• This may now be getting underway with share markets down slightly over the past week. There are plenty of potential triggers with ongoing worries about China and a range of events across the US and Europe that may create volatility. These include Fed Chairman Bernanke’s Jackson Hole address on Friday, the ECB’s meeting on September 6, the German constitutional court’s ruling on the validly of the ESM bailout fund on September 12, the Dutch election on September 12, the Fed’s next meeting on September 13, a decision on whether Greece continues to get funding and whether Spain and maybe Italy apply for assistance. It’s looking increasingly likely that Greece will get more time to adjust but that we may not get the full details of the ECB’s bond buying plan till mid September.
• The cancellation or delay of various marginal resource projects in Australia, such as the Olympic Dam expansion or Peak Downs, are bad news for the workers and communities directly involved but for the country as a whole should really be seen as good news. There is still a huge pipeline of resource projects yet to be completed over the next few years so the actual peak in mining investment probably won’t be seen until in 2013-14. However, it has long been known that doing all the approved and proposed projects in a relatively short period of time was not going to be possible. The delays will help spread the projects into the longer term, help take pressure of excessive costs, reduce the size of the commodity supply surge over the decade ahead thereby helping to support commodity prices and provide breathing space for other sectors of the economy such as construction, retailing, manufacturing and tourism to grow and invest probably with the help of lower interest rates. In other words the end of the mining investment boom should lead to a more balanced economy with more growth coming from the non-mining parts of the economy that have been under the screw for the last few years and from export volumes which should start to flow from the completed projects.

Major global economic releases and implications

• US data remains consistent with continued modest growth. Home sales rose in July, albeit with new home sales constrained by a lack of supply, house prices rose for the fifth month in a row and the Markit flash PMI manufacturing conditions index rose slightly to 51.9 in August. Against this jobless claims edged higher and core durable goods orders fell.
• The US Congressional Budget Office released yet another report highlighting that if the currently scheduled fiscal cutback at the start of next year is not modified it will likely knock the economy into recession. US politicians are well aware of the issues and will do something about it but probably not until after the November elections, leaving plenty of room for uncertainty in the meantime.
• The good news though is that the Fed is also aware of the problem and more importantly the minutes from its last meeting highlight that unless the economy picks up pace further monetary stimulus will be forthcoming and Fed Chairman has told Congress that he sees scope for more easing. This could take the form of extending the commitment to keep rates low into 2015, a cut to the interest rate on bank reserves, some sort of “funding for lending” operation or more asset purchases, ie QE3. Additional stimulus is almost certain to be announced at the Fed’s mid September meeting.
• Euro-zone PMI business conditions indicators were stable in August with a slight fall in services conditions offset by an improvement in manufacturing and remain at levels consistent with a mild recession. We continue to expect a 1% contraction in Euro-zone GDP this year, which is still a bit worse than consensus expectations.
• A deepening slump in Japanese exports adds to the picture of slowing global trade.
• In China, the HSBC’s flash manufacturing conditions PMI fell in August. While it remains stuck in the same range its been in since late last year its failure to improve highlights the need for more policy stimulus. It’s interesting to note the Chinese central bank has injected record funds into the money market suggesting a preference for this over rate cuts and reserve ratio cuts and three cities have announced “stimulus” packages.

Australian economic releases and implications

• In Australia the minutes from the RBA’s last board meeting and parliamentary testimony from Governor Stevens just reinforced the position that given the downside risks to global growth but with Australian growth around trend and inflation expected to be around target, the RBA is comfortable with current interest rate settings for now. We still see more rate cuts but it may not be for a few months. Its also clear from question time that Governor Stevens is rightly not keen on intervening to cap the $A at this point partly on the grounds that its not particularly overvalued and its not clear that it would have much impact.
• Data releases were mixed with skilled job vacancies softening but the Westpac/Melbourne Institute’s leading indicatory picking up in June and housing affordability continuing to see a modest recovery in the June quarter.
• The Australian June half profit reporting season is now 80% complete and the results are much better than feared and much better than was the case a few weeks ago. 33% of results have now come in better than expected which is still well down on the norm of 43%, but its up from just 22% two weeks ago and the proportion coming in worse than expected has fallen to 16% from 35% two weeks ago. Consistent with this 52% of companies have seen their share prices outperform the market on release day. 69% of companies have seen profit gains on a year ago and the biggest surprise is that outlook statements are mildly positive on balance (bottom right chart). 2011-12 earnings per share growth is likely come in around -3% which is little changed from expectations a month ago, but bottom up consensus estimates for 2012-13 profit growth have edged down by around 2 percentage points, but this is mainly due to analysts using the cover of the reporting season to revise down previously unrealistically high expectations for around 10% profit growth.
• The main themes have been expensive defensives underperforming if they deliver ok to sub-par results, but sold down cyclicals getting heavily rewarded with share price gains if they are better than feared (notably Bradken, JB HiFi, Downer EDI, Hills, AMP, Wesfarmers, Breville, Qantas). The resources sector is seeing a sharp 15% fall in profits for 2011-12 on lower commodity prices, capex spend and cost pressures, but the banks and nonfinancial industrials are seeing modest growth. So far only 18% of companies have cut dividends with 62%
  raising them, highlighting the determination of companies to maintain or raise dividends despite weaker profits.

