• Emerging market worries and no signs that the Fed is too concerned as it announced a further tapering of its monetary stimulus program saw share markets remain under pressure over the last week with bonds benefitting from safe haven demand.
• Our assessment remains that last year’s strong gains and high levels of investor confidence had left share markets vulnerable to a correction and that emerging world worries helped provide the trigger. There are several points to note. First, the emerging market (EM) problems are consistent with a longer term deterioration in their relative outlook that reflects a combination of slowing productivity growth and political problems. The Fed’s taper has merely helped expose these problems rather than cause them.
• Second, while emerging country growth is likely to be slower than we have become used to – with rising interest rates in several countries not helping – a plunge into a 1997-98 style emerging market recession seems unlikely: much of the emerging world is in better shape than back then with less reliance on debt, current account surpluses, lower inflation and floating exchange rates. What’s more while its still a time to be cautious on emerging markets generally, some do offer good value – particularly the surplus countries like Korea and China.
• Thirdly, a downturn in the emerging world is unlikely to have a major impact on advanced countries. Historically EM crisis have not had a big impact on advanced countries, eg the Mexican crisis of 1994-95 had little impact on the US and nor did the 1997-98 Asian-emerging market crisis.
• For Australia, the key remains China and its growth outlook hasn’t changed that much, but the broader problems in the emerging world provide a reminder that growth in commodity demand in the years won’t be what we have become used to. Which all points to the need for continued low interest rates and a lower $A.
• Once the share market correction has run its course and investor sentiment readings have fallen back to less exuberant levels the bull market in shares is likely to resume.
• With January seeing share market falls of around 3%, its worth having a look at the so called January barometer again. This basically says that “as goes January for shares, so goes the year”, but its track record is messy. For the US S&P 500 there have been 22 positive Januarys since 1980 of which 19 saw positive years, indicating an 86% hit rate. But the hit rate for negative Januarys (of which there were 12 going on to negative years was only 42%. It’s the same for Australia – since 1980 there have been 20 positive Januarys for the All Ords index of which 15 saw positive years, giving a hit rate of 75%. But of the 14 negative Januarys since 1980 only 5 saw negative years resulting in a hit rate of 36%. The bottom line is that while a positive January augurs well for the rest of the year, the fact that January has been negative doesn’t tell us much at all. In both Australia and the US, January’s in 2003 and 2009 saw shares fall but both years had solid returns.
• Finally, the news wasn’t all bad over the last week with confirmation that US growth has picked up, strong US earnings results, a further rise in European confidence measures, more solid Japanese data including a further rise in inflation and a good pick up in Australian business conditions in December. So despite the emerging market woes and a rough patch in shares, the world is in reasonable shape.

Major global economic events and implications

• The Fed provided no surprises with another $US10bn reduction in its QE program and ongoing assurances that further tapering is data dependent and that rates will remain near zero for a long time. The Fed’s failure to mention the issues in the emerging world probably suggests it does not see it as a big problem.
• US economic data remained good. Home sales and durable goods orders fell but the first was affected by bad weather and the latter was distorted by aircraft orders. Meanwhile consumer confidence and house prices rose solidly and December quarter GDP growth was a solid 3.2% annualised with the highlight being strong growth in consumer spending and business investment. The overall impression is that US growth has picked up pace.
• US December quarter earnings continue to improve with now 80% of results beating earnings expectations and 66% exceeding sales expectations. It now looks like quite a good reporting season.
• Eurozone money supply and lending growth remained weak highlighting the case for more ECB stimulus, but against this bank lending standards eased a bit and consumer and business confidence continue to improve.
• Japanese data for December saw more evidence that Abenomics is working with strong household spending, lower unemployment, the jobs to applicant ratio at a new 6 year high, industrial production growing at 7.3% and a further rise in headline inflation to 1.6% year on year and 0.7% in terms of the core.
• A possible crisis of confidence in China’s wealth management funds was averted when investors in a fund that invested in a failed coal venture were bailed out. While concern may linger regarding such funds, this one was complicated by fraud so may be a special case. The fund’s name “Credit Equals Gold #1”!
• Finally, strong and better than expected growth data from Korea, Taiwan and the Philippines highlighted that many Asian countries are in good shape and a long way from any sort of Asian-emerging market crisis.

Australian economic events and implications

• Australian data was reasonable. Skilled job vacancies slipped in December and the Westpac leading indicator showed only weak growth. But against this business conditions improved solidly in December, new home sales held on to held on to the bulk of a big November gain and remain in a strong uptrend and credit growth picked up a notch. Finally producer price inflation remained benign at 0.2% month on month or 1.9% year on year.

Major market moves

• Share markets had another difficult weak as emerging market concerns lingered.
• Bond yields were flat to down helped by safe haven demand. Yields particularly fell in Spain and Italy, highlighting that they are well and truly off the radar screen as investor concerns.
• Commodity prices were mostly softer, but the $A had a bit of a bounce after the previous week’s fall.

What to watch over the next week?

• In the US, the big focus will be on the January payrolls report due Friday which is expected to show a recovery from December’s weather affected gain of just 74,000 jobs. Expect payrolls to gain 190,000 with unemployment remaining at 6.7%. In other data expect a slight fall back in the ISM manufacturing conditions index (Monday) to a still strong reading of 56 and a slight bounce in the services conditions ISM (Wednesday).
• In Europe, both the Bank of England and the ECB are likely to leave monetary policy unchanged on Thursday, but the ECB is likely to signal it retains an easing bias.
• In Australia, the Reserve Bank is expected to leave interest rates on hold for the fifth meeting in a row on Tuesday. Interest rates have already been cut to record lows, evidence continues to build that rate cuts are getting traction – with housing construction indicators up strongly, retail sales improving and consumer and business confidence up from their lows, the $A has continued to fall and inflation is running slightly higher than expected. While problems in the emerging world pose a threat it’s way too early to respond to this. Our assessment remains that the RBA would prefer to wait for the full impact of past rate cuts to flow through and is now more focussed on achieving and maintaining a lower level for the $A.  On the data front expect the trend in building approvals, house prices (both Monday) and retail sales (Thursday) to remain up in December.
• Australian December half 2013 earnings results will also start to flow. Consensus expectations are for 14% earnings growth in 2013-14 led by 35% growth in resources profits on the back of the lower $A and reduced capex and 8% growth for industrials, so earnings results should show signs of this turnaround starting to come through. Key themes are likely to be the benefits of the lower $A for miners and offshore earnings, early and tentative signs of top line revenue improvement, ongoing focus on cost control and solid dividend growth.

Outlook for markets

• Despite a poor start to the year, global shares are likely to push higher this year helped by reasonable valuations, improving earnings on the back of the global economic recovery and easy monetary conditions helping to entice investors to switch out of cash and bonds and into shares. However, with shares no longer dirt cheap returns are likely to be a bit more constrained and volatile, and the current correction could go a bit further until investor confidence readings fall back a bit more.
• Despite a likely more volatile ride, Australian shares are expected to perform well as profits pick up and interest rates remain low. The ASX 200 is expected to rise to around 5800 by year end.
• Government bond yields are likely to continue their gradual upward trend as global growth improves and investors switch to risky assets. Cash and bank deposits offer pretty poor returns given low interest rates.
• The $A looks messy with Fed tapering, China/emerging market uncertainties and RBA jawboning all working against it right now. The break below December’s low of $US0.8820 also points lower – down to around $US0.85. The $A is likely ultimately on its way to around $US0.80 over the next few years.

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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