Europe continued to cause concerns for investors over the past week with Cyprus getting a new bailout deal but fears that it still sets precedents for future bank bailouts and worries about the lack of a new Government in Italy weighing on confidence.
- Against this though the US S&P 500 powered on to a record all time closing high. With uncertainty over Europe weighing on investor confidence, European share fell 1.7% over the last week. Chinese shares also continued their recent correction. However, Australian shares were unchanged, but US shares rose 0.8% to a new record closing high and Japanese shares rose 0.5%.
- Australian shares fell 2.7% in March, but this followed 3 consecutive months of gains over December to February which saw them rise a cumulative 13% and had left them vulnerable to a correction.
- The revised bailout of Cyprus struck a reasonable compromise between providing €10 billion in assistance and protecting insured depositors, ie those with less than €100,000, but without blowing out Cyprus’ public debt to unsustainable levels. While the Dutch Finance Minister, who now chairs the Eurogroup of finance ministers that approved the bailout, created concerns when he said that the bank closures and losses for large depositors could be a template for future bank bailouts in the rest of Europe this appears to be his personal view and in any case he subsequently said Cyprus was a special case and a confidential Eurogroup paper said that it was not a template. Our view is that Cyprus’ minute size, outsized banking sector and large non-Eurozone deposit base do make it a special case and so the same approach is very unlikely to apply in any future bank bailouts. Moreover, the long awaited reopening of Cypriot banks hasn’t seen the panic that had been feared. I suspect that worries about Cyprus and its implications will quickly die down.
- The Italian political situation remains messy. Social Democrat leader Bersani has been unable to form a new government. Since it’s unlikely anyone in Berlusconi’s coalition or the Five Star Movement will be able to either, the most likely option is for the President to try and find a nationally respected person to run the government who is acceptable to the major parties, which may not be a bad outcome as it would probably hold the line on Monti’s reforms, or to call a new election. A new election would clearly add to uncertainty as it wouldn’t take place until June at the earliest and it would be unclear as to which way voters would go. One consolation though is that Monti would likely remain in office until a new government is formed after the election. The situation in Italy is probably not a major global threat, but it’s a risk worth keeping an eye on nonetheless.
- In Japan, the more aggressive approach to policy stimulation that the new leadership of the Bank of Japan will bring was highlighted by Deputy Governor Iwata’s comments that it will commit to hitting 2% inflation in 2 years and that there are “no excuses if we don’t achieve it”. This is all pointing to far more aggressive monetary stimulus ahead. The BoJ’s meeting on Thursday will be watched closely.
- More broadly the strengthening US economy combined with aggressive reflationary policies in Japan are helping to serve as a counterweight to the ongoing problems in Europe.
- US strength is reflected in the S&P 500 rising to a new record closing high. This is clearly supported by profits which are running well above levels seen at past share market peaks in 2007 and 2000. It’s a good sign that the US is emerging from a 13 year malaise. By the same token though it should be noted that since the March 2000 tech boom peak, US shares are up just 2% whereas Australian shares are up more than 50%.
- In Australia, weak growth in credit, a sharp 10% fall in job vacancies over the 3 months to February and a benign reading for inflation in March according to the TD/MI inflation gauge highlight that the risks are still skewed towards the RBA having to cut interest rates again.
What to watch over the next week?
- In the US, the focus will be on the ISM manufacturing conditions index (due Monday) which is expected to be little changed and employment data (Friday) which is expected to see a 200,000 gain in payrolls but with unemployment unchanged at 7.7%. The non-manufacturing ISM (Wednesday) is also expected to be little changed and trade data will be released Friday.
- In Europe, the focus is likely to be on the ECB which meets Thursday where Mario Draghi’s response to recent weak growth indicators and the turmoil around Cyprus will be watched closely. Ideally he should be providing more monetary stimulus. Final business conditions PMIs for March (due Tuesday and Thursday) will likely confirm the setback already reported in the flash estimates.
- The Bank of England also meets Thursday and could announce more quantitative easing.
- In Japan, the Bank of Japan which also meets Thursday is expected to announce a more aggressive asset purchase program as new Governor Kuroda takes over. The Tankan business survey (Monday) is expected to show improving confidence.
- In China, the official and HSBC March manufacturing conditions PMIs (Monday) will likely improve consistent with the improvement already reported in HSBC’s flash PMI.
- In Australia, the main focus is likely to be on the Reserve Bank which is expected to leave interest rates on hold. While benign inflation and risks to the growth outlook suggest the RBA will retain an easing bias, improving housing related indicators and consumer confidence suggest rate cuts are getting some traction, so with the impact of previous rate cuts still working through the pipeline, the Bank is likely to remain in wait and see mode.
- On the data front expect a $1.5bn trade deficit for February, a further gain in new homes sales (both due Wednesday), a 2% gain in building approvals and a 0.4% rise in retail sales (both due Thursday).
Outlook for markets
- Shares remain vulnerable to a further correction in the short term as overbought conditions are worked off and nervousness regarding Europe, and to a less degree China, remains. However, the set back in shares is likely to remain mild and the broad trend is likely to remain up.
- Equity valuations remain reasonable, the strengthening growth outlook led by the US points to stronger profits ahead and investors are likely to increasingly switch from low yielding cash and bonds into shares as confidence continues to build ensuring solid “buy on the dips” demand. A pick up in M&A activity from cashed up lowly geared companies is also likely to be a big positive for shares this year. So notwithstanding the usual bumps along the way, such as the one we are going through now, this all adds up to a positive backdrop for share markets.
- Notwithstanding some short term support as equities correct, sovereign bonds are vulnerable as the improving global, and Australian, growth outlook will likely see bond yields move higher over the year ahead resulting in capital losses for investors in them.
- The outlook for the Australian dollar remains messy. Mixed Australian economic data is a negative but quantitative easing in the US and Japan is a positive. The likely outcome is for a $US0.95 to $US1.10 range.
- US and European shares rallied on Thursday before the Easter break as worries about Cyprus eased. Economic releases have generally been positive with strong US consumer spending in February and a rebound in US consumer sentiment and solid German retail sales. The US S&P 500 rose 0.4% on Thursday taking it to a record closing high. European shares rose 0.4%. Chinese shares were flat on Friday and Japanese shares rose 0.5%.
- While futures trading in the ASX 200 is up 21 points or 0.4% providing a positive pointer for the start of trading next week, bear in mind that US shares will reopen on Monday ahead of the Australian share market reopening on Tuesday.