Modi’s anti-free-market stance in by passing pro-business measures to revive India’s stalled industrialisation.

India’s new Prime Minister Narendra Modi had only been in power three months before he did an estimated $1 trillion worth of damage to the global economy. In Bali in August of this year, India’s 15^th prime minister sank the biggest deal the 160-member World Trade Organisation has ever nearly reached in its 19-year history. Modi reneged on a global agreement approved by his predecessor that would have reduced the cost of moving goods through the world’s ports. His motive was to indefinitely protect subsidies that lower food prices for about 800 million of India’s 1.25 billion citizens.

While the domestic political motive of India’s first prime minister born after independence in 1947 was stark, Modi’s sabotage of one of the least-contentious aims of the almost-dead Doha round of WTO negotiations was a surprise. For it clashed with the promises of free-market reforms Modi used to propel his Bharatiya Janata Party to victory in elections in May after 10 years in opposition. The BJP’s triumph was so sweeping the right-wing party gained India’s first lower-house majority in 30 years.

Thankfully for investors, the aberration is likely to be Modi’s anti-free-market stance in Bali. And by passing pro-business measures to revive India’s stalled industrialisation, the 64-year-old former chief minister of western Gujarat province could well repair some of the damage he has done to the world economy. The Hindu-favouring BJP’s rare majority in India’s lower house gives Modi the ability to compensate for China’s diminishing role as a driver of global growth. For with a little more government help, India’s economy can achieve a rate of growth that exceeds China’s – say, India’s could top 7% while China’s sinks below this level. Such an outcome would be a rare feat, for only once since New Delhi implemented market-based reforms in 1991 has India’s economy expanded at a faster annual pace than China’s. That was in 1999 when India outgrew China by 1.2 percentage points; 8.8% versus 7.6%. The average annual gap in growth over the past 23 years is 3.4% percentage points in China’s favour – 9.1% average annual growth for China against 5.7% for India.

Modi has taken control of India at a time when it has much catching up to do compared with China mainly because India gave China a 13-year start at reform. India, almost ironically, last had a higher GDP-per-capita than China in 1990, the year before the IMF helped India navigate a balance-of-payments and currency crisis on condition the country modernised. (US$395 output per person India versus US$341 for each Chinese). After more than two decades of better performance, China’s GDP-per-head is now more than four times that of India’s (US$6,747 for China versus US$1,505 to India in 2013), which means, as they have roughly the same population, that China’s economy is more than four times larger than India’s – China’s 1.36 billion people created US$9.2 trillion in output in 2013 versus US$1.9 trillion produced by Indians. (The size difference means India’s economy needs a rate of growth four times faster than China’s to contribute the same amount to global GDP growth.)

Much could disrupt a Modi-led rejuvenation of India, of course, for the country’s challenges are vast. The flipside to India’s ascent over its northern neighbour in terms of the pace of growth is China’s economic descent as it confronts the consequences of the lending boom that Beijing engineered to protect the country during the global financial crisis. So perhaps Modi won’t need to be too much of a star for India to outpace its neighbour. Much of the credit for any improved showing by India would be due to the Reserve Bank of India under Governor Raghuram Rajan, if the central bank were to win its battle against inflation, now down to a five-year low of 6.5%. But whoever Modi would deserve to share any acclaim with, the more pertinent fact for investors is that India’s policymakers are helping unleash, once again, the entrepreneurship of the world’s largest liberal democracy.

Modi’s mojo

India achieved praiseworthy economic growth after reforms were enacted from 1991, even if the pace of growth undershot China’s. But the economy has spluttered in recent years. Economic growth slowed from an average of 8.5% from 2009 to 2011 to less than 5% in 2012 and 2013 as corruption scandals tore at the minority government led by Manmohan Singh of the Indian National Congress party.

The resulting political paralysis and reform setbacks battered foreign and local confidence in a country where inflation is the highest among Asia’s major economies. India’s stock benchmark, the S&P BSE Sensex Index, only rose 3% over 2011, 2012 and 2013 as investors held back their money (compared with, say, the S&P 500 Index’s 47% gain over those three years). The rupee sagged to a record low of 62.62 to the US dollar on 30 September 2013 while foreign investment stagnated.[1] Amid all the economic inertia, widening current-account deficit and budget red ink, rating agencies threatened to slash India’s sovereign credit rating to “junk”.

In contrast, the BJP victory in May this year that ended a decade of rule by Singh’s Congress party drove the Sensex to an immediate record high, the benchmark having already risen 15% since the start of the year to the election day as polls predicted a Modi triumph. (The rally can almost be said to have started with Rajan’s appointment to head the Reserve Bank of India on August 6 last year. The Sensex rose 13% from that day to year end.) Investors saw that the electorate was largely voting for capable and clean administration and for higher economic growth, thus making the politics of reform easier, all accomplishments Modi achieved in his near-13-year stretch as chief minister in Gujarat. Investors became upbeat that the (sometimes disputed) pro-business and corruption-free reputation that Modi brought to the country’s top office could overcome India’s political paralysis and spark a wave of investment.

If Modi is successful, it may well prove because India has so much potential rather than any genius that resides within the leader from India’s lower caste who started out selling tea. India’s economy has potential because the country’s population is young (800 million people are aged under 35) and fast-growing. It is the world’s largest liberal democracy, which means, for all its faults, that the country is blessed with a free media, an independent judiciary, enshrined property rights, a bias towards transparency, an apolitical public service and moderate politics. Its people are industrious and risk-takers. Many of them are highly educated and speak English. Past growth has created a situation where development is self-perpetuating for it’s fashioned a middle class whose consumption can drive the economy. There is much Modi needs to overcome, of course; poor infrastructure, bureaucracy squared – India is ranked 134 out of 189 economies in the World Bank’s “Ease of doing business index”[2], a lame export performance that leads to a chronic current-account deficit, tangled land laws, an energy shortfall, a stubborn budget deficit, benchmark interest rates at 8% as a result of high inflation, a weak banking industry, debt-heavy companies, poor public services and hundreds of millions of Indians who lack basic education and the means to meet everyday needs. Politically, Modi needs to engage about 175 million Muslim Indians who are wary of a Hindu-chauvinistic government.

Modi’s is enjoying a boost from the fact that world economic events are helping his cause. The drop in oil prices helps oil-importing India’s trade performance. It eases pressure on the central government’s budget by reducing subsidy payments. Most of all, it helps reduce inflationary pressures, hopefully allowing the Reserve Bank of India to ease monetary policy to spur the economy.

On top soon

Modi is up against excessive, perhaps even unrealistic, expectations. He faces cynicism that his promises to remove supply-side bottlenecks, attack the fiscal deficit, stimulate investment in infrastructure, encourage labour-intensive manufacturing and improve governance will largely prove talk. Some wonder that he might care too much about his approval rating to take unpopular reform. His first 100 days were a good reply to these critics for he took some risky steps. His boldest moves included boosting railway passenger fares by 14%, reducing the subsidy on diesel and announcing an assortment of changes to encourage more foreign investment in restricted industries, such as introducing a bill to allow 49% foreign ownership of insurance companies. He is trying to impose a national sales tax, a policy he has opposed in the past, and has laid out plans to streamline the country’s rigid labour laws, even if he seems reluctant to privatise state-owned companies or curb many of the subsidies that help India’s poor while cruelling the government’s finances.

