Weekly market & economic update – week ending 24 October, 2014
27
Oct
2014
From Shane Oliver - AMP chief economist
Investment markets and key developments over the past week
- Share markets continue to recover from their recent falls helped by a combination of good earnings news in the US, better than expected economic data in Europe, China and Japan and as the ECB started up its quantitative easing program with indications that it might be widened. Global and Australian share markets have roughly recovered half the fall they saw in the correction, with the Australian share market also being helped by investors taking advantage of 6% grossed up dividend yields. Bond yields were flat to up slightly over the past week, commodity prices were mixed with oil flat but metals up and the $A was little changed.
- Events in Canada provided a reminder of the terror threat posed to countries participating in the efforts to combat IS. (A colleague has pointed out that the term “Islamic State” should be avoided in referring to the Insurgent Savagery currently threatening Iraq, Syria and beyond as it defames one of the world’s great religions – he’s right, so I won’t).Terrorist attacks are horrible in terms of their human consequences and there is no doubt that IS related terrorist attacks in western countries will be taken badly initially by share markets, as we saw with the 1.5% dip in Canadian shares after the attack in Ottawa. But the experience with various Al-Qaida related attacks last decade is worth recalling: after an initial negative impact share markets bounced back as it was clear that there would not be a major economic impact and it seemed the effect on markets weakened as the terror threat continued. It only took just over a month for the US share market to recover from its 12% post 9/11 slump and it took the UK share market 1 day to bounce back from its 1.3% fall on the day of the July 2005 London bombings.
- The wall of worry (global growth, deflation risks, end to US QE3, the IS terror threat, HK protests, Ukraine, Ebola, etc) remains for investors but there were some positives in the last week: manufacturing conditions PMIs unexpectedly rose in the Eurozone, Japan and China; the ECB has now started its quantitative easing program and looks to be thinking about expanding it to include corporate bonds which would allay any concerns that it may not be big enough to have a meaningful impact; and Nigeria was declared Ebola free after earlier being seen as the next country at risk in Africa – if they can contain it the West should be able to too.
Major global economic events and implications
- US economic data was mostly favourable. While the Markit manufacturing conditions PMI cooled it remains strong at 56.2, jobless claims continue to trend down, leading indicators rose and home sales are trending up. What’s more, continued low CPI inflation of just 1.7% leaves the Fed with plenty of flexibility on interest rates.
- Of greater interest for investors, September quarter earnings continue to impress. So far 192 S&P 500 companies have reported of which 79% have beaten earnings expectations (compared to a norm of 63%) and 61% have beaten on sales. Earnings growth looks likely to have come in around 10%, compared to market expectations for a 6% gain. Sales growth is running around 5% year on year.
- The Eurozone saw some good news on the economic front with unexpected gains, albeit modest, in manufacturing and composite business conditions PMIs for October. This suggests growth continues. That said, it’s still slow and with the risk of deflation the ECB will need to ramp up its quantitative easing program.
- Japan’s manufacturing conditions PMI rose in October suggesting the recovery from the sales tax hike inspired slump earlier this year is continuing.
- Chinese data remains relatively steady. September quarter GDP growth came in at 7.3% year on year, down from 7.5% in the June quarter but slightly stronger than expected. While retail sales slowed to 11.6% this was probably due to lower inflation and growth in industrial production accelerated to 8%. Growth in investment was little changed with slower property investment being offset by strength in manufacturing and infrastructure. Meanwhile the flash HSBC PMI for October improved slightly. While the property sector will remain a drag on growth various mini-stimulus measures already announced and likely more to come should be enough to see growth this year come in “around 7.5%”. No boom, but not bust either.
Australian economic events and implications
- Benign inflation supports the case for rates to remain low. The September quarter saw a broad based fall in inflation in with headline inflation falling to 2.3% year on year. While price rises in government related sectors remain the main driving force of inflation, inflation in market related sectors fell to just 1.8% year on year. The September quarter saw price weakness in areas like clothing (-2.7% year on year), furnishings and household equipment & services (+0.4% year on year), transport (+0.2% year on year) and communications (-1.8% year on year). Subdued wages growth and falling commodity prices suggest that inflation will remain. So no pressure for a rate hike here. The message from the Minutes from the last RBA Board meeting and various speeches from RBA officials remains unchanged: rates are on hold, the $A remains too high and measures to slow bank loans to investors are being considered by the RBA and APRA.
