How does the current economic environment  impact fixed income markets and which investment strategies are best positioned to benefit?

The forces shaping fixed-income markets found themselves at a confluence of economic, fiscal, and political factors heading into 2025. Inflation dynamics remained in flux, a new Treasury Department was in place to strategise the balance between fiscal and monetary conditions, and Donald Trump’s incoming second administration continues to introduce important dimensions to policy and growth.

This convergence of factors will play a pivotal role in shaping the trajectory of financial markets and determining whether balance can be restored to fixed income markets in 2025.

As 2025 progresses, the above-mentioned economic, fiscal, and political factors have created a landscape filled with both opportunity and risk for fixed income investors as we are likely entering a new regime characterised by higher volatility in interest rates, inflation and credit spreads.

Inflation is dead…or is it?

For years, the forces of economic optimism have prevailed. Asset prices have tested all-time highs, growth has been robust in both nominal and real terms and the labour market remains healthy despite some normalisation. However, inflation – though tempered – continues to cast a shadow and threatens to destabilise the balance.

The US Federal Reserve (the Fed) aims to balance economic growth and, at the same time, prevent inflationary forces from wreaking havoc in fixed income markets. How the Fed navigates this challenge will hinge on a few key factors:

Timeframe informs perspective

This struggle in financial markets has had no definitive conclusion in recent quarters. Inflation was declared dead in Q3 2024, only for it to reemerge in Q4 2024 as the new year approached. Various measures of annualised inflation over a 3-month period suggest inflation gaining strength, while those measures annualised over a 6-month period suggest a more positive outlook (figure one).

Since the December 2024 FOMC meeting, Jerome Powell and the Fed have signalled unease regarding the recent rise in inflation measures, subtly shifting their focus from labour and growth to containing inflation.

Shifting market forces

Market forces can shift in both cyclical and structural ways. Cyclical shifts can occur rapidly, rendering forecasts outdated, increasing uncertainty and driving price volatility across financial assets. Structural shifts typically take longer to unfold and require time to unveil unexpected impacts.

At the start of 2025, the Fed faced a mix of structural and cyclical forces that challenged forecasting and rendered conventional monetary policy less effective in their quest to dampen inflation. For example, cyclical forces such as normalising supply chains, productivity green shoots and contained commodity prices typically support more stable prices. Conversely, structural forces like deglobalisation, rising geopolitical tensions and higher fiscal deficits are often inflationary. To complicate matters further, President Trump’s administration is introducing additional forces to reckon with. Tariffs, immigration policy and pro-business measures are generally associated with wide-ranging outcomes that will require the Fed to carefully assess which factors to prioritise as forecasts are determined and policy is implemented.

Although inflation has declined materially over the medium term, a shorter-term perspective suggests it is not yet dead. Meanwhile, shifting market forces will likely make forecasting more challenging as inflation volatility increases. As a result, the Fed may need to keep monetary policy tighter than previously expected to maintain order in bond markets. 

The treasury strikes back

Scott Bessent, the newly appointed Treasury Secretary in the Trump administration, succeeded Janet Yellen. Bessent, a legendary macro investor and former Chief Investment Officer of Soros Fund Management, worked alongside investing titans George Soros and Stan Druckenmiller.

Renowned for his expertise in global macroeconomic trends, Bessent’s appointment marks a notable shift at the Treasury Department from Yellen’s background in academia and public policy to Bessent’s deep roots in the private sector and financial markets. Thus far, financial markets have received the Bessent appointment with optimism, given the expectation that his policies will include pro-growth and fiscally pragmatic measures.

While this combination will play an important role during his time at the Treasury, other pieces to the Bessent policy puzzle might prove crucial to bond markets.

Over the last several quarters, in both public interviews and written commentary, Bessent has suggested a meaningful shift in policy is necessary to guide the US economy towards a more sustainable trajectory.

A sustainable economy is one that withstands business cycle volatility, achieves price stability, and fosters robust real wage growth. It is an economy that ensures equitable opportunities across demographics. Most critically, it is an economy where inflation is contained, and the underlying forces are decisively countered. Although Bessent’s goal is to contain inflation, the strategies by which that goal is achieved could diverge significantly and have a material impact on financial markets.

Financial conditions

“Jay Powell has been easing. For whatever reason, he felt compelled to ease financial conditions last fall. After the FOMC meetings in November and December the statements were very anodyne, and he walked out and in the press conference gave very dovish guidance that rate cuts were coming, and you had a massive ease in financial conditions. By doing that, what happened? He pushed up the stock market, which benefits the top 20%, and then we’re back to the bottom 50% who don’t own assets, they have debt, and so rates have had to stay higher for longer.”
– Scott Bessent during an interview with the Manhattan Institute 13 June 2024.

Why is Bessent arguing that financial conditions are too easy and for higher rates as a result? This is seemingly at odds with the general market consensus that monetary policy is restrictive, and that the Fed should reduce its policy rate to prevent deterioration in the labour market and a slowdown in growth.

The answer lies in the notion that the US economy today is less sensitive to Fed policy and the level of front-end interest rates compared to prior cycles. This is because the current cycle has been driven by income and wage growth rather than debt, augmented by healthy balance sheets across US households and corporations.

Notably, US household debt relative to GDP is at the lowest level in 15+ years. US Corporate net interest payments as a share of after-tax income are at the lowest level in 60+ years. As a result, traditional measures that inform the appropriate level of monetary policy, like the Taylor rule (a guideline that adjusts interest rates based on inflation and economic output gaps), might be less useful in the current environment.

The US economy exhibited signs of slowing activity and declining growth expectations in Q3 2023 and Q3 2024. In both periods, market expectations shifted sharply toward a Fed cutting cycle, and Jerome Powell reinforced this shift by signalling easing measures were imminent (figure two).

As a result, interest rates declined, asset prices rose, and financial conditions eased. This created a growth impulse while measures of inflation subsequently rose to levels inconsistent with the Fed’s target. This feedback loop later forced the Fed to adjust its dovish stance as interest rates moved higher. Bessent might look to break this feedback loop by tightening financial conditions with the tools at his disposal.

Approach to debt issuance

“I have been very outspoken, and I noticed with great pleasure in the past 48 hours that Senator Kennedy from Louisiana and Senator Haggerty from Tennessee took Secretary Yellen to task for shortening the US debt maturity, which has also eased financial conditions.”
– Scott Bessent during an interview with the Manhattan Institute June 13, 2024

Bessent’s primary tool as Treasury Secretary is the department’s approach to debt issuance (US Treasuries). He has voiced strong opposition to Janet Yellen’s decision to rely on short-term debt issuance during a non-recessionary period, arguing that it has contributed to easier financial conditions and undermined the sustainability of the US economy.

A plausible outcome is a more balanced approach to debt issuance, with a greater reliance on long-term debt. This shift would tighten financial conditions as asset prices, particularly equities and real estate, are more sensitive to longer-term interest rates.

The likely effects would include reduced demand, slower growth, and lower inflation. If these conditions materialise, Jerome Powell and the Federal Reserve would have justification to reduce interest rates, simultaneously alleviating the US federal interest expense burden.

This outcome would result in the following: long-end interest rates rise, financial conditions tighten, demand slows and inflationary forces are subdued.