The budget brought down in July was viewed by some as a missed opportunity, even though it included steps to reduce the deficit. Critics say it failed to take tougher action against subsidies to mend government finances. More to Modi’s reform credentials, his Independence Day address on August 15 contained a promise to abolish the Planning Commission that recalls India’s pre-1990 socialist ways and the announcement of a goal to boost India’s share of world exports from 1.6% to 2.4% in coming years. (China’s exports comprise 11.1% of the world’s total.) In September, Modi launched a “Made in India campaign” to boost manufacturing from 15% of GDP to 25%, to create jobs for the 12 million young entering the labour market each year. In October, he took steps to shift to make energy prices more market-based.

Perhaps Modi’s biggest economic accomplishment so far could well be that the optimism he generated during his election campaign and by his victory helped India’s economy grow 5.7% in the June quarter from a year earlier. While this is still slower than China’s 7.3% achievement for the September quarter, it was India’s quickest expansion in two years.

It will be a while yet before Modi can be judged. But the Sensex’s 32% surge to record-setting highs over the first 10 months of 2014 shows that stock investors think Modi is as credible a reformer as any country has. They are inadvertently saying that within a couple of years the fastest growing of Asia’s superpowers on an annual basis will be India. The IMF forecasts India to be ahead by 2018;[3] others predict 2017. On a quarterly basis, India’s leap ahead of China could occur even sooner.

Information on Indian and Chinese economic growth rates comes from the IMF World Economic Outlook Database http://www.imf.org/external/pubs/ft/weo/2014/01/weodata/index.aspx. India and China’s share in world trade comes from the WTO trade profiles. http://www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm

Other financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

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Important information

Investments in small and emerging markets can be more volatile than investments in developed markets. Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment.

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Westpac Report: “Tapping into the Renminbi Opportunity – Trade, Capital and People flows in the Asian century”

Westpac Institutional Bank yesterday launched a Special Report on the liberalisation of China’s financial system and the benefits for customers across Asia, Australia and New Zealand as economic ties with China grow closer.

The Chinese Government is rolling out a sequence of reforms designed to increase the use of its currency, the renminbi (RMB) in international trade and investment. Establishing RMB settlement hubs in major financial centres outside of China and reducing restrictions on cross boarder capital flows are focal points of this initiative.

Westpac’s China Report, “Tapping into the Renminbi Opportunity – Trade, Capital and People flows in the Asian century”, delves into the expected benefits and challenges of this as Australia builds stronger links with its largest trading partner.

According to Balaji Swaminathan, General Manager Westpac Asia, the expanded use of the RMB and carefully sequenced opening of China’s capital account will integrate China as a key player in global capital markets and have profound economic implications for its major trading partners such as Australia.

“China’s economic size, diversified trade and high growth economy mean the RMB has the potential to become one of the world’s most widely used currencies by 2020.

“This has broad implications for many of our customers as the RMB becomes a fully convertible, global currency – as important in daily operations and trade flows as the AUD, NZD and USD,” he said.

According to the Report, while China is an established global economic power the country’s economic might has not yet been matched by its global financial integration.

This will not persist in the long run, as the Chinese authorities are committed to a liberalisation process and have already taken a number of important deregulatory and market-oriented steps.

The Report highlights the benefits of this process, including;

The tip of the iceberg

Huw McKay, Westpac’s Senior International Economist believes that China’s tightly controlled capital account has artificially restricted China’s share of international financial transactions, which are trivial when compared with its slice of the real economy.

“Today, China accounts for around 16% of world GDP but its share of private capital flows are a mere fraction of that. But as barriers to capital movement are progressively lifted, this anomaly will be corrected.

“China’s geographic share of global foreign exchange transactions could rise from a meagre 0.4% in 2010 to 15% by 2030.

“However, trade related flows alone will not be enough to achieve this outcome. Diversified cross holdings of Chinese assets abroad and foreign assets in China must develop if these projections are to be reached,” he said.

Challenges to overcome

Westpac’s China Report highlights that while many corporates may be aware that there could be benefits available from direct RMB payments, for a number of reasons, these are not being captured.

The RMB is the second most used currency in trade finance, but at present very few Australian businesses actually invoice and settle trades in RMB.

Westpac anticipates that momentum in Australia will follow a similar accent as other offshore RMB settlement hubs around the world such as Singapore and London, as larger pools of liquidity, trade and transactional flows have encouraged confidence and further market activity.

Until this happens, Australia isn’t necessarily going to see advantages of direct transactions with the renminbi straight away. Years of familiarity dealing with the US dollar are unlikely to be replaced overnight. Many businesses prefer the certainty of the familiar over the promises of the new. Others may be uncertain about their ability to negotiate discounts and settlement terms to reduce operating costs – with flow-on effects to working capital management.

In response to these dynamics, Balaji Swaminathan said that although our customers may not consider direct dealings in RMB imperative yet, it is central to our Asia strategy to support them as they navigate this change that is likely to take place in the medium term as new opportunities emerge.

“Establishing deeper financial and trading relationships with China is not without its challengeshowever it will be enviable as China continues to liberalise its financial market.

“From Westpac’s point of view, sitting on the sidelines and observing the transformation in China is not an option. Now is the time to help our customers understand the current state of play and look for ways to grow their business through China’s more accommodative markets and freely traded currency,” he said.

Click here to view the report.

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Craig Meller

AMP Limited, Australia and New Zealand’s leading independent wealth management business, announced it has agreed to acquire a 19.99 per cent stake in China Life Pension Company Limited, the largest pension company[1] in China.

The acquisition, for a total consideration of AUD$240 million, makes AMP the first foreign company in the world to purchase a stake in a Chinese pension company with three licences allowing end to end services throughout China.

China Life Pension Company was founded in 2006 to provide enterprise annuities (EA) products to state-owned and private enterprises and is one of only five pension insurance companies in China.  It currently has around 850 employees and is majority owned by China Life Insurance Company Limited, China’s largest listed life insurance group[2] and one of the largest institutional investors in China.

AMP has operated in China since 1997 and has had a formal relationship with China Life since 2005.  In August 2009, AMP and China Life signed a Memorandum of Understanding for Strategic Cooperation.

“This acquisition provides AMP with a strategic foothold in the rapidly growing Enterprise Annuity segment of China’s pension market and also extends our relationship with China Life, a leading global financial services brand,” said AMP Chief Executive Officer Craig Meller.

“AMP has a proud 165 year history and has contributed significantly to the development of the AUD$1.85 trillion superannuation and pension market in Australia, the world’s fourth largest pension savings pool.

“Having had a successful venture in funds management from last year, we look forward to sharing our expertise in corporate superannuation and investment management to help grow China Life Pension Company’s business in a market where we see significant growth potential.”

Enterprise Annuities in China are forecast to overtake the equivalent size of the Australian employer sponsored superannuation sector in 2015[3].  Growth in this market has been around 26 per cent per annum during the past five years and is expected to be aided by a significant ageing of China’s population with the 65+ age group anticipated to double over the next 15 years, as over 100 million people enter this age bracket.

China’s Enterprise Annuities market represents the second pillar of the Chinese pension system, a voluntary system provided by the employer.  There are currently over 66,000 participating enterprises and more than 20 million members.

As part of the transaction, AMP will enter into a Business Cooperation Undertaking to provide technical support to China Life Pension Company.  AMP will nominate two directors to the 11 member board of China Life Pension Company and be positioned as its second largest shareholder and a major strategic partner in this venture with China Life.

