The past week has been another good one for investors as various key events that investors had been worrying about have continued to pass with positive outcomes.
- The big news is that the Fed is commencing open ended quantitative easing (QE3) with the purchase of $40bn worth of mortgage backed securities a month that will continue until the outlook for the labour market improves substantially, which on the Fed’s own forecasts may not be for some time. What’s more the Fed extended its low interest rate guidance into mid 2015 and indicated it will do more if need be. QE3 is positive on multiple fronts. First, it will provide a further boost to US economic growth by lowering mortgage rates and pumping more cash into the US. To the extent QE3 forces other central banks around the world to run easier monetary policy to stop their own currencies rising it helps boost global growth. Secondly, rather than having a specific end date it will continue until the Fed gets what it wants which means investors don’t have to worry about what will happen when the end point is reached as occurred with QE1 and QE2. Finally, because it is only buying mortgage backed securities the Fed is less likely to be accused of monetising public debt. The fact that shares surged on its announcement indicates the Fed has done more than the market was expecting.
- In terms of investment implications from QE3 there are likely to be several. First it’s a big positive for US shares, just as QE1 and QE2 were, and risk assets generally. Second, it’s a short term negative for the $US but just as QE1 and QE2 did not cause a $US collapse, QE3 is unlikely to either. Thirdly, it’s positive for commodity prices on the back of any boost to global growth and as they are priced in US dollars. Gold is likely to be a big beneficiary. Fourth, the combination of higher spot commodity prices and potentially the resumption of carry trades could see the $A pushed higher, which is the last thing Australia needs now particularly if bulk commodity prices remain subdued on Chinese softness. As a result it adds more pressure for the Reserve Bank of Australia to resume rate cuts – which we expect next month. Finally, if QE3 boosts global confidence it should see some reversal of safe haven bond buying and hence modest ongoing upwards pressure in bond yields.
- In Europe, there were a number of positive developments. First, the German constitutional court refused to grant an injunction against the new ESM bailout fund clearing the way for its start up soon and its use as part of the ECB’s bond buying plan. What’s more the conditions imposed by the court were not new or onerous. While the court’s requirement that German liabilities be well defined may be interpreted as preventing the ESM from becoming a bank, this is no longer an issue as the ECB’s proposed bond buying in the secondary market means it no longer needs to be a bank anyway. Second, the Dutch election saw pro-European parties achieve a clear victory. Third, the troika of the IMF, European Union and the ECB agreed to an extension of Portugal’s adjustment period and an easing of deficit reduction targets. Uncertainty remains over when Spain will apply for assistance, as it now seems to be hoping that it can deliver a structural reform package that will enable it to avoid seeking assistance. But I think it’s just a matter of time because if it doesn’t it will soon see its bond yields start to rise again, which will force it to do so.
- The bottom line is that the global news flow is remaining positive, key areas of uncertainty are being resolved positively – notably the actions by the ECB and the Fed – and all of this is removing the risks of a return to global recession that many had feared and rather pointing in the direction of better global growth next year. All of which is likely to help keep the rally in share markets going.
Major global economic releases and implications
- US data was mixed, remaining consistent with continued but still sub-par growth and highlighting the necessity for more stimulus as is now being provided by the Fed. On the positive side small business confidence improved slightly in August, consumer sentiment improved and weekly mortgage applications rebounded. Against this, retail sales were soft in August after allowing for the impact of higher gasoline prices, industrial production fell, job openings fell in July, consumer credit fell and unemployment claims rose. Underlying inflationary pressures remained benign with core inflation of just 1.9%, so the Fed has no worries on this front.
- Euro-zone industrial production rose more than expected although weakness in previously released business conditions PMIs suggest the bounce won’t be sustained. As in the US core inflation remains benign at just 1.7%.
- Japanese economic data was messy with June quarter GDP growth revised down, a fall in economic sentiment and weak tertiary activity in July but a solid rise in machine orders, a slight rise in consumer confidence and a fall in bankruptcies.