Return of the Red Wave

Lower corporate taxes, reduced regulation, and the strategic use of tariffs as a negotiating tool defined the economic playbook during President Trump’s first term as president. Fiscal discipline took a back seat while positive animal spirits swept through corporate America.

Capital expenditures and M&A activity surged, hiring accelerated, consumption increased and growth prospects improved. This combination fuelled a surge in asset prices, propelling them to new highs. This was the central storyline of Trump’s first presidency and the red wave in 2016. Will his second term follow a similar path and reach the same conclusion as the original? The clues may lie in today’s economic starting point and incentive structure for President Trump relative to 2016.

The economic paradox: inflation vs growth

Growth in the US has been above five percent in nominal terms for seven out of eight quarters and above 2.5 percent in real terms for seven out of eight quarters. Asset prices, including US equities and housing prices, are at or near all-time highs, while credit spreads are near 20-year lows. The US economy is doing well and does not need more growth, with some arguing it could even benefit from less growth (figure three).

Donald Trump’s victory in the 2024 elections was largely driven by voters prioritising the economy, particularly inflation, over asset appreciation or economic growth.

While growth figures and a healthy labour market suggest the economy is not struggling, prevailing levels of inflation which are well above those experienced in 2016, likely weighed more heavily on voters’ minds.

The administration’s strategic balancing act

The ideal outcome for the Trump administration would involve a balanced approach, combining growth-oriented measures such as lower taxes and deregulation with policies aimed at tightening financial conditions and containing inflation. Augmenting these balanced measures with wins in hot-button voter issues like immigration and foreign policy could help dampen the lack of excitement associated with a benign environment for asset prices during the first year of the new administration.

At the beginning of 2025, the question was whether the new administration could successfully lower inflation at the expense of growth and make good on a key campaign promise to the middle class and restoring order to the markets. The imposition of tariffs on all imports is likely to derail that goal – the extent of the derailment remains to be seen.

Impact on bond markets

Bond markets are at an inflection point. Conditions have been supportive over the last two years, with solid growth, stable employment and record-high asset prices. The interplay of economic, fiscal and political factors has created a landscape filled with both opportunity and risk for bond investors.

Inflation remains elevated (which tariffs won’t help) and bond market volatility is high. A rise in yields, particularly in longer-term maturities, would tighten financial conditions and temper growth expectations. At the front end of the curve, 2-year interest rates just above the Fed Funds Rate and aligned with the Fed’s reaction function to any deterioration in the labour market or growth.

Fixed income specialists Payden & Rygel believe we are likely entering a new regime characterised by higher volatility in interest rates, inflation and credit spreads. Consequently, the ability for portfolio managers to adapt, without being constrained by a bond benchmark, will become increasingly important this year in the face of greater uncertainty.

In a landscape of shifting economic forces, a flexible and adaptable investment approach – or absolute return strategy – is best positioned to deliver reliable income for investors and avoid capital losses on bonds.

What is an absolute return fund?

Unlike traditional bond funds or passive bond funds, where most of the return is driven by the performance of the benchmark (figure four), returns from absolute return strategies are driven by the investment approach adopted by the manager.

An absolute return investment strategy is not beholden to a benchmark; instead, it’s a strategy generally designed to better navigate the complexities of the evolving fixed income landscape than traditional bond funds or passive bond funds that are constrained to managing a fund to a specific benchmark.

Absolute return strategies are typically managed to beat a cash or equivalent benchmark rather than a bond index, thus removing constraints around duration and sector positioning. The portfolio managers are better able to manage the fund’s risk and return profile by utilising all fixed income sectors.

Consequently, absolute return funds typically have lower duration (i.e. are less sensitive to changes in interest rates), a good thing when the interest rate environment is volatile.  At such times, it can be more challenging for managers of traditional funds to make quick changes to allow for a changing economic environment or market circumstances. Absolute return fixed income managers have greater flexibility and can typically make portfolio changes more nimbly.

Why absolute return in this environment?

Inflation dynamics remain in flux as President Trump’s second administration introduces important dimensions to policy and growth such as tariffs and US-focused policies.

An absolute return approach provides fund managers with greater flexibility to adapt to changing market conditions, focusing on reasonable returns relative to cash while prioritising capital preservation.

Investing in fixed income offers a range of benefits, from providing a steady stream of income to reducing overall portfolio risk. With predictable interest payments and principal repayment, fixed income securities can offer stability and preserve capital in uncertain market conditions, while providing diversification benefits to an investment portfolio. In the current economic landscape, absolute return funds are best positioned to provide a fixed income exposure to meet your client’s needs.

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The information included in this article is provided for informational purposes only and is general advice only. It does not take into account an investor’s own objectives. The information contained in this article reflects, as of the date of publication, the current opinion of Payden and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Payden & Rygel, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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Jante Yellen

Meet the new boss

“Two days after the actual Federal Open Market Committee (FOMC) meeting, President Trump officially nominated Jerome Powell to be the new Fed chair, replacing Janet Yellen when her term expires on February 3, 2018. A relatively smooth confirmation is expected. President Trump also has four Fed governor vacancies to fill, although it could only be three if Yellen serves the remainder of her term as governor, which expires in January of 2024; possible but unlikely.

“At age 64, Powell comes to the position of Fed chair with a law degree (the first Fed chair in over 30 years without a PhD in Economics) and a varied career in law, investment banking, and government.”

Continuity man

“Compared to the present Fed chair, Janet Yellen, Governor Powell is generally characterised as ‘like-minded’ on monetary policy and will likely maintain consistency and continuity in the pace and magnitude of federal funds policy rate increases. He has never cast a dissenting vote during his term as governor, although in September 2012 when then-Fed chairman Ben Bernanke announced QE3, Powell reportedly disagreed and pressed for a ‘clarification’ of the Fed’s goals, establishing what came to be called an ‘offramp’ or ‘unwind’ procedure for what proved to be the final phase of the purchase program. He then voted in favor of its implementation.

“His recent public comments on monetary policy are basically interchangeable with those of Janet Yellen. He is generally rated ‘neutral’ (neither dovish nor hawkish) compared to other members of the Fed Board of Governors. In a recent compilation, his projected federal funds rate at year-end 2018 was 2.13%, in line with seven other members, which was the largest group and included Yellen and Vice chair Bill Dudley. He is known as a ‘consensus builder’ and is reported to be well-liked and respected by colleagues and staff within the Fed.”

More open to de-regulation?

“We feel his leadership on monetary policy itself, is not likely to represent a structural shift over the medium-term; with a bit of caution: Jerome Powell the governor could be different than Jerome Powell the Fed chair. The area where he is most likely to be different is regulation.

“He feels that higher capital and liquidity requirements, along with more rigorous stress tests, have made the financial system safer and should be preserved for large banks. But, he also feels that the Volker rule should be re-written to exclude smaller banks.”

In other news, the Fed stayed put: “Amid the news on Powell, the FOMC met, and as expected, produced no change in policy. Aside from positive identity of the next Fed Chair, the main question was whether the FOMC would proceed with another policy rate boost prior to year-end. Of course, the Fed never allows this question to be answered directly, but the FOMC statement was upbeat enough about the growth outlook to guide the market to another rate hike in December. Futures traders after the meeting put an 87% likelihood on another 0.25% federal funds rate increase at the December FOMC meeting.”

The post Jerome Powell a “continuity candidate”, says Principal Global Investors  appeared first on AdviserVoice.

