What does it all mean?

• The average Australian probably doesn’t know just how good the current economic circumstances are. The cash rate is at a 54-year low of 2.50 per cent. And it hasn’t been there for just a month or so, it has been at historic lows for 16 months – almost the longest period of stable rates – but certainly the longest period that official rates have held at cyclical lows. Economic growth remains good – the current 3.1 per cent annual rate is close to “normal”. Inflation is near the middle of the Reserve Bank’s target band. And rising share and home prices are boosting wealth levels to record highs.
• CommSec expects interest rates to remain stable until the second half of 2015. While we believe that underlying economic conditions are firmer than the Reserve Bank assumes, that needs to be translated into actual business spending and employment. The problem at present is that Australian companies are super-conservative – a point the Reserve Bank Governor makes at every opportunity.
• When Australian companies start investing and employing again, then the economy will be provided with fresh momentum and the Reserve Bank Board will have more to think about at each monthly meeting.
• Rate hikes are still more likely that rate cuts – despite what financial market pricing shows. In fact the Reserve Bank Governor outlined seven reasons to be positive on economic prospects when he fronted the House of Representatives Economics Committee meeting in August.
• In terms of the housing market and Australian dollar, the Reserve Bank made statements of fact rather than observations about whether recent changes have been either positive or negative. We get the sense that the Reserve Bank is exceedingly comfortable with current rate settings and the performance of the economy and financial markets.
• On the housing market, the Reserve Bank observed, “Credit growth Credit growth is moderate overall, but with a further pick-up in recent months in lending to investors in housing assets. Dwelling prices have continued to rise.”
• On the Aussie dollar, the Reserve Bank noted “The exchange rate has traded at lower levels recently, in large part reflecting the strengthening US dollar. But the Australian dollar remains above most estimates of its fundamental value, particularly given the further declines in key commodity prices in recent months. It is offering less assistance than would normally be expected in achieving balanced growth in the economy.”
• Reserve Bank Board members are very comfortable with current interest rate settings. And why wouldn’t they? Inflation is under control; low wage growth is capping inflationary pressures; the supply of homes is lifting to meet strong demand; and global economic conditions are mixed. Rates certainly don’t need to go up in the current environment; nor are there grounds for lower rates.
• The next key economic data is the release of October employment figures on Thursday. The quarterly Statement on Monetary Policy, containing the latest Reserve Bank economic growth and inflation forecasts, is issued on Friday.

What are the implications of today’s decision?

• Reserve Bank Board members are very comfortable with current interest rate settings. And why wouldn’t they? Inflation is under control; low wage growth is capping inflationary pressures; the supply of homes is lifting to meet strong demand; and global economic conditions are mixed. Rates certainly don’t need to go up in the current environment; nor are there grounds for lower rates.
• The next key economic data is the release of October employment figures on Thursday. The quarterly Statement on Monetary Policy, containing the latest Reserve Bank economic growth and inflation forecasts, is issued on Friday.

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David Bassanese

Anticipation of an increase in US interest rates in 2015 drove a rise in the US dollar, falling commodities prices and a sustained sell-off in the Australian equities market during the month of September, according to BetaShares’ Global Market Review.

The review, which analyses performance across seven major asset classes, found that international equities was the best performer for the month, experiencing 3.7% growth as increased confidence in the economy drove the US share market higher. The price of international equities in real terms also increased as the Australian dollar headed towards a four-year low against the US dollar.

US dollar strength was a major theme in global markets in September, with the greenback rising 6.8% against the Australian dollar over the month. Continued weakness in iron ore prices was also a major contributing factor to the weak AUD, said BetaShares Chief Economist David Bassanese.

“The fear of an end to quantitative easing hurt commodities and commodity exporting equity markets such as Australia’s – and emerging markets like Brazil – particularly hard,” Mr Bassanese said. “The strength of the US dollar added another negative factor to increasing commodity supplies and only modest global growth, making it hard to be positive on the commodity price outlook.”

Australian bonds and listed property also fell over the month, as the sell-off in the local equities market suppressed any increase in bond yields as a result of anticipated Fed tightening. Low global inflation and geopolitical tensions were likely to drive a further fall in yields by the end of the year, which could also affect the property sector, said Mr Bassanese.

“Unless the RBA moves to an easing policy bias again, 10-year bond yields are likely to head back to 4% p.a. by year end,” Mr Bassanese said. “While property is holding up well thanks to the uplift in residential construction and high land values, it could also be at risk of underperformance once the increase in bond yields begins.”

Looking ahead, Mr Bassanese noted an expectation of further international equities outperformance, with the Australian dollar moving down to 85 cents by the end of the year. “Given falling commodity prices and the AUD’s still uncomfortably high real level, I would expect medium-term weakness against the US dollar, the Euro and the Pound,” he said.

