• The past week saw more messy and volatile trading in share markets with some mixed economic data and corporate news in the US and intensifying concerns about Ukraine weighing on US and European shares. While the slightly less tough than expected Budget may have provided some relief for the Australian share market, overall its impact was negligible. Bond yields fell further, despite signs that US inflation looks to be bottoming. Commodity prices mostly rose slightly, but the Australian dollar was little changed. The euro remained under pressure though on increasing expectations for an ECB easing next month.
• The situation in Ukraine continues to deteriorate towards full blown civil war with no signs of a solution just yet. Whilst we remain of the view that the US and Europe will avoid getting too heavily involved in a way that threatens the global economic recovery, Ukraine nevertheless could cause volatility in markets in the near term.
• The BJP led alliance’s (almost certain) victory in the Indian election is good news for India as it should usher in a new round of economic reforms – after they have been sadly lacking over most of the last decade as evident in a now poor growth/inflation trade-off. This will likely include fiscal consolidation, cutting red tape and bureaucracy and re-starting stalled projects. A parliamentary majority may smooth the reform path, but even so in the short term it won’t be easy. And the surge in the Indian share market to relatively high valuations suggest that it could see a classic short term “sell on the fact”, having already “bought the rumour” of a BJP led Government. The new Government’s policies should be a positive for Indian assets on a long term basis though.
• In Australia, the Federal Budget proved not to be as tough as feared with new budget savings amounting to just 0.1% of GDP in 2014-15 and 0.3% in 2015-16. While most of the key measures – welfare cut backs, tax hikes for high income earners, the reintroduction of fuel excise indexation, etc – were as expected, the phased introduction of many of the spending savings along with extra spending on infrastructure mean that the tightening only builds over time. This is as it should be because front loading the savings would have seriously threatened the still fragile economy. And it would be unnecessary as for the next few years the deficit will decline anyway. Rather the budget savings on spending will kick in just when needed from 2017-18. So in terms of getting the budget deficit back under control and doing it in a way that does not threaten the economy when it is vulnerable the Budget gets a tick. So too do measures to reduce public sector inefficiency, deregulate higher education, privatise and spend more on infrastructure in terms of helping productivity.
• The risks though are clear: the household sector bears of lot of the brunt of the budget savings and this could weigh on confidence in the short term and of course some of the key Budget measures may not pass the Senate (at least without some compromise) and the next election poses a threat to many of the long term savings. An outworking of the threat to growth though via reduced confidence is that the first rate hike – which we have been anticipating for September/October – may be delayed into next year.
• New Zealand remains on track for a budget surplus in the next financial year, five years ahead of Australia on current projections, and with a top marginal tax rate of just 33% (albeit it kicks in earlier than in Australia).

Major global economic events and implications

• US data was mostly good. The key disappointments were another fall in the NAHB home builders’ conditions index and a fall in industrial production. Against this though the trend in retail sales growth remains strong, small business confidence rose and manufacturing conditions in the New York and Philadelphia regions were strong and unemployment claims fell. Inflation readings – with a stronger than expected gain in producer prices and CPI inflation bouncing up to 2% year on year from 1.5% as a distortion from a year ago dropped out – add to evidence that inflation has bottomed. Core inflation remains low at 1.8% but nevertheless debate is likely to increase over the next six months as to when the Fed will commence rate hikes and this might cause bouts of volatility in investment markets.
• Eurozone March quarter GDP data showing a softer than expected 0.2% rise taking year ended growth to 0.9% confirms that its recovery is continuing. However, the recovery remains patchy and slow, inflation remains very low at 0.7% and this plus slow bank lending and the strong euro is a concern for the ECB. Reports that the Bundesbank is ready to support various ECB easing measures excepting the purchase of sovereign bonds add to expectations for an ECB easing in June. This is likely to take the form of further rate cuts, the additional supply of liquidity and possibly the purchase of private sector asset backed securities.
• Japanese March quarter GDP at 1.5% quarter on quarter was much stronger than expected reflecting strong growth in consumption and investment, but it was distorted by the bring forward effect of the April tax hike and so it is likely to be followed by very weak growth this quarter. However, the fact that it was well above expectations is positive in suggesting underlying momentum is solid. Gains in the Economy Watchers outlook survey & April machine tool orders also provide confidence the negative impact of the tax hike will be temporary.
• Chinese April economic activity data was disappointingly soft with industrial production, fixed asset investment and retail sales all a bit slower on a year on year basis. Clearly the property sector slowdown is continuing to weigh. However, money supply growth picked up a notch and the softness in growth points to further policy fine tuning to ensure growth this year comes in around 7.5%. And we are seeing more cities ease property restrictions, now that property price momentum has faded. Expect the Renminbi to stay weak and a gradual easing in monetary conditions.

Australian economic events and implications

• >    Australian economic data told us nothing new. Business conditions remained around flat in April according to the latest NAB business survey but confidence and employment improved. New housing finance slipped slightly in March but after a 40% of so gain over the last two years it should start to top out soon (otherwise we will really have to start worrying about a bubble). Finally, the ABS home price index gained another 1.7% in the March quarter but this is down from three very strong quarters and so may represent a healthy moderation in momentum. We anticipate house price gains to continue this year but at a slower pace than seen last year.

What to watch over the next week?

• In the US, the minutes from the last Fed meeting and a speech by Fed Chair Janet Yellen (both on Wednesday) will be watched for clues on the outlook for interest rates after tapering ends, but are likely to indicate the Fed still sees that rate hikes remain a fair way off. On the data front, expect the Markit manufacturing conditions PMI (Thursday) to have remained around the solid 55 level and April data for both existing home sales (Thursday) and new home sales (Friday) are likely to show bounces.
• Eurozone business conditions PMIs (Thursday) are likely to remain around the 53-54 level consistent with continued economic recovery.
• The Bank of Japan meets Wednesday but is likely to remain on hold, awaiting more clarity on whether or not there has been any lasting impact from the sales tax hike.
• China’s flash HSBC manufacturing PMI (Thursday) is expected to remain soft at around 48.
• In Australia, the minutes from the RBA’s last Board meeting (Tuesday) will likely again confirm that the RBA sees rates remaining on hold for some time yet. Meanwhile, consumer sentiment data (Wednesday) will show household’s initial response to the Budget and it’s likely to be negative given all the noise about cutbacks and tax hikes. Wages data (also Wednesday) is likely to show that wages growth remains very weak at an annual pace of around 2.5%, which should provide further comfort to the RBA that inflation will remain contained.

Outlook for markets

• Shares remain vulnerable to a 10-15% correction around mid-year, with worries about China, worries about the risk of earlier than expected Fed rate hikes and worries about Ukraine all being potential triggers. However, any mid-year correction is likely to be in the context of a continuing upwards trend for shares. Share market fundamentals remain favourable with reasonable valuations, global earnings are improving on the back of rising economic growth and monetary conditions are set to remain easy for some time. So any dip should be seen as a buying opportunity. With the Budget proving not to be as tough as feared our year-end target for the ASX 200 remains 5800.
• Bond yields are likely to resume their gradual rising trend as it becomes clear that US inflation has bottomed and this combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.
• With $A short positions now largely unwound, it’s likely that the short covering rally in the $A, that saw it rise from a low of $US0.8660 in January, is over and that the broad downtrend is likely to resume. Commodity prices remain relatively soft and the $A is likely to revert to levels that offset Australia’s relatively high cost base.

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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