• 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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Russia’s incursions into the Ukraine have been condemned around the world, have caused a steep sell-off of the Russian rouble and equities and have hurt financial markets in other central and Eastern European markets. However, any measures taken to isolate Russia from the global community will affect European countries more than the US given the former region’s closer economic ties with Russia, and especially given that Europe is only just emerging from recession. Russia has at least taken a step back from the brink by pulling some of its troops back to base and saying that it will only use the military as a last resort. Markets reacted positively but this story has definitely not gone away.

Ukraine’s economic problems remain a concern

While markets believe that the turmoil in Ukraine is unlikely to have broad-based implications for emerging markets (EM), any default in the EM world would prompt negative headlines. Certainly, the confrontation between Ukraine and Russia has distracted investors from a potential EU/IMF rescue deal for Ukraine, where there is a pressing need to address the US$13bn of debts (including obligations from the state-owned gas company Naftogaz), which are due to be repaid this year. Asian markets are not ignoring the possibility that the situation in the Ukraine will deteriorate.

 

Crowded calendar of political events ahead in 2014

Other notable newsflow came from Thailand where more negative headlines were generated by the rice purchasing scheme scandal. The continuing investigation by the anti-corruption body could lead to the Prime Minister being removed from office, while domestic violence continues to affect Bangkok. In addition, the 2014 presidential election in Indonesia has come to life with the incumbent Democratic Party conducting its presidential-nominating convention to boost the popularity of potential candidates such as Dahlan Iskan, the minister of state-owned enterprises. The reformist and current Jakarta governor Joko Widodo of the PDIP is likely to be the front runner if he is put forward as the party’s official contestant. Finally, politics has returned to the centre stage in India where 11 small political parties have joined forces (the up-and-coming, newly-formed AAP, however, is absent) to form a third-front to wrest power from the popular-opposition BJP and the underdog-governing Congress party.

Asia to see a correction?

Lately, the market has faced many “on-the-brink-of” situations. Ukraine appeared on the brink of civil war and Russia’s aggressive intervention in Crimea, and the uncertainty surrounding the Ukraine’s economic and financial position means it is still close to disaster. Meanwhile, the opaqueness of Chinese government policies towards interest rates and currencies means investors are close to resetting their consensus views (especially in terms of the currency) and perhaps resizing their investment allocations to China. Given the challenges facing Europe, China and the US, Asian fixed income markets are likely to experience some form of correction following the robust performance seen in February. We will monitor developments closely and use our active approach to exploit any opportunities created by further volatility.

Commentary by Clifford Lau, Head of Fixed Income, Asia Pacific

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Mark Burgess

Commenting on the effect on global markets from the Ukraine crisis,Threadneedle Investments’ Chief Investment Officer Mark Burgess, said: “To date, the fallout from the Ukrainian crisis has been largely confined to the emerging market debt, emerging market equity and commodity markets.

At current levels, emerging market local currency debt appears to offer value, although we expect both the hard and local currency markets to remain volatile in the short term.

Emerging equities reflect concerns not only around Russia and Ukraine but also the weaker growth outlook in Brazil and China. In commodities, Russia is a significant oil player, supplying 30% of Europe’s gas, with 50% of that piped through Ukraine. Any move to curb Russian oil exports by the EU could easily drive Brent crude oil into the $140-160 a barrel range. We therefore do not expect major sanctions against the country.

“Elsewhere, investment grade and high yield markets have been unmoved by the crisis in Ukraine. Foreign exchange markets, outside of the obvious areas such as the rouble, have also ignored it. Developed market equity and bond markets have recently been driven by other factors such as the headwinds from a stronger pound for UK equities, the severe weather in the US and the weaker than expected European corporate results.

Finally, core government bond investors have been focused on the softer US macroeconomic data, which has seen 10-year Treasury yields fall. We are monitoring the situation closely, but as it looks today, markets are not expecting further intervention or action by Russia.”

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Oliver comments of the economic impact of the Ukraine, Russian situation.

Worries about Ukraine have adversely affected share markets yesterday (US S&P futures -0.8%, ASX 200 -0.5%,).

The Ukrainian economy is too small and its problems too specific to have a direct impact on the global economy or an impact via contagion.

The main risk has always been that it triggers wider Russian/West conflict – resulting eg in a disruption to gas supplies to Europe or a broader military conflict.

The Russian action in Crimea over the weekend adds to this risk. Note though that Crimea has a predominant Russian population, it was part of Russia prior to 1954 and the Russian Black Sea naval fleet is based there. So this all confuses the situation a bit, eg Russia may have done all it plans to do.

At the moment though markets are focussed on the risk to gas supplies, eg the Eurozone obtains 25% of its gas from Russia – mostly via Ukraine. This could be threatened by a broader civil war in the Ukraine and/or if Russia decides to punish Europe for supporting Ukraine. Ukraine is also a big grain producer – hence wheat futures are up 3.4%.

Much now depends on how Europe and the US respond in terms of how much support they provide Ukraine, and hence by how much they antagonise Russia. My view is that the EU and US will tread carefully knowing how much the Ukraine means to Russia. It would be a bit like Russia meddling in Canada. The EU is also likely to be wary of doing anything that might threaten its gas supplies and hence its economic recovery. So I suspect that while there may be a lot of noise on this front it may die down in time.

The prospect and implications of a broader (Yugoslavian style) civil conflict between western and eastern (more pro-Russia) Ukraine and its impact on the flow of gas is harder to read.

The best outcome – in terms of reducing market uncertainty – would be some sort of IMF support for Ukraine to enable it to service its debt supported by Russia, the US and the EU with Ukraine staying out of the EU.

My suspicion is that Ukraine is just another distraction for markets that will fade in the months ahead. But it may take a while to settle down and the uncertainty could get worse before it gets better.

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