• The past week has seen worries about Ukraine fade but concerns the Fed will raise rates earlier than expected take centre stage. This saw bond yields push higher, but equity markets were mixed with US shares and European shares up helped in part by better economic data and European agreement on a banking union but Asian and Australian shares generally flat to down a bit as worries about China continue to impact. The bring forward to Fed rate hike expectations pushed the $US higher against the Yen and Euro, but the $A bucked the trend moving up slightly helped by a continuing reduction in prospects for further rate cuts in Australia.
• The risks regarding Ukraine seem to be receding. Russia does not appear to be interested in moving on other parts of Ukraine, Ukraine seems to have accepted Crimea’s move to Russia and is pulling its military out of the region, US and European Union sanctions and tit for tat moves from Russia will have close to zero economic impact and comments from the Ukrainian PM appear more conciliatory towards Russia with commitments to not join NATO and to decentralise power to its regions. Key to watch now will be: any escalation in ethnic violence in east Ukraine as it could still lead to civil war and Russian intervention on the grounds of “protecting Russians”; more substantial sanctions from the US and Europe; and of course how the Ukrainian elections turn out in May. The risks are still high but I remain of the view that the crisis in Ukraine is just another distraction. It won’t derail the European or global economic recoveries or the bull market in shares.
• From taper talk to “dot plots”. Fed Chair Janet Yellen has been misinterpreted as more hawkish than she is, just like Bernanke was last year when he first raised tapering. Fed rate hikes still look a fair way off, but with the end of quantitative easing in sight, their timing will become an increasing focus for investors. There were no surprises from the Fed’s decision to continue winding down its quantitative easing program, which at the current rate means it will come to an end either in October or December. There were also no surprises with its move to drop the 6.5% unemployment threshold and replace it with a qualitative assessment that it will be appropriate to maintain the current Fed Funds rate for a considerable time after quantitative easing ends. This was all pretty dovish. Against that though, an upwards revision in the median Fed meeting participant’s rate expectations – the so-called “dot plot” – by 0.25% for end 2015 and by 0.5% for end 2016 along with Fed Chair Yellen’s comment that the first rate hike may come 6 months after QE ends led to fears of an earlier and sharper tightening by the Fed. I suspect that Janet Yellen actually meant to sound more dovish than she came across as so a move to clarify her comments from the Fed is likely in the weeks ahead. My assessment is that Fed rate hikes are still at least a year away, but as we saw with taper talk last year it will likely be a source of debate and market as the year progresses. But the key is to always keep the big picture in mind:  the Fed is only tapering and discussing when rates will start going up because the US economy is on the mend. This is a good thing, because it means stronger profits. And when rates do start going up it will be a long time before they reach levels that fundamentally threaten profit growth and the share market outlook.

Major global economic events and implications

• US data revealed more of the same with messy weather affected readings for housing starts, the NAHB’s home builders’ conditions index and existing home sales but better than expected growth in industrial production and good gains in manufacturing conditions according to surveys in the New York and Philadelphia regions consistent with a rebound in growth in the months ahead. Meanwhile the current account deficit fell to its lowest level in 16 years as a percentage of GDP helped by collapsing oil imports and inflation remained benign at just 1.6% year on year for core in February, highlighting no rush for the Fed to raise rates.
• In China, a default by a small property developer, Zhejiang Xingrun Real Estate, has added to concerns about a broader property collapse. It’s worth putting it in context though. First, the default was due to illegal activities with both the Chairman and his son being arrested and has nothing to do with property related stress. Second, in any case there have been numerous defaults from property developers in recent years. Third, fears of a mass collapse in property related businesses are overdone. The absence of a surge in house prices relative to incomes and low household debt levels suggests there is no generalised housing bubble that’s about to burst. But there are pockets of oversupply and many property developers have taken on too much debt which leaves them vulnerable as house price growth slows. So more defaults are likely amongst property developers as well as in industries with excess capacity such as cement, coal, steel, solar cells and ship building. This shouldn’t be a major problem, unless the Government keeps its foot on the brakes for too long. As China’s savings rate is huge by global standards – savings which mostly have to be recycled via debt – encouraging or allowing a deleveraging cycle would be very dangerous. I think the Chinese authorities realise this. As result, slowing growth and low inflation appears to be resulting in gradual policy easing with the Government announcing a speeding in construction activity following moves in recent weeks towards a lower Renminbi and lower interest rates. The authorities have already indicated that they will not allow defaults to become a systemic threat.
• Meanwhile under its New Urbanisation Policy, by 2020 China plans to shift another 110 million workers to cities. This amounts to about 15 million workers a year. At the same time it is gradually reforming its hukou (welfare registration system) that will transfer guest workers in cities over time from dormitory workers to full city citizens wanting everything that goes with that. This means ongoing strong growth in demand for urban property, infrastructure, consumer services, etc. Notwithstanding short term cyclical swings – like the inventory cycle now affecting iron ore demand – Chinese raw material demand is likely to remain strong long term as a result.

