• The past week saw share markets lose a bit of momentum after a couple of weeks of strong gains, with growth trades like commodities prices and the Australian dollar actually falling back a notch.
• With US fiscal issues slipping back into the background it seems worries have returned about China with many fretting that the Peoples Bank of China is embarking on another monetary tightening to combat inflationary pressures and rising home prices after money market rates spiked igniting fears of another mini-credit crunch like that seen in June. However, the justification for a significant tightening is dubious as underlying inflation is just 1.6% and house price growth is running below that of growth in household income. It’s possible that the PBOC is just seeking to avoid a surge in liquidity at present given strong capital inflows. However, it would help if Chinese policy makers were a bit less opaque.
• In Europe, the ECB created a bit of nervousness by promising tough bank stress tests and indicating that some banks may fail the tests. The challenge is to have a backstop in place to recapitalise such banks by the time the results are released in November 2014. However, undertaking serious stress tests and recapitalising banks that don’t measure up will be a great step forward in terms of restoring confidence in the Eurozone banking system just as the 2009 bank stress tests cleared the air in the US.

Major global economic events and implications

• US economic data was soft with weaker than expected payrolls, existing home sales and house prices, a fall back in the Markit manufacturing condition’s PMI in October as the shutdown/fiscal debate impacted and a smaller than expected fall in unemployment claims as California IT problems continued to distort the data. While mortgage applications for purchase rose they remain soft. Construction activity was stronger than expected, but the overall impression remains consistent with the Fed not starting to taper its stimulus program until early next year, probably in March.
• The US September quarter profit reporting season is looking good. Out of 228 S&P 500 companies to have reported so far, 77% have exceeded earnings expectations and 54% have exceeded sales expectations.
• In Europe, advance business conditions PMIs were mixed in October – up for manufacturers but down for services. The overall trend remains up though and consistent with a continuing but gradual recovery. Consumer confidence also rose further in October.
• Japanese data showed further evidence of fading deflationary pressures with headline inflation rising 1.1% over the year to September and core inflation now zero having ground up from around 1% two years ago.
• Korean GDP growth rose more than expected in the September quarter on the back of recovering domestic demand continuing the upswing seen over the last year.

Australian economic events and implications

• Australia’s inflation rate spiked to 1.2% quarter on quarter in the September quarter. However, while the headline surge in inflation clearly shows the flow through of the earlier fall in the $A, the underlying picture for inflation remains benign: annual headline inflation is only 2.2%; underlying inflation averaged just 0.65% quarter on quarter and 2.3% year on year; the rebound in the $A over the last two months will dampen inflation in the current quarter; still weak demand and excess capacity is likely to continue to constrain price gains for the next year or so; and the September quarter is normally seasonally strong. The bottom line is that while the higher than expected inflation outcome has further reduced the chance of another interest rate cut, it still remains benign and consistent with rates staying low for an extended period.
• There was some good news from the Housing Industry Association which reported a rise in land sales – which is a good pointer to rising housing construction going forward.
• RBA Deputy Governor Phil Lowe expressed confidence that the combination of low interest rates, a lower $A and improved consumer and business confidence will drive a gradual lift in the non-mining economy. I agree, rates have been cut enough, the housing sector is recovering and confidence is moving in the right direction.
• The Federal Government’s $8.8bn recapitalisation of the RBA is to be welcomed but its more about maintaining faith in the RBA’s ability to respond to a crisis as opposed to whether it can or not. While the RBA’s Reserve Fund had fallen a few years ago, this was mainly because of the surge in the value of the Australian dollar which reduced the value of the RBA’s foreign exchange reserves. If a crisis arose whereby the value of the $A crashed the Reserve Fund would have bounced back in value sharply. And in any case, from these levels, the $A would have to fall a long way before it could be considered a crisis. So the RBA’s crisis management was never really at risk. And foreign exchange reserves have no bearing on the RBA’s implementation of monetary policy or if it wants to directly intervene to push the $A down. One thing it does all mean though is that the budget deficit this year will now blow out to around $40bn, but it doesn’t mean any deterioration in Government’s net asset position as the increase in its liabilities will have been offset by its investment in the RBA.

Major market moves

• Share markets lost a bit of momentum with solid gains in Australia, but some slowing in Europe and the US and falls in Japan and China. Continuing talk of taper delay in the US and good profit results helped, but fears of another bout of monetary tightening in China weighed.
• While gold prices rose, Chinese credit fears weighed on metal prices and oil prices fell back below $US100 a barrel. US gasoline prices are falling again and if the oil price stays where it is and the $A holds around current levels it could knock 4-5 cents a litre of average petrol prices in Australia.
• The Australian dollar slipped on the back of China credit fears and lower commodity prices.
• Bond yields mostly fell helped by firming expectations that Fed tapering is a long way off.

What to watch over the next week?

• In the US the focus is likely to be on the Fed (Wednesday) which is expected to make no changes to its quantitative easing program in view of softer recent economic data and the uncertainty caused by the shutdown/debt ceiling impasse and the ISM manufacturing conditions index (Friday) which is expected to show a slight fall on the back of the fiscal uncertainty. Data will also be released for industrial production and pending home sales (both Monday), producer price inflation, retail sales, house prices and consumer confidence (all Tuesday) and consumer price inflation (Wednesday). The inflation data is likely to be benign.
• The US earnings reporting season for the September quarter will continue. Consensus expectations have increased to around 2.5% growth year on year, but profit growth is ultimately likely to come in around 4 to 5%.
• Eurozone business condition measures (Wednesday) may see a small setback, but against a rising trend.
• In Japan, expect data for household spending, the labour market and industrial production to show ongoing evidence of economic growth.
• In China, the official manufacturing conditions PMI for October is expected to rise slightly consistent with the gain already recorded in the HSBC flash PMI.
• In Australia, a speech by RBA Governor Stevens will be watched closely for any clues regarding the interest rate outlook. Given the confidence Deputy Governor Lowe recently expressed in the economic outlook, it’s likely that Governor Stevens will signal a degree of comfort with current interest rate settings – assuming he offers any comments on current economic conditions. On the data front expect to see a continuing rising trend in new home sales and building approvals but modest growth in credit (all due Thursday). Data for house prices, the AIG’s PMI and producer price inflation will also be released Friday. Bank profit results will also be released for the ANZ (Tuesday), NAB (Thursday) and Macquarie (Friday).

Outlook for markets

• While shares are vulnerable to a correction or pause after recent strong gains the broad trend is likely to remain up as valuations remain reasonable, monetary conditions are set to remain easy and profits are likely to improve next year as global and Australian growth picks up. Australian shares look on track to hit 5500 or even higher by year end, with a little help from a Santa rally.
• Government bond yields are likely to resume a gradual upwards trend in the months ahead as the global economy continues to gradually pick up momentum and as Fed tapering eventually comes back into focus either later this year or early next. Low yields and an unwinding of years of massive inflows point to poor sovereign bond returns ahead.
• Signs that Australian interest rates are bottoming, a delay in Fed tapering, stable growth in China and improving global growth at a time when short $A positions remain extreme suggest that in the months ahead the $A is likely to see more upside, probably up to around $US0.98, before the medium term downtrend resumes.

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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