AMP forecasts China Life Pension Company, which already holds national licences for trustee services, investment management and account administration, to break even in the next 24 months.  The acquisition is expected to settle in late 2014, subject to regulatory approvals, and is expected to be Earnings Per Share (EPS) accretive to the AMP Group results from 2017.  EPS dilution will not be material in 2015 and 2016 to AMP Group.

“This strategic investment by AMP is a significant moment in the history of China Life Pension Company’s development and is another important milestone event following the establishment of China Life AMP Asset Management Company, between China Life and AMP, in 2013,” said China Life Insurance Group Chairman Yang Mingsheng.

“This marks a new chapter of transformation for China Life in the diversification of its equity base, internationalising its business and making its operations more market-orientated. China Life Pension Company will become an indispensable driver of new growth for China Life Group’s business development strategy and provide a significant contribution to the Chinese social security system.”

In September 2013, AMP Capital and China Life Asset Management Company formed a joint venture, China Life AMP Asset Management Company, to offer retail and institutional investors in China access to investments in domestic listed equities and fixed income.

The asset management venture launched its first mutual fund in January 2014, followed by three other funds during the year, and is already in the top third of fund management companies in China.  The venture’s Money Market fund has raised AUD$3.8 billion to date.  AMP Capital holds a 15 per cent stake in the asset management venture.

Consideration for AMP’s 19.99 per cent stake in China Life Pension Company will be funded via existing surplus capital and liquidity facilities.  It is anticipated the transaction will reduce the surplus capital over minimum regulatory requirements of AMP Life Limited (the acquirer) and consequently AMP Group by approximately AUD$180 million.

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Is autocracy built on the misconception that tyranny does away with some of the perceived economic shortfalls of liberal democracy?

Autocratic capitalism as an economic development model has won converts in recent years, especially as the increase in wealth achieved by China’s dictatorship swamps that of, say, India’s system of democratic capitalism.

The developed world’s financial crisis, political dysfunction in the US and the inability of the eurozone to formulate solutions for its crisis add to those losing faith in liberal capitalism as a path for economic advancement.

The case for the economic prowess of autocracy, when power resides in one person or one party, is built on the misconception that tyranny does away with some of the perceived shortfalls of liberal democracy. There are many myths behind the case for autocracy but two stand out when analysing China’s economic risks. The first is that dictators don’t have to bow to public opinion as do elected lawmakers. Tyrants can supposedly implement whatever changes are needed to spur economies, no matter how unpopular they are. Despots, in reality, are rightly paranoid for they survive by keeping people either happy or frightened. Either way, they are attuned to the popular mood for they have more to lose if their people become miserable and less terrified. In democracies, politicians beaten at the polls trudge unwillingly into comfortable retirement and their parties generally regain power within a couple of elections. Few dictators, however, die of old age in their palaces, metaphorically speaking. Mao Zedong, Stalin, Haiti’s “Papa Doc” Duvalier, Spain’s Franco, Syria’s Hafez al-Assad and North Korea’s Kim Il-sung and his son Kim Jong-il died this way, due largely to the effectiveness of their brutality as did China’s more humane though still purge-prone Deng Xiaoping. The rule of most tyrants, though, is usually cut short, even if they are ruthless (and sometimes happens via foreign invasion). Their chaotic ends include suicide (Hitler), firing squad (Ceau?escu of Romania), shot soon after capture (Mussolini and Libya’s Gaddafi), hanged (Saddam Hussein), jail (Noriega of Panama), exile (Cambodia’s Pol Pot, Haiti’s “Baby Doc” Duvalier, Iran’s last Shah, Paraguay’s Stroessner, Uganda’s Idi Amin and Zaire’s Mobutu) and house arrest amid legal harassment (Chile’s Pinochet and Egypt’s Mubarak).

The second myth spouted by autocracy advocates that is relevant when looking at China’s risks is that supposedly enlightened tyrants can enforce their will – as in, they don’t have a judiciary, free media, interest groups, trade unions, constitutions, state governments, opposition parties, independent MPs holding the balance of power, upper houses or even coalition partners blocking their policies. Only dictators with total control over all facets of society, such as Hitler, Mao, Stalin and North Korea’s Kims achieved, can boast such supreme enforcement of will. Most authoritarian systems are insecure dictators sitting atop a balance of power between fiefdoms that can generally block changes that will hurt their interests. Within a one-party state, most of these fiefdoms reside within the party and the major organs of power, such as the army, it controls.

These two myths about autocratic (or state or illiberal) capitalism are being exposed as such in China these days. While Beijing talks about reforms, rebalancing and other applauded intentions, the reality is that the government is failing to fully pursue the steps it advocates. Fears of a public backlash and countermoves by lower levels of government are nullifying much of any advances China’s central government has taken to diffuse the damage wrought by the excessive lending that insulated China from the global financial crisis.

This is not to underplay the economic achievements of autocratic societies in recent times. These regimes take many forms so it can be an oversimplification to generalise about countries such as Bolivia, China, Ecuador, Hungary, Russia, Singapore and Turkey that use different blends of coercion, populism, nationalism and centralism to rule. Autocratic regimes can change over time too. China’s dictatorship has moved from a Communist to a capitalist economic model since 1978 and has eased some political restrictions, all the while holding onto total political power. China’s government has allowed China’s economic growth to cool below double-digits so it has some credibility when it says it’s righting its economy. Perhaps President Xi Jinping will engineer such power that he can enforce his will throughout the country – he’s already being described as the most powerful and popular leader China has had for decades.[1]  Democratic systems are not perfect systems, either. While China has other political risks to monitor, especially the crackdown on corruption aimed at the highest echelons of the Communist Party, there’s little doubt that China’s autocratic model carries flaws that are adding to China’s longer-term economic risks.

How will the masses react?

China’s leaders have acknowledged in recent years that their investment-driven, construction-biased and debt-fuelled economic model that relies on low-cost and low-valued-added exports is in crisis. They accept that the economy’s distortions, financial weaknesses and inequalities this model spits out means the country needs to upgrade to a consumption-driven, services-led value-add-industrial prototype that will produce “slower but safer” growth, in the words of the IMF.[2]

Beijing, however, for all the good moves it has made, is failing to swiftly reform its economy for it worries that growth might slow too much and lead to excessive unemployment. It is sacrificing steps that would generate longer-term stability in favour of moves that will fan immediate growth. The regime has declared a 7.5% growth target for 2014 and has succumbed to the temptation of more stimulus to ensure the economy attains this goal. Recent plans to spur the economy include more fiscal stimulus including extra money for infrastructure, more lending for rural poor, pruning bank reserve requirements and reduced taxes for small and medium-sized businesses. A Bloomberg gauge that weights average loan growth, real interest rates and China’s real effective exchange rate shows that China loosened monetary conditions in the second quarter at the fastest pace in two years.[3] The central People’s Bank of China, which is just another arm of the Finance Ministry rather than being “independent”, is loosening monetary policy to help the economy. Over 2014, the central bank has steered loans to public housing and infrastructure. It recently gave about 1 trillion yuan (US$180 billion) to China Development Bank to stimulate lending[4] and injected 500 billion yuan into the country’s five largest banks to prop up lending.[5]

The risk is that more fiscal and monetary stimulus will add to the vulnerabilities and inefficiencies of China’s economy and make any reckoning more shattering. The IMF warns Beijing is “increasing the risk of a disorderly adjustment” – its jargon for crisis – if it to relies on government intervention to underpin growth and fails to rejig its economy and haul in the credit boom that has boosted total debt from 130% of GDP in 2008 to 207% of output now.[6] Yet the recent slowing in industrial production, investment, retail sales and sentiment and the slump in property construction, sales and prices is only likely to compel Beijing to do more prodding (possibly too via a devaluation of the yuan).

