Central Bank Watch – October 2014

Principal Global Investors has released its monthly Central Bank Watch for October 2014.

The report outlines key concerns of the Reserve Bank of Australia which includes the slowing momentum in the Chinese economy, the strength of the Australian dollar and commodity prices.

The report includes graphs and analysis of current monetary policy in the US, England, Europe, Japan and Canada.

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• Share markets had another volatile week with concerns about a strike on Syria weighing on confidence, and emerging market assets, particularly currencies, coming under significant pressure.
• The concern in the run up to any US led military involvement in the Middle East is that it will lead to a wider confrontation threatening oil supplies. It’s no different in the case of Syria with worries that it may draw in Iran or Israel. So even though Syria is just a tiny oil producer (about 300,000 barrels a day) the talk of intervention has contributed to a small spike in oil prices and share market jitters. While such concerns invariably are not realised, past experience points to share market weakness/oil price strength in the run up to any intervention followed by a recovery in share markets from around the time it commences. The 1991 Iraq invasion, the December 1998 bombing of Iraq, the March 2003 Iraq invasion and the March 2011 Libyan bombing saw US shares fall 5.6%, 3.5%, 14% and 6.3% respectively in the run up to the events only to see the losses recovered within two months afterwards. I would expect a similar pattern this time around, particularly as it becomes clear that any intervention will be limited and that surrounding countries are unlikely to become involved.
• Meanwhile, the rout in emerging markets, and notably the currencies of India and Indonesia, continued with Fed taper fears combining with current account and budget imbalances to worry investors. Both Indonesia and Brazil hiked their benchmark interest rates again to combat inflation and support their currencies and this will only further weaken their growth outlook making them even less attractive to foreign investors in the short term. This problems in the emerging world look like having a way to run yet.
• More broadly, Syria and emerging world uncertainty has added to an already longish worry list for investors in the short term that includes the Fed’s taper decision, coming negotiations to fund the US Government and raise its debt ceiling, the nomination of the next Fed Chairperson, the German election, political instability in peripheral European countries and the prospect of a post election fiscal tightening in Australia. This vulnerability is enhanced because September is normally the weakest month of the year for US shares (with an average monthly decline of 0.8% since 1985) and October is normally the weakness month of the year for Australian shares (with an average monthly fall of 0.7% since 1985). As a result, shares remain at risk of further weakness in the month or two ahead. However, most of these worries should ultimately be resolved in an unthreatening way allowing a strong rebound in share markets into year end as seasonal strength returns.

Major global economic events and implications

• US economic data was mixed highlighting the difficult decision the Fed will face at its September 17-18 meeting in terms of whether to taper its monetary stimulus or not. On the positive side consumer confidence and house prices rose, jobless claims fell and June quarter GDP growth was revised up from 1.7% to 2.5% thanks to stronger contributions from trade and inventories. But against this, durable goods orders were weak (albeit with a still reasonable underlying trend) and pending home sales slipped again. Higher mortgage rates and now higher oil/gasoline prices are clearly a bit of a headwind for US growth. The net result may be that the Fed will either delay the start of tapering till later in the year or alternatively just cut it back by $10bn a day.  
• German, French and Italian business confidence readings confirmed the ongoing recovery in the Eurozone.
• Japanese data for July was mostly favourable with falling unemployment, a rise in the jobs to applicant ratio, growth in household spending, a solid bounce back in industrial production with a higher August PMI pointing to more strength and fading core pressures. Abenomics looks to be working albeit it’s a slow process.

