Weekly market & economic update: week ending August 2

Key events of the past week and implications

• Shares continued to trend higher over the past week helped by dovish central bank comments and good news from the US and Europe in particular. Perhaps the big event though was a further leg down in the Australian dollar on the back of dovish RBA comments and news of a further deterioration in the budget outlook.
• In Australia, despite little change in the economy since the May Budget the Government’s economic statement showed a surprising $33bn deterioration to the Budget outlook over the next four years as a result of the adoption weaker economic growth and revenue assumptions and new spending commitments being only partly offset by savings. The latter included an increase in tobacco excise, a bank deposit levy, public sector savings and delayed foreign aid payments. The good news is that the savings don’t kick in for two years by which time the economy should be better able to withstand them and a projected surplus is maintained for 2016-17. The bad news though is that the budget blow out is much worse than feared, uncertainty has been increased yet again as to when we will get back to surplus, our public finances after the biggest boom in our history should be in much better shape and the deteriorating budget outlook may only add to fears of an aggressive post election fiscal tightening regardless of who wins. In terms of the latter, while the latest budget tightening doesn’t commence to 2015-16 and even then is only modest at just 0.2% of GDP the continuous deterioration and uncertainty regarding the budget outlook combined with fears that more aggressive tightening is on the cards post the election is likely to further undermine business and consumer confidence. The implication is that more pressure is being placed on the RBA to support growth via interest rate cuts. While the consensus is for the cash rate to bottom out at 2.5% (following a cut on Tuesday), the odds are starting to favour a cut to 2% by year end. The deteriorating fiscal outlook also highlights the need for the $A to fall towards $US0.80.
• In the US, the basic message from the Fed was little changed: tapering of its quantitative easing program will only commence when the economy strengthens and interest rates will remain low for a long time. However, the Fed’s post meeting statement injected a more dovish tone with a downgrade in its characterisation of economic growth from “moderate” to “modest” and concerns about the rise in mortgage rates and low inflation. Overall this suggests that if tapering starts in September it could be a relatively modest one off move (say cutting asset purchases from $US85bn a month to $70bn) or that it may be pushed out to even later in the year. For tapering to commence employment growth needs to remain around 200,000 jobs a month and economic growth needs to pick up to a 3% plus pace to be consistent with the Fed’s forecasts.

Major global economic events and implications

• Forward looking US data was pretty positive. To be sure June quarter GDP data confirmed that the first half has been soft. However, growth is likely to pick up in the current half as the impact of tax hikes and sequester spending cuts fade and a strong rebound in the ISM and Markit PMI manufacturing conditions indicators along with solid jobs data adds to confidence that this will occur. Unemployment claims have in fact now fallen to their lowest since January 2008 and strong gains in house prices are providing a strong boost to household wealth.
• The improving US economic outlook is backed up by the June quarter profit results. So far of the 382 S&P 500 companies to have reported, 73% have surprised on the upside for earnings and 56% for sales revenue. Continued profit strength is good for shares and good for jobs and business investment.
• Eurozone economic confidence readings rose further consistent adding to evidence that economic growth will return in the current half year. The ECB left monetary policy unchanged but with core inflation running at just 1.1% there is plenty of scope for further easing and certainly ECB President Draghi’s comments remain dovish.
• Japanese economic data was mixed with weak data for household spending, industrial production and a manufacturing PMI. However, manufacturers expect a strong rebound in production in July, the trend in the PMI is still up strongly, and jobs data and housing starts were stronger. So overall ok.
• In China the official PMI defied the fall recorded in the flash HSBC PMI and actually rose slightly. The official PMI is probably the more reliable but taking an average of the two would suggest a gradual moderation in growth. Meanwhile Chinese authorities continue to provide assurance that growth will be held above its bottom line of 7%, while at the same time indicating a big stimulus program is unlikely.