China’s rulers feel pressured to keep the economy humming now rather than worry about where it will be in the medium term for two reasons. The first is that leaders are under pressure from vested interest to indulge in more of the investment and lending that buttress their wealth and power. The bigger reason, though, is that the Communist Party is afraid of the consequences of breaking its compact with its 1.3 billion subjects that goes something like; trust us with political power and we will enrich you. While the Chinese know that the ruling classes gorge themselves first, this agreement has held because hundreds of millions of citizens have risen from poverty in recent decades. Beijing’s fear is that the compact may crumble if lower growth spells unemployment and renewed impoverishment for the masses. Deeper despair, it frets, may add to the disquiet in China about land grabs, pollution, corruption and the inequality that each year is triggering, by the government’s count, about 180,000 “mass incidents” of unrest (demonstrations involving protests of more than 500 people) at a time when unemployment is officially 4% and wages are growing at a 10% pace.[7] While democratic leaders burdened with a sagging economy face losing the next election, China’s autocrats fear another Tiananmen, which started over concerns about inflation before encompassing wider political grievances. The protests in Hong Kong will only serve to rattle them more.

Unruly lower tiers

China’s central government has numerous national organs (or fiefdoms) clashing over the direction of economic policy. The outcome of the infighting in recent years has been a decision to reform the economy, even at the cost of growth. In November last year, for example, China’s rulers announced their biggest package of reforms since the 1990s that aim overall to boost the role of market forces in allocating resources. China’s leaders said they would ease price controls, relax the curbs on the exchange rate, liberalise interest rates, bolster financial regulation and supervision, reorganise fiscal management and rules of government land ownership and rein in local government excesses.

If only they had the power to do all this (assuming they had the will). China’s multi-tiered system of government includes 34 provincial governments (if you include Beijing’s claim on Taiwan) and almost countless lower levels of governments below that. This term “local” covers thousands of governments controlling provincial-level cities, counties, county-level cities, county-level districts down to villages. Officials in charge of these lower tiers are often in competition with neighbouring peers to achieve faster growth and build better infrastructure, to further their own careers, feed local prestige and to placate vested interests. The way China works, these lower-tier officials often ignore central economic directives that clash with their self-interest (though they are more in step on political matters). “Far from surging like a single river out of the capital, the transmission of economic policy is more like a series of locks, in which each locality takes what they want out of the policy waterway,” writes Richard McGregor in his book The Party. The secret world of China’s Communist rulers.[8] “Feigning compliance with the centre … they then let the policy stream flow downwards to the next level of government.”

Total central control in China or elsewhere is not necessarily an appropriate way to run a society or economy. But in China today the rulers in Beijing appear more attuned to China’s economic and financial instabilities than are local authorities. The list is growing of worthwhile actions decreed by the centre that are being unwound in the peripheries of government. As this count grows, so too do China’s risks.

Of special note is that local authorities are adding to China’s debt load and heightening the risk of a financial crisis by countermanding central directives on how to deal with collapsing businesses. In July this year, for instance, the government of northern Shanxi province bailed out Huatong Road & Bridge when the construction company faced being the second Chinese business in four months to default. Apart from the moral hazard in shielding businesses from bad decisions, this step was against Beijing’s request that small and medium-sized business should be allowed to collapse to prevent the misallocation of resources. It conflicted with Beijing’s goal to reduce total public liabilities, so as to lower the risk that the central government will need to prop up local or regional governments. It heightens the risk of a greater reckoning by encouraging more excesses.

Analysis at a macro level highlights how Beijing is failing to enforce its will on lower levels of government. A Bloomberg study in July found that 20 of 25 provinces and provincial-level cities in China reported a largely debt-fuelled pickup in growth in the first half of 2014, which basically shows provincial governments are undermining Beijing’s plans to rebalance growth and rein in lending.[9]

More micro analysis shows the same pattern. The Wall Street Journal reports that Beijing is having trouble reducing overcapacity in the 19 industries it classes as producing excessive supply because of countermoves by subordinate governments. In the debt-laced steel industry, for example, government officials in the northeastern city of Xingtai in July reopened a steel mill that Beijing had ordered shut eight months earlier. Government officials in the steel-making Hebei province that surrounds Beijing are stalling to obey orders to shrink an industry that provides 10% of its tax revenue and about 200,000 jobs for locals.[10]

These moves against central directives and Beijing’s timidity when it comes to confronting popular opinion do two things and will probably achieve a third. Firstly, they boost China’s short-term economic growth prospects. Secondly, they undermine China’s longer-term wealth by boosting the damage of any reckoning. Thirdly, they will probably eventually help those arguing that liberal capitalism is the best way to achieve sustainable prosperity.

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• 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

————-

Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

The post Weekly market & economic update – week ending 24 October, 2014 appeared first on AdviserVoice.

• Chinese economic data: The Chinese economy grew at 7.3 per cent annual pace in the September quarter – ahead of forecasts (7.2 per cent) but the weakest growth in five years.
• The Chinese economy grew by 1.9 per cent in the September quarter, down from 2.0 per cent in the June quarter.
• Reserve Bank Board minutes: There was no discernible change in the tone of the Board minutes when it comes to view on interest rates. The Reserve Bank reiterated “that the most prudent course was likely to be a period of stability in interest rates”.
• Housing the key focus: Board members discussed the need to monitor and ensure responsible lending practices. Policymakers noted that “the current setting of monetary policy was accommodative, with lending rates remaining very low and continuing to edge lower over recent months as competition to lend had increased. In this context, members discussed the importance of lenders maintaining strong lending standards and the ongoing dialogue between the Bank and APRA on the matter”.
• Consumer confidence falls: The weekly ANZ/Roy Morgan consumer confidence rating eased by 1.9 per cent in the week to October 19 after lifting by 1.1 per cent in the prior week.

What does it all mean?

• There are two reasons why the Chinese economic data is important. First, China is the biggest driver of the global economy. And second, China is Australia’s largest trading partner.
• Overall it is clear that the Chinese economy slowed over the past year with growth in the September quarter easing from 2.0 per cent to 1.9 percent. The world’s second largest economy is growing at a 7.3 per cent annual pace. Yes, it is the slowest growth rate in five years but importantly inflation remains well contained. In fact the result was ahead of forecasts, while the monthly data showed a surprising lift in industrial production.
• Importantly the slowdown was engineered by policymakers to ensure that a sustainable level of growth is maintained. In addition Chinese officials have made it clear that they are willing to sacrifice a faster pace of growth in order to correct imbalances across the economy – predominately focusing on improving environmental reforms, more transparency in the financial system and more equitable social reforms.
• Whether it is production, investment or retail spending, growth rates will slow in coming years as the economy matures. But an economy of 1.3 billion people travelling at around a 7 per cent annual pace is a sight to behold. The focus will now shift to the HSBC/Markit “flash” October manufacturing activity index, out next Thursday.
• The Reserve Bank continues to preach stability in interest rates. There is nothing in the latest minutes to suggest that Board members have become more optimistic, nor more pessimistic. The Board believes that the cash rate is at the right level to support the economy and keep inflationary pressures in check.
• However the Central Bank did once again discuss the ongoing lift in investor housing demand, noting that annual growth of investor demand has increased by close to 10 per cent compared with around 7 per cent growth in overall housing credit. Interestingly the focus by Board members was on ensuring responsible and sustainable lending practices with “ongoing dialogue between the Bank and APRA on the matter”.
• The Reserve Bank will continue to assess measures to cool the demand for investor housing. Importantly policymakers will take a soft approach when introducing any new measures.
• Despite the latest pullback, consumer confidence remains healthy. Over the past few months households have been generally upbeat, shrugging off global economic concerns. The mild pullback over the past week is probably more to do with the recent slide in equity markets than any deep structural issue with household finances.
• In fact even in the latest survey Aussie households’ views about their finances over the next 12 months held at 6½-month highs. In addition confidence levels are holding just 4 per cent shy of the seven month highs reached in late July.