Major market moves

• Most share markets had a pullback on worries about Chinese growth and whether policy makers in Europe would get their debt problems under control. Australian and US shares fell 0.5% and European shares fell 1.8%.
• Commodity prices were mixed with base metals and gold up on QE3 speculation, oil unchanged and the iron
  ore price continuing to fall on China worries.
• Bond yields in major countries reversed some of their recent back up, partly in response to talk of QE3
  which involves buying US bonds. Spanish and Italian bond yields continued their fall.

What to watch over the week ahead?

• In the US, the big focus for investors will be Fed Chairman Bernanke’s address to the annual gathering of central bankers in Jackson Hole to see whether he foreshadows QE3, much as he did with QE2 in 2010. Our assessment is that with recent economic readings improving a bit, he is unlikely to commit to anything specific but rather simply reiterate and maybe expand upon his assertion that there is still more that the Fed can do and that it stands ready to act if economic conditions don’t continue to improve. On the data front expect the Case-Shiller house price index to show a further modest gain in June (due Tuesday), a solid bounce back in pending home sales (Wednesday), June quarter GDP growth to be revised up to 1.9% from the 1.5% pace initially reported (Wednesday). The Fed’s Beige book (Wednesday), personal income and spending data (Thursday) and consumer sentiment data (Friday) will also be released.
• In Europe economic sentiment indicators (Thursday) will likely confirm that its recession continues.
• Chinese manufacturing conditions PMIs will be released on Friday and will likely remain subdued.
• In Australia, most interest will be on the June quarter data construction activity (Wednesday) and capital spending (Thursday) with both likely to show modest gains after the huge surge reported in the March quarter.
  The capital spending data will also be watched for any slowing in capex plans consistent with recent talk of a peak in the mining investment boom and projects delays. July Building approvals (Thursday) are expected to fall by 3%. Expect only modest gains in new home sales (Tuesday) and private credit (Friday).
• The Australian profit reporting season will wrap up with around with 35 major companies reporting including Caltex, Aristocrat, Virgin Australia, Transfield, WorleyParsons and Perpetual.

Outlook for markets

• After 10% plus gains since early June shares have become a bit overbought and vulnerable to a short term setback on the back of worries about global growth and given the range of events in the US and Europe that may create volatility in the month ahead. However, with the ECB on the brink of a major game changer, the Fed providing a win/win for the US sharemarket in that either the economy improves or it eases, further easing likely in China and shares cheap we remain of the view that shares will be higher by year end. As such any weakness over the next month or so will likely provide a good buying opportunity as the broader trend from June remains up.
• While sovereign bonds in safe countries are a good diversifier, bond yields in major countries remain
  very low and point to low medium term bond returns. Corporate debt is a better proposition for those after
  income but not willing to accept the volatility that comes with shares.
• Apart from normal volatility, the $A is likely to remain strong as global central banks undertake further
  monetary easing, commodity prices hold up and as central bank reserve diversification continues.

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• What ECB President Draghi has put on the table amounts to a major game changer for Europe in that it will effectively lever up the less than €500bn in the Euro-zone bailout funds to push Spanish and Italian bond yields down to more sustainable levels. All that has to happen is that Spain and Italy need to apply for support and sign a commitment to economic reforms and this of course is the remaining fly in the ointment as it may require a bit more pressure on their bond yields to convince them to apply given the blow to national pride. So there could still be bout of share market weakness to come out of Europe as we go through the August holiday period but the key is that help is on the way and so any weakness is likely to be a great buying opportunity.
• Chinese data was disappointing with production up “just” 9.2%, new bank lending slowing and exports up just 1%. Fortunately inflation fell to 1.8%, suggesting plenty of scope for policy easing. We expect another two 0.5% cuts in bank reserve ratios and two rate cuts in the next few months. However, the pace and quantum of easing is likely to remain modest compared to what investors would prefer. This means Chinese shares, commodity prices and resources stocks will ultimately be given a boost but could remain volatile in the next few months.
• There were no surprises from the Reserve Bank of Australia which left interest rates on hold. The RBA’s Statement on Monetary Policy made few substantive changes to its forecasts, reinforcing the impression it is comfortable with current interest rate levels balancing the more subdued global outlook with domestic growth around trend and inflation consistent with the target. Our assessment remains that with growth likely to slow a bit as the impact of Government handouts to households wears off, as unemployment rises slightly, as the $A remains strong and as inflation remains low the RBA will cut rates again, but it may not be for several months.
• The RBA’s Statement particularly highlighted that it is keeping a close eye on the strong $A as a risk, observing that part of its strength may reflect safe haven demand and that it may exert a more contractionary impact on the economy and inflation than historical relationships suggest. Our assessment for some time is that the $A is a lot more contractionary than the RBA has been allowing. At this stage the RBA may just be contemplating what to do rather than signalling imminent action. Given that the divergence in the $A from fundamentals is likely relatively modest, our assessment is that it is too early to contemplate intervention to push the $A down and we remain of the view that a better approach would be to cut interest rates further in order to take some of the pressure off the $A. Time will tell, but either move would be a dampener for the $A.