“This should drive global equities outperformance against the Australian market in unhedged terms, with the current pullback in global equities likely only a correction in a broader bull market.”

Click here for a copy of the full Global Market Review is attached.

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• 

  Housing approvals rose for the second month in a row.

  Dwelling approvals: Dwelling approvals rose by 3.0 per cent in August and are up 14.5 per cent over the year. Over past 12 months a record 197,571 dwellings were approved – marking the highest result on record.

• Trade deficit narrows: Australia’s trade deficit narrowed by $288 million to a deficit of $787 million in August – largely in line with forecasts.
• Exports to China eased for the fourth straight month with receipts of $98.5 billion for the year to August. Exports to the US hit a near 5-year high of $10.42 billion in the year to August.
• Reserve Bank Assistant Governor, Malcolm Edey, and Head of Financial Stability Department, Luci Ellis, appeared before the Senate Committee. The RBA officials stressed that no specific macro-prudential controls have been ruled in or out although restrictions on loan to valuation ratios (LVRs) were considered unlikely.

What does it all mean?

• The latest economic data was clearly encouraging – particularly the lift in dwelling approvals. Dwelling approvals rose for the second straight month in August and hit record highs when viewed over the past 12 months. At the same time the trade deficit narrowed.
• Over the past 12 months there were 197,571 approvals to build new homes, marking the highest result on record. And despite the fact that approvals have consolidated over the past few months it is pretty clear that housing activity is going to be the backbone of Australia’s growth story over the coming year.
• Keep in mind that dwelling approvals (16,810) are holding over 24 per cent above decade averages, underpinned by pivotal private sector house approvals, suggesting that home building is set to lift further over the second half of 2014.
• Lower interest rates, strong population growth, improving affordability, and pent up housing demand will see the housing sector gather pace over the medium term. In addition the recent cuts to fixed interest rates by the major banks will spur a further round of home building.
• The lift in approvals will appease policymakers to some degree. Fundamentally, the growth in house prices has been driven by a lack of stock, and a substantial lift in new housing stock should ensure more sedate price growth over the longer term.
• The latest trade figures were more positive than in recent times. Australia recorded its fifth consecutive trade deficit, but the August deficit of $787 million was the smallest deficit over that period. In addition the recent slide in the Australian dollar is yet to filter to through to the trade accounts and should support a lift in exports in the next result.
• From a broader sense Australia is certainly less vulnerable to external shocks than compared with the past and the demand for Australian resources will continue to underpin the trade accounts. That is not just an ongoing lift in iron ore volumes, but also the anticipated lift in LNG exports. And to some degree the slide in commodity prices will be offset by the fall in the Australian dollar.
• Interestingly Australia’s exports to China and the US are looking more encouraging. Australia’s exports to China held just shy of $100 billion the year to August, and account for over 36 per cent of Australia’s total exports. And exports to the US hit a near 5-year high of $10.42 billion in the year to August. No doubt the lift in growth across the super economies bodes well for Australia’s external growth prospects.
• While rate hikes are off the near term agenda, it is unlikely that the Reserve Bank will shift away from its “interest rate stability” rhetoric any time soon. A few solid months of robust employment would be required to change the “on hold” message. The data suggests that the Reserve Bank will continue to keep a neutral view on rates with a slightly dovish skew.

What do the figures show?

Building Approvals:

• Dwelling approvals rose by 3.0 per cent in August after rising by 2.1 per cent July. Approvals are up 14.5 per cent over the year. Over past 12 months a record 197,571 dwellings were approved – marking the highest reading on record.
• The current number of dwelling approvals (16,810) is well above the decade average (13,555) and five-year average (14,291).
• House approvals fell by 1.4 per cent in August (private sector down 1.8 per cent). Meanwhile ‘lumpy’ apartment approvals rose by 9.2 per cent in August after rising by 3.0 per cent in July.
• House approvals are up 12.6 per cent over the past year while apartments are up 17.1 per cent.
• Across states in August: NSW approvals rose by 2.9 per cent; Victoria rose by 15.5 per cent; Queensland rose by 1.4 per cent; South Australia rose by 11.3 per cent; Western Australia fell by 16.2 per cent; Tasmania fell by 0.6 per cent.
• The value of all commercial and residential building approvals rose by 0.5 per cent in August after falling by 10.9 per cent in July. Residential approvals rose by 3.0 per cent with new building up by 3.4 per cent and alterations & additions up by 0.4 per cent. Commercial building fell by 4.5 per cent in August after falling by 27 per cent in July.