Australian economic events and implications

• In Australia, while business investment rose a much stronger than expected 4% in the June quarter, this masked a decline in plant & equipment investment which is what feeds into GDP estimates. More importantly business investment plans were revised down for this financial year and now point to a 1% fall in investment this financial year using a comparison of past investment intentions with actual outcomes or an 11% fall based on a comparison of investment plans for 2013-14 with those made for 2012-13 a year ago. However, whether it’s a 1% fall or an 11% fall the outlook for business investment is poor with weakness pretty much across the board, highlighting the need for further monetary easing in Australia.
• Meanwhile, credit growth remained subdued in July albeit with signs of a bottoming and there was mixed news in relation to housing with a fall in new home sales but another rise in housing affordability to its best in a decade pointing to an ongoing housing recovery ahead.
• The June half profit reporting season is now essentially complete. Results have been weak but not as bad as feared and dividends have increased by 10% which partly explains why the Australian share market has performed reasonably well in August. Overall, results have been a little bit better than expected with 39% of companies exceeding analyst expectations as against 27% missing expectations. 64% of companies have seen their profits rise from a year ago and 60% of companies have increased their dividends from a year ago as against only 12% which have cut them. And while corporate outlook comments have been subdued, the fact they haven’t been too gloomy is a good sign.
• Consequently, and because the bad news had already been factored in we haven’t seen the earnings downgrades some had feared. Earnings expectations for 2012-13 are little changed at -0.5% (with resources earnings down by around 21% but with earnings for the rest of the market up by around 6%). And for 2013-14 earnings growth expectations remain around 13%, made up of a 35% gain for resources and 8% growth for the rest of the market. As a result of increased dividends from resources stocks, dividend growth ran much stronger than earnings last financial year, rising by around 10%. Reflecting the better than feared results and increasing dividends, 53% of companies have seen their share price outperform the market on the day their results were released. Key themes are ongoing cost control and weak revenue growth, but a prospective boost to profits from the lower $A and for iron ore companies from a higher iron ore price. Strong dividend growth reflects both a degree of comfort with the profit outlook along with pressure from shareholders for increased dividends.

Major market moves

• Shares had a rough week, not helped by worries about a strike on Syria and problems in some emerging countries.
• Commodity prices were mixed with gold and oil up on Middle East uncertainty, but metal prices down.
• A stronger $US and weaker metal prices saw the $A fall.
• Bond yields fell in the US, Germany, Japan and Australia partly as a bit of safe haven buying crept back in.

What to watch over the next week?

• In the US, the focus is likely to be on the manufacturing conditions ISM (due Monday) and payroll employment data (Friday) as guides to whether the Fed will commence tapering its monetary stimulus this month. Both may not provide decisive readings though with the ISM expected to slip slightly to 54 from 55.4 and payroll employment growth expected to be around 180,000 which is solid but not overwhelmingly strong. The Fed’s Beige Book of anecdotal indicators along with trade data and the non-manufacturing ISM will also be released.
• In the Eurozone, final manufacturing PMIs (Monday) and services PMIs (Wednesday) are expected to confirm the recovery already reported in the flash estimates. The ECB and the Bank of England are both likely to leave monetary policy unchanged when they meet Thursday, but indicate they retain easing biases.
• The Bank of Japan is also expected to leave monetary policy unchanged on Thursday.
• In Australia, the focus will no doubt be on the election to be held on Saturday 7^th September. The RBA meets Tuesday but, given the proximity to the election and its signal that another interest rate cut is not imminent, rates are likely to be left on hold. However, the post meeting statement is likely to retain an easing bias, particularly with the capex outlook weakening further and inflation benign, which the RBA is likely to act upon at its October or November meetings unless the $A falls rapidly.
• On the data front expect a solid bounce in July building approvals after a sharp fall in June, soft June quarter company profits and continued modest growth in RP Data’s house price series (all due Monday), continued weak growth in retail sales (Tuesday) and June quarter GDP growth (Wednesday) to have remained subdued at 0.5% quarter on quarter or 2.4% year on year. While consumer spending and building activity look to have been weak in the June quarter, trade is likely to have provided a modest boost to GDP growth. Data for the June quarter current account deficit, the trade balance and the AIG’s business conditions PMIs will also be released.