Major global economic releases and implications

• US data releases were positive. Consumer credit increased, job openings rose and weekly jobless claims fell, productivity growth picked up, a survey of bank lending officers showed a modest easing in lending standards and a pickup in demand for mortgages and better June trade data points to an upward revision to June quarter GDP growth to around 2%. With the US earnings reporting season now 90% complete the number of companies surprising on the upside has remained solid at around 68% and corporate guidance has become less negative.
• Euro-zone data stayed soft with falls in industrial production and German factory orders. June quarter earnings reports have seen 57% of companies better expectations which makes it a reasonably good reporting season.
• Japanese data was mixed with a fall in leading indicators and confidence, but gains in machine orders and bank lending. The Bank of Japan left monetary policy on hold leaving little hope it will meet its 1% inflation objective.

Australian economic releases and implications

• Australian data releases were mixed. Jobs growth was stronger than expected and housing finance had a rise suggesting rate cuts are starting to help. Against this it’s hard to describe the labour market as strong as jobs growth is not keeping up with growth in the working age population and leading labour market indicators remain soft. On top of this the AIG’s construction sector activity index weakened further in July. Meanwhile the TD/Melbourne Institute Inflation Gauge rose only marginally in July suggesting that the impact of the carbon tax on inflation has been much less than expected, so far at least. Underlying inflation remained very benign at 1.4% year on year. The bottom line is that mixed economic data and benign inflation are keeping the prospect of a further cut in interest rates alive even though the RBA is comfortable about current settings right now.
• The profit reporting season in Australia is off to a poor start with 34% of results so far coming in worse than expected and just 22% coming in better, against a norm of around 43%. The disappointment has been reflected in share price reactions with 65% of companies seeing their share prices fall relative to the market on the day they reported. Defensives are proving particularly vulnerable, having run hard their share prices are now vulnerable even when they deliver good earnings as was seen with Telstra. By contrast sold down cyclicals are prone to see their share prices surge if they can deliver in line or better results as we saw with Bradken.

Major market moves

• Share markets rose as investors took a more positive view of the ECB’s plan to buy bonds, US economic data was generally positive and expectations of Chinese easing strengthened. US shares rose 1.1%, European shares 1.6% and Australian shares 1.3%.
• Commodity prices rose & the $A was little changed despite weak Chinese data & fears of RBA intervention.
• Bond yields backed up in the US, Japan, Germany, the UK and Australia as safe haven demand abated.

What to watch over the week ahead?

• In the US, expect a modest bounce in retail sales (Tuesday), 0.5% growth in industrial production (Wednesday), an unchanged reading in a survey of home builders after a strong rise in July (Wednesday) and a slight fall in housing starts after a huge surge in June (Thursday).
• Euro-zone June quarter GDP (Tuesday) is expected to contract by 0.25% confirming an ongoing recession.
• In Australia expect sub-par readings in business conditions and confidence in the NAB survey (Tuesday), a modest rise in consumer sentiment and a 0.9% rise in June quarter wages (both Wednesday).
• The Australian June half profit reporting season will hot up with 45 major companies due to report including James Hardie, JB HiFi, Newcrest, CBA, AMP, ASX, Brambles, QBE and Wesfarmers. Results are expected to be weak on the back of falling commodity prices, the strong $A, cost pressures and poor domestic demand. The risks are on the downside to consensus expectations for a 1% fall in earnings for 2011-12. Resources stocks are likely to fare the worst with a 15% fall in profits under the weight of falling commodity prices at a time of cost pressures associated with massive investment programs. Financials and industrials will likely have modest positive profit growth of around 3 to 4%. Key things to watch are dividends and outlook statements with consensus expectations for 9% profit growth in 2012-13 likely to remain at risk.

Outlook for markets

• After a period of strong gains, shares have become a bit overbought and vulnerable to a short term setback on implementation delays for the ECB’s plan and worries about poor economic data in Europe, the US and China as we approach the seasonally weak month of September. However, with the ECB on the brink of a major game changer, the Fed set for further easing if needed, further easing likely in China and shares cheap we remain of the view that shares will be higher by year end. As such any weakness over the next month or so will likely provide a good buying opportunity as the broader trend from June remains up.
• While sovereign bonds in safe countries are a good diversifier, bond yields in major countries around record lows suggest very low medium term bond returns. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
• Apart from normal volatility, the $A is likely to remain strong as global central banks undertake further monetary easing, commodity prices hold up and as central bank reserve diversification continues.

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