Investment markets and key developments over the past week
Shares got a strong boost from the ECB signalling further monetary easing ahead and from some better earnings reports in the US. As a result most share markets rose over the past week. While bond yields were little changed in the US and Australia they fell sharply in the Eurozone on the prospect of more ECB quantitative easing. Commodity prices fell slightly as the $US rose & this drove a slight fall in the value of the $A.
The ECB looks to be replacing the Fed as investors’ best friend. As expected the ECB left its quantitative easing program unchanged, but ECB President Draghi signalled further easing in December unless the risks to the outlook fade. While Eurozone growth is heading in the right direction it’s still slow with inflation way below target and it remains vulnerable to weaker emerging market growth. Further easing is likely to take the form of an extension of its quantitative easing program beyond September next year and another cut in the rate of interest banks “receive” on deposits they have with the ECB, eg from -0.2% to -0.3%. The ECB’s strong easing bias is very supportive of Eurozone shares, but because it puts downwards pressure on the value of the euro it adds to pressure on the Bank of Japan to consider further easing and on the Fed to further delay rate hikes.
There is still a way to go for the US to avoid another debt ceiling/shutdown crisis. The debt ceiling will be reached early next month and finance for spending is only approved out to December 11. But with former vice presidential candidate Paul Ryan looking like he will be the next House Speaker, after securing support from “conservative” House Republicans, the risk of a crisis is now quite low. Ryan is in favour of increasing the debt ceiling and understands the negative impact that would flow from a default or shutdown. There could still be short term uncertainty though as there may still be a bit of brinkmanship and there is some chance that the debt ceiling might be suspended into December until another spending deal is worked out with President Obama (like the two year deal Ryan achieved in 2013).
The moves by the Commonwealth Bank & the National Australia Bank to hike their variable mortgage rates, following Westpac, add further pressure on the RBA to cut its official cash rate to offset the flow on to households with mortgages. While the RBA looks like it doesn’t want to have to cut interest rates again, it won’t want to see households with a mortgage paying higher rates just now either given the risk this will pose to consumer spending at a time when economic growth is still weak. So we remain of the view that the RBA should and ultimately will cut rates again to ensure that this does not happen. We have pencilled in the November meeting for a cut, but the RBA may need more convincing and so there is a risk it could be delayed into early next year.
While the Australian economy is doing a lot better than many have feared there are five reasons why the RBA will likely cut rates again: to stop big bank mortgage rate increases flowing to households with mortgages; the contribution to growth from home construction will likely peak next year; the non-mining capital spending outlook remains poor; El Nino related drought risks pose an additional threat to growth next year; and the $A is at risk of drifting back higher if the Fed continues to delay rate hikes.
Another El Nino on the way. Over the years I have heard so many false warnings about a new El Nino weather phenomenon that I am sceptical about getting too worried about it. However, the latest indications are getting more concerning. An El Nino sees trade winds that normally blow across the Pacific to the west weaken or reverse causing more rain in the east Pacific and less rain/drought in the west, ie Asia and Australia. It is commonly measured by the Southern Oscillation Index which measures sea surface pressures across the Pacific and it is now approaching levels seen around the last major El Nino of 1997-98 and so warning of drought in Asia and the east coast of Australia, pointing to lower farm production and higher food prices. For Australia, the link from El Nino to farm production varies, eg farm production was little effected by the severe 1997-98 El Nino but was more affected by weaker El Nino’s last decade. And swings in farm production don’t have the impact they used to on the economy as it is now only just above 2% of GDP. That said a severe El Nino drought induced slump in Australian farm production at a time when growth is already sub-par due to the unwind of the mining investment boom would not be good. For example a 20% slump in far production (which is what occurred in the 1982-83 severe El Nino would knock around 0.45 percentage points off GDP growth. While food prices may see some upwards pressure, the hit to growth would likely dominate the RBA’s thinking and so is another reason why the RBA is likely to be under pressure to cut interest rates further. An El Nino could be good news for soft commodity price indexes though, particularly for wheat.
Major global economic events and implications
While there are concerns that US economic growth may be losing some momentum, housing related indicators remain strong with housing starts and existing home sales up solidly in September and further strength in the NAHB home builders’ conditions index pointing to more gains ahead. Home construction remains well below long term averages in the US and with household formation rising is likely to be a solid contributor to US growth going forward. Meanwhile US September quarter earnings results came in a bit better over the last week with impressive results from Dow Chemical, McDonalds, eBay, Google and Amazon. Of the 33% of S&P 500 companies to have reported so far 75% have beaten earnings expectations but only 45% have beaten on revenue. Fortunately the big drags on US earnings over the last year from the collapse in the oil price and the surge in the $US have faded.
