Weekly market & economic update – week ending 8 November

 Key events of the past week and implications

• The past week saw US shares pushed lower by increasing fears that the Fed will start to taper its quantitative easing program in December. This weighed on most global share markets and Australian shares, pushed the US dollar slightly higher and commodity prices lower. Bond yields were little affected though.
• While the “when to taper” debate continues to rage in the US, it’s looking increasingly likely that when it does commence it will be accompanied by a reduction in the unemployment threshold (currently 6.5%) below which the Fed would consider raising interest rates. Two papers prepared by Fed staffers appear to lay the groundwork for such a move effectively arguing that demand growth needs to be boosted to avoid further damage to the supply potential of the economy and that one way to do this is to lower the unemployment rate threshold. Cutting the threshold to 6% or 5.5% would suggest that the Fed Funds rate will remain near zero out to 2016 or maybe 2017. It’s highly likely these papers are consistent with the thinking of Bernanke and Yellen. As a result when the Fed starts to taper either next month or early next year, it will be paired with a reduction in the unemployment threshold. By doing this the Fed will be able to limit any upwards pressure on bond yields.
• The timing of such a move remains uncertain though with tapering still conditional on seeing stronger data. I attach a 30% probability of tapering next month, 20% chance in January, 40% chance in March and 10% for later. Most Fed officials who spoke over the last week don’t appear convinced of a December taper just yet.
• In China, Premier Li reiterated that 7 to 7.5% growth was the minimum necessary to keep unemployment down, suggesting that 7.5% may again be the growth target for next year, but he also highlighted that there is limited room for fiscal or monetary stimulus with the focus being on structural reforms to unleash growth.
• There were no surprises from the RBA which left interest rates on hold, but its quarterly Statement on Monetary Policy was a bit more dovish than expected. While the Bank acknowledged that rate cuts are helping the economy it has restated an explicit easing bias and backed this up by downwards revisions to its GDP growth forecasts,  which now see growth stuck around 2.5% out to end next year, and a slight downwards revision to its 2015 inflation forecast. The key concerns the RBA has are a faster slowing in mining investment, fiscal cutbacks and the still strong $A. These are real risks but just as the RBA was arguably too optimistic at the ‘top’ in 2011, there is now a risk that it is getting too pessimistic at the “bottom”. Our view remains that the RBA will leave the cash rate on hold ahead of eventual rate hikes starting around September/October but the near term risks are still on the downside, particularly if the $A stays high.
• On the $A, clearly the Reserve Bank is stepping up its efforts to jawbone it lower, noting that it’s “uncomfortably high” and will likely need to fall. More efforts from the RBA to try and talk the $A down are likely, but with it clearly more concerned about it than surging house prices, if talk fails it may resort to another rate cut.
• The new Australian Government’s decision not to proceed with various taxes will add to the blow out in the budget deficit. The decision to recapitalise of the RBA along with softer revenue assumptions has probably pushed the 2013-14 deficit to around $45bn. All of which is likely setting the scene for significant spending cuts.

Major global economic events and implications

• US economic data was mostly positive with the ISM non-manufacturing conditions index up in October, a leading index continuing to rise, September quarter GDP growth rising a stronger than expected at 2.8% annual rate and a Fed survey pointing to a further easing in bank lending standards. However, there were some soft areas with continued weakness in mortgage applications and the pre-shutdown downtrend in jobless claims looking like it has stalled. And the upside surprise in GDP growth was all due to a 0.8% contribution to growth from inventories. So it’s still not clear that growth is strong enough to justify monetary tapering in December.
• In Europe, the ECB rightly responded to the recent plunge in inflation by cutting its key interest rate to 0.25%. Actually they should have done this years ago, but better late than never and President Draghi’s forward guidance of low or even lower interest rates for an extended time should help keep bond yields down adding to the monetary stimulation. Economic data was positive with the final services sector October PMI revised up slightly. German industrial production fell in September but rising factory orders point to gains ahead.