Outlook for markets

• Shares are vulnerable over the next month or two with various events and risks that could trigger investor nervousness including the Fed’s September meeting where it may start to taper its monetary stimulus, US Government funding and debt ceiling negotiations, the nomination of the next Federal Reserve chairperson, various imbalances in the emerging world, a possible military intervention in Syria, political instability in Italy and the election in Australia.
• However, a pullback should be seen as a buying opportunity as the broad trend in shares is likely to remain up: valuations are not dirt cheap but they are not expensive either; monetary conditions will remain very easy with interest rate hikes a long way off in the US and in other developed countries and interest rates still at risk of falling further in Australia; and the gradually strengthening global growth outlook points to stronger profits ahead. So by year end we see further upside in global and Australian shares.
• Sovereign bond yields still remain low and point to low medium term returns as yields gradually adjust higher in response to the improving global growth outlook. An unwinding of years of massive inflows into bond funds though runs the risk of causing a more aggressive rise in bond yields and hence losses on sovereign bonds.
• With commodity prices in a downtrend and the Australian economy deteriorating versus the US, it’s likely the $A will fall further. Given its overvaluation in terms of relative prices and costs, expect the $A to fall to $US0.80.

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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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That’s nice, so I can now go back to worrying about Greece in peace. Or maybe not. In fact it’s starting to feel a bit like Ground Hog Day for investors. Here we are with another year that started fine with share markets up on optimism about an improved global outlook, to now be in May and see the same old worries back with a vengeance. Europe seems to be falling apart again, worries about a Chinese hard landing are back and US economic data has become mixed with worries it will fall off a “fiscal cliff” next year. So far since their highs this year global shares have fallen 8% and Australian shares by 5.5%. 

Europe
Quite clearly Europe remains at the head of the worry list with increasing signs of a backlash against fiscal austerity, fears Greece is about the exit the euro and increasing concerns about Spanish banks:

• The Socialist victory in France and the fall of the Dutch Government are probably less of a concern as even Chancellor Merkel is likely to agree to some easing of the pace of fiscal austerity following her own coalitions’ electoral losses and the EU seems to be moving towards a more relaxed enforcement anyway having realised that austerity is just making things worse. (That’s the downside to Austrian economics!)
• Greece is far more problematic. It is now headed for a new election with Greeks seemingly schizophrenic in wanting to stay in the euro but thinking they can substantially renegotiate the terms of their bailout. It seems that each successive crisis in Greece is taking it closer to exiting the euro, whether its via a new Government rejecting the bailout deal or if several months down the track it fails to meet its agreed deficit reduction targets. An exit from the euro would mean complete chaos for Greece – a 50-70% collapse in its new currency, the inability to fund its budget deficit and hence even worse fiscal austerity, a banking system collapse, etc. For the rest of Europe a Greek exit would be far less problematic than might have been the case a year ago as private sector financial exposure to Greece has been substantially reduced and firewalls have been strengthened. But uncertainty would still be intense in the process of Greece exiting and this may result in more market turmoil, as investors will look around for who will be next to leave – Portugal? Spain? 
• Spain being much much bigger is more of a worry, with a recession and falling property prices making the situation of its banks more difficult risking the need for a public sector bailout. Some estimates put the requirement at €100bn which would add 10 percentage points to Spain’s public debt to GDP ratio which would take it to around 80% of GDP. This would still be below the Euro-zone average of 87% and normally wouldn’t be a problem but these are not normal times. And if Spain gets into deeper trouble, investors will likely focus on Italy again.

This has all resulted in a renewed blowout in bond yield spreads between Spain and Italy on the one hand and Germany on the other. Despite Europe stagnating in the March quarter rather than confirming recession as expected, we continue to expect a 1% contraction in Euro-zone GDP this year. Whichever way you cut it Europe is a mess and it is still hard to see the way out. However, several things are worth noting.

First, while the sovereign crisis in Europe has returned anew, interbank lending spreads remain under control suggesting the risk of banks not being able to fund themselves and hence a systemic banking crisis, threatening a re-run of the GFC and a huge blow to global growth, is currently low. This is thanks to the provision of cheap ECB funding for banks.

Second, the experience of the last two years where fears that European blow-ups would trigger a return to global recession and financial meltdown highlight that policy makers have the power to calm things down. Right now Europe needs a slowing in austerity and much easier monetary policy. The odds are that European authorities will move in this direction. But as always it may take more bad news before they get there.

