Weekly market & economic update – week ending October 11

Key events of the past week and implications

• Political argy bargy around the US Government shutdown and the debt ceiling remained the focus over the last week – but there are signs of progress. The off-ramp from a potential prang with the debt ceiling seems to be coming into view! While the shutdown and debt ceiling debate has tested investor nerves, markets have remained surprisingly calm. This may suggest a degree of complacency – or reality as we have all seen this particular US movie before – but it also suggests markets are quite resilient thanks to increasing signs the global economic recovery will continue and the reality that there is a lot of money still sitting in cash. In other words investors are using any weakness to buy into shares and with signs of a path to resolving the US debt ceiling now appearing my assessment is that conditions are falling into place for the next up leg in shares.
• The economic impact of the shutdown has been substantially reduced by the move to back pay furloughed workers and the reinstatement of around 350,000 civilian defence workers leaving only about 450,000 Federal workers on furloughs. The net impact on growth is probably running around 0.1% of GDP a week or less.
• More importantly, the path to a solution for the debt ceiling is now falling into place, with the Republicans proposing an extension of the debt ceiling through to November 22 in return for President Obama negotiating on fiscal savings including entitlement reform to clear the path for a long term debt ceiling increase. To be sure a long term debt ceiling extension right away would be preferred, and there is likely more bickering to occur before such an approach is agreed to. But seeing both sides now talking constructively about solutions is a very positive sign and highlights they are serious about avoiding a debt default, the probability of which is very low.
• There was also good news in relation to another uncertainty with current US Fed Vice Chair Janet Yellen confirmed as the nomination to replace Ben Bernanke as Fed Chairman. Her nomination is very positive. Janet Yellen has been a co-architect with Ben Bernanke of the Fed’s approach to dealing with the global financial crisis and its aftermath. So having Janet Yellen take over means a steady hand at the Fed with minimal risk that the Fed will exit from its stimulatory approach before the economy is ready. Her nomination (and likely confirmation) to the Fed job has removed a risk that has been hanging over financial markets.
• It’s worth noting that the worry list for markets has dwindled lately. Uncertainties around Syria, Italy, the German election, the Australian election, the replacement of Bernanke and the Fed’s taper decision have all faded or been resolved favourably. Now we are starting to see clearer signs that the US debt ceiling issue will be resolved positively too. This is very important as its setting share markets up for a strong rally into year end.

Major global economic events and implications

• In the US it’s been a quiet week as the partial Government shutdown has seen the data flow limited to mostly private sector economic surveys. On this front small business optimism fell in September, but only marginally, and consumer confidence has fallen a bit suggesting the Government shutdown and debt ceiling showdown are weighing on confidence. Weekly unemployment claims were released but they were distorted upwards by a backlog of claims related to an IT upgrade in California and Government shutdown related layoffs. The minutes from the last Fed meeting confirmed the decision not to taper was a close call and that most Fed officials still expected to start tapering later this year provided economic conditions pan out in line with their economic projections. However, the uncertainty created by the shutdown/debt ceiling debate has rendered the minutes badly dated and mean an October taper is off the table and it may even be delayed into early next year.
• Japanese economic data was favourable with increases in economic sentiment, consumer confidence, a tertiary activity index and machine orders and falling bankruptcies. Abenomics looks to be on track.

Australian economic events and implications

• Australian economic data added to confidence that interest rate cuts are getting traction. To be sure jobs growth remained soft in the September quarter at just 0.8% year on year, but against this the NAB business survey reported a further strong gain in business confidence with new orders at a three year high, consumer confidence eased a bit in October but held on to the bulk of recent gains, job ads improved for the first month in a while and the AIG’s construction conditions index improved in September consistent with gains in its manufacturing and services indicators. Overall, I am becoming increasingly confident that we have seen the low for the RBA’s cash rate. That said rate hikes are probably a year or so away.

Major market moves

• Share markets suffered earlier in the week on the back of concerns about the US debt ceiling, but rebounded as signs of a potential path to a solution came into sight. This saw most share market rise over the week.
• While commodity prices ended down slightly the $A rose as confidence returned that the US would not default and threaten global growth and as better economic data in Australia added to confidence that the RBA has finished cutting interest rates.
• Bond yields rose as share markets recovered later in the week and safe haven demand faded.

What to watch over the next week?

• In the US, the main focus will be on progress towards raising the debt ceiling and ending the shutdown. It’s worth noting that October 17, beyond which the US Government can no longer borrow, is only a soft deadline. It could come and go without anything happening as the hard deadline when the Government actually runs out of cash is not till around November 1 when $US67bn in Social Security and Medicare payments are due. If the shutdown continues, apart from Fed reports and initial jobless claims only private data will continue to be released. On this front the New York and Philadelphia regional manufacturing conditions surveys for October (due Tuesday and Thursday respectively), various short term measures of consumer confidence and the NAHB’s home builders’ conditions index (Wednesday) will be watched for signs that the shutdown and debt ceiling uncertainty are starting to effect economic confidence. The Fed’s Beige book of anecdotal evidence (Wednesday) will also be watched closely on this front. If the shutdown ends data for inflation, housing starts and industrial production are also due for release along with already delayed data for payrolls, unemployment and retail sales. What is not clear though is the extent to which official data compilation has been affected and so some data releases may actually skip a month or so.
• The US earnings reporting season for the September quarter will start to get underway in earnest. Consensus expectations are currently for 2% growth year on year but after allowing for a bit of the usual upside surprise is likely to come in around 4 to 5%.
• In the Eurozone, expect industrial production (Monday) to show a bounce back in August, led by Germany.
• Chinese GDP growth for the September quarter (Friday) is expected to confirm a pick up in the pace of growth after a first half soft patch, consistent with an improvement in PMIs and partial economic indicators released over the past few months. GDP growth over the year to the September quarter is expected to rise to 7.8%, from 7.5% in the June quarter, but more importantly the quarterly growth rate is expected to jump to 2.1% from 1.7% in the June quarter. However, the more timely September data for industrial production, retail sales and fixed asset investment is likely to show some moderation or stabilisation in growth consistent with annual GDP growth this year coming in around the official 7.5% target rather than continuing to accelerate. Inflation is likely to have risen to 2.8% year on year in September, from 2.6% in July, but due to higher food price inflation.
• In Australia, the Minutes from the last RBA Board meeting will be looked at for a return of an explicit easing bias that has been absent from the last three post meeting statements but evident in the minutes to the August and September meetings. Housing finance data due Monday will likely show an ongoing rising trend.

Outlook for markets

• Uncertainty around the US Government shutdown and debt ceiling have led to a modest 3% or so correction in global and Australian shares. Further weakness and volatility is a risk, but with the worry list for investors diminishing and US politicians finally starting to work constructively towards a debt ceiling solution our assessment is that shares will have a solid rally into year end with further gains next year. Share market valuations remain reasonable, monetary conditions are set to remain easy and profits are likely to improve next year as global and Australian growth picks up. Australian shares look they could hit 5500 by year end, with a little help from a Santa rally.
• Government bond yields are likely to resume a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering eventually comes back into focus either later this year or early next. 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 and 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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