Janet Yellen

Principal Global Investors Chief Global Economist, Bob Baur, comments on U.S. monetary policy, China’s latest trade data and the synchronised global upturn.

In a recent Wall Street Journal interview, President Trump said, ‘I do like a low-interest rate policy, I must be honest with you,’ quite a natural feeling from a real-estate baron who likely thrives on borrowed money. Then-Federal Reserve (Fed) Chair Ben Bernanke first took the fed funds rate to its lowest ever range of 0% to 0.25% during the financial crisis. But, current Fed Chair Janet Yellen was the ultra-dove, keeping the super-low interest rates and staying extremely reluctant to raise them.”

Is Yellen “toast” next year?

Not necessarily; President Trump did not suggest that Yellen would automatically be replaced when her term as Fed Chair expires in February 2018, saying “I like her, I respect her.” The President also noted it was “very early” in the process of rethinking Fed policy, especially with three new Fed board members to be appointed before then. Of course, these comments don’t square with then-candidate Trump’s criticisms of the Fed before last November’s election. But, a more accommodative monetary policy for longer might make the President’s growth goals easier to attain and provide a boost in later elections. Time will tell.

Global Upturn: Synchronized, Strengthening

The world began to recover from 2015’s near-recession as early as the first quarter of last year. The real recession was in manufacturing, energy, and industrial goods as oil and commodity prices plunged, inventories got too large, China had a hard landing, and the U.S. dollar surged. Markets began to reflect the opportunities for better growth late in the first quarter last year as energy, emerging market, and basic-materials stocks outperformed through the summer. After the July low in interest rates, banks, financials, and industrials led markets higher. Cyclical securities, those that benefit the most from better growth, had the best returns in 2016. The consensus didn’t catch on to the better prospects until the U.S. election forced investors to realise a global economic bounce was in motion.

Consolidation

March trade data suggest that growth in China is still picking up because imports are soaring. The late breaking first-quarter GDP report from China beat expectations in all categories, confirming the quickening. Real GDP growth picked up a tick to 6.9%; but, nominal growth surged to 11.8%, the best in years, well above the fourth quarter.

Even in Europe

With business surveys near six-year highs and unemployment trending lower, speculation is growing about when the ECB’s forward guidance of “low interest rates for longer” will be changed. So far, there has been no substantive discussion about an exit strategy. But, if the Eurozone’s better growth continues into the summer and beyond, the first indications of a policy change will likely occur by September, or before if the upcoming French election contains no big surprises.

The post Learning to love Janet Yellen appeared first on AdviserVoice.

Janet Yellen

Markets appear to have settled in the belief that Trump will be positive for US businesses, says Instreet managing director George Lucas.

“Sectors such as construction and banks have done particularly well as investors expect the new president to deliver a surge in infrastructure spending and a lighter regulatory touch,” he says.

“The possible economic leg-up that the market believes Trump’s policies will deliver has also put a spark under the US Dollar.

“In turn, investors have fled government bonds on expectations the US Federal Reserve (Fed) may need to raise interest rates faster than expected to contain inflation.

“Chair of the Federal Reserve Janet Yellen backed this up last week when she said an increase in short-term interest rates could ‘become appropriate relatively soon’.

“We believe solid US data is also supporting the case for tighter monetary policy.

“Markets are now expecting a rate rise in December with the federal futures market implying a 95% probability of a 25 basis points hike at the FOMC meeting on 14th December.

“10-year US Treasury yields are at a 12 month high after climbing around 40 basis points since the election,” he said.

Commenting on the negative reaction to a Trump presidency in emerging markets Mr Lucas said he understands the reasons for the decline but does not necessarily agree with the sentiment.

“While the MSCI US Index has risen since the election, the MSCI Emerging Markets Index has fallen by around 4% in local currency terms.

“This implies two things. One, emerging market investors are exiting amid uncertainty about policymaking and a sell-off in US Treasuries. Second, investors in US shares have taken solace in the likelihood that Trump will loosen the public purse strings once he takes office in January.

“This could in part be driven by speculation that Trump’s policies will not benefit emerging markets. However, we at Instreet don’t necessarily agree with this view.

“China is already taking initiatives to protect trade in the region and the likely long-term outcome is for the Asia Pacific region to become less reliant on US trade.

“There’s likely to be a lot of talk and plenty of action over coming months and years as China seeks to expand its influence and presence by adopting more liberal trade initiatives as the US digests and deals with the Trump anti-trade rhetoric,” Mr Lucas said.

The post Markets continue to believe in Trump now the shock has receded appeared first on AdviserVoice.

Soon after, a very weak payroll report on 3 June and the pending vote for Brexit on 23 June caused Fed officials – or at least the Chair – to lose confidence in their outlook. After their meeting on June 14th and 15th, they backed away from signaling a rate hike would be appropriate “in coming months.”

Since then, though, U.S. economic data have been surprising on the upside – most notably with the gangbuster employment report on 8 July which indicated that 287,000 jobs had been created in June, with a three-month average of 147,000 jobs. That was well above the roughly 100,000 jobs per month (or less) the Fed itself estimates is the new normal for the economy given the slowdown in labor force growth.

So coming into the 27 July meeting, the question was not “Will the Fed hike?” That had been taken off the table with the publication of the minutes of the June meeting. But rather, “Will the Fed recognize the stronger economic data received since the June meeting and signal a desire to hike ‘in coming months’ – perhaps in September?” In other words, would the Fed acknowledge the May payroll report appears to have been a blip and that the post-Brexit reality had not been “the Lehman moment” some had predicted, implying that a rate hike would be justified given the criteria laid out by the Chair in May?

The Fed statement did acknowledge that “the labor market strengthened and that economic activity has been expanding at a moderate rate. Job gains were strong in June following weak growth in May. On balance, payrolls and other labor market indicators point to some increase in labor utilization in recent months.” The Fed also conceded that “economic activity has been expanding at a moderate rate,” a rate faster than the very slow growth of the first quarter. Finally, and of greatest interest, the Fed did acknowledge that “Near-term risks to the economic outlook have diminished.”

That said, the Federal Open Markets Committee (FOMC) continues to state, as it did in June, that “the Committee continues to closely monitor inflation indicators and global economic and financial developments.”
Fed says economy improving but offers no guidance.

So while the Fed now appears to be less worried than it was in June about the “near-term risks to the economic outlook” and to accept that ”labor market utilization” has increased in the context of moderate, at- or above-trend growth, it is not willing to signal to markets that a hike will be appropriate in “coming months” – let alone September.

So for now, the Yellen Fed has given up on “calendar guidance” but is unwilling – or unable – to replace it with outcome-based guidance, or really any guidance whatsoever. This is a Fed that prizes “optionality” above all else.

That appears to be working for now. But options have a positive price, which so far the Fed has not had to pay. This is a free lunch that won’t last forever.

By Dr. Richard Clarida, PIMCO Global Strategic Adviser

The post The Fed: Silent on September appeared first on AdviserVoice.

It’s been another volatile week in financial markets with most share markets (except Chinese shares) dragged lower as global growth worries continue highlighted by more weak Chinese data and sharp falls in some emerging market currencies and a miss by Caterpillar and ongoing uncertainty regarding the Fed. Australian shares have retested their late August lows and European shares have slipped below them, not helped by VW, refugees and uncertainty regarding the Catalonian election. Commodities have held up a bit better but this didn’t stop the $A from falling back to around $US0.70. Bond yields mostly fell on safe haven demand.