What do the figures show?

Consumer sentiment:

• The ANZ/Roy Morgan consumer confidence rating fell by 1.9 per cent to 111.6 in the week to October 19 after rising by 1.1 per cent in the previous week. The confidence rating is down 4.0 per cent on the 7-month highs recorded for the week to July 27.
• Four of the five components of the index fell in the latest week:
• The estimate of family finances compared with a year ago was down from +9 to +4;
• The estimate of family finances over the next year was unchanged from +25 to +25;
• Economic conditions over the next 12 months was down from -4 to -5;
• Economic conditions over the next 5 years was down from +4 to +3;
• The measure on whether it was a good time to buy a major household item was down from +35 to +31.

Reserve Bank Board minutes:

• Minutes of the Reserve Bank Board meeting held on October 7 can be found here.

Chinese economic data

• The Chinese economy grew at a five-year low of 7.3 per cent annual pace in the September quarter, mildly ahead of forecasts (7.2 per cent). The economy grew by 1.9 per cent in the September quarter, down from 2.0 per cent in the June quarter.
• Industrial production rose at an 8.0 per cent annual rate in September, above the forecast average (7.5 per cent) and up from the 6.9 per cent annual rate in August. Production was up by 8.5 per cent on a year ago for the first nine months of 2014.
• Retail sales rose at an 11.6 per cent annual rate in September, mildly below forecasts (+11.7 per cent) and down from the 11.9 per cent annual rate in August. Over 2014, annual growth has averaged 12.0 per cent. But in real terms, spending was up 10.4 per cent in September – the fastest growth in nine months.
• Urban investment rose at a 16.1 per cent annual rate in the first nine months of 2014, below forecasts of a 16.3 per cent increase and below the 16.5 per cent growth recorded for the eighth months to August.

Imports of goods:

•  “In seasonally adjusted terms, goods debits rose $1,480m (7 per cent) between August and September 2014 to $22,948m. Intermediate and other merchandise goods rose $973m (11 per cent), capital goods rose $187m (4 per cent), consumption goods rose $186m (3 per cent) and non-monetary gold rose $135m (59 per cent).”
• The ANZ/Roy Morgan weekly survey of consumer confidence closely tracks the monthly Westpac/Melbourne Institute consumer sentiment index but the former measure is a timelier assessment of consumer attitudes and is now closely tracked by the reserve Bank.
• The Reserve Bank releases minutes of its monthly Board meeting a fortnight after the event. The minutes give a guide to Reserve Bank thinking on interest rate settings.
• China’s National Bureau of Statistics releases its monthly economic statistics around mid-month. Quarterly GDP data is released around the 16th of January, April, July and October. China’s Customs Office releases trade data, and the People’s Bank of China releases financial statistics, around the 10^th of each month. China is Australia’s largest trading partner and changes in the Chinese economic have major implications for the Aussie economy.
• At present the Reserve Bank is in a delicate balancing act of keeping interest rates low to support the broader economic recovery while hoping house price growth eases over the medium term. And the ongoing lift in home building should provide policymakers with some added comfort.
• The latest Chinese economic data was mildly better than expectations. And while the longer term growth story remains sound, it is likely that the ongoing structural reform in China is likely to create further volatility and ongoing patchiness in activity in coming months.
• The latest data give the Reserve Bank no reason to change its views on the economic recovery or interest rates. Low rates will continue to foster stronger domestic growth. CommSec expects no change to monetary policy until next year with one rate hike pencilled in the March quarter of 2015.

What is the importance of the economic data?

• The ANZ/Roy Morgan weekly survey of consumer confidence closely tracks the monthly Westpac/Melbourne Institute consumer sentiment index but the former measure is a timelier assessment of consumer attitudes and is now closely tracked by the reserve Bank.
• The Reserve Bank releases minutes of its monthly Board meeting a fortnight after the event. The minutes give a guide to Reserve Bank thinking on interest rate settings.
• China’s National Bureau of Statistics releases its monthly economic statistics around mid-month. Quarterly GDP data is released around the 16th of January, April, July and October. China’s Customs Office releases trade data, and the People’s Bank of China releases financial statistics, around the 10^th of each month. China is Australia’s largest trading partner and changes in the Chinese economic have major implications for the Aussie economy.

What are the implications for interest rates and investors?

• At present the Reserve Bank is in a delicate balancing act of keeping interest rates low to support the broader economic recovery while hoping house price growth eases over the medium term. And the ongoing lift in home building should provide policymakers with some added comfort.
• The latest Chinese economic data was mildly better than expectations. And while the longer term growth story remains sound, it is likely that the ongoing structural reform in China is likely to create further volatility and ongoing patchiness in activity in coming months.
• The latest data give the Reserve Bank no reason to change its views on the economic recovery or interest rates. Low rates will continue to foster stronger domestic growth. CommSec expects no change to monetary policy until next year with one rate hike pencilled in the March quarter of 2015.

The post Chinese growth at five year lows appeared first on AdviserVoice.

• Share markets had a rough week weighed down by a combination of worries about the Fed, tough action against US companies seeking to reduce their tax by relocating outside the US, worries about Chinese growth, geopolitical concerns and worries about the loss of breadth in the US share market rally. The poor global lead, falling iron ore prices and the retreat of foreign investors to the sidelines saw the Australian share market give up its gains for the year. Weakening share markets saw bonds rally across the board suggesting in part that investors fear that talk of US rate hikes is premature. The outlook for relatively tighter monetary policy in the US versus other major regions saw the US dollar continue to rally, leaving it up nearly 7% over the last three months, and this is also weighing on commodity prices. The falling iron ore price and the rising $US saw the $A continue its slide.
• Geopolitical threats are continuing. While the global threat from the Ukraine conflict seems to be receding a bit, the conflict with IS in the Middle East is hotting up bringing with it the threat of global terrorist activity. So far global oil supplies are not under threat, with the oil price running below the levels when IS in Iraq first started hitting the headlines. But increasing prospects for the deployment of ground forces in Iraq by the US and its allies and talk of the terrorist threat are weighing on investor confidence. Terrorist attacks are horrible in terms of their human consequences and there is no doubt that an IS terrorist attack in a western country would be taken badly by share markets. But the experience with various Al-Qaida related attacks (9/11, Bali Bombing, 2005 London bombings, etc) 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.
• In Australia, the Reserve Bank’s Financial Stability Review expressed concern that the housing market is becoming too speculative and that if left unchecked poses risks to the broader economy for when the property cycle turns back down. As a result APRA has stepped up its surveillance of the banks and given the desire to avoid a rate hike at this point the RBA is discussing with APRA further steps that may be taken to ensure sound lending practices are maintained, particularly with respect to property investors. The focus looks like it may be on tougher capital requirements and interest rate tests banks apply when assessing new loans rather than restrictions on loan to valuation ratios. It’s likely that if the property market does not soon cool an announcement could be made in the next few months. To the extent that the use of macro-prudential controls might delay the first rate hike further into 2015, it could be good news for existing home borrowers.
• The term “macro prudential controls” is really just the latest buzzword for the failed credit rationing policies used prior to the 1980s. The RBA would be well aware of the risk of unintended consequences – eg, the potential impact on first home buyers many of whom are investors these days and in forcing borrowers into the shadow banking system – but it no doubt feels such controls are better than raising interest rates right now.
• The Australian dollar is continuing to slide helped by an ascendant US dollar, the continuing slide in the iron ore prices (now down 41% year to date) and the possibility that the use of macro-prudential controls to slow the housing market will further delay the first rate hike in Australia. Comments by Reserve Bank of NZ Governor Wheeler that the level of the $NZ was “unjustified and unsustainable” also helped as they apply just as much to the level of the $A. I remain of the view that by year end the $A will have fallen through the January low of $US0.8660 on its way to around $US0.80 over the next year or so. A lower $A will help rebalance the economy.