International trade:

• Australia’s trade deficit narrowed by $288 million to a deficit of $787 million in August. The July trade balance was revised from a deficit of $1,359 million to a deficit of a $1,075 million.
• In August, exports of goods and services fell by 1.5 per cent (goods down by 1.9 per cent) while imports of goods and services fell by 2.5 per cent (goods down 3.1 per cent). Exports are down 4.7 per cent on a year ago, while imports are down by 5.1 per cent.
• Rural exports fell by 4.2 per cent in August while non-rural exports fell by 0.1 per cent.
• Within imports, consumer imports fell by 0.9 per cent in August with capital goods imports up by 5.9 while intermediate goods imports fell by 8.7 per cent.
• Consumer goods imports are down 2.6 per cent on a year ago while capital goods imports are down by 8.2 per cent and intermediate goods imports are down by 3.3 per cent.
• The net services deficit narrowed marginally by $26 million to $878 million in August.
• Australia’s exports to China eased further from record highs, posting earnings of $98.5 billion in the year to August. And down from a record $100.6 billion in the year to April. Annual exports were up 19.1 per cent on a year ago and accounted for 36.13 per cent of Australia’s total exports, just down from a record high of 36.73 per cent in the year to April.
• Australia exports to the US hit a near 5-year high of $10.42 billion in the year to August. The share of exports going to the US hit a 3½-year high of 3.82 per cent.
• Australia’s imports from China eased from a record $50.3 billion in the year to July to $50.0 billion in the year to August, up 10.2 per cent on a year ago and accounting for a record 19.99 per cent of Australia’s total imports.
• Australia’s rolling annual trade surplus with China stood at $48.5 billion in August, easing further from the record high of $51.1 billion in April.

Senate Economics Committee – Inquiry into Affordable Housing

• Reserve Bank Assistant Governor, Malcolm Edey, and Head of Financial Stability Department, Luci Ellis, appeared before the Senate Committee today. Their opening statement can be found here.
• To date, the transcript of the Senate hearing is not available.
• Key points:
• One key measure of affordability – the repayment on a typical new housing loan expressed as a ratio to disposable income – “has fluctuated around a broadly stable average over the past three decades, with average repayments varying between around 20 and 30 per cent of disposable incomes.”
• “the ratio of housing prices to incomes is at the top of its historical range; but…
  over time, this has been more than offset by falls in financing costs, so that the typical repayment burden as a share of income is not particularly high. This of course does not rule out affordability problems in particular market segments or for particular types of households.”
• The composition of housing finance has become unbalanced with investor demand dominating, especially in Sydney & Melbourne.
• The RBA officials stressed that no specific macro-prudential controls have been ruled in or out although restrictions on loan to valuation ratios (LVRs) were considered unlikely.
• The RBA officials were at pains to point out that the strength of investor housing demand was largely limited to Sydney and Melbourne. The key would be to devise controls that didn’t discourage new housing supply that was required to meet strong demand and lead to more sustainable growth of home prices.
• The Bureau of Statistics’ monthly Building Approvals release contains figures on local council approvals to build residential structures such as homes and units as well as commercial premises such as offices and shops. Approval is one of the first stages of the construction ‘pipeline’ and is thus a key leading indicator of future activity. An increase in approvals would point to stronger future activity for construction-related companies.
• The monthly International Trade in Goods and Services release from the Bureau of Statistics provides estimates on exports and imports of physical goods (such as coal, beef and computers) and services (such as travel receipts). The balance of goods and services (BOGS) is a narrower description of Australia’s external position than the current account estimates. The import data is a useful gauge of consumer and business spending while exports reflect global demand as well as domestic influences such as drought.
• The Reserve Bank would be heartened by the second wind in dwelling approvals. Housing activity is no doubt supporting the overall lift in spending and will continue to absorb the weakness in mining investment.
• Overall the economy is on a solid footing and remains fundamentally sound. Given the low interest rate environment, falling Australian dollar and the lift in home prices, the Reserve Bank is likely to be watching for an improvement in labour market conditions before thinking about a lift in interest rates. We expect the Reserve Bank to maintain a neutral monetary policy stance, while keeping a close eye on the transition of growth from mining investment to other parts of the economy. Rates are expected to remain on hold over the rest of 2014.

What is the importance of the economic data?

• The Bureau of Statistics’ monthly Building Approvals release contains figures on local council approvals to build residential structures such as homes and units as well as commercial premises such as offices and shops. Approval is one of the first stages of the construction ‘pipeline’ and is thus a key leading indicator of future activity. An increase in approvals would point to stronger future activity for construction-related companies.
• The monthly International Trade in Goods and Services release from the Bureau of Statistics provides estimates on exports and imports of physical goods (such as coal, beef and computers) and services (such as travel receipts). The balance of goods and services (BOGS) is a narrower description of Australia’s external position than the current account estimates. The import data is a useful gauge of consumer and business spending while exports reflect global demand as well as domestic influences such as drought.

What are the implications for interest rates and investors?