Fed Chair Janet Yellen indicated the Fed still expects to tighten this year – which was the message from last week’s Fed meeting anyway – but left plenty of wiggle room in that “surprises” may delay this with ongoing reference to “global economic and financial developments” and talk of gradual tightening. While there has been much criticism lately of the Fed (mostly sour grapes from those who bet wrong I think), they are only responding to the same information and risks everyone else sees. Maybe we should turn down the noise on all the over-analysis of the Fed. Meanwhile, other central banks are still easing – Norway and Taiwan being the most recent.

It’s still too early to say that the lows in share markets have been seen. The volatility and consolidation we have seen in share markets since late August could be a sign of base building but it could also just be a pause before another dip to new lows. This is particularly so given that worries about global growth and the Fed remain and worries about a US Government shutdown might start to impact. September is historically the worst month of the year for US shares – and the US share market invariably sets the direction for other markets.

However, beyond near term uncertainties we see the cyclical bull market in shares as likely to resume. Shares are getting even cheaper relative to bonds; monetary conditions are set to remain easy with the latest global growth scare already driving further easing and keeping the Fed cautious; this in turn should help see the global economic recovery continue; and finally investor sentiment is around the levels of pessimism that provides great buying opportunities. October is often seen as a “bear killer” month, ie a month where share market falls finally bottom out giving way to seasonal strength into year-end. It’s likely we will see something similar this year. The key for investors is not to be thrown off well thought out long term investment strategies and to recognise the opportunities that share market falls provide, eg shares are now a lot cheaper than they were around April and May and yet are still paying the same (or higher) dividends.

While a potential US Government shutdown and/or debt ceiling standoff may add to global growth worries our base case is that there will be another last minute solution or if there is to be a shutdown it won’t go too long. Congress needs to pass either a new Budget or extend budget funding by the new US fiscal year that begins October 1. The risk is that the desire by a group of extreme Republicans to tie budget funding to defunding Planned Parenthood could lead to the usual brinkmanship. The GOP leadership knows that it will end up getting blamed by the American people for any shutdown, and this is something they will likely be keen to avoid given next year’s elections. So our base case is a last minute deal but no shutdown. Similarly, expect some argy bargy around increasing the debt ceiling later this year and again another last minute deal. However, budget funding and the debt ceiling could end up getting rolled in together again if budget funding is only extended to say December and the risk of some market impact is certainly there, so it’s worth keeping an eye on. It’s worth noting though that the two week US Government shutdown/debt ceiling brinkmanship last seen in October 2013 had no discernible negative impact on the US economy at the time. December quarter 2013 GDP growth of 3.8% annualised was the strongest quarter for the whole year.

The European refugee crisis is unlikely to have major negative economic implications, but will generate lots of noise (just like refugee boats coming to Australia). The past week saw the European Union vote to distribute 120,000 refugees across its membership but with some fearing that the vote against such a move by four countries reflected dangerous disunity and that this and the imposition of border restrictions threatens the EU. This is all a bit too negative as a big majority of EU countries supported the refugee plan and temporary border restrictions have always been allowed (and don’t appear to prevent the free movement of labour that helps underpin the EU). The migrant crisis is a big one but needs to be put in perspective against the EU’s 500 million population. In the short term it may provide a boost to anti-establishment parties but I suspect it will result in Europe becoming a lot more motivated to put an end to the war in Syria (which will probably involve siding with Russia in supporting a solution involving President Bashar al-Assad) as this is where the bulk of the refugees are coming from. It is also likely to involve more government spending (less austerity) and ultimately “more Europe, not less” (as it comes together to help secure its external borders).

While Eurozone shares have been hit hard by worries about global growth, the VW scandal, refugees, the Catalonian election, etc – down 19% from their April high making new lows in the last week, they look very attractive for when the dust settles. Our valuation indicators shows to be very cheap, the ECB remains very supportive and economic indicators like PMIs and business surveys remain solid.

Major global economic events and implications

US economic data was again mixed. Existing home sales fell and new home sales surged. While regional manufacturing conditions indexes point to weakness, the national Markit manufacturing PMI was unchanged in September at a solid level of 53. While durable goods orders fell in August, core capital goods orders are reasonable. The US growth story remains one of solid but unspectacular growth leaving plenty of scope for the Fed to take its time.

Eurozone business conditions PMIs slipped in September, but given the concerns about global growth the fall was modest and leaves them well up last on year’s lows and still solid. Meanwhile, ECB President Draghi remains dovish indicating that more time is needed to assess the emerging market slowdown and in particular that the ECB “would not hesitate to act if downside risks to inflation materialise”.

Japan’s manufacturing PMI softened to a still ok 50.9 in September and Japanese inflation rose to 0.8% yoy on a core basis in August, but is still well below the Bank of Japan’s 2% target. The case for more BoJ easing remains strong.

The flash Chinese manufacturing PMI fell further in September. While it could be distorted by the early September Beijing area factory shutdowns it nevertheless highlights that small and medium sized manufacturers are still struggling.

Australian economic events and implications

In Australia, the main development was a strong 9% bounce in consumer sentiment according to ANZ-Roy Morgan index, with the elevation of Malcolm Turnbull to PM having the predictable favourable impact. This is good news but we have seen several bounces before. For it to be sustained, the Government needs to avoid a return to the accidents that seem to have characterised Australian governments since 2010 and put in place a positive economic reform agenda. Meanwhile, ABS data confirmed that home price growth remained very strong in the June quarter but this was mainly driven by Sydney and Melbourne and is likely to slow as APRA measures bite. Slowing population growth to 1.4% over the year to the March quarter from 1.8% yoy 3 years ago, mainly due to lower immigration, will also take pressure off house price growth. It’s also one reason along with lower productivity growth why potential growth in the economy has slipped from around 3-3.25% pa to around 2.75% pa. The RBA is still likely to have to cut interest rates again.

What to watch over the next week?

In the US the focus will no doubt be on whether Congress passes Budget funding to avoid a Government shutdown when the new fiscal year starts on Thursday. Our base case is that it will, but there is often a bit of argy bargy over these things. On the data front, the focus is likely to be on the September manufacturing conditions ISM (Thursday) which is expected remain around a solid but moderate 51 and jobs data (Friday) which is expected to show solid jobs growth of 200,000, flat unemployment of 5.1% and a lift in wages growth to around 2.4% yoy. Meanwhile, the core private consumption deflator is expected to show September inflation of 1.2% yoy which is well below target, existing home sales are likely to show a modest gain (both Monday) and consumer confidence (Tuesday) is expected to fall back.

In the Eurozone, the outcome of Sunday’s Catalonian election may generate interest with pro-independence parties likely to win, but with polls showing a majority of Catalonians preferring to stay in Spain this issue may not go anywhere fast. Expect economic confidence indicators (Tuesday) to fall back a bit but remain solid and September inflation (Wednesday) to remain well below target.

Japanese industrial production (Tuesday) is expected to show a gain and labour market data (Friday) is likely to remain solid.

China’s official manufacturing conditions PMI (Thursday) will be watched to see whether it followed the Caixin flash PMI lower in September.

In Australia, expect credit data (Wednesday) to show ongoing modest growth but with evidence of a slowing in lending to property investors, building approvals (also Wednesday) to fall back after a strong July, the Core Logic-RP Data home price indicators (Thursday) to show further signs of slowing in home price growth and retail sales (Friday) to show a modest gain.