Major global economic events and implications

• US economic data remains mostly strong. While existing home sales surprisingly fell in August new home sales surged to a six year high, the Markit PMIs for September remained solid and durable goods orders continue to trend higher. While Fed officials are continuing to provide mixed messages on the timing of rate hikes its noteworthy that a couple of hawks will not be voting members at the Fed next year and so their calls for an earlier move by the Fed should be ignored. Our view remains that the Fed won’t start raising rates till around the June quarter, but the 7% gain in the $US since June has probably not been lost on Janet Yellen who would be thinking its delivering a de facto monetary tightening.
• Eurozone PMIs continued to edge down in September leaving them at levels consistent with only modest growth and ECB President Draghi described the recovery as losing momentum. There was a slight improvement in money supply and credit momentum, but not enough to allay the mounting pressure on the ECB.
• A slight fall back in Japan’s manufacturing conditions PMI for September was disappointing but leaves in place a gradual recovery after the April tax hike induced fall. Japanese core inflation excluding the impact of the tax hike is continuing to run around 0.5% year on year, which is better than deflation but not much of a buffer really. The latest leg down in the value of the Yen should help provide a further boost to inflation though.
• While Chinese officials continue to indicate there won’t be any major policy stimulus, it’s worth noting similar comments were made earlier this year before various mini-stimulus measures were introduced. An unexpected slight rise in the HSBC flash PMI for September helped relieve Chinese growth fears a bit.

Australian economic events and implications

• In Australia, job vacancies fell slightly over the 3 months to August according to the ABS but this followed  a 5.3% gain over the previous six months and skilled vacancies rose in August for the 11^th month in a row so the basic picture remains one of forward looking indicators pointing to stronger jobs growth ahead.

What to watch over the next week?

• In the US, the main focus will be on the ISM manufacturing and services indexes (due Wednesday and Friday respectively) which are both expected to remain strong and employment data (Friday) which is expected to show a 210,000 gain in payrolls for September and unemployment unchanged at 6.1%. Consumer spending data (Monday) is also expected to show that the Fed’s preferred inflation measure remained benign with a fall to 1.4% year on year.
• In the Eurozone, business confidence data (Monday) is likely to have weakened a bit further and September inflation (Tuesday) is likely to be just 0.3% year on year. Despite this, the ECB (Thursday) is unlikely to announce further monetary easing but may provide details of its proposed QE program involving asset backed securities.
• Japanese data for jobs, household spending, industrial production, labour cash earnings and housing starts due Tuesday will be watched for signs of further improvement following the impact of the April sales tax hike, but the September quarter Tankan business survey (Wednesday) is likely to have weakened slightly.
• In China, the official PMI (Wednesday) is likely to be little changed from the 51.1 reading for August.
• In Australia, given the RBA’s concern about the property market, credit data (Tuesday) and RP Data house price figures (Wednesday) for September may see greater than normal interest. Expect to see overall credit growth remaining modest but interest will be on whether growth in credit going to property investors accelerated from the roughly 10% annualised pace seen over the last few months. RP Data is expected to show that house price gains remained strong in September. Meanwhile, expect a modest gain in retail sales (Wednesday), a renewed deterioration in the August trade deficit (Thursday) and solid building approvals (also Thursday).

Outlook for markets

• Shares remain at risk of further short term weakness particularly ahead of the end of US quantitative easing next month, the US mid-term elections in November and as we are still in a seasonally weak part of the year for shares. Australian shares are also vulnerable in the short term to further falls in the iron ore price and as foreign investors stay on the sidelines as the $A falls.
• However, this is likely to be nothing more than a healthy correction, allowing shares to let off a bit of steam, and should be seen as a buying opportunity as the cyclical bull market in shares likely has further to go. We still don’t see the signs of shares being over valued, over loved and over bought normally seen at major market tops. Valuations remain okay, global earnings are continuing to improve on the back of gradually improving economic growth, global monetary conditions are set to remain easy and there has been no sign of investor euphoria.
• Although the falling $A is initially a drag on the Australian share market as foreign investors retreat to the sidelines, after a while it will start to become a source of support as it flows through to upwards revisions to earnings expectations. Roughly speaking each 10% fall in the value of the $A boosts company earnings by 3%.
• Low bond yields will likely mean soft returns from government bonds, particularly as we continue to edge closer to the start of a gradual interest rate tightening cycle in the US.
• The combination of soft commodity prices, the likelihood the Fed rate hikes before the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. 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

———–

Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

The post Weekly market & economic update – week ending 26 September, 2014 appeared first on AdviserVoice.