• The Reserve Bank would be heartened by the second wind in dwelling approvals. Housing activity is no doubt supporting the overall lift in spending and will continue to absorb the weakness in mining investment.
•  Overall the economy is on a solid footing and remains fundamentally sound. Given the low interest rate environment, falling Australian dollar and the lift in home prices, the Reserve Bank is likely to be watching for an improvement in labour market conditions before thinking about a lift in interest rates. We expect the Reserve Bank to maintain a neutral monetary policy stance, while keeping a close eye on the transition of growth from mining investment to other parts of the economy. Rates are expected to remain on hold over the rest of 2014.

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Financial Accounts; Population; Job Vacancies; Final Budget Outcome

• Household wealth stood at a record $7,780.6 billion at the end of June, up $97.4 billion or 1.3 per cent over the quarter. In per capita terms, wealth rose to a record $330,841 in the June quarter, up $2,860 over the quarter
• Population: Australia’s population grew by 111,500 people over the March quarter to 23,452,700. Annual population growth eased from 1.72 per cent to 1.69 per cent. Population growth is above decade averages in just NSW (32 per cent above decade averages) and Victoria (14 per cent above decade averages).
• Baby boom: In the year to March, 306,500 babies were born, just shy of the record 312,200 babies born in the year to September 2013. A total of 231,500 people migrated to Australia over year to March, well off the low of 172,100 in the year to December 2010.
• Job vacancies: Job vacancies fell by 0.7 per cent in the three months to August – the first fall in three quarters. Job Vacancies are up 4.1 per cent on a year ago.
• The final Federal Budget deficit for 2013/14 was $48.5 billion. The result was inflated by the contribution to bolster the Reserve Bank’s balance sheet.
• The Reserve Bank Governor was a panel discussant at the Melbourne Economic Forum. The Governor once again reiterated the concerns about the lift in house prices and “unbalanced” investor demand. The Governor was sceptical about using macroprudential tools “as a panacea” but is open to using them to ensure sustainable housing and  lending practices.

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Labour market conditions had remained subdued: RBA Board

The September RBA Board Minutes look a little dated. The RBA Board meeting preceded the recent data batch which showed that the Australian economy is travelling along better than what the RBA has assumed in its growth forecasts. And the recent slide in the AUD, if maintained, means that the RBA is likely to upgrade its growth and inflation forecasts.

The Minutes are “neutral” in their outlook for monetary policy, as they have been this year. But concerns change over time. One way to assess the evolution in the Board’s thinking on considerations for policy is to look at what has changed in the narrative from the previous month’s minutes.  And on that score, the Bank has some growing concerns around house price growth. The Minutes note that, “policy also needed to be cognisant of the risks to future growth that could accompany a large further build‑up in asset prices, particularly if that was associated with an increase in leverage.”  Indeed, a decent chunk of the Minutes are attempts to jawbone the housing market.

Stevens just recently stressed that the RBA has done as much as they can in creating a backdrop that should support economic growth¹.  Stevens all but ruled out any further rate cuts by stating that “further inflating an already elevated level of house prices seems an unwise route (to reduce unemployment)”.  House price data for August showed that prices surged again in Sydney and Melbourne over the month. And the most recent loan data showed that investor loans are around their highest share on record of total loans.

On the labour market, the Board stated that “labour market conditions had remained subdued” and that “forecasts of a period of below‑trend growth in economic activity meant that it would be some time before the unemployment rate declined consistently”. The most recent jobs figures (published after the September meeting) recorded a huge 121k spike in employment and a large 0.3ppt fall in the unemployment rate to 6.1%.  Cutting through the monthly noise shows that trend employment growth is running at 20k on a three‑month basis. Employment growth around this level is in line with a flat unemployment rate. And coupled with the positive leading indicators suggests that the RBA is, in our view, being overly pessimistic in its assessment of the jobs market. The risk is that the unemployment rate starts to decline ahead of the RBA’s expectations.

There was very little from the Bank on inflation given the SMP was published last month just after the QII CPI.  Nonetheless, we note that the softer AUD, if sustained, is likely to mean that inflation runs ahead of RBA forecasts (the latest RBA forecasts used an AUD worth 93 US cents).

The good economic data reads since the last RBA meeting, coupled with the slide in the AUD, has seen market pricing for a further rate cut wane substantially. We have been arguing for some time that market pricing was overstating downside risks to the growth and inflation outlooks. Our base case has the RBA on hold until Q1 2015 where we have pencilled in a rate hike.