- Chinese trade data remained soft in August, particularly with a fall in imports partly on the back of destocking. There was good news though in the form of stronger lending in August and while annual money supply growth slowed it still looks to be tracing out a bottoming to gently rising trend. Both President Hu Jintao and Premier Wen Jiabao made reference to recent economic weakness and commitments to promote stable growth, although investors have lots of that before and are becoming a bit sceptical.
- Indian industrial production remained lacklustre in July, but still high inflation in August will limit monetary easing.
Australian economic releases and implications
- Australian economic data was generally soft. Housing finance fell in July and is still stuck in the basically sideways trend it has been in since the start of last year. While dwelling starts rose in the June quarter, this was driven by a rebound in normally volatile multi unit starts after weakness the previous quarter. The broad trend remains soft. The NAB business survey for July showed a rise in conditions but a fall in confidence but with both remaining sub-par. While consumer sentiment rose slightly in September, perhaps on talk of more rate cuts, it remains well below long term averages. And finally in an effort to keep the Queensland budget on track coal royalties were raised, providing another blow to mining sector sentiment, and 14,000 public service jobs will go adding to the anecdotes of job layoffs. Unfortunately it didn’t help Queensland retain its AA+ credit rating from Fitch which downgraded it to AA.
Major market moves
- Share markets rose strongly on the back of the German constitutional court’s decision clearing the way for the start up of Europe’s new bailout fund and the Fed’s announcement that it will commence QE3.
- Commodities prices also rose on the back of QE3 and this helped push the $A back above $US1.05.
- Bond yields rose further in the US, Germany, the UK and Australia as safe haven buying reversed.
What to watch over the week ahead?
- In the US, the focus will be back on the housing sector with data for home builders conditions (due Tuesday), housing starts and permits and existing home sales (all Wednesday) likely to confirm the ongoing housing recovery. Manufacturing conditions surveys for the New York (Monday) and Philadelphia (Friday) regions will likely show an improvement but remain at subdued levels.
- In Europe, preliminary business conditions PMIs will be released for September (Thursday) and will likely show further evidence of stabilisation at levels consistent with a mild, as opposed to a deep recession.
- In Australia, the minutes from the RBA’s last Board meeting will be looked at closely to see how concerned the Bank is about China and the fall in the iron ore price. Our assessment is that the RBA is shifting back towards an easing bias ahead of the resumption of rate cuts in October. The ongoing rebound in the $A is only adding to the urgency for more rate cuts.
Outlook for markets
- It seems the world’s luck is turning for the better – all the events that could have hurt markets over the last month (Bernanke’s Jackson Hole speech, the ECB meeting, the German court decision, the Dutch elections and the Fed meeting) have been resolved with positive outcomes. While we are still waiting for news on Spain’s application for assistance and a decision on Greece, these events are unlikely to derail the rebound in share markets. With the ECB undertaking a major game changer for the better in terms of finally addressing the European debt crisis, the Fed providing a huge shot in the arm for the US economy and global share markets, further easing likely in China and shares cheap, we see shares rallying into year end. The fact that shares have managed to rise strongly so far through the seasonally weak period around September is a positive sign. If there are any set backs in the weeks ahead they should be seen as a good buying opportunity.
- While sovereign bonds in safe countries are a good diversifier, bond yields in major countries remain very low and point to low medium term bond returns as investor confidence returns over time. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
- US QE3 is unambiguously positive for the $A as it will help boost US and hence global growth and it will increase the supply of US dollars relative to the supply of Australian dollars. Against this though if China remains subdued, bulk commodity prices remain weak and the RBA cuts interest rates as we expect then this will provide an offset. Overall, the $A is likely to remain strong but it’s hard to see it rising above last year’s high of $US1.10. A more likely outcome is a range of $US0.95 to $US1.10.