Outlook for markets

It’s still too early to say that we won’t see a further leg down in shares with worries remaining around global growth, the Fed, the US budget, etc. But beyond near term uncertainties we see the cyclical bull market in shares as likely to resume: shares are cheap relative to bonds; monetary conditions are set to remain easy; this in turn should help see the global economic recovery continue; and finally investor sentiment is around the levels of pessimism that provides great buying opportunities. As such, despite near term uncertainties, developed country share markets are likely to resume a broad rising trend. This includes the Australian share market.

Low bond yields point to soft medium term returns from bonds, although the recent share market downswing which saw bonds rally provides a reminder that government bonds remain a great portfolio diversifier.

The recent bounce in the $A proved short lived, only reaching $US0.7280. In the short term, the $A will take its lead largely from ongoing swings in global investors’ risk tolerance, but the broad trend in the $A is likely to remain down as the Fed is still likely to raise interest rates sometime in the next six months whereas the RBA is likely to cut rates again and the trend in commodity prices remains down. The $A is expected to fall to $US0.60 in the next year or so, with the risk that it will go even lower.

The post Weekly market update – week ending 25 September, 2015 appeared first on AdviserVoice.

US recovery going strong.

Some may be surprised that US stocks took just over 5 ½ years to regain previous highs after the so-called Great Recession compared with the 25 years it took the Dow Jones Industrial Average to recover from the Great Depression.[1]

The losses triggered by the US sub-prime crisis were recouped on 10 April 2013, when the S&P 500 Index climbed back to the pre-Lehman-crash intraday high of 1,576.09 it set on 11 October 2007. Since that April day last year, the bellwether US index had added another 22% by July 31 just gone when it ended at 1,930.67.

Amid some talk that central-bank asset buying is fuelling asset bubbles including stock prices, there is a more fundamental reason why US stocks are at record highs; healthy earnings growth. In fact, profit growth has been so strong that US profits have reached a record share of GDP, at the expense of wages.

The encouraging news for US stock investors is that earnings are poised to grow in absolute terms in coming years as the US economic recovery appears durable, even as some of the forces that have driven earnings growth become less helpful. If there’s any link between profits as a percentage of GDP and share prices, then investors can look forward to more years of a rising S&P 500 Index, for chances are that profits as a percentage of GDP will crack fresh record heights in the coming era.

The US economy could, of course, crumble and retard earnings growth. Some other shock could sink shares. Quantitative easing, which shaves longer-term interest rates, played some role in helping stocks so any rise in long-term yields due to its upcoming end could dampen enthusiasm for stocks. There is no ironclad relationship between stock prices and earnings as a percentage of GDP. Profits can never reach 100% of output so there must be some limit to their rise on this basis against wages, even aside from the political consequences that steeper inequality would inspire to reverse the shift. Analysis that focuses just on earnings doesn’t necessarily take into account what’s already priced into share prices. But overall, if the outlook in coming years is one where earnings rise in absolute and in relative terms, the environment for stocks will be more inclined to be favourable.

At labour’s expense

US earnings have risen in recent years largely because supportive low interest rates and overlooked fiscal stimulus have engendered an economic recovery that has just entered its sixth year.[2] US companies have enjoyed low short-term interest rates since December 2008 because the Federal Reserve was quick to slash the cash rate to close to zero to make borrowing costs out to five years as favourable as possible for business once Lehman Brothers collapsed. To ensure longer-term borrowing rates supported the economy, the Fed embarked on three quantitative-easing or asset-buying programs; from 2008 to early 2010, from late in 2010 to 2011 and since 2012.

In economic terms, these low interest rates made more businesses profitable, reduced company debt repayments and encouraged consumers to spend. As far as the stock market goes, puny interest rates justify higher valuations such as elevated price-earnings ratios. Low bond yields prompt investors to look for higher returns from other asset classes – in particular, they helped property and infrastructure stocks whose bond-like qualities make them proxies for fixed income when yields are negligible. Low rates fanned IPOs and M&A activity that are fuel for stock rallies. They encouraged investors to re-rate mediocre companies to higher multiples. They prompted asset allocators to switch money away from rising assets – in this case, bonds – to stay within strategic limits. Lastly, low interest rates combined with pledges by central banks to keep rates low appear to have engendered a complacency about the outlook that is reflected in low readings on volatility, which in turn helps shares. A more stable outlook for prices justifies paying a higher price for an asset and the price stability attracts other, warier, investors. As the low cash rate has the most powerful spurt for the economy and stocks via its dampening effect on bond yields out to three to five years, the ending of the Fed’s asset-buying in coming months shouldn’t be detrimental to stocks. Any unforeseen jump in the cash and thus other short-term interest rates, however, would be harmful.

On the fiscal side, the boost to the US economy and US stocks is staggering when the sum is totalled over the past five years. From 2009 to 2013, US federal fiscal stimulus amounted to 41% of US GDP in aggregate.[3] This US$7.1 trillion (A$7.5 trillion) equivalent of stimulus at 2014 prices[4] that ranged from tax credits to “shovel-ready” projects helped fill the demand void created when workers lost their jobs and businesses and households focused on reducing their debts rather than spending, even if US state governments reduced the stimulus a touch by imposing austerity policies to meet laws that required budgets to be balanced. The US recovery has been robust enough to survive the austerity imposed by Congress over the past year or so. These cuts and higher tax receipts are expected to help lower the fiscal deficit to below 5% of GDP this year from a peak of 10% in 2010.[5]  

Three other forces that boosted earnings growth are worth mentioning too. The first is that companies engaged in cost-cutting to protect margins. Another is that technological improvements allowed business to become more efficient; in economic jargon, innovation cut the labour intensiveness of production. Goldman Sachs analysis shows that from 1998 to 2011 the ratio of spending on technology to labour grew in auto, oil and gas, communications, mining, retail, wholesale trade and warehousing. The other boost is that globalisation created fresh foreign markets for US companies and eased access to long-standing ones. In 2012, US companies earned 21% of their profits from abroad, triple the 7% share recorded in 1969, according to the US Bureau of Economic Analysis.

These stimulants helped US profits expand at a much faster rate than earnings did in other developed countries in absolute and relative terms – hence the outperformance of US stocks in 2012 and 2013. Minack Advisors says profits at US listed companies surged from about 3% of GDP in 2009 to about 5.5% of output in early 2014, while listed profits in other developed countries have only hovered around 3% of GDP over the past five years.[6]

This jump in US earnings has boosted the share of profits from all US companies to a record 11.1% of GDP at the end of 2013, according to the Federal Reserve Bank of St Louis, compared with an average of about 6.4% since 1947. At the same time that US profits have soared, the percentage of wealth heading to workers declined to 43% of GDP at the end of last year from a peak of 52% in 1969 and from an average of 47% since 1947.[7]

There is one key reason why increased US profits have headed to shareholders at the expense of workers. Labour has lost its bargaining power over the past 30 years as right-wing ideology triumphed and globalisation expanded the pool of cheap workers for hire, and thus lowered wage pressures. Labour’s negotiating power weakened ever more during the Great Recession, when the jobless rate peaked at 10.0% in October 2009 when looking at the most-watched (U-3) measure, or at 17.2% in April 2010, when looking at the wider (U-6) gauge that includes reluctant part-timers and those dropping out of the workforce in despair.[8]

Piketty’s insight

Even after five years of recovery, there’s no sign that US wages are rising in real terms, let alone relative to GDP, even though the most-watched jobless rate was 6.1% in June just gone, when the wider unemployment measure stood at 12.1%. This wage stagnation reflects job insecurity and the fact that many middle-class jobs have been replaced with poorly paid, even part-time or temporary, ones. Fed Chair Janet Yellen in April even remarked on the “historically slow pace” of wages growth in this recovery.[9]

Even if wages were expanding at a pace to trouble inflation, it would be hasty to assume – as fans of mean reversion seem to – that somehow US profit share will drop towards its long-term average, or even lower. There’s no automatic force in play that returns the profit and labour ratios to GDP to some fairer equilibrium. Outside of wars and other such catastrophes, financial or otherwise, that destroy wealth, only human endeavour that coalesces into a political force capable of effecting changes in labour’s favour can eat away at profits’ share in GDP.