China
A month ago, Chinese economic data was showing signs of bottoming, but this vanished with official data for April showing a further sharp slowing in industrial production, retail sales, fixed asset investment, imports, exports and bank lending. While this contrasts with business conditions indicators pointing to a stabilisation in growth it nevertheless suggests that growth could dip to 7% in the current quarter.

Fortunately with inflation and the property market having cooled there is plenty of scope for further policy easing in China which we expect over the next few months. China doesn’t have the debt constraints that the US and Europe have and so growth should stabilise over the second half. 

The US
Until about a month ago US economic data was universally surprising on the upside, but recently it has been a bit mixed with notably soft readings on employment. However, current indications are that the US is growing around 2 to 2.5%. The real concern for the US is an impending fiscal tightening that will follow the end of the Bush era tax cuts and various stimulus measures at the end of this year. The fiscal cutback, commonly referred to as a “fiscal cliff” will amount to around 3.5% of GDP next year. While this is likely to be reduced to 2% of GDP, it is hard to see Congress and the President agreeing to do this until after the presidential election in November and naturally uncertainty regarding it may intensify into year end.

Some positives
While the risks are significant it is worth noting there are several positives compared to 2010 and 2011, when shares fell roughly 15% from their April high in 2010 and 20% from their April/May high in 2011.

• Firstly, business conditions indicators, notably the US ISM index, have improved after last year’s falls but haven’t yet reached the cyclical highs they got to a year ago. In other words, having not increased that much, there is not as much downside. Right now they are at levels consistent with modest global growth.

• Second, the US economy is looking better in three key areas: the housing sector looks like it is bottoming; manufacturing is experiencing a renaissance and US oil production is surging thanks to shale oil. 
• Third, the global economy hasn’t been hit by the supply chain disruptions that flowed from the Japanese earthquake in March last year. This time a year ago the US economy was already slowing partly due to this.
• Similarly, the rise in oil prices this year hasn’t been as great as occurred early last year in response to the “Arab Spring”. Consequently the blow to household income hasn’t been as great.
• Global monetary policy has been easing, whereas a year ago it was being tightened. This was notable in the emerging world where inflation in China was on its way to a high of 6.5%, but also evident in Europe and in Australia the RBA was still threatening to raise interest rates. Now monetary policy has been easing, notably in most emerging countries and in Australia. 
• At their April highs this year shares were cheaper than at their early 2010 and 2011 peaks in terms of the earnings yield pick up they provide over Government bonds. This can be seen in the next chart.

• Finally, it seems everyone is fearful of a re-run of the last two years where shares fell 15 to 20% after highs in April or May. When everyone expects something, sometimes it doesn’t happen.

On balance, while the tenuous situation in Europe along with normal seasonal weakness from May into the third quarter points to the likelihood of further weakness ahead, there are some positives suggesting the downside in markets won’t be as great as the 15-20% falls seen in 2010 and 2011.

What does this mean for Australia?
There are several implications in this for Australia.

• Firstly, while recent domestic data for retail sales, building approvals and employment suggest that the chance of a further June rate cut has fallen, the uncertainty regarding the global growth outlook and weakness in China which has pushed down commodity prices suggest that further interest rate cuts are likely to be justified. We continue to see the cash rate falling to 3-3.25% over the next six months.
• To the extent that global shares remain vulnerable over the next few months, Australian shares will as well. However, the combination of monetary easing (in contrast to the higher rates and threat of further tightening a year ago) and a weaker $A provide some buffer. We continue to see share markets higher by year end, notwithstanding the risk of further downside over the next few months.
• The growth sensitive Australian dollar, like share markets, is vulnerable to further weakness in the short term, possibly taking it down to last years low of around $US0.95. By year end it is likely to be back above parity though as it becomes clear that global growth is continuing, possibly helped along by more quantitative easing in the US (QE3) and Europe which will reduce the value of the $US and euro..

Concluding comments
Renewed uncertainty regarding the global growth outlook, particularly fears around a Greek exit from the euro and worries about Spanish banks, mean that further downside is possible for share markets over the next few months. However, key differences compared to the last two years including a stronger US economy, global monetary easing and cheaper share markets hopefully should help limit the downside in shares and help result in a better year end.

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