Investment markets and key developments over the past week
- Global share markets had a messy week as good economic data, earnings reports and reduced concerns regarding Banco Espirito Santo helped markets only to see them hit by worries about Ukraine, after a Malaysian Airlines flight was downed, and the Middle East, as Israel launched a ground offensive in Gaza. The geopolitical tensions saw bonds rally, oil rise and the $A fall. Australian shares proved relatively resilient though.
- Our thoughts are with those affected by the downing of MH17. I also feel very sorry for Malaysian Airlines and Malaysia generally which has lost two planes this year for reasons that look to be beyond its control.
- It is the time of year for share market corrections (with the September quarter often being soft for shares), but the fall in US and European shares in response to the news regarding Ukraine and the Middle East looks like an overreaction. The downing of the MAS plane won’t necessarily increase the risks around Ukraine, if it has been shot down its likely to have been in error anyway, airlines will simply no longer fly through eastern Ukraine with little impact on international travel and the Israeli/Palestinian crisis has been flaring up for years with no broader consequences. In some ways it is just a continuation of what we have seen all year with occasional geopolitical flare ups which simply constrain markets, but without having a major impact.
- While Fed Chair Janet Yellen’s comments about stretched share valuations in some sectors caused nervousness it’s noteworthy that she also said that in general “price equity ratios and other measures are not outside of historical norms”. Nasdaq stocks remain the main focus of valuation concerns with a PE of 35 times, but this is one third of tech boom levels. Moreover, the forward PE for the broad US share market at 15.5 times is around its long term average and remains well down on its tech boom high of 24.5.
- Should new entrants to the Australian housing market buy or rent? An RBA paper which, after allowing for the costs of owning a house versus renting, concluded that “if house price growth were to be slower than the historical average…then the average home buyer would be financially better off renting” has understandably created much discussion. After nearly two decades of above trend house price growth which has taken Australian housing from being relatively cheap to relatively expensive my assessment has for some time been that we are in for an extended period of range trading around a broadly flat trend for real house prices, which on the RBA’s analysis would point to renting as the way to go. However, I think it’s more complicated than this. First, the RBA’s analysis ignores the forced saving implicit in buying a house which will likely mean that even if house price growth turns out to be sub trend home buyers will likely end up building more wealth than renters over the long term. Second, there is more to buying a house than just a financial decision. I would much rather own than rent. Finally, there is a risk to my sub trend view of house prices if we don’t solve the housing supply shortage.
- Carbon tax no more. It’s a pity that an attempt to put a price on carbon that made sense from an environmental and economic perspective turned into such a political mess. Moving straight to an emissions trading scheme, which would have seen the price of carbon fall by two thirds, would have made more sense. But back to the here and now – just as the introduction of the carbon tax had little macro-economic impact I can’t see its demise having much impact either. It will cause a temporary fall in inflation of around 0.75 percentage points but the RBA will look through this just as it did the temporary boost to inflation in 2012-13. More broadly the sooner the Senate returns to reality – and starts finding savings to replace the Budget cuts it is threatening to reject the better.
- Dividend imputation is not a distortion. The past week saw the interim report of the Financial System Inquiry question whether dividend imputation was creating a bias to invest in domestic equities and adversely affecting the development of the corporate bond market. The trouble is that dividend imputation actually corrects a bias by removing the double taxation of earnings – once in the hands of companies and again in the hands of investors. It also encourages corporates to give decent dividends to shareholders as opposed to irrationally hoarding earnings. Interest on corporate debt never suffered from double taxation as it is paid out of pre-tax corporate earnings. The removal of dividend imputation would not only reintroduce a bias against equities but substantially cut into the retirement savings of Australian investors and lead to lower returns from Australian shares.