• Global share markets mostly rose over the last week helped by indications from the Fed that it’s still in no hurry to raise interest rates, expectations that the ECB might have to provide more stimulus, the Scottish No vote removing risks over UK assets and the continuing slide in the Yen to a six year low providing a boost to Japanese shares. Chinese shares fell but only slightly thanks to signs of monetary easing. The combination of poor Chinese economic data and the falling $A weighed heavily on the Australian share market as foreign investors tend to retreat to the sidelines whenever the $A is under threat.  Bond yields were little changed but the $US continued its ascent which in turn saw the Australian dollar remain under pressure and falling below $US0.90.
• The US Federal Reserve provided no surprises with another $US10bn taper to its QE program leaving it on track to end next month and an ongoing assessment that considerable labour market slack remains and that a “considerable time” is likely to elapse between the end of QE and the first rate hike. However, the Fed is incrementally continuing to become less dovish with Fed officials’ “dot plot” of interest rate expectations getting revised up slightly and Janet Yellen highlighting that the timing of the first rate hike is dependent on how the economy performs. Our assessment remains that the Fed can afford to take its time for now, but in the June quarter next year it will start to gradually raise rates. The anticipation and then the reality of this could cause bouts of share market volatility – particularly whenever there is a run of strong US economic data, but it’s unlikely to derail the bull market as rate hikes will be reflecting strong economic and profit conditions.  Only when interest rates reach onerous levels will there be a significant problem, but that will be a fair way off.
• Thankfully common sense prevailed in Scotland and the No vote won. This is good news for UK and Scottish assets and more broadly for the Eurozone as other pro-independence movements likely the Catalonians in Spain weren’t given the encouragement a Scottish Yes vote might have provided. Catalonia’s potential referendum for November will be the next one to watch though.
• The Ukraine crisis may be heading towards a resolution of sorts, with the Ukrainian Parliament granting a degree of autonomy to the eastern regions currently in conflict. There may still be more to go before the conflict is resolved, but with Russia describing the move as positive we may be getting to the point where Ukraine starts to recede as an issue for investment markets.
• In Australia, the minutes from the RBA’s last meeting repeated the “period of stability” mantra on interest rates but expressed more concern about the growth in investor housing credit and house prices. The RBA is stuck between a rock – in terms of the risk of accelerating house prices – and – a hard place in the form of the Australian dollar which remains too high, despite recent falls. The best approach is likely to be more jawboning to the effect that home buyers need to be cautious and that the $A remains overvalued. If the property market does not cool down a bit and the $A remains too high, I suspect that the RBA may then be tempted to go down the path of encouraging APRA to raise the risk weighting for home loans rather than start raising interest rates.
• Right now the Australian dollar is going in the right direction helped by the Fed’s gradual move towards monetary tightening. There is a bit of technical support around $US0.89 but I expect that by year end the $A will have fallen through the January low of $US0.8660 on its way to around $US0.80 over the next year or so. A lower $A will provide a shot in the arm for trade exposed sectors of the economy at a time that we need them to perk up as mining investment slows.

Major global economic events and implications

• US economic data was mostly favourable with solid growth readings but low inflation. Industrial production unexpectedly slipped in August, but strong regional manufacturing surveys point to a bounce back this month. While housing starts and permits fell this was only after a huge surge in July and a stronger than expected gain in the NAHB homebuilder index points to strength head. Finally, jobless claims fell and household net wealth rose 10% over the last year, providing a strong wealth boost. Meanwhile, inflation remains low with headline and core CPI inflation falling to 1.7% year on year in August which partly explains why the Fed is in no hurry.
• Bank take-up of the ECB’s first auction of cheap funding under its new Targeted Long Term Refinancing Operation (TLTRO) program was around half expectations at €83bn, which may partly reflect bank caution ahead of the ECB’s review of the quality of their assets. So hopefully the next auction in December will see more interest, but in the meantime it puts pressure on the ECB to quickly ramp up its quantitative easing program.
• In China a sharp fall in the MNI business indicator suggests that the growth slowdown may have continued into September and home prices continued to fall in August with average prices down just over 1% with virtually all cities seeing falls. Meanwhile, the Chinese central bank may be reacting to the growth slowdown with reports that it is providing RMB500bn to the major banks and a fall in the 14 day money market rate. While a cut to the PBOC’s 12 month benchmark interest rate would be more appropriate as Chinese interest rates remain too high for the Chinese private sector, its latest moves are welcome and highlight that the authorities are prepared to support growth.

Australian economic events and implications

• There were only secondary data releases in Australia over the last week and they were all soft. Auto sales and the Westpac leading index both fell in August and the weekly ANZ Roy Morgan consumer confidence index fell slightly.

What to watch over the next week?

• Globally, the main focus in the week ahead will be the release of September business conditions PMIs (Tuesday) in China, Europe and the US. The flash HSBC manufacturing PMI for China will be watched to see whether the latest slowdown continued into September, Eurozone PMIs are expected to remain off their previous highs and the US PMI is expected to remain strong.
• In terms of other US data, expect further gains in existing homes sales (Monday) and new home sales (Wednesday), a fall back in headline durable goods orders (Thursday) after the aircraft inspired surge seen in July but a continuing trend rise in underlying orders and another upwards revision to June quarter GDP growth (Friday) to 4.6% annualised from 4.2%.
• Japanese inflation data will be released Friday, but is being boosted by the April sales tax hike. Excluding this it’s likely to remain around 0.5% year on year on a core basis, which is better than the deflation that prevailed for a long time but still has a fair way to go to reach the 2% inflation target.
• In Australia, the RBA’s half yearly Financial Stability Review (Wednesday) is likely to indicate that the financial system remains in good shape, but express concern that the residential property market may be getting too hot and potentially posing risks for financial stability in the future if it continues to hot up. Speeches by RBA Governor Stevens (Thursday) and Assistant Governor Richards (Friday) will be watched for further comments on how the RBA sees the risks around the property market, the broader economic outlook and the $A. They are likely to reinforce the rates on hold message. Data for job vacancies will also be released.

Outlook for markets

• Shares are still at risk of occasional corrections particularly ahead of the end of US quantitative easing next month, the US mid-term elections in November and with September and October often proving volatile for shares. Australian shares are also vulnerable in the short term to further falls in the iron ore price and as foreign investors stay on the sidelines as the $A falls.
• However, occasional corrections are healthy in allowing shares to let off a bit of steam and should be seen as a buying opportunity as the cyclical bull market in shares likely has further to go. We still don’t see the signs of shares being over valued, over loved and over bought normally seen at major market tops. Valuations remain okay, global earnings are continuing to improve on the back of gradually improving economic growth, global monetary conditions are set to remain easy and there is no sign of investor euphoria.
• Our year-end target for the ASX 200 remains 5800. Although the falling $A is initially a drag for the Australian share market as foreign investors retreat to the sidelines, after a while it will start to become a source of support as it flows through to upwards revisions to earnings expectations. Roughly speaking each 10% fall in the value of the $A boosts company earnings by 3%.
•  Low bond yields will likely mean soft returns from government bonds, particularly as we continue to edge closer to the start of a gradual interest rate tightening cycle in the US.
• The combination of soft commodity prices, the likelihood 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. 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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Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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George Lucas

Two events are set to grab the most attention this week – the outcome of the US Federal Reserve’s policy meeting and the referendum on Scottish independence. Both are important for currency markets, which is where most of the action has been taking place recently.

Dollar domination

The US Dollar continues to rally boosted by the relative strength of the US economy. We believe this theme has a lot further to run as the divergence widens between the US, Japan and the Eurozone with regards to the outlook for monetary policy.

Further support for the US Dollar came in the form of a technical note issued by economists at the San Francisco Federal Reserve who pointed out that market expectations for the path of US interest rates is lower than that anticipated by the Federal Open Market Committee (FOMC).

This also caused a sell-off in US long bonds with 10-year treasury yields back up to around 2.60% (from below 2.40%) in a matter of weeks.

These events demonstrate the sensitivity of markets to what the Fed has to say after this week’s meeting. The focus will be on nuances in the Fed’s language that indicate any potential amendment to the pledge to keep rates on hold for a “considerable time”.

Looking at recent data – including stronger retail and lending figures as well as lower petrol prices, job growth and easier lending conditions – we expect the market will need to get used to the idea of a sooner-than expected rate rise, most likely in the second quarter of next year.

Scottish referendum

The British Pound has been weakening against the US Dollar driven by shifts in yield differentials and the fall in the Euro.

If the Scots vote ‘aye’ to their referendum for independence this week, there is likely to be further fallout for the Pound. Longer term, there will be other implications across the European region.

China numbers disappoint

Numbers released by China over the weekend were disappointing and likely to lead to more stimulus measures. The poor data included:

• Lower fixed-asset investment driven by cooling property investment
• Reduced industrial production driven by a slowdown in infrastructure spending
• Lower-than-expected retail sales despite recent indicators suggesting the labour market remains strong
• A slowdown in year-on-year outstanding credit growth – a drop in outstanding social financing from 15.9% y/y in July to 15.1%.