———-

¹“The Economic Scene” – Glenn Stevens address to a CEDA Luncheon, Adelaide 3 September 2014

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• Share markets continued to move up over the past week helped by a combination of good economic data in the US, expectations that central banks will remain supportive and as geopolitics took a back seat. Good earnings results also helped boost the Australian share market to a post GFC high. Reflecting better US data and an abatement of safe haven demand bond yields mostly rose. Commodity prices were mixed though with oil and gold down but metals up. A stronger $US saw the Yen and euro down but the $A little changed.
• The message from the last week hasn’t really changed much. The US looks good but continuing low inflation is giving the Fed plenty of breathing space, Japan seems to be gradually emerging from the tax induced June quarter slump but Europe remains soft and Chinese data came in a bit softer than expected. Reflecting this, August business conditions PMIs rose nicely in the US and Japan, but slipped in China and Europe. The overall global recovery remains on track, but its gradual and it is not an environment where central banks will be in a hurry to take away the punch bowl.
• Rates on hold for a while yet, is also the key message in Australia. Governor Steven’s Parliamentary Testimony providing a good insight to the RBA’s thinking. In essence, Governor Stevens thinks the RBA has done enough on rates and we are seeing a pick-up in financial risk taking, but we now need to see a pick-up in “animal spirits” to drive more real economy risk taking via increasing non-mining investment. So it’s now a matter of keeping rates stable and low until this flows through. So the RBA has no real inclination to raise or cut rates. Given likely sub-trend growth in the near term and benign inflation and the still strong $A, the cash rate could be stuck at 2.5% out to mid next year at least.
• The Ebola threat is worth keeping any eye on as its continuing to rage in West Africa and the chance of travellers returning with it from Africa to a western country sooner or later can’t be ignored. In terms of assessing the market impact, signposts to watch are: the number of new cases (for signs of a peak or otherwise), its rate of spread into Nigeria, cases showing up in Western countries and transmission within Western countries. Just bear in mind though that it’s about as transmissible as HIV so if it does find its way into western countries modern medical facilities and higher hygiene standards should mean it is contained. So for investors I think it remains a case of being alert, but not alarmed.

Major global economic events and implications

• US economic data remains pretty positive with strong gains in home builder conditions, housing starts, existing home sales and the Markit and Philadelphia Fed business conditions indexes but softer than expected inflation in July of just 1.9% year on year at a core level. The rise in housing indicators confirms that the housing recovery is getting back on track but at the same time benign inflation gives the Fed plenty of breathing space. So while the Minutes from the Fed’s last meeting saw a more hawkish tone and acknowledgement of progress on the labour market, the majority on the Fed are still cautious having seen a few false starts before and in no rush to tighten.
• It was a similar story on inflation in the UK with the July CPI actually falling and adding to signs that the Bank of England’s first rate hike is still some time away.
• Japanese economic data is showing signs the economy is shaking off the tax hike hit with the Markit manufacturing PMI up more than expected in August and gains in leading indexes and machine tool orders.
• Eurozone business conditions PMIs disappointingly, but not unsurprisingly, fell in August. While they remain at levels consistent with quarterly growth of around 0.3% they highlight that the recovery remains fragile and that the ECB has more work to do.
• Chinese economic data economic data is a mixed bag with profit growth up in July and the MNI business confidence indicator rising to its highest in nearly three years, but the flash August HSBC PMI falling back more than expected and the decline in house prices picking up in July with 64 of 70 cities seeing price declines and average prices falling by around 1%. The HSBC PMI is just stuck in the same range around 50 it has been in for the last three years now which remains consistent with growth around 7.5%, but the risks from the housing slowdown mean more mini-stimulus measures may still be required.

Australian economic events and implications

• There were only second order data releases in Australia, but the ANZ/Roy Morgan weekly consumer confidence survey and skilled job vacancies both rose nicely highlighting that there is a bit of light at the end of the tunnel for the Australian economy.
• The profit reporting season is now 75% done and is looking good. Sure it’s not been easy for non-financial industrial companies and there is still another week of results left with poorer performers often reporting late in the season. But the bottom line is that the June half earnings results are nowhere near as bad as many feared. In fact, the profit results overall are looking pretty good. 53% of companies have exceeded expectations (compared to a norm of 43%), which is the best result in nine years; 71% of companies have seen their profits rise from a year ago (compared to a norm of 66%); 67% of companies have increased their dividends from a year ago (up from around 60% in the last two years); and 58% of companies have seen their share price outperform the market on the day they released results, which is the best result in four years. Key themes have been continued strength for resources (notably Rio, although BHP disappointed), banks doing well (with a good result from CBA), ongoing cost control making up for still soft revenue growth and strong growth in dividends reflecting investor demand for income and corporate confidence in earnings prospects. Australian earnings for 2013-14  look to be on coming in a bit stronger than consensus expectations for growth of around 12 to 13%. This is being led by resources with a 28% gain, followed by banks up 10% and the rest of the market up around 4.5%. Consensus expectations for 5% earnings growth in the current financial year look a bit low to me.

What to watch over the next week?

