The past week saw most share markets rise with Chinese shares up 4.3%, European shares up 1% and Australian shares up 0.7%, but fiscal cliff worries weighed on US shares dragging them down 0.3%.
- So far this month US shares are down marginally, but the first few weeks of December are normally pretty flat with the so called Santa Claus rally only clicking in around the Christmas/New Year period.
- Progress in resolving the US fiscal cliff remains slow. Our assessment is that a solution will be found which will cut fiscal drag next year to 1-2% of GDP. However, this could involve Congress returning to Washington between Christmas and New Year to vote on any agreement. An agreement before year end would be a good outcome for equity markets particularly if it deals with the debt ceiling issue as well. Alternatively if little progress is made in the next two weeks, the risk of which appears to be rising, the House may pass the Senate tax bill that extends Bush era tax cuts for low and middle income earners for one year and caps tax rates on capital gains and dividends at 20% as a stop gap measure leaving a decision on a final solution till early in the New Year. Such an outcome could create a bit of uncertainty for investors as it would still leave in place fiscal tightening equal to around 2.7% of GDP and see budget and debt ceiling negotiations drag on into early next year.
- The Fed signalled a determination to keep the US recovery going by enhancing its quantitative easing program by another $45bn a month in government bond purchases. The Fed also announced it was replacing its guidance to keep interest rates low out to mid-2015 with a thresholds for unemployment and inflation forecasts. Based on the Fed’s forecasts the new thresholds don’t imply any rate hike before mid-2015, but the Fed has given itself more flexibility to change course. Expanded quantitative easing in the US is a positive for share markets as it means even more money sloshing around looking for a home at a time when interest rates remain near zero. For bonds a key risk is that we see a sharper than expected back up in bond yields next year, if US unemployment starts to fall more quickly towards the Fed’s 6.5% threshold.
- Growing US quantitative easing also has the effect of encouraging easier global monetary conditions which adds to the boost to growth assets. This occurs as countries seek to keep their currencies down against a weak $US. We may see more of this from Japan following a likely change of Government and the continuing strength in the Australian dollar is adding to pressure for the RBA to ease further and may force it to consider its own form of quantitative easing via intervention in the foreign exchange market.
- Tail risk in Europe is continuing to recede. Yes Berlusconi threw a spanner into the works in Italy but its very hard to see Berlusconi getting enough votes now to return as PM especially with Monti’s resignation likely to cause many Italians to blame Berlusconi for messing things up again. More interestingly there was only a temporary impact on Italian shares and bonds suggesting investors aren’t too worried. What’s more the Greek bond buyback was successful and so it will now get more aid with the risk of Grexit rapidly fading and finance ministers agreed to the start of a banking union with the ECB as the common regulator by 2014, which will pave the way for Europe’s bailout fund to lend directly to banks. Again this is all about “more Europe, not less”. With European tail risks receding European shares trading at a 20% discount to US shares are good value.
- Gains in manufacturing conditions PMIs in the US, China and Europe in December augur well for global growth next year and this should provide a key underpinning for further gains in share markets.
- Debate about the Australian Government’s surplus commitment for this year is hotting up. Put simply, its best to let the automatic stabilisers in the budget run their course as the economy slows as more austerity will only worsen the economy and public finances will still be in very good shape. So forget the surplus for this year.
Major global economic events and implications
- US economic data was good, with industrial production up strongly in November, a further gain in the Markit manufacturing PMI, a further sharp fall in jobless claims and gains in job openings, a rise in November retail sales, a smaller than expected widening in the trade deficit and a further sharp rise in mortgage refinancing.
- In the Euro-zone industrial production fell sharply in October but manufacturing and services conditions PMIs rose for the second month in a row suggesting the Euro-zone recession may be easing.
- Japanese economic data was mostly weak with falls in business confidence according to the latest Tankan survey, consumer confidence and a tertiary activity index.
- While Chinese export growth was slower than expected as was new bank lending, HSBC’s flash manufacturing conditions PMI rose to a 14 month high in December providing further evidence that Chinese economic growth has bottomed. This also adds to confidence that the Chinese share market has seen its lows.
Australian economic events and implications
- Australian economic data was weak with falls in both business and consumer confidence. Housing finance rose in October but mainly due to investor interest. While gloomy talk following the RBA’s latest rate cut probably weighed on consumer sentiment, the clear message is that interest rates – particularly the rates that businesses and households pay – are still too high for the changed more cautious environment we are now in.
- I remain of the view that the cash rate needs to fall to 2.5%. While economists and commentators are now falling over themselves projecting ever lower levels for the cash rate – maybe I better forecast 1% just to get ahead of the crowd! – there is a danger in getting too carried away. While there has only been a very modest response to rate cuts so far, this is only because they haven’t been cut enough. After several years of weakness there is plenty of pent up demand and scope for a rebound in areas like housing construction and non-mining investment. It’s hard to see at least some of the $3500 pa in interest savings for someone on a $300,000 mortgage not getting spent.
- One big concern is the Australian dollar as more US quantitative easing is pushing it even higher. This is rapidly becoming a serious threat to the economy. If a cut in the cash rate to 2.5% doesn’t start to bring the $A down then the RBA should consider some form of intervention.
Major market moves
- Global shares mostly rose helped by reasonable economic data, the anticipation of more Fed easing and more progress in Europe in stabilising its debt crisis. While Chinese shares surged though, US shares actually fell slightly on fiscal cliff worries.
- Commodity prices were little changed but the $A rose buoyed in part by more quantitative easing in the US.
- Bond yields generally rose, except in Spain.
What to watch over the week ahead?
- In the US, negotiations on the fiscal cliff will dominate, but on the data front manufacturing conditions surveys in the New York and Philadelphia regions (Monday and Thursday respectively) are likely to confirm continued but modest growth in the manufacturing sector. Home builders’ conditions (Tuesday) and housing starts (Wednesday) may fall a touch after several months of strong gains but the trend is likely to remain up. Existing home sales (Friday) are likely to show modest growth. Data for durable goods orders, personal spending and consumer sentiment will also be released Friday.
- The Bank of Japan meets Thursday and may announce further quantitative easing following recent weak economic data.
- In Australia, the minutes from the RBA’s last Board meeting are likely to confirm that it retains an easing bias. In fact based on recent experience the minutes are more likely to signal continuing rate cuts ahead than the post meeting statement which was very bland. It’s a quiet week on the data front though with only second order data for motor vehicle sales, the Westpac leading index and a skilled vacancy survey due for release.
Outlook for markets
- Fiscal cliff uncertainties will likely weigh on investment markets in the short term. However, our assessment is that shares are still likely to see their normal seasonal strength into year end. Shares remain cheap, monetary conditions are ultra easy and a slight pick-up in global growth on the back of easing by the Fed, a likely solution to the US fiscal cliff (at least by late January), the ECB’s bond-buying program and improving momentum in China should support profit growth in 2013. Australian shares are being given an added impetus by lower RBA interest rates which should help boost profit growth through 2013. As a result we see further gains in share markets by year end and through 2013.
- Sovereign bonds in safe countries are a good diversifier most of the time, but bond yields are very low and point to low medium-term bond returns. The year ahead is likely to see a rising trend in bond yields as global economic growth improves which will result in capital losses for investors in sovereign bonds.
- The outlook for the Australian dollar remains messy. Uncertainties regarding global growth and ongoing RBA rate cuts are negatives. But growing quantitative easing in the US, central bank buying and prospects for improved global growth are positives. The likely outcome is for a $US0.95 to $US1.10 range.