The money in US politics that buys the rich a veto over threats to their wealth, recent Supreme Court decisions empowering the political power of this cash, another high-court decision that eroded the ability of unions to collect fees from all the workers they cover, the weakening of minimum wage standards at state level even amid a push to raise the federal minimum hourly rate and the ability of business to get away with underpaying staff are just some of the forces suppressing wages growth and wages’ share of GDP in the US. The probability is high that Republicans will regain control of the Senate and hold the largely gerrymandered House of Representatives in Congressional elections in November. These results would only add to the power that capital has enjoyed over labour since the early 1980s no matter which party controlled Congress or the White House.

On top of these political pressures, workers face a sub-par economy – it expanded at an annual pace of about 2% in the first six months of 2014. For an historical perspective of how the pace of economic growth affects the relative splits of wealth and income between capital and labour, investors can turn to the book by French economist Thomas Piketty Capital in the Twenty-First Century, an analysis of inequality that is topping best-seller lists.[10]

Piketty has tracked inequality since the 18th century by looking at the breakup of wealth and income across key western societies. His findings on the US show that the recent political shift in favour of capital is pushing inequality towards its peak in 1910 for capital[11], when the top 10% owned 70% of wealth, and its highest for income[12] which was around 2007, when the top 10% earned just under 50% of income. (Income’s previous peak was in the late 1920s. Inequality fell over the middle of the 20^th century because world wars, a Great Depression and government intervention in the form of higher taxes and increased welfare payments made for a more egalitarian society.)

Piketty’s central thesis, which is grounded more in observation than theory, is that the returns flowing to the owners of capital grow faster than GDP and this fact means that capitalism’s natural state is one where inequality rises. Over time, the return on capital is, say, 3% to 7% (profits, dividends, rent, etc.) versus about 1% to 2% for economic growth (and thus wages). Other things being equal, the slower the economic growth, the faster inequality rises. “It is an illusion to think that something about the nature of modern growth or the laws of the market economy ensure that inequality of wealth will decrease and harmonious stability will be achieved,” Piketty says.[13]

The US outlook is only one of modest economic growth – the recovery is robust enough to survive a decline in fiscal stimulus and less promiscuous monetary policy. No political forces are marshalling to tilt laws or regulations in labour’s favour. Therefore, capital’s saunter to a second Gilded Age appears unhindered for now. That’s better news for investors in US stocks than US workers in coming years.

Financial information comes from Bloomberg unless stated otherwise.

by Michael Collins, Investment Commentator at Fidelity

———-

The post Why the US gilded age is poised to last appeared first on AdviserVoice.

• Share markets retreated over the last week on worries that problems at some European banks might spark a return of its debt crisis and nervousness about a possible correction in the US. Most share markets fell, including in Australia and China. Share market nervousness saw bonds rally, except in peripheral Eurozone countries where Portuguese bank problems weighed. Commodity prices were little changed but interestingly the oil price continued to drift down as worries about Iraq abated and Libyan and Saudi supplies rose. The $A saw a brief bounce higher, but it was short lived.
• It seems there is always something to worry about. Just as investors were getting a little less concerned about oil supply disruptions from Iraq, along comes a scare about problems at European banks. A week ago Austria’s Erste Bank issued a profit downgrade and then the parent company of Portugal’s largest bank Banco Espirito Santo delayed a debt payment. Investors fear this may be a sign of problems at other Eurozone banks, which might require public support leading to renewed budget blowouts. So far there is no evidence of this but the slow recovery in Europe does present risks as does the ECB’s bank stress tests this year. It’s certainly worth keeping an eye on, but several considerations suggest we won’t see a return to the dim dark days of the Eurozone crisis. First, the problems at both Erste Bank and Banco Espirito Santo look to be partly specific to those organisations, eg issues in its Romanian and Hungarian businesses for Erste and a troubled parent and exposure to dodgy Angolan loans for Espirito Santo. Second, the backstop support for Eurozone banks is now huge compared to the situation three or four years ago, eg the ECB’s commitment to supply cheap funding to banks. Third, the rally in Eurozone banks had arguably gotten ahead of itself. Eurozone banks are down 13% from their high in April this year, but from the Eurozone crisis lows in 2011-12 to their April high they rallied 122%, nearly double the 68% gain in Eurozone shares generally. So a correction was inevitable.
• Results from the Indonesian election may take a week or two to be finalised, but most exit polls suggest a win by Joko Widodo, who is the most market friendly and reform oriented of the two candidates, so if he has won it would be a positive for the Indonesian economy and assets. However, it would appear likely to be only a narrow win, so a strong reform mandate may be lacking, unlike in the case of the recent Indian elections.
• The first Budget of the new Modi led Indian Government was a bit of a non-event in terms of announcing dramatic reforms. But it did present a sensible fiscal strategy in terms of reducing the deficit and focussing on productive spending. The Budget should be seen as just a start with significant reform still on the way in India.
• The debacle in Canberra regarding the passage of the Budget and associated policy changes through the Senate is depressing, particularly given the optimism that had come with the demise of minority government last September. There is a risk that it starts to act as a broader drag on confidence in the economy. That said, it would be dangerous to read too much into it at this stage. So far the Australian share market and the $A are rightly ignoring it. And if it results in a softening in some of the harsher measures in the Budget (perhaps funded by a “delay” in the paid parental leave scheme) then it could have a positive impact on confidence.

Major global economic events and implications

• US data continues to point to stronger US growth. Job openings are at their highest since 2007, consumer credit continues to rise, weekly mortgage applications rose, jobless claims fell and a private survey of June retail sales pointed to solid gains. Meanwhile, the minutes from the Fed’s last meeting offered little that was new with the Fed on track to end quantitative easing in October and nothing to change the view that the first rate hike is unlikely till around mid next year. There was some discussion about whether investors had become too complacent on interest rates, but Janet Yellen’s recent comments suggest she was not that concerned. Finally, the June quarter profit reporting season kicked off with a solid result from Alcoa auguring well.
• Japanese data was mostly okay with the June Economy Watchers outlook survey remaining solid, bank lending trending up, a rise in tertiary activity and higher consumer confidence but a sharp fall in machine orders.
• Chinese import and export growth were a little weaker than expected in June, but continue to pick up consistent with better growth. On top of this inflation remains low, posing no constraint to further easing in China.
• The divergence in the state of Asian economies was highlighted in the past week with Malaysia raising interest rates for the first time in three years citing strong growth and inflation risks, whereas the Bank of Korea left rates on hold but with a clear easing bias after revising its growth forecasts down. Korea seems to be more of a special case though with the ferry accident earlier this year having a negative impact on spending.