• In the US, expect a solid bounce in new home sales after a weak June and continued strength in the Markit services PMI for August (both Monday), a continued trend rise in durable goods orders, modest gains in home prices, a slight fall in consumer confidence (all Tuesday), a rise in pending home sales (Thursday) and a continued benign reading for the core private consumption deflator (Friday) which is the Fed’s preferred inflation measure.
• In the Eurozone, expect a slight fall in confidence readings (Thursday) and continuing low inflation in August (Friday).  Lending data (Thursday) will be watched for signs that recent improved momentum is continuing.
• Japanese data for household spending, industrial production and the labour market to be released Friday will be watched for further signs of recovery following the tax induced growth contraction in the June quarter. Inflation data will also be released Friday.
• In Australia, expect June quarter construction data (Wednesday) to be soft but supported by the ongoing housing construction recovery but June quarter capital spending (Thursday) to remain soft as mining investment continues to slow. The focus in the capex survey though will be on investment intentions which are expected to show further signs of an improving outlook for non-mining related investment. Expect new home sales (Thursday) to remain solid and private credit (Friday) to show a further modest improvement in momentum.
• It will also be the final week of the Australian June half profit reporting season with 50 major companies due to report, including Worley Parsons, Qantas and Woolworths. The final week often sees a few rough results as laggards sometimes come last.

Outlook for markets

• While we remain in the time of the year renowned for share market corrections, so another bout of volatility in the next month or so is possible, the broad trend in shares is likely to remain up.Valuations remain okay particularly once low interest rates and bond yields are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. Our year-end target for the S&P/ASX 200 remains 5800.
• Low bond yields, eg 10 year yields of just 0.5% in Japan and 3.5% in Australia, will likely mean soft returns from government bonds.
• 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 $US0.80 in the next few years, but as always with currencies getting the timing right is hard.

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.

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• The Governor’s opening statement forecast that growth of 2‑3%pa is the most likely outcome for 2014/15 and inflation to remain consistent with the 2% to 3% target.
• Economic growth could be higher but there are significant forces restraining activity.
• There are signs of a pick‑up in non‑mining investment but investment intentions are mixed and dependent on the domestic growth outlook. Australians have become more risk averse since the GFC.
• The unemployment rate could stay near present levels and not fall significantly until 2016.
• The AUD remains high because of comparatively attractive yields in Australia. The USD is unusually weak. The RBA is not keen on market intervention to weaken the AUD.

RBA Governor Stevens and other officials appeared before the House Economics Committee in Brisbane this morning.  While the recent Statement on Monetary Policy (SMP) seemed to emphasise the downside risks to growth, the Governor was a touch more positive yesterday. The Governor was willing to contemplate some upside growth risks and noted that recent forecast changes didn’t really indicate a shift in thinking. Assistant Governor Kent muddied the waters a little by suggesting that the labour market outlook was little changed from earlier thinking as well, with a turning point in unemployment a little sooner than suggested in the SMP. The comment certainly suggests a reluctance to cut rates. But equally, the Governor made it clear that the RBA had not thought about raising rates lately.

The opening statement repeated some of the themes evident in the detailed media interviews and speeches in recent months. Namely, in terms of the world economy, growth is continuing at a “moderate pace”.  Importantly for Australia, major trading partner growth is running around its long‑run average rate.  China’s growth has been close to the official target of 7.5%.  The Governor noted the low volatility across global financial prices which is partly a reflection of the “exceptional” accommodative monetary policy that has been conducted across the world.

In terms of the Australian economy, GDP growth looks set to be between 2% and 3% in 2014/15 which is below its trend rate. The forces restraining growth are well known. The current fall in mining investment could be a bit larger than previously expected. The Australian dollar (AUD) remains relatively high, especially when compared to the level and direction of bulk commodity export prices. The USD, unusually, appears to be relatively weak given its firming growth and interest rate outlooks. Consumer spending is unlikely to lift significantly and could rise in line with modest income growth.

Offsetting these domestic weaknesses there is clear evidence of stronger activity in the interest‑rate‑sensitive areas like housing and other construction. The labour market reflects the conflicting forces in the real economy. The RBA expects the unemployment rate to stay high for a considerable period, until 2016. June quarter GDP growth is likely to be relatively weak compared to the strong QI figure.

The Governor’s testimony indicates that other issues, besides monetary policy, are holding growth back from its potential rate. Namely, a consistent and sustained lift in business confidence is required which would lead to higher non‑mining business investment. The shift to more risk aversion by households and business restrains economic growth.

