The volatility in share markets remained over the past week as investors continued to fret about a premature tightening by the Fed putting upwards pressure on bond yields, worries that Japan will not be successful in boosting growth and inflation and as disappointment regarding Chinese data further fuelled concerns about growth in emerging countries generally.
- Reflecting the poor global lead Australian shares also remained volatile as concerns about China weighed on resources stocks and uncertainty about the $A kept foreign investors side lined. However, it’s worth noting that after a 15% fall, and with dividend yields having rebounded, interest seems to be returning to bank shares.
- From their mid May highs Japanese shares have had falls of 20%, Australian shares -10%, Eurozone shares -6% and US shares -3.5%. Global shares in aggregate have corrected by around 5.5%.
- Our view remains that:
1. The Fed will only start to slow and then unwind its stimulus programs when it’s completely comfortable that the economic recovery is self sustaining and more importantly that it is likely to stress at its FOMC meeting on Wednesday that interest rate hikes are still a long way away. So the recent sharp spike in bond yields and the bring forward of Fed interest rate hike expectations has gotten way ahead of itself.
2. The correction in Japan is more about positioning with investors having got very long Japanese shares and very short the Yen and now realising that Japan’s reinvigoration will be a long process. However, our view has not changed that Japan is on track for better times ahead.
3. While Chinese data for May was disappointing it’s still consistent with growth around 7.5%, so recent market consternation regarding China is overdone.
4. Similarly for the Australian share market, lower interest rates and a lower $A will provide a boost to the economy and to the share market once current nervousness dissipates, albeit in the short term its too early to say whether we have seen the bottom or not. - Our assessment is that the recent turbulence in markets is just a correction and that markets will resume their uptrend as it becomes clear that the global economy is continuing to gradually improve, that the Fed is not going to prematurely remove its monetary stimulus and that the Bank of Japan is committed to its inflation target.
Major global economic events and implications
- US economic data continues to provide a picture of solid, but not booming, growth and low inflation. Retail sales rose more than expected in May, jobless claims continue to trend down, small business and CEO optimism continued to improve and mortgage applications for new purchases rose solidly despite rising mortgage rates. Against this, consumer sentiment fell slightly but from a six year high, industrial production was weaker than expected and job openings fell. Readings for import prices and producer prices point to benign inflation.
- There was good news for America with Standard and Poor’s recognising the lessening of fiscal risks facing the US, after the deal to head off the fiscal cliff and the budget deficit is falling faster than expected, by shifting the US’ AA+ sovereign rating outlook from negative to stable. This is good news, highlighting the improvement seen in America’s public debt situation. Of course, there is still a risk that Moody’s and Fitch will downgrade the US from the equivalent of AAA to AA+ in a belated catch up to S&P, maybe later this year when the debt ceiling debate returns.
- European news wasn’t too bad with a nice rise in industrial production adding to indications from business conditions PMIs that the recession may be losing some of its intensity. While the German Constitutional Court began to hear a legal challenge to the ECB’s Outright Monetary Transactions program (which underpins Mario Draghi’s “whatever it takes” commitment to defending the euro) it’s unlikely to make a decision till September and is unlikely to declare it unconstitutional.
- In Japan the main disappointment was that the Bank of Japan failed to extend its reflation program or do anything to reduce the upwards pressure on bond yields as some had hoped they would. This was based on an assessment by the BoJ that it wasn’t necessary, but it clearly stands ready to do more if need be. Notwithstanding investor nerves Japanese data, apart from a fall in machine tool orders was mostly positive with a widening current account surplus, a fall in bankruptcies and increased consumer confidence.
Australian economic events and implications
- Australian data was slightly better than expected. While the value of housing finance for owner occupiers fell slightly, this followed a strong month, the trend remains up and finance for investors continues to rise solidly, confirming that rate cuts continue to get traction here.
- Moreover, business conditions and confidence improved slightly in May but both remain pretty soft, consumer confidence rose around 5% albeit remaining sub-par for this far into a rate cutting cycle and the official labour market figures were much stronger than expected. There is reason for caution in interpreting the jobs figures though as full time employment is weak, hours worked is falling, the labour force underutilisation rate (the unemployed plus those who want to work more) rose to its highest since the GFC at 12.9% and weakness in various job vacancy surveys point to soft labour market conditions ahead.
Major market moves
- Share markets had another volatile week on the back of worries about a premature Fed tightening, Japan and soft Chinese data. Asian shares were particularly hard hit by fears that earlier than previously expected Fed rate hikes will lead to capital outflows. However, reduced concerns about the Fed saw relief later in the week.
- Commodity prices were mixed with gold and oil up slightly but base metals down reflecting the conflicting influences of concerns about China but a weakening in the $US. A slightly stronger tone to Australian economic data, particularly for jobs and consumer confidence, along with some abatement in worries about the Fed saw the $A rise slightly.
- Bond yields rose into mid week as market expectations for the first Fed tightening were brought forward but then rallied later in the week leaving them up in Europe and Australia, but actually down slightly in the US.
What to watch over the next week?
- In the US, the focus will be on the Fed’s meeting Wednesday. The Fed is very unlikely to make any changes to monetary policy, but it will likely move to dampen market fears of a premature slowing of quantitative easing and interest rate hikes. Our assessment is that it will signal that it’s too early to start tapering yet, but it may do so later this year but only if the economy strengthens further and the improvement looks sustainable.
- But it is also likely to signal that the pace of QE can be increased or decreased in the future depending on how the economy is performing and that any decision to slow QE does not mean that interest rate hikes are any closer. This could be supportive of both shares, because QE will only be reduced if the economy is stronger which is good for profits, and bonds, as interest rate hikes are no closer. We are looking for a tapering around September at the earliest, but by the time it happens it will hardly be a surprise.
- On the data front in the US expect to see a further improvement in the NAHB home builders’ conditions index (Monday), a strong rebound in housing starts (Tuesday) and a continuing increase in existing home sales (Thursday). June manufacturing conditions indexes for the New York (Monday) and Philadelphia (Thursday) regions and the Markit flash PMI (Thursday) are likely to show manufacturing conditions hanging around levels seen in May. The CPI (Tuesday) is likely to remain benign.
- In Europe, Markit’s flash business conditions PMI’s for June will be released Thursday and are expected to show a continuing but gradually improving trend.
- The HSBC flash manufacturing conditions PMI for China will also be released Thursday.
- In Australia, the minutes from the RBA’s last rate setting meeting are expected to confirm that it retains an easing bias and will be watched closely to see how concerned the RBA is about increasing evidence that mining investment has peaked at a time when the rest of the economy is still subdued. Data for car sales (Monday) and skilled vacancies (Wednesday) are also likely to be released with the latter likely to remain weak.
Outlook for markets
- It’s too early to say that the falls in shares are over, however we remain of the view that it’s just a correction and that the broad cyclical trend remains up. Shares are far from expensive, monetary conditions are likely to remain very easy with interest rate hikes a long way off and the gradually strengthening global growth outlook points to stronger profits ahead. So by year end we see further upside in global and Australian shares.
- While bond yields have moved up too far too fast lately given the outlook for short term interest rates, sovereign bonds are fundamentally vulnerable as improving global growth will likely see yields gradually move higher.
- The $A seems to be finding support around $US0.94-95 and could have a decent bounce given now large short speculative positions. However, with commodity prices in a downtrend and the outlook for the Australian economy deteriorating relative to the US, it’s likely the $A is ultimately headed lower. Given its overvaluation in terms of relative prices, expect the $A to head towards $US0.80 over the next few years.