• The partial US Government shutdown was the dominant event globally over the past week. While initially financial markets took it in their stride investor nervousness seemed to increase as the shutdown wore on.
• US Government shutdowns are far from new and since they only mainly involve non-essential government services (ie, not the whole Government) their economic impact can be relatively small. The current shutdown is estimated to be costing the US economy around 0.1% to 0.2% of GDP a week, and this will be partly reversed once the shutdown ends and Government spending plays catch-up. In fact there were 17 shutdowns between 1976 and 1996, lasting an average 8 days. Interestingly the impact on share markets is mixed: US shares actually rose through 9 of the last 17 shutdowns, with even a 0.5% gain through the 32 day shutdown in 1995-96. The risks are a bit greater this time though as the economy is somewhat fragile and the budget debate now looks like rolling into the need for Congress to increase the US Government’s debt ceiling later this month (October 17 is the supposed drop dead date for new borrowing, but it looks like it could limp on to month end using cash reserves), with a failure to raise the ceiling leading to fears of US default on its debt.
• There are several points to note on all this. First, both sides of US politics are aware of the longer term consequences of the US defaulting on its debt servicing and so a last minute solution remains the most likely outcome for the debt ceiling. Second, while it would be good for the shutdown to end soon, the longer the shutdown lasts the greater the odds the Republicans will cave in earlier on the debt ceiling as they will likely be politically weakened as Americans are likely to mostly blame them for the shutdown and the longer it goes on the heavier the blame. Third, even if the debt ceiling is not increased in time the US Treasury is almost certain to prioritise servicing commitments on debt (as it indicated it would prior to the 2011 debt ceiling debate) so a partial debt default is very unlikely. Fourthly, it’s worth noting that there are now several positives compared to the situation around the August 2011 debt ceiling/sovereign rating downgrade in the US: the budget deficit is much smaller (at around 4% of GDP compared to 9% in 2011), global growth is picking up and the Eurozone is no longer threatening to implode. Finally, even though a last minute solution remains the most likely it won’t stop investors fearing the worst, so the next few weeks could see further weakness in share markets.
• There was good news out of Italy with PM Enrico Letta surviving a confidence vote, as Berlusconi was forced to back down on a threat to have his PdL party senators cast a no-confidence vote after some threatened to defy him and were talking of breaking away from the PdL. This has left Berlusconi substantially weakened and removed a big cloud that had been hanging over Italy as the odds of another destabilising Italian election are now substantially reduced.
• There were no surprises from the Reserve Bank of Australia which left interest rates on hold. It was disappointing to see the RBA not include an explicit easing bias, because it would have helped maintain downwards pressure on the $A without having to do anything. However, our assessment is that, with the global economy on the mend, the housing sector recovering (with worries of a house price bubble) and consumer and business confidence perking up, interest rates have now hit bottom with the next move likely to be up, albeit not for 12 months or so. To get another rate cut would require a renewed loss of global confidence (perhaps if the US budget/debt ceiling issue spirals out of control and renewed weakness in domestic economic indicators). At this stage the chance of another rate cut has fallen to around 30%.

Major global economic events and implications

• US economic data, was mostly favourable pointing to continued moderate growth. The ISM manufacturing conditions indicator rose slightly and the non-manufacturing conditions indicator fell but both are at levels consistent with solid economic growth. Labour market reports were mixed with lower than expected jobless claims but a weaker than expected gain in the ADP private employment survey. The overall impression is that the Fed can take its time in deciding when to taper.
• Economic data out of Europe remains favourable with final business conditions PMIs for September revised up slightly and unemployment holding steady at 12% in August, below the peak of 12.1%. Reflecting the economic improvement the ECB made no changes to monetary policy, but clearly retains an easing bias.
• Japanese industrial production was weaker than expected in August but gains in its PMI and the Tankan survey provide confidence that the recovery remains intact. Against this background, the confirmation that the sales tax rate would be increased next April (from 5% to 8%) is less worrying, particularly with the impact being partially offset by a fiscal stimulus package and the BoJ standing ready to ease further if needed, despite making no change to monetary policy this month.
• In China, the manufacturing PMI only rose marginally in September but the non-manufacturing PMI rose more decisively. The overall picture remains consistent with 7.5% growth. Not the return to boom some might have been hoping for but no sign of any bust either.

Australian economic events and implications

• Australian economic data added to confidence that rate cuts, helped by the confidence boost from the change in Government, are getting traction and that economic growth is bottoming. To be sure credit growth remained subdued in August but the rising trend in housing finance suggests it will likely pick up in the months ahead. Moreover, house prices rose solidly in September providing a boost to household wealth, new home sales and building approvals are trending up and the AIG’s business conditions PMIs rose strongly in September.

Major market moves

• Share markets fell over the last week on the back of worries that the partial US Government shutdown and debt ceiling debate will adversely affect global confidence and growth.
• US shutdown fears also weighed on commodity prices. However, the combination of a generally weaker $US and stronger data adding to confidence that rate cuts are over in Australia saw the $A rise.
• Bond yields rose in Australia on the back of stronger than expected economic data, but were flat to down elsewhere helped a bit by safe haven buying on the back of US fiscal fears.

What to watch over the next week?

• In the US, progress in resolving the shutdown and approaching debt ceiling will likely be the main focus. However, the minutes from the last Fed meeting (due Wednesday) will be watched for more clues on why the Fed decided not to taper and how close the decision was. And assuming the shutdown ends soon and official data starts to be released, September payrolls are expected to show a 180,000 gain with unemployment remaining unchanged at 7.3%, retail sales (Friday) will likely show continued modest growth, and producer price inflation and trade data will also be released.
• In China September economic data will start to flow with export and import data (Saturday) expected to show continued modest growth. Money supply and lending data (Thursday) are likely to show that liquidity conditions remain growth supportive.
• In Australia, business and consumer confidence readings (with the NAB business survey due Tuesday and the Westpac/MI consumer survey due Wednesday) will be watched for evidence of a follow through from the election related boost reported a month ago. September employment data is expected to show a modest 5000 gain after two soft months but with unemployment remaining at 5.8%.

Outlook for markets

• Shares are at risk of further weakness over the next few weeks as the US budget and debt ceiling negotiations roll on with fears of a flow on to global confidence and growth.
• However, any pullback will provide a great buying opportunity as the broad trend in shares is likely to remain up. Valuations remain reasonable, monetary conditions are set to remain easy, profits are likely to improve next year as global and Australian growth picks up and the US fiscal debate is likely to have been resolved by early November, just in time for the usual year-end rally to commence. So by year end we see further upside in global and Australian shares with gains continuing next year. Australian shares look they could hit 5500 by year end, with a little help from a Santa rally.
• Government bond yields globally are falling after having risen too far too fast and being helped by short term safe haven demand given political uncertainties in the US, but are likely to resume a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering comes back into focus. Low yields and an unwinding of years of massive inflows point to poor sovereign bond returns ahead.
• Signs that Australian growth and interest rates may be bottoming, stable growth in China, improving global growth at a time when short $A positions remain extreme suggest that in the months ahead the $A is now likely to see more upside, possibly up to around $US0.98, before the medium term downtrend resumes.

By Dr Shane Oliver, Head of Investment Strategy & Chief Economist

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Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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