• While the past week got off to a bad start after a weather affected slump in the US ISM manufacturing conditions index, mostly good economic data and earnings reports thereafter along with some settling of emerging market worries and a strong easing bias from the ECB saw shares bounce back somewhat along with bond yields.
• It’s too early to say that a full blown emerging market “crisis” has been averted. Several emerging countries remain vulnerable, the Fed is likely to continue its tapering which is a bit like a falling tide exposing who was swimming naked and emerging market growth in the years ahead is likely to be lower than we have become used to. However, investors seem to have become a bit more discriminating, emerging market currencies seems to be stabilising a bit and fears of an emerging market downturn dragging down growth in the US and Europe seem to have faded a bit.
• Our view remains that coming into this year high levels of investor confidence and last year’s strong gains had left shares vulnerable to a correction and that is what we have seen. While it may be premature to say we have seen the bottom for sure, the combination of improved valuations and more subdued investor sentiment suggest there is a good chance that we have and that the bull market in shares can resume.
• In Australia, the RBA surprised no one by leaving interest rates on hold at 2.5%. But its quarterly Statement on Monetary Policy clearly indicates it has become a bit more optimistic about the growth outlook and a bit more concerned about inflation. Reflecting this it has revised up its growth forecasts for the next 18 months by around 0.25% pa and sees headline inflation rising above 3% by June before heading back into the 2-3% target range. As a result it has dropped its easing bias in favour of a period of stability in interest rates and now seems relaxed and comfortable about the $A. Our view remains that interest rates have hit bottom and are likely to be left on hold at 2.5% ahead of rate hikes starting around September/October this year. However, I am bit concerned that the RBA has over-reacted to the higher than expected December quarter inflation reading and so has given up too early on jawboning the $A lower, as it is still too high given Australia’s cost base and the mining investment slowdown. The $A has already had a 3 cent bounce from last month’s low which could go further and take it above $US0.90 as short covering continues, in which case I suspect the RBA will at some point revert to jawboning.

Major global economic events and implications

• US economic data was a mixed bag with a weather related slump in the manufacturing conditions ISM and January auto sales helping to drive US shares down, but the Markit manufacturing PMI holding up, both the ISM and Markit services PMI’s rising and employment indicators looking okay. The Fed’s latest bank lending survey showed a further easing in lending standards and increased loan demand for most types of loans but with the exception being mortgages – hopefully lower mortgage rates will help. Overall, while US GDP growth will likely slow in the current quarter due to a weaker contribution from inventories, final demand looks okay albeit a bit distorted by bad weather. At the same time strong productivity growth and falling unit labour costs point to continued low inflationary pressures for now.
• Meanwhile the US December quarter profit reporting season remains solid. It’s now 70% complete and so far 77% of companies have beaten on earnings and 66% have beaten on sales. As a result earnings growth estimates for the quarter are now running around 9.8% which is double where they were a month ago.
• The latest Congressional Budget Office projections for the US Federal Budget point a further improvement to 3% of GDP this year and 2.6% next which is a big turnaround from 10.1% of GDP in 2010. The bad news remains that it will head back up to 4% of GDP next decade due to the aging population.
• While ECB disappointed by leaving monetary policy unchanged the extremely dovish comments from President Draghi indicate it’s very close to easing further, so expect a move next month. This could include a further incremental cut in interest rates and some form of quantitative easing.

Australian economic events and implications

• Australian data was mostly okay adding to evidence of a brightening economic outlook. To be sure a further slight fall in the AIG’s manufacturing PMI was a disappointment as was a decline in building approvals, but the former is still up from its lows and building approvals are still around previous cyclical highs. More importantly, retail sales saw their strongest annual growth rate since 2009, the AIG services PMI rose in January, the trade balance came in with a surprisingly strong surplus for the second month in a row and house prices continued to rise in January. What’s more the TD Securities Inflation Gauge was benign in January going some way to allay fears about higher inflation.
• While higher food prices helped boost December retail sales, the pick-up in momentum through the second half of last year is very positive suggesting retailing may be throwing of the malaise of the last four years.
• Likewise the return to trade surpluses is great news. While exaggerated by a surge in grain exports the combination of reduced mining capex resulting in reduced capital goods imports and rising resources export volumes from completed projects points to more trade surpluses ahead.

Major market moves

• Shares started the week badly on weather affected US data before recovering somewhat as the news flow improved.
• Bonds did the reverse with bond yields mostly rising over the last week.
• While commodity prices were mixed the $A had a good bounce as traders covered short positions after the RBA shifted its easing bias and wound down its efforts to jawbone it lower.

What to watch over the next week?

• In the US, there will be a lot of interest in Janet Yellen’s first Congressional testimony as Fed Chairman on Tuesday. Our expectation is that she will likely signal a continuation of the message Ben Bernanke has been communicating, ie that growth is gradually improving and that as long as this remains the case tapering will continue. On emerging markets she is likely to signal that the Fed is aware of the risks but at this stage doesn’t see it as a major threat. On the data front expect only a 0.1% gain in January retail sales (Thursday) and a 0.3% gain in industrial production (Friday) with bad weather being a possible drag on both.
• In the Eurozone, expect a 0.3% gain in December quarter GDP due Friday consistent with business conditions indicators pointing to continued gradual recovery.
• Chinese data for January is expected to show softish exports and imports (Wednesday), another fall in inflation to 2.4% (Friday) but a pick up in bank lending and total financing. Bear in mind though that Chinese data over the January/February period is notoriously unreliable due to the floating New Year holiday.
• In Australia, expect housing finance data (Tuesday) to show a continuing rising trend, house prices (also Tuesday) are likely to have increased 2% or so in the December quarter and a 10,000 bounce in employment is expected but not enough to stop unemployment rising to 6% (Thursday). The NAB business survey (Tuesday) and consumer confidence (Wednesday) will also be watched closely.  
• Australian December half 2013 earnings results will start to hot up with 30 major companies due to report including the Commonwealth Bank, Rio, Telstra and Qantas. 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

• Our view remains that, although returns will be more constrained and volatile, shares will nevertheless push higher this year helped by reasonable valuations, improving earnings on the back of improved economic growth and easy monetary conditions helping to entice investors to switch out of cash and bonds and into shares. Against this backdrop recent weakness having led to improved valuations and less ebullient investor sentiment provide a good buying opportunity. The ASX 200 is expected to rise to around 5800 by year end.
• The recent decline in bond yields should be seen as a correction against the background of a slow rising trend in yields on the back of gradually improving global growth. As such it provides an opportunity for investors to further lighten bond exposures. Cash and bank deposits continue to offer pretty poor returns given low interest rates.
• The broad trend in the $A remains down on the back of softer commodity prices, a reversion to levels that offset Australia’s relatively high cost base and a decline in Australia’s growth relative to that in the US. However, short positions in the $A have become excessive and so it appears to be going through another short covering rally – supported in part by the RBA’s more relaxed stance on the currency – that could see it rise to around $US0.92-93 before the 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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