The ECB’s latest bank lending survey pointed to a further recovery in credit demand and easing in lending standards which is a positive sign for growth but clearly not enough to ease the ECB’s concerns.
Chinese economic data was mixed with September quarter GDP growth coming in slightly better than expected at 6.9% year on year and retail sales growth showing a further improvement but industrial production and investment slowing further. The weakness in industrial production likely reflects Beijing area event shutdowns and more broadly the GDP data, helped by strength in retail sales and services sector activity, suggest growth may be stabilising. Improving credit growth, a gain in the MNI China business sentiment index and further gains in home prices in September are consistent with a stabilisation in Chinese growth. Chinese hard landing risks appear to be receding but then again it’s hard to see a strong growth rebound either.
Australian economic events and implications
The minutes from the RBA’s last meeting added nothing new and confirmed that the RBA was content with current interest rate settings. However, with the big banks hiking their variable mortgage rates, resulting in a de facto monetary tightening, the minutes are now a bit dated. Economic data was light on over the last week but it painted a mixed picture with another strong reading for skilled vacancies but a slight fall in weekly consumer confidence and a soft Westpac leading index.
What to watch over the next week?
Globally the focus will return to the Fed which meets on Wednesday, but is expected yet again to leave interest rates on hold. While financial markets have improved since the last meeting, US economic data has been mixed suggesting that underlying US growth may have slowed a touch and uncertainties regarding growth in emerging countries remain. It’s doubtful that conditions will have improved enough to warrant a first rate hike by the Fed’s December meeting and the probability of such a move is now below 50%, but the Fed will likely signal that it remains hopeful of a move by year end.
On the data front in the US, expect September quarter GDP growth (Wednesday) to have slowed to 1.7% annualised from 3.9% in the June quarter. While the slowing is mainly due to negative contributions from inventories and trade it will highlight the fragile and constrained nature of US growth at present. In terms of other data expect to see a fall back in new home sales (Monday), flat September core durable goods orders, a modest rise in home prices, a slight fall in consumer confidence (all due Tuesday), a rebound in pending home sales (Thursday) and continued softness in the core private consumption deflator and employment cost index (Friday).
In the Eurozone, expect economic confidence measures to remain reasonably solid but inflation for October to have remained around zero (all Thursday).
The Bank of Japan meets Friday and is expected to leave monetary policy unchanged. However, another October surprise easing like last year’s is possible. Meanwhile industrial production data will be released Thursday and data for inflation and jobs on Friday.
In China, the Fifth Plenum of the 18th Chinese Communist Party Congress (starting Monday) will be watched for a downwards revision in the growth target for the next five years from 7% to 6.5% and for further economic reforms.
In Australia the main focus will be September quarter inflation data (Wednesday) which is expected to show a 0.6% quarter on quarter rise driven by higher prices for imported items including travel costs (from the lower $A), housing construction and tobacco, only partly offset by falls in petrol and electricity prices. However, inflation is likely to remain low at 1.6% year on year with underlying inflation measures remaining benign at 0.5% qoq and 2.4% yoy. September quarter goods exports prices (Thursday) are likely remain weak pointing to a further fall in the terms of trade, September quarter producer price inflation is likely to remain low and credit growth (both Friday) is likely to remain moderate and show a further softening in lending to investors.
Outlook for markets
So far October is living up to its reputation as a “bear killer” month. While we could see a bit of a pause in November, markets are likely to see the normal “Santa Claus” rally into year end and the broad trend in shares is likely to remain up. Shares are cheap relative to bonds; monetary conditions are set to remain easy; this in turn should help see the global economic recovery continue; and investor sentiment remains negative such that it’s actually positive from a contrarian perspective. As such, share markets are likely resuming a broad rising trend. This includes the Australian share market, where we continue to see the ASX 200 rising to around 5500 by year end.
Low bond yields point to soft medium term returns from bonds, although government bonds remain a great portfolio diversifier.
In the short term, the $A could bounce a bit higher, particularly if the Fed continues to delay and if the RBA fails to cut or signal a cut next month. However, the broad trend is likely to remain down as the Fed is still likely to raise interest rates sometime in the next six months whereas the RBA is more likely to cut rates again and the trend in commodity prices remains down. This is expected to see the $A fall to $US0.60 in the next year or so.