What to watch over the next week?
- First up will be the market reaction to the ECB’s Asset Quality Review and Stress Tests to be released Sunday (9pm Sydney time). This will assess the adequacy of 130 Eurozone banks’ capital levels against both baseline and adverse scenarios and those that fail will be given 6 to 9 months to boost their capital ratios. Some failures are likely but mainly for technical reasons (ie before allowance is made for 2014 capital raisings) and mainly amongst unlisted and mutual banks, but not many of the major listed banks are likely to fail given pre-emptive capital raisings (€75bn since 2013) and conservative lending practices in the lead up to this review. In fact, just as occurred with the Fed’s stress test of US banks in 2009 it could prove to be a watershed event that helps restore confidence in Eurozone banks and clears the way for more bank lending
- In the US, all eyes will be on the Fed (Wednesday) which is expected to end the final $US15bn of QE3 it is doing each month. There is a chance that the fall in US inflation expectations will prompt the Fed to just taper by $US10bn leaving QE alive at $US5bn a month. However, in the absence of more bad global news or market turmoil ahead of the meeting we would only attach a 40% probability to this. That said, the Fed is likely to restate that a “considerable time” is expected to elapse before it starts to raise interest rates and indicate that it will allow for the impact of softer global growth, the impact of a stronger $US in holding US inflation down and the recent fall in inflation expectations which will likely serve to reinforce market expectations that the first Fed rate hike won’t come till late 2015. It may also indicate that it will ramp up QE again if needed.
- Meanwhile September quarter US GDP data (Thursday) is likely to show that growth slipped back to a 2.9% pace, which is good but not booming after just 1.3% growth in the first half. Expect reasonable growth in pending home sales (Monday) and durable goods orders (Tuesday) along with solid consumer confidence (also Tuesday). The Fed’s preferred inflation indicator (Friday) is likely to remain around 1.5% year on year, leaving plenty of scope for the Fed to keep rates down. More than 100 US S&P 500 companies will report Q3 earnings.
- In Japan, industrial production for September ((Wednesday) will be watched for a rebound after August weakness and data for household spending, unemployment and inflation will be released Friday.
- China’s official manufacturing conditions PMI for October (November 1st) will likely be little changed.
- In Australia, expect trade prices (Thursday) to show a further decline in the terms of trade, September quarter producer price inflation (Friday) to remain benign and private credit growth (also Friday) to remain moderate. The main focus in the credit stats will be on housing credit, in particular whether growth credit to investors in housing shows any signs of moderating given RBA concerns.
Outlook for markets
- Our assessment remains that the roughly 10% top to bottom fall in share markets seen from September highs to recent lows represents a correction and not the start of a new bear market. A retest of the lows cannot be ruled out but the cyclical bull market most likely remains intact. The correction pushed share valuations well into cheap territory, the global growth outlook remains for okay growth (“not too hot, but not too cold”), monetary conditions globally and in Australia look like they will remain very easy with Europe and Japan filling the quantitative easing gap that will be left by the US and US rate hikes looking even further away and investor sentiment remains very bearish which is positive from a contrarian perspective. October is often a month where market falls come to an end ahead of a Santa Claus rally into year end and I expect to see the same happen this year. The winding up of ECB QE, getting the ECB’s bank stress tests out of the way and US November 4 mid-term elections which look like seeing the Republicans take both the House and the Senate are likely to help.
- Low bond yields will likely mean soft medium term returns from government bonds. That said, in a world of too much saving, spare capacity and low inflation it’s hard to get too bearish on bonds.
- To its recent low of $US0.8640 the $A fell a bit too far too fast (just as the $US has risen too far to fast), so a short covering bounce has been underway and could go further. That said the broad trend in the $A is likely to remain down reflecting soft commodity prices, the likelihood the Fed hikes interest rates before the RBA and the relatively high cost base in Australia. Expect to see it fall to around $US0.80 in the next year or so.
By Dr Shane Oliver, Head of Investment Strategy & Chief Economist
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