Whilst all these credit indicators are a negative for China in the near term, it’s a good sign that there is a focus on weaning China off its dependence on credit to a more sustainable growth trajectory.

Finally, Australia

A final word on Australia where the economy is still adjusting to a sharp slowdown in mining investment but is doing better than expected. We expect the RBA to maintain its view and keep the target cash rate at its current low level of 2.5%.

With regards to currency, the Australian Dollar is currently the only G10 currency that is up against the USD for the year.

By George Lucas, Managing Director, Instreet Investment

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Nathan Lim

Australia Headlines

• Western Australia’s energy market is broken – wholesale electricity prices ($180 per megawatt hour) cost more than unsubsidised solar and wind, more than double rates in Eastern Australia
• Renewable Energy Target review delivers on preconceived conclusion – local renewable energy industry in peril

AEI Assessment

The Renewable Energy Target review lead by climate skeptic Dick Warburton has recommended changes that would effectively arrest renewable energy development in Australia. While the grandfathering option in the recommendation should provide some security for existing investments (assuming it is adopted), there is nothing to support further large scale developments. We are disappointed that the government seems to be deliberately ignoring the global trend whereby nations are reducing their emission intensity from power generation to address climate change. Support for this trend also comes from the added benefit that it also improves local air quality.

North America Headlines

• California oil refiners take in record oil-by-rail from Utah
• Colorado activists drop fracking opposition in return for new task force to address concerns regarding hydraulic fracturing
• Consolidated Edison sees nearly 100% growth in solar rooftop installation in 2013 – solar cheaper than residential electricity rate
• Democrats increasingly backing oil and gas industry
• Energy Information Administration (EIA) says imported oil to meet 22% of US demand, the lowest level since 1970
• Reinstatement of the Production Tax Credit by Congress before year end remains highly uncertain
• California, under Assembly Bill No.327, starts rulemaking process to integrate cost-effective distributed energy resources into the grid
• Department of Energy, 2013 Wind Technologies Market Report – Wind Power Purchase Agreements at record low of US$25 per megawatt hour
• California passes bill to streamline residential solar applications and installations
• Gina McCarthy, Environmental Protection Agency (EPA) head, says renewable fuel standard ruling out shortly and could be higher because of increased gasoline usage
• EPA to decide this year whether to regulate methane emission from drilling (fugitive emissions)
• FutureGen 2.0 (experimental near-zero emission coal plant) gets EPA approval for CO₂ injection wells
• EPA must rule by December 1 on Ozone standard. Tightening to 60-70 parts per billions will impact power generators through additional nitrogen oxides and volatile organic compound abatement equipment

AEI Assessment

The policy debate around shale oil and gas continues to swing towards the moderates and away from the critics. The growing realisation of its transformational impact on the economy has broadened its appeal as it seems to hold the promise of jobs, prosperity and energy security. As a result we have raised our assessment for oil to Positive.

Renewable energy support policy continues to slide but the cost of solar and wind has fallen so dramatically that financial supports are becoming decreasingly important. As noted above rooftop solar and large scale wind are now competitive in conventional energy markets. Even after deducting the benefits of various subsidies, the economics are not so drastically affected as to completely negate renewable energy’s competitive position. Scale in both technologies and sensible policy support (like California’s decision to make rooftop solar installations less bureaucratic), continues to drive cost down making renewables so close to being strongly competitive against conventional energy on an unsubsidised basis.

The EPA is signalling its strong desire to continue to improve air quality by all means possible with FutureGen now able to proceed to construction and the department’s finding that ozone levels still too high.

Europe Headlines

• UK Department of Energy and Climate Change, less than one-quarter of UK public support shale gas development
• German electricity price go negative again from high wind production
• Italy passes changes to Feed-in-Tariffs for solar, effectively a 20% retroactive cut
• European Commission expected to confirm 40% carbon emission target by 2030 in October, efficiency and renewable targets to be considered
• Ukraine and Russia moving towards a permanent ceasefire

AEI Assessment

The next major policy development for the EU is their 2030 targets. Preliminary discussions continue to suggest efficiency and renewable targets will only be binding at the EU level and not at the country level. Given the ongoing divergence in energy policy amongst member states (Poland versus everyone else essentially), this seems to be a reasonable compromise as it recognises that some countries are more willing than others to migrate to higher levels of renewable energy and take responsibility for their contribution to climate change. Countries have exceeded EU targets in the past so an aggregate target does make sense as long as there are not too many other countries looking to get a free ride. Making the efficiency target non-binding is disappointing though as these are easily the most direct and least difficult technologically to reduce a nation’s energy intensity.

A political resolution in the Ukraine, at the time of publication, appears to be in the making which will substantially reduce the political risk in this region.

China Headlines

• Beijing cuts coal consumption 7% in first six months of 2014
• Smaller cities steer away from GDP as primary performance metrics, focus on raising living standards for poor, reducing poverty and environmental protection
• 70% of Chinese coal companies losing money as coal price at seven year low
• China appeals mixed World Trade Organisation ruling on US duties levied on solar panels, wind towers
• National Development and Reform Commission says China will start national carbon trading by 2016

AEI Assessment

It is becoming abundantly clear that China has recognised that business-as-usual will further aggravate the economic, societal and environmental imbalances in the country. Bringing forward its national carbon trading market and the move away from solely using GDP as a measure of success is tacit recognition by the government that externalities cannot be ignored forever. This will continue to put downward pressure on energy intensive, high emission industries.

Japan Headlines

• Japan has added 9,770 megawatts of clean energy since July 2012 – 98% is solar
• Minister of Environment, Japan should target 30% renewables by 2030
• Abe appoints new cabinet with the popular Yuko Obuchi tasked to push through the unpopular nuclear re-start agenda

AEI Assessment

Japan’s version of President Obama’s “all of the above” energy policy is best demonstrated by the expansion of solar power over the past two years. Over this time, Japan has approved an astonishing 65 gigawatts of new solar projects which actually exceeds Australia’s entire installed base of all forms of generation. The comment made by the Minister of Environment hardly seems necessary but is an important recognition by the government of the role of renewable energy in the energy mix. Yuko Obuchi appointment as the first female Trade and Industry Minister is hoped to appeal to the broader electorate as a recent Nikkei newspaper poll found 65% of female respondents opposed restarting Japan’s nuclear fleet.

Global Headlines

• India is considering adopting a Feed-in-Tariff regime for solar
• India proposing 10,000 megawatts of wind per year
• Brazil energy auction attracts offers of 26 gigawatts of wind, solar
• Africa to install more renewable power in 2014 than in previous 14 years
• 2,200 cellphone towers in India to be powered exclusively with solar
• India does not impose solar dumping duties
• Global solar installations on track for record for 2014, 52 gigawatts
• India’s Prime Minister Modi says good governance and clean energy are top priority

AEI Assessment

Momentum is building for an energy transformation in India and Africa. The deployment of solar cellphone towers in India is significant because it was needed to address the lack of dependable power in the area. This is a reflection of the larger problem facing the developing world where a centralised grid strategy has failed to lift nations out of energy poverty. Building a distributed energy grid around where energy is consumed instead of where resources are located is expected to be a fundamental principle in grid deployment in the developing world.

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