Major global economic events and implications
- US data provided more evidence that the pace of growth has picked up with strong underlying retail sales, strong readings for regional manufacturing conditions, okay growth in industrial production and a fall in jobless claims to their lowest since June 2007. Housing starts fell, but the decline was narrowly based and a gain in the NAHB home builders’ index points up. Meanwhile, Janet Yellen’s Congressional testimony maintained a dovish tone, still seeing plenty of slack in the economy, but she does acknowledge the upside risk to interest rates if the economy improves faster than anticipated. Our assessment remains that the first US rate hike is still a while away, but the reality is that the Fed is now in data dependent mode and as growth continues to pick up speculation about rate hikes is likely to cause volatility just as last year’s taper talk did.
- US earnings are coming in better than expected again. We are only 15% through the June quarter earnings reporting season but so far so good with 75% of results beating on earnings and 70% beating on sales.
- Chinese data confirmed that the growth slowdown seen earlier this year is over and suggests mini-stimulus efforts are working. June quarter GDP growth bounced back to 2% quarter on quarter after 1.4% in the March quarter, June growth in industrial production and fixed assets investment accelerated, retail sales growth remained strong at 12.4% and money supply and credit growth picked up. Overall, Chinese growth looks to be on track to come in “around” 7.5% this year. Over the last few years China has had a hard landing scare once a year, but it seems the latest fears regarding a hard landing will also come to nothing.
Australian economic events and implications
- In Australia, an 8.7% surge in dwelling commencements in the March quarter to a record high confirms that a home construction boom is on the way. Meanwhile, the minutes from the RBA’s last Board meeting offered little that was new. While it repeated that a period of stability is the most prudent course, its comments about the mining investment slowdown, fiscal tightening and the high $A suggest it has a slight easing bias.
What to watch over the next week?
- In the US, expect to see an elevated rise in June headline inflation (Tuesday) due to higher energy costs but core inflation remaining around 2% year on year, a modest increase in existing home sales (Tuesday) but a fall in new home sales (Thursday) after an 18.6% gain in May, continued strength in the Markit PMI for July (Thursday) and an ongoing rising trend in durable goods orders (Friday). June quarter earnings results will continue to flow with close to 100 major companies reporting.
- Eurozone business conditions PMIs for July (Thursday) are likely to be consistent with ongoing gradual recovery.
- Japan’s manufacturing PMI (Thursday) will likely show a continued recovery after the fall associated with its sales tax hike. Inflation data will also be released Friday.
- China’s HSBC manufacturing PMI (Thursday) for July is likely to show a further modest improvement to 50.8.
- In Australia, June quarter inflation data is likely to be benign leaving plenty of scope for the RBA to keep the cash rate low at 2.5%. We expect headline inflation of 0.5% quarter on quarter or 3% year on year, with underlying inflation of 0.6% quarter on quarter or 2.6% year on year. Key drivers are likely to be the ongoing increase in tobacco excise and seasonal price increases for health, offset by falls in prices for petrol and food and ongoing weak pricing power on the back of soft final demand. The RBA is unlikely to be fussed by the headline inflation rate being at the top end of the target range as it reflects the inflation surprise of the last half of last year, underlying inflation has been benign over the last six months and wage cost growth remains weak.
Outlook for markets
- Could shares have a correction? Yes. After all we are in the seasonally weak September quarter and there is no shortage of possible triggers – Ukraine is back in the headlines, the Israeli Palestinian dispute is hotting up again, civil war is continuing in Iraq and there is the potential for a Fed rates scare as the US economy continues to hot up. Are we at a major share market top? No. Valuations are not stretched, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In terms of the latter if anything there is still a lot of scepticism – about the global recovery and about financial markets – which is a long way from the sort of confidence that is normally seen when bull markets end. Given all, this any short term dip in shares should be seen as a buying opportunity.
- Bond yields are likely to resume their gradual rising trend led by increasing evidence that US growth is picking up pace. This combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.
- Although the continuing carry trade from ultra easy money in the US, Europe and Japan risks pushing the $A higher, the combination of soft commodity prices, an increasing likelihood that the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. RBA jawboning is already making a bit of a comeback.
By Dr Shane Oliver, Head of Investment Strategy & Chief Economist
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