Australian economic events and implications

• Australian data was rather messy. Consumer confidence rose in July but only slightly and is yet to fully recover its Budget related slide, but against this business confidence is running slightly above average. Employment also rose by more than expected in June but jobs growth is still not enough to bring unemployment down, with it bouncing back to the top of the 5.8 to 6% range it has been in for the last nine months. The good news though is that leading employment indicators such as ANZ job ads and the hiring component of the NAB survey are pointing to stronger jobs growth ahead. There was also good news for the construction sector with the AIG’s construction PMI rising strongly in June. While housing finance slipped in May adding to evidence of a welcome moderation in momentum in the home buying market, it remains at a high level.
• With interest rates set to remain low and on hold probably into next year and the Budget likely to be softened to get it though the Senate, its likely that consumer confidence will gradually improve over the months ahead.
• According to Australian Property Monitors capital city rental growth over the year to the June quarter ranged between -6.6% (in Perth) and +5.6% (in Melbourne. The point though is that with dwelling prices up around 10% over the same period rental yields are continuing to fall.

What to watch over the next week?

• In the US, a key focus will be Fed Chair Janet Yellen’s Congressional testimony starting Tuesday. Its unlikely she will waver much from the message following the June Fed meeting which was basically that the economy is improving allowing continued tapering but that monetary tightening is still a considerable time away given slack in the economy. She may elaborate a bit on the risks around inflation and rates and the Fed’s exit strategy. On the data front, expect a 0.6% gain in June retail sales, a 0.3% rise in June industrial production (Wednesday), a further rise in the NAHB homebuilders conditions index (Wednesday)  and gains in housing starts and permits (Thursday). Producer price inflation data will also be released.
• The US June quarter earnings reporting season will start to hot up. The consensus is for earnings growth of 6% year on year and sales growth of 3%. Given the downgrade from 8% three months ago and a high level of negative profit warnings it’s likely that earnings growth will come in stronger than this.
• Chinese activity data released Wednesday is expected to confirm a pick-up in growth, after the slowdown in the March quarter. June quarter GDP growth is expected to grow 1.8% quarter on quarter (after 1.4% QOQ) in the March quarter, leaving annual growth at 7.4%. June industrial production is expected to pick up to 9% year on year, with growth in retail sales expected to remain unchanged at 12.5%.
• In Australia, the minutes from the last RBA Board meeting (Tuesday) are likely to express a more dovish bias than seen in the post meeting statement consistent with the more dovish tone seen in the previous minutes and in Governor Steven’s recent speech. Data for dwelling starts (Wednesday) will likely show a further rise.

Outlook for markets

• Could shares have a correction? Yes. As always there is no shortage of possible triggers with Eurozone bank issues back in focus and the potential for a Fed rates scare as the US economy continues to hot up. Are we at a major share market top? No. Valuations are not stretched, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, global and Australian 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. In terms of the latter if anything there is still a lot of scepticism – as evident in headlines about capital markets being out of step with reality (Financial Times) and markets being so high that the air is thin (Wall Street Journal) – which is a long way from the sort of confidence that is normally seen when bull markets come to an end. Given all, this any short term dip in shares should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.
• Bond yields are likely to resume their gradual rising trend led by increasing evidence that US growth is picking up pace. This combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.
• While the continuing carry trade from ultra easy money in the US, Europe and Japan risks pushing the $A higher in the near term (potentially up to $US0.97), the combination of soft commodity prices, an increasing likelihood that 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. RBA jawboning is already making a bit of a comeback.

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 11 July, 2014 appeared first on AdviserVoice.

• The past week has seen worries about Ukraine fade but concerns the Fed will raise rates earlier than expected take centre stage. This saw bond yields push higher, but equity markets were mixed with US shares and European shares up helped in part by better economic data and European agreement on a banking union but Asian and Australian shares generally flat to down a bit as worries about China continue to impact. The bring forward to Fed rate hike expectations pushed the $US higher against the Yen and Euro, but the $A bucked the trend moving up slightly helped by a continuing reduction in prospects for further rate cuts in Australia.
• The risks regarding Ukraine seem to be receding. Russia does not appear to be interested in moving on other parts of Ukraine, Ukraine seems to have accepted Crimea’s move to Russia and is pulling its military out of the region, US and European Union sanctions and tit for tat moves from Russia will have close to zero economic impact and comments from the Ukrainian PM appear more conciliatory towards Russia with commitments to not join NATO and to decentralise power to its regions. Key to watch now will be: any escalation in ethnic violence in east Ukraine as it could still lead to civil war and Russian intervention on the grounds of “protecting Russians”; more substantial sanctions from the US and Europe; and of course how the Ukrainian elections turn out in May. The risks are still high but I remain of the view that the crisis in Ukraine is just another distraction. It won’t derail the European or global economic recoveries or the bull market in shares.
• From taper talk to “dot plots”. Fed Chair Janet Yellen has been misinterpreted as more hawkish than she is, just like Bernanke was last year when he first raised tapering. Fed rate hikes still look a fair way off, but with the end of quantitative easing in sight, their timing will become an increasing focus for investors. There were no surprises from the Fed’s decision to continue winding down its quantitative easing program, which at the current rate means it will come to an end either in October or December. There were also no surprises with its move to drop the 6.5% unemployment threshold and replace it with a qualitative assessment that it will be appropriate to maintain the current Fed Funds rate for a considerable time after quantitative easing ends. This was all pretty dovish. Against that though, an upwards revision in the median Fed meeting participant’s rate expectations – the so-called “dot plot” – by 0.25% for end 2015 and by 0.5% for end 2016 along with Fed Chair Yellen’s comment that the first rate hike may come 6 months after QE ends led to fears of an earlier and sharper tightening by the Fed. I suspect that Janet Yellen actually meant to sound more dovish than she came across as so a move to clarify her comments from the Fed is likely in the weeks ahead. My assessment is that Fed rate hikes are still at least a year away, but as we saw with taper talk last year it will likely be a source of debate and market as the year progresses. But the key is to always keep the big picture in mind:  the Fed is only tapering and discussing when rates will start going up because the US economy is on the mend. This is a good thing, because it means stronger profits. And when rates do start going up it will be a long time before they reach levels that fundamentally threaten profit growth and the share market outlook.