The unemployment rate could stay near present levels until well into 2016. While forward indicators are positive there are other issues, like strong population growth, which impede a marked reduction in the unemployment rate.The highlights of the Q&A session include:

•  The high AUD reflects strong inflows of capital seeking higher yields, as well as a weak USD.
•  The RBA is keeping direct currency intervention as “part of the toolkit”.  So far, the Governor believes that it was been the “right call” not to intervene in the currency market.
•  Low wages growth is a product of elevated job concerns but it will help the economy adjust to a more competitive position and support jobs growth.
•  Productivity trends appear to be improving but more efforts are required to replicate the 1990s gains.
•  The RBA’s inflation target has a priority in policy deliberations over the setting of the cash rate.

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• The share market correction continued over the last week with a whole range of issues weighing on confidence including Russian retaliatory sanctions, increased fears of a Russian invasion of Ukraine, the US finally committing to air strikes on northern Iraq, poor data in Europe, strong data in the US continuing to feed Fed tightening fears and even the latest Ebola virus outbreak. From their recent highs US shares have now fallen 4%, Eurozone shares 10%, global shares 4% and Australian shares 3.5%. The risk off tone saw bond yields and metal prices fall and the gold price rise. The $A also came under pressure helped along by a sharp rise in unemployment in Australia and a dovish statement from the RBA.
• The share market correction may have a bit more to run, but we are getting close to a buying opportunity. To be sure, the combination of factors now roiling markets is scary. But this is the usually the case during periods of market volatility. Some of the factors floating around continue to look like an excuse for a correction: Russia’s ban on various agricultural imports will hurt but needs to be put in perspective – Russia only takes 0.3% of Australia’s exports (the same as Turkey), 0.7% of America’s and 4% of the European Union’s; US airstrikes on northern Iraq have been on the cards since June, do not signal a return of US ground forces to that country and are unlikely to threaten the bulk of Iraqi oil exports most of which comes from the south; and numerous pandemic scares have come along in recent years (SARs, bird flu and swine flu) only to fade reasonably quickly. Moreover, if Europe does weaken anew it will be met by more aggressive easing by the ECB and even if these considerations further dampen global growth they will just have the effect of further pushing out any Fed tightening removing what is probably the biggest source of nervousness for investors at present.
• More fundamentally, the absence of investor euphoria and reasonable valuations at recent share market highs, continuing easy global monetary conditions and the improving economic outlook are not consistent with the start of a major bear market. So while the share market correction could go a bit further, it’s likely to prove mild and the broad trend in shares is likely to remain up with new share market highs likely to be seen in the months ahead. The key is to look for signs of the selling exhausting itself in the days/weeks ahead as a signal to buy in. Rising levels of investor pessimism tell us that the complacency seen last month is getting washed out, which in turn will help set up a base for shares to start heading up again.
• Interest rates to remain on hold in Australia. There were no surprises from the RBA which continues to indicate that a period of interest rate stability remains prudent. While the RBA’s quarterly Statement on Monetary Policy had a more dovish tone with its growth forecasts revised down by 0.25% pa and growth not seen rising above 3% until 2016, it doesn’t appear to regard these changes as “material” enough to justify another rate cut. The improvement in housing indicators, business confidence and forward looking labour market indicators tells us that rates are low enough, but with unemployment still rising, the $A still strong and uncertainty remaining about the speed of the mining investment slowdown its hard to justify a hike in rates either. Particularly with inflation expected by the RBA to remain consistent with target helped by weak growth in wages. So while the dovish tone in the RBA’s SOMP implies a greater risk of a rate cut than a hike in the short term, the most likely outcome is an extended period on hold into next year until the cycle eventually starts turning up again. In fact, the first rate hike is unlikely to come until after the Fed has started to raise rates, in other words not until second half 2015.

Major global economic events and implications

• US economic was mostly solid with the Fed’s latest survey of banks revealing a further easing in lending standards and increased demand for credit, a stronger than expected rise in factory orders, a rise in the ISM non-manufacturing conditions index to its highest since 2005, another fall in jobless claims, a smaller trade deficit for June and the mortgage delinquency rate falling to its lowest since 2007.
• Meanwhile, US June quarter earnings results remain strong. 90% of the S&P 500 has now reported with 75% beating on earnings (against a norm of 63%) and earnings growth for the quarter now running around 11% year on year, which is about 6 percentage points above expectations at the end of June. The big improvement has been on sales with 64% beating expectations compared to an average of just 41% over the last three years.
• Eurozone data was soft with a sharp fall in German factory orders, mixed readings on industrial production and a fall in Italian GDP adding to growth concerns. As expected the ECB left policy on hold, clearly preferring to give the June easing measures a chance to work. However, ECB President Draghi clearly recognises the downside risks and reaffirmed the ECB’s commitment to use quantitative easing if necessary.
• In China, soft July services PMIs raised concerns that the stimulus measures seen so far haven’t spread much beyond manufacturing. With the latest property slump likely weighing economic policy will likely need to be eased further. Meanwhile trade data provided mixed signals with weaker imports but a double digit gain in exports.