Australian economic events and implications

• In Australia, RBA Governor Stevens gave a relatively dovish speech highlighting that increased uncertainty domestically and structural forces globally are likely to hold interest rates down at relatively low levels, that recent inflation readings were no barrier to further rate cuts and that a further fall in the $A would not be surprising.
• Meanwhile Australian data releases were pretty mixed. On the positive side house prices rose another 1.6% in the July according to RP Data taking their year on year gain to 4.9%, new home sales rose again in June having risen now in 8 of the last 9 months and credit growth picked up albeit only very marginally. But against this building approvals fell in June, the AIG’s manufacturing PMI fell and producer price inflation remained low.

Major market moves

• Share markets rose on the back of good data releases and profit results in the US and Europe along with dovish indications from the Fed and ECB. Australian shares benefitted from the strong global lead along with dovish comments from RBA Governor Stevens and Chinese shares were helped by growth supportive comments from the Chinese Government.
• Dovish comments from the RBA along with better news from the US saw the $A slide below $US0.90.
• Bond yields rose as investors continue to rotate into growth assets.

What to watch over the next week?

• In the US, the ISM non-manufacturing index (Monday) is expected to show a modest rise and the trade deficit (Tuesday) is expected to narrow slightly. A speech by Fed Chairman Bernanke on Wednesday will be watched for more clues regarding the start of tapering, although its doubtful he will say anything new.
• The Bank of Japan meets Thursday, but is unlikely to announce any changes to monetary policy.
• The focus globally though, will likely be back on China with July export and import data (Thursday) likely to show continuing softness and data for industrial production, investment and retail sales (Friday) likely to have remained relatively subdued by Chinese standards. Inflation is expected to rise slightly to 2.8%.
• In Australia, the RBA is expected to cut the cash rate to an historic low of 2.5% on Tuesday. Since the last RBA Board meeting we have seen more weak readings for consumer and business confidence, a further rise in unemployment, benign inflation and more uncertainty regarding the outlook for China. With the economy still struggling and budget uncertainty escalating, more monetary stimulus is needed. This should ideally come in the form of both lower interest rates and a lower $A. Following a relatively dovish speech by Governor Stevens in the last week the money market has priced in a 90% chance of a rate cut on Tuesday. While a weekend announcement from the Government setting the Federal election for September 7 could cause the RBA to hold back this would be dangerous as it would effectively mean delaying the rate cut till October, and may risk triggering a rebound in the $A. As a result we would see such a delay as being unlikely. The RBA will also release its Statement on Monetary Policy on Friday which is expected to retain a dovish tone.
• On the data front, expect retail sales (Monday) to show continued modest growth, but with flat retail sales in the June quarter in real terms, June house prices (Tuesday) to show a 2% rebound after a flat March quarter, housing finance data (Wednesday) to show an ongoing rising trend and labour force data (Thursday) to show a 15,000 loss of jobs in July resulting in a rise in unemployment to 5.8%.
• The June half Australian profit reporting season will also ramp up with 40 major companies due to report, including CBA, Leightons, Worley Parsons, AMP and Wesfarmers. Consensus estimates for 2012-13 earnings growth have slipped to a fall of 0.5% from +12% earlier this year, so a lot of bad news is already factored in. Resources profits may show signs of bottoming, but domestically exposed cyclicals are vulnerable to further weakness. On the positive side though, ongoing cost control and the fall in the $A are likely to be supports for the profit outlook going forward, with the fall in the $A to date potentially boosting profits by around 4.5%.

Outlook for markets

• We remain in a seasonally weak period of the year for shares and worries about the Fed tapering its monetary stimulus, US debt ceiling negotiations, growth in China and the profit reporting season in Australia have the potential to cause more volatility. However, the broad trend in shares is likely to remain up: valuations are reasonable; monetary conditions will remain very easy with interest rate hikes a long way off in the US and rates still likely to fall further in Australia; 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.
• Sovereign bond yields still remain low and point to low medium term returns.
• With commodity prices in a downtrend & the Australian economy deteriorating versus the US, it’s likely the $A will fall further. Given its overvaluation in terms of relative prices, expect the $A to fall to $US0.80.