the next month or so will likely provide a good buying opportunity as the broader trend from June remains up.
- While sovereign bonds in safe countries are a good diversifier, bond yields in major countries around record lows suggest very low medium term bond returns. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
- Apart from normal volatility, the $A is likely to remain strong as global central banks undertake further monetary easing, commodity prices hold up and as central bank reserve diversification continues.