Weekly market & economic update – week ending 1 August, 2014
04
Aug
2014
From Shane Oliver - AMP chief economist
Investment markets and key developments over the past week
- Global shares had a poor week with a range of issues reportedly weighing with more sanctions on Russia and worries about the Fed, earnings, Banco Espírito Santo and Argentina’s “default”. This dragged down global shares for July by 1%. While Australian shares got hit on Friday it came after a very strong month with the ASX 200 up 4.4% in July. The “risk off” move by investors weighed on the euro and $A, commodities were mixed with oil down but metals up and bond yields actually rose in the US and Australia.
- Many of the reasons reportedly unnerving investors look to reflect isolated instances rather than systemic problems, ie more like an excuse for a correction: Banco Espirito Santo’s situation is not indicative of other Eurozone banks; Argentina’s problems are well known and its “default” reflects a problem with a hedge fund rather than broader emerging market debt problems; tougher sanctions for Russia will harm it a lot more than the West with Russia unlikely to cut off gas supplies to Europe given the long term damage it will do to what is a key export earner for it; and overall US earnings reports have been very strong.
- That said, having not had a decent pullback since January/February US shares (and hence global shares) have become vulnerable to a correction and this may be it. We are also in the weakest quarter of the year for shares seasonally and worries regarding the Fed may be with us for a while yet. However, the absence of investor euphoria, reasonable valuations, easy global monetary conditions and the improving economic outlook suggest that what we are seeing is just a correction, not the start of a major bear market.
- While the Fed will remain an ongoing source of investor nervousness as the case for a rate hike gradually builds, there were no surprises from the Fed’s latest meeting. As expected the Fed announced another $US10bn cut its in quantitative easing program and it now sees less risk of too low inflation and recognises the stronger labour market. However, it still sees significant labour market slack and has not changed its assessment that the Fed Funds rate will remain in its current range for a considerable period after the end of QE. Expect to see a gradual hawkish shift over time, but no rate hike till around mid-2015.
- The justification for tax concessions in Australia – such as negative gearing, the capital gains tax discount, dividend imputation, superannuation – seems to be a hot topic these days. The often put arguments for their removal/curtailment are that the rich get the greatest advantage from them and it would help balance the Budget. Such views are frequently put by Treasury, which, according to Paul Keating, has long hated them. However, the arguments working the other way are more powerful. First, many of the tax concessions are fundamentally justified: negative gearing just allows for the legitimate costs of investing; dividend imputation removes the double taxation of dividends and puts shares on an equal footing with other Australian assets; and superannuation concessions encourage savings for retirement and helps provide patient capital. Second, that they are used so much by the rich is a reflection of Australia’s very high marginal tax rate and the fact that it cuts in at a relatively low income level. Cut the reliance on income tax for revenue and the top marginal tax rates, and the desire to minimise tax via concessions will fall. Removing or curtailing the concessions without cutting income tax rates will just reduce savings and incentive which will work against Australia’s long term growth potential.
Major global economic events and implications
- US economic data confirmed growth has rebounded. June quarter GDP growth rose at a stronger than expected 4% annualised pace after a 2.1% contraction in the March quarter, consumer confidence rose to its highest since October 2007, the Markit services sector PMI remained very strong and jobs data remains solid. However, the US economy is a long way from booming – inventory accumulation contributed 1.7 percentage points to June quarter GDP growth and housing indicators have been a bit mixed. So the recovery continues but I can understand why the Fed is a bit reticent about getting too hawkish. While employment costs rose more than expected in the June quarter, they are still up just 2% year on year which is stuck in the same range as the last few years. So not a lot of inflation pressure here.
- Meanwhile, US June quarter earnings results remain strong. 75% of the S&P 500 has now reported with 76% beating on earnings (against a norm of 63%), 66% beating on sales and earnings growth for the quarter now running around 10% year on year, which is about 5 percentage points above expectations.
- In the Eurozone, economic confidence drifted slightly higher in July consistent with ongoing economic recovery and the unemployment rate continued to drift down to 11.5%, from a high of 12%. That said inflation has fallen to a new cyclical low of just 0.4% year on year highlighting the need for easy monetary policy.
- Japanese data was mixed. Industrial production fell much more than expected in June and the unemployment rate rose slightly but against this real household spending rose more than expected in June, small business confidence rose and the ratio of job openings to applicants rose to its highest since 2002.
- China’s official manufacturing PMI rose further in July adding to confidence that growth is improving.
Australian economic events and implications
- Australian data provided a mixed but ok picture. On the downside a sharp fall in export prices saw the terms of trade resume its slide in the June quarter, resulting in an ongoing headwind to nominal growth and national income. Against this though, while building approvals fell in June, the level remains strong, new home sales rose in June, house prices continue to rise albeit at a more moderate pace than through the last half of last year, the AIG’s manufacturing PMI rose again in July and a weekly Roy Morgan survey indicated that consumer confidence continues to recover from its Budget related hit. What’s more private credit growth picked up further in June driven by a rebound in personal and business borrowing. So while the resources boom continues to fade, evidence continues to build that the economy is rebalancing towards a greater reliance on other sectors.
What to watch over the next week?
- In the US, the Fed’s loan officers survey (Monday) is expected to confirm that lending conditions are favourable, the ISM services index (Tuesday) is expected to show that services sector conditions remain solid and the trade deficit (Wednesday) is likely to be flat. Productivity growth (Friday) is expected to bounce back.
- Having just eased again two months ago the ECB (Thursday) is unlikely to make any changes, but is likely to restate its easing bias and that it is continuing to look into a quantitative easing program.
- Chinese inflation data for July (Saturday) is expected to be benign. Trade data will be released Friday.
- In Australia, as nothing much has changed over the last month the RBA at its Board meeting on Tuesday is expected to leave rates on hold and repeat that a period of interest rate stability remains prudent. Its quarterly Statement on Monetary Policy (Friday) is also likely to express a neutral inclination on rates.
- On the data front in Australia, expect to see June retail sales (Monday) bounce back 0.3% after their fall in May, the June trade balance to remain in deficit (Tuesday), labour force data to show a 10,000 gain in employment leaving unemployment unchanged at 6% and housing finance data (Friday) to show a slight bounce back.
- The Australian June half profit reporting season will start to get underway in the week ahead with 8 major companies reporting including Downer and Rio. Consensus earnings estimates for 2013-14 are for 12% growth led by resources with +28%, banks at +10% and industrials ex-financials at +3%. The combination of the lower iron ore price, the higher $A and the hit to confidence from the Budget in the June quarter suggest a bit of downside risk to consensus estimates for resource and industrial stocks, although the banks are likely to remain strong. Given relatively elevated PEs compared to a few years ago underperformers are likely to be slammed. Most interest is likely to be on outlook statements with resources companies at risk but a bit of upside potential for companies exposed to housing and non-mining construction and retailing. Consensus 2014-15 earnings growth estimates are relatively modest at +5%, with resources at 2%, banks at 4% and industrials at 10%.
Outlook for markets
- Shares have been vulnerable to a correction for a while and so the weakness seen over the last week may have a bit further go, but we continue to see little evidence suggesting we are at or near a major market top. Valuations remain reasonable, 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 which is a long way from the sort of confidence normally seen when bull markets end. Given all this, any short term dip in shares should be seen as a buying opportunity as the broad trend is likely to remain up. Our year-end target for the ASX 200 remains 5800.
- Bond yields are likely to resume their gradual rising trend over the next six months 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.
- While the 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.
By Dr Shane Oliver, Head of Investment Strategy & Chief Economist
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