Australian economic events and implications

• A bad run of Australian data, but not that bad. The past week saw a bad combination of Australian data with the unemployment rate spiking to 6.4%, the trade deficit remaining large in June and June quarter real retail sales falling 0.2%. Australia’s official unemployment rate is now above that in the US and as a result of the June quarter trade and real retail sales data there is a possibility that June quarter GDP growth will be negative. However, there are several reasons not to be too alarmed. First, just as the jobs figures at the start of the year looked unbelievably strong, they now look too soft. In particular the rise in the unemployment rate looks to have been exaggerated by a rotation in the ABS sample and a change in the ABS survey questions. Second, forward looking jobs indicators – such as ANZ job ads, skilled vacancies and the employment component of the NAB business survey – all point to stronger jobs growth. Third, the June quarter trade data looks to be payback for the strength seen in the March quarter. Fourth, June retail sales showed a solid bounce back from the Budget related hit in May. Fifthly, it’s worth noting that the AIG’s services, construction and manufacturing conditions indexes all rose in July. Finally, housing finance remained strong in June telling us the housing recovery remains on track.
• It’s way too early to draw any conclusions from the June half profit reporting season in Australia as only a few companies have reported. But so far so good with more companies seeing profits up than down and dividends continuing to increase with Rio being a standout on this front. The big miners are clearly responding to investor demand for dividends with Rio’s dividend yield now being 4.8% and BHP’s 4.9%.

What to watch over the next week?

• In the US, expect a 0.3% gain in July retail sales (Wednesday), a 0.3% rise in July industrial production, another solid reading in the Fed’s New York regional manufacturing index and a benign July PPI reading (all Friday).
• Eurozone June quarter GDP data (Thursday) is expected to show flat growth.
• Japanese June quarter GDP (Wednesday) is expected to fall by 1.8%, reflecting payback for the pull forward of demand ahead of the sales tax hike. This was expected and does not represent the start of another recession.
• Chinese July activity data (Wednesday) is expected to hold around the improved pace seen in June with retail sales expected to be up 12.5%, industrial production expected to rise 9.1% and fixed asset investment to come in around 17.4%. Money supply and credit growth is expected to have slowed back a bit from the strong June pace.
• In Australia, expect to see July business confidence hold around June’s reasonable levels according to the NAB business survey (Tuesday), a 1% rise in June quarter house prices (Tuesday), a further recovery in consumer sentiment (Wednesday) reflecting the gains already seen in weekly consumer sentiment surveys and continued modest wages growth in the June quarter (also Wednesday) of just 2.5% year on year.
• The Australian June half profit reporting season will ramp up with 36 major companies reporting. Consensus earnings estimates for 2013-14 are for 12% growth led by resources with +28%. The combination of the lower iron ore price, the higher $A and the hit to confidence from the Budget suggest a bit of downside risk to consensus estimates. Given relatively elevated PEs compared to a few years ago underperformers will be hit hard. Most interest is likely to be on outlook statements with a bit of upside potential for companies exposed to housing, non-mining construction & retailing. Consensus 2014-15 earnings growth estimates are modest at +5%.

Outlook for markets

• Shares have been at risk of a correction for some time and it now seems to be upon us. It may have a bit further to go but we see little evidence suggesting we have seen a major market top. Valuations were not onerous at recent highs, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. As a result the current pullback should be seen as providing a buying opportunity as the broad trend is likely to remain up. Our year-end target for the ASX 200 remains 5800.
• Bond yields are likely to resume their gradual rising trend over the next six months as the US economy continues to strengthen. This and low yields is likely to mean pretty soft returns from government bonds.
• The combination of soft commodity prices, an increasing 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.

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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Economic & financial perspectives

• 

  Overall, it has been a positive year.

  A good year:  Total returns on Australian shares (All Ordinaries Accumulation index) are currently up 17.3 per cent over 2013/14. If returns hold at these levels through to June 30 then investors will have experienced the best back-to back returns in seven years.

• Other returns higher: Returns on dwellings are up 15.3 per cent while returns on government bonds have lifted by 4.2 per cent. A rare event – bonds, property and shares have all lifted over the past year.

What does it all mean?

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RBA Board minutes

• Reserve Bank Board minutes: Board members continue to expect a period of stability in interest rates. Board members appeared to spend a lot of attention on the labour market, commenting “that a range of indicators of labour demand suggested a modest improvement in prospects for employment, although the unemployment rate was still expected to edge higher for a time”.
• Forward-looking Reserve Bank. Board members discussed the “industry composition of output, investment and employment growth over the past two decades”, and downplayed the manufacturing job losses: “future employment growth was likely to continue to be concentrated in service industries”.
• Cautiously optimistic outlook. Policymakers noted “promising signs” of stronger home building and consumer spending to offset weaker mining investment and public spending.

What does it all mean?

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