Australian economic events and implications

• The minutes from the last RBA Board meeting offered little that was new with the Bank repeating that “a period of stability in interest rates” remains prudent and that the $A remains “high”. The RBA’s comment that it had discussed macro prudential controls with respect to house prices sounds like nothing more than a statement of the obvious given their use in New Zealand. Apart from their obvious problems – ie they are a return to the more regulated and less successful past and some hit first home buyers hardest – it seems the RBA is not too concerned about the housing market at present seeing little sign of relaxing lending standards, no risk at present to financial system stability and little sign of speculative behaviour. Apart from the need to involve APRA which would take time I suspect that the imposition of macro prudential controls on the housing market are way off, if at all. Meanwhile, car sales rose only fractionally in February and skilled vacancies trended higher for the sixth month in a row adding to evidence that the jobs market is stabilising.

What to watch over the next week?

• Monday is PMI day, with a bounce in MNI’s Chinese business survey pointing to a bounce in China’s flash HSBC manufacturing conditions PMI, Europe’s PMIs likely to confirm ongoing economic recovery although it will be interesting to see whether the uncertainty regarding Ukraine has had any impact and the Markit PMI in the US expected to remain around a solid reading of 57.
• In the US, expect to see further gains in house prices, a fall back in new home sales after a near 10% bounce in February and a slight improvement in consumer confidence (all due Tuesday), a modest gain in durable goods orders (Wednesday) and soft weather affected pending home sales (Thursday).
• Japanese economic activity data (Friday) is likely to show continued reasonable growth albeit it is distorted by the pull forward associated with the coming GST rate hike. Inflation will likely show ongoing signs of tracking higher.
• In Australia, the RBA’s bi-annual Financial Stability Review (Wednesday) will likely reiterate that the Australian financial system remains in reasonably good shape. Speeches by Governor Stevens and Deputy Governor Lowe will also be watched for any clues regarding the outlook for interest rates.

Outlook for markets

• The combination of emerging market worries – notably China and Ukraine at present – along with growing uncertainty as to when the US Fed will start to raise interest rates are likely to ensure that 2014 will be a more volatile year for shares.  Investors should allow for the likelihood of a 10 to 15% correction at some point along the way this year. However, the broad trend in share markets is likely to remain up reflecting the combination of reasonable valuations, better 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. Our year-end target for the ASX 200 remains 5800.
• A slow rising trend in bond yields on the back of gradually improving global growth combined with low yields to start with means pretty subdued returns from government bonds. Cash and bank deposits also continue to offer pretty poor returns.
• Notwithstanding the potential for a bounce in the $A back to around $US0.95 on the back of excessive short positions, the broad trend in the $A remains down reflecting softer commodity prices, a reversion to levels that offset Australia’s high cost base and a decline in Australia’s growth relative to that in the US.

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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