Australian economic events and implications

• Australian jobs data remains very weak with trend employment now falling at 4,000 a month. While unemployment looks to have flattened out at 5.7% this is only due to a falling participation rate as discouraged job seekers give up and baby boomers are starting to retire.
• However, while the employment data is weak it’s worth bearing in mind that the labour market is a lagging indicator. This is particularly relevant now with a range of economic indicators on the improve. This was certainly evident over the past week with gains in retail sales for the fifth month in a row, a 1.9% increase in house prices in the September quarter leaving them up 7.6% year on year, gains in the AIG’s performance indicators for the services and construction sectors with the latter actually looking quite strong and indications that the ANZ job ads index is starting to stabilise after earlier falls. With forward looking indicators improving, jobs growth is likely to improve next year with the unemployment rate likely to peak around 6% before mid-year.

Major market moves

• Share markets mostly fell in response to rising expectations that the Fed will start to taper in December. US, Asian and Australian shares fell, but Eurozone shares were up very slightly.
• Taper talk also saw the $US pushed slightly higher and this weighed on commodity prices & the $A, with the latter not helped by more RBA jawboning designed to push it lower and a weaker than expected jobs report.
• Bond yields were mixed: down slightly in the US, but up in parts of Europe and Australia.

What to watch over the next week?

• In the US, a speech by Fed Chairman Ben Bernanke (Wednesday) will be watched closely for any clues as to whether it will start to taper its quantitative easing program next month and whether it will cut the unemployment threshold for raising interest rates from 6.5% to 5.5% or 6%. On the data front the shutdown is expected to have constrained October industrial production (Friday) to only a 0.1% gain, but a post shutdown bounce back in small business optimism (Tuesday) and the New York manufacturing conditions survey (Friday), are likely to point to stronger demand growth ahead. Data for the trade balance will also be released.
• Eurozone GDP for the September quarter (Friday) is likely to show growth of around 0.2% quarter on quarter as the modest recovery that commenced in the June quarter continues.
• Japanese September quarter GDP growth (Thursday) is expected to have slowed to 0.4% quarter on quarter after a couple of quarters around 1%. Leading indicators point to a rebound in the current quarter though.
• In China, the focus will be on the reaction to October economic data released over the weekend and the Third Plenum of the Chinese Communist Party which wraps up Tuesday. The Plenum occurs every 5 years but this being the first under the new leadership is widely expected to announce an aggressive reform agenda possibly covering the role of the state – with more privatisation, the financial system with a faster move to opening up the capital account and deregulating interest rates and the exchange rate, fiscal reform, land reform and the Hukou household registration rules. The new Chinese President is regarded as politically conservative and an economic liberal and appears to have a lot of support. However, only a broad outline is likely so the lack of specifics may disappoint some. Particularly so given the hype that seem to be surrounding this plenum.
• In Australia, the NAB’s business survey (Tuesday) and Westpac’s consumer sentiment survey (Wednesday) will be watched to see whether the recovery in confidence evident over the last few months is sustained. Given more upbeat news flow and the rising share market and house prices it’s likely that it will be. Housing finance data (Monday) is expected to show a bounce back after a fall in August and September quarter wages growth (Wednesday) is expected to remain soft at 2.9% year on year.

Outlook for markets

• After solid gains from early October lows and with technical and sentiment indicators a bit stretched a short term correction or consolidation in shares would not be surprising. More Fed taper talk may well be the trigger. However, the trend in shares is likely to remain up as 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 remain on track to hit 5500 or even higher by year end, with a little help from a Santa rally.
• Government bond yields are likely in a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering 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. However, dovish forward guidance from central banks is likely to ensure the rising trend in yields remains very gradual.
• Expect the $A to be buffeted in the short term between signs Australian interest rates have bottomed and stable growth in China but talk of Fed tapering and RBA jawboning. The medium term trend in the $A is likely to remain down.

By Dr Shane Oliver, Head of Investment, AMP Capital

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