Major global economic events and implications

• US data revealed more of the same with messy weather affected readings for housing starts, the NAHB’s home builders’ conditions index and existing home sales but better than expected growth in industrial production and good gains in manufacturing conditions according to surveys in the New York and Philadelphia regions consistent with a rebound in growth in the months ahead. Meanwhile the current account deficit fell to its lowest level in 16 years as a percentage of GDP helped by collapsing oil imports and inflation remained benign at just 1.6% year on year for core in February, highlighting no rush for the Fed to raise rates.
• In China, a default by a small property developer, Zhejiang Xingrun Real Estate, has added to concerns about a broader property collapse. It’s worth putting it in context though. First, the default was due to illegal activities with both the Chairman and his son being arrested and has nothing to do with property related stress. Second, in any case there have been numerous defaults from property developers in recent years. Third, fears of a mass collapse in property related businesses are overdone. The absence of a surge in house prices relative to incomes and low household debt levels suggests there is no generalised housing bubble that’s about to burst. But there are pockets of oversupply and many property developers have taken on too much debt which leaves them vulnerable as house price growth slows. So more defaults are likely amongst property developers as well as in industries with excess capacity such as cement, coal, steel, solar cells and ship building. This shouldn’t be a major problem, unless the Government keeps its foot on the brakes for too long. As China’s savings rate is huge by global standards – savings which mostly have to be recycled via debt – encouraging or allowing a deleveraging cycle would be very dangerous. I think the Chinese authorities realise this. As result, slowing growth and low inflation appears to be resulting in gradual policy easing with the Government announcing a speeding in construction activity following moves in recent weeks towards a lower Renminbi and lower interest rates. The authorities have already indicated that they will not allow defaults to become a systemic threat.
• Meanwhile under its New Urbanisation Policy, by 2020 China plans to shift another 110 million workers to cities. This amounts to about 15 million workers a year. At the same time it is gradually reforming its hukou (welfare registration system) that will transfer guest workers in cities over time from dormitory workers to full city citizens wanting everything that goes with that. This means ongoing strong growth in demand for urban property, infrastructure, consumer services, etc. Notwithstanding short term cyclical swings – like the inventory cycle now affecting iron ore demand – Chinese raw material demand is likely to remain strong long term as a result.

Australian economic events and implications

• The minutes from the last RBA Board meeting offered little that was new with the Bank repeating that “a period of stability in interest rates” remains prudent and that the $A remains “high”. The RBA’s comment that it had discussed macro prudential controls with respect to house prices sounds like nothing more than a statement of the obvious given their use in New Zealand. Apart from their obvious problems – ie they are a return to the more regulated and less successful past and some hit first home buyers hardest – it seems the RBA is not too concerned about the housing market at present seeing little sign of relaxing lending standards, no risk at present to financial system stability and little sign of speculative behaviour. Apart from the need to involve APRA which would take time I suspect that the imposition of macro prudential controls on the housing market are way off, if at all. Meanwhile, car sales rose only fractionally in February and skilled vacancies trended higher for the sixth month in a row adding to evidence that the jobs market is stabilising.

What to watch over the next week?

• Monday is PMI day, with a bounce in MNI’s Chinese business survey pointing to a bounce in China’s flash HSBC manufacturing conditions PMI, Europe’s PMIs likely to confirm ongoing economic recovery although it will be interesting to see whether the uncertainty regarding Ukraine has had any impact and the Markit PMI in the US expected to remain around a solid reading of 57.
• In the US, expect to see further gains in house prices, a fall back in new home sales after a near 10% bounce in February and a slight improvement in consumer confidence (all due Tuesday), a modest gain in durable goods orders (Wednesday) and soft weather affected pending home sales (Thursday).
• Japanese economic activity data (Friday) is likely to show continued reasonable growth albeit it is distorted by the pull forward associated with the coming GST rate hike. Inflation will likely show ongoing signs of tracking higher.
• In Australia, the RBA’s bi-annual Financial Stability Review (Wednesday) will likely reiterate that the Australian financial system remains in reasonably good shape. Speeches by Governor Stevens and Deputy Governor Lowe will also be watched for any clues regarding the outlook for interest rates.

Outlook for markets

• The combination of emerging market worries – notably China and Ukraine at present – along with growing uncertainty as to when the US Fed will start to raise interest rates are likely to ensure that 2014 will be a more volatile year for shares.  Investors should allow for the likelihood of a 10 to 15% correction at some point along the way this year. However, the broad trend in share markets is likely to remain up reflecting the combination of reasonable valuations, better earnings on the back of improved economic growth and easy monetary conditions helping to entice investors to switch out of cash and bonds and into shares. Our year-end target for the ASX 200 remains 5800.
• A slow rising trend in bond yields on the back of gradually improving global growth combined with low yields to start with means pretty subdued returns from government bonds. Cash and bank deposits also continue to offer pretty poor returns.
• Notwithstanding the potential for a bounce in the $A back to around $US0.95 on the back of excessive short positions, the broad trend in the $A remains down reflecting softer commodity prices, a reversion to levels that offset Australia’s high cost base and a decline in Australia’s growth relative to that in the US.

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 21 March, 2014 appeared first on AdviserVoice.

Financial markets had a roller coaster week, thanks mainly to events in the Crimea. A referendum in that region over the weekend, and international reaction to it, could prolong the volatility for shares, currencies and bonds. The US FOMC meeting may add to market moves if they depart from current views about the tapering program.

On Thursday the RBNZ lifted the Overnight Cash Rate, which had stayed at 2.50% for 3 years, to 2.75%. The ASB Chief Economist, Nick Tuffley, analyses in an article inside, the RBNZ’s reasoning. He forecasts the OCR to rise further over 2014 and 2015. NZ QIV GDP data this week is expected to show annual growth above 3%.

Australia’s financial markets received some shocks on Thursday. The first was a startling 47k jump in February jobs, with some upward revisions, unpalatable for some, to a previously quite weak history. Bond yields and the AUD/USD jumped initially, then regained some composure as more details about the survey methodology emerged. In our view, the February spike in employment is a “statistical reversal” of previously reported weak numbers given the limitations of a survey‑based data measure. On a three‑month average basis, jobs growth is around 14K. Firm population growth means around that 18K jobs are required every month to keep the unemployment rate stable. So it is reasonable, in our view, that while the short term risk remains with a rising unemployment rate, market watchers should prepare themselves for a gradual improvement in the jobs market around mid‑year. Markets are now pricing in the next RBA rate move as a rise, in mid‑2015. In our view it is more likely to be in late 2014 given our expectations about rising inflation risks. We expect the RBA to lift the cash rate to 3.5% in late 2015.

Weaker than expected China data on industrial production and retail sales was the second shock on Thursday. It restored the faith of those with bearish views on China, Australia and commodity prices. Our view is that the January‑February data in China is unduly influenced by shifts in the timing of the Lunar New Year. Another issue relating to the direction of the Chinese Yuan, CNY could become more important for markets in coming months. The CNY, which is controlled by China’s central bank (the PBoC), has fallen recently against the USD when its usual trend of the past few years is to appreciate. A weaker CNY will help China’s exporters but lift the cost of imports and possibly, inflation.

The US data in the coming week covers industrial production, CPI, housing construction and, most importantly, the US FOMC meeting. It will be the first meeting with Janet Yellen in charge. The Fed is expected to continue its tapering of asset purchases. It is also likely to change its forward guidance on monetary policy. Namely, the general unemployment rate target may be replaced by a broader set of jobs market indicators. The Fed could also adopt an approach that discusses what they intend to achieve with an interest rate rise and whether further rate rises will be gradual.

Australia has a reasonably light data calendar in the coming week. The only major release is the RBA’s February Board Minutes. We expect the RBA to repeat its “neutral” monetary policy bias. There could be some further signs from the RBA that they believe the uptick in cyclical parts of the economy is gaining more traction. We believe that the next move in RBA cash is up in the December quarter.

CBA’s economic and financial forecasts are attached, along with the weekly and events calendar. Articles inside include an overview of the RBNZ rate rise and an overview of Queensland’s economic outlook by Senior Economist, John Peters.

Shane Workman – CBA Economics

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