Weekly Market Update – 20th June 2014

Investment markets and key developments over the past week

• Global share markets generally rose over the last week as a dovish US Federal Reserve (Fed) and solid economic data offset continuing uncertainty regarding Iraq and Ukraine. US shares gained 1.4%, European shares gained 0.3%, Japanese shares rose 1.7% and Australian shares rose 0.3%. Chinese shares fell 2.1% though, partly dragged down by worries about new share initial public offerings. Bond yields were flat to down helped by indications that the Fed sees lower long-term interest rates, but yields backed up a bit in Spain and Italy. While oil was little changed, gold and metal prices had a rise. The Australian dollar was essentially unchanged.

• The message from the Fed’s latest meeting was supportive of both bonds and equities. While our concern for some time has been that there will be some sort of inflation/Fed rates scare this year – much like last year’s taper scare – at this stage it still seems a while off. While the Fed is more confident on the growth and unemployment outlook, it doesn’t look to be too fussed by the recent rise in CPI inflation because its preferred measure of inflation is running somewhat lower and the CPI may have been boosted by noise and it would clearly like to see broader measures of spare capacity in the labour market improve. As a result, Fed Chair Janet Yellen continues to point out that below normal levels for the Fed Funds rate may be warranted even after inflation and unemployment have returned to target. What’ s more, the Fed meeting participants revised down their median long run Fed Funds rate level by 0.25% to 3.75%. So understandably both bonds and equities rallied.

• However, it’s not necessarily all smooth sailing. Fed meeting participants did creep up their interest rate expectations for 2015 and 2016 and, as Janet Yellen points out, the key will be what happens to the data going forward. Our view remains that the first Fed rate hike is still 9-12 months away, but we are likely to see more focus on this in the months ahead, particularly if US economic data remains solid. With US (and global) bond yields a lot lower than they were at the start of the year there is a bit of complacency on this front. So a US inflation/rates scare could still be a source of market volatility in the months ahead.

• Ukraine and Iraq are clearly bubbling away as risks but not posing major threats, at least not yet. The conflict in Iraq is still building with the US committing military advisers and considering air strikes, but our assessment remains that it will have to get a lot worse before it becomes a major threat. The conflict is currently in the north of Iraq but 2.1 million barrels per day (mbd) of its 2.3 mbd of oil exports comes from the south, OPEC has sufficient spare capacity to meet any shortfall from Iraq and US shale oil production means that the US is less affected than in times past. Historically the oil price needs to double within 12 months before economic growth is severely impacted and right now we are a long way from that.

Major global economic events and implications

• US economic data provided more evidence that growth has bounced back after the first quarter soft patch, with a solid gain in May industrial production, strong readings for the New York and Philadelphia regional manufacturing conditions surveys, a decline in jobless claims, another rise in the Conference Board’s leading index and an increase in the NAHB home builders’ conditions index. Housing starts fell in May but this was after a very strong gain in April and permits to build standalone homes rose strongly. One concern though was a stronger than expected gain in CPI inflation with both core and headline inflation running around 2% on a year ended basis and around a 3% annual rate over the last three months. While at this stage the Fed is not too concerned as its preferred inflation measure is a bit weaker, the risk of a mini-inflation/Fed rates scare in the next six months is worth keeping an eye on.

• Chinese house prices are down, but there are signs that growth is stabilising. Chinese house prices fell an average 0.1% in May, their first decline in over two years. However, so far the property downturn is little different to those seen around 2008 and 2011 and it should also be remembered that this is what the Government has been hoping to achieve. Meanwhile, a second consecutive gain in the MNI business indicator in June adds to confidence that growth in China has bottomed and that the various mini stimulus measures of the last few months are getting traction. Meanwhile, Premier Li indicated that “smart and targeted regulation” will ensure that the 7.5% growth target for this year will be met.

Australian economic events and implications

• It was a light week on the economic news front in Australia with a marginal rise in new vehicle sales, the Westpac leading index and the minutes from the Reserve Bank of Australia’ s (RBA’s) last meeting confirming its rates on hold stance. The minutes did express a degree of uncertainty as to whether low interest rates would be enough to offset declining mining investment and fiscal consolidation but this should be interpreted as supporting the case for rates to remain on hold at current low levels rather than signalling new dovish leanings on the part of the RBA. Meanwhile, comments by RBA Assistant Governor Kent regarding spare capacity in the labour market and falling unit labour costs highlights the RBA’s comfort in the benign outlook for inflation.

• Australia’ s population rose another 1.7% last year to 23.3 million, which is above its long term average rate of population growth highlighting that this remains a strong force for growth in Australia. This is both via a rising labour force and rising demand, particularly in terms of the demand for housing. Australia’ s strong population growth stands in contrast to parts of Europe and Japan where populations are flat or falling.

What to watch over the next week?

• Globally, its purchasing managers’ index (PMI) day again on Monday with June business conditions PMIs set to be released in China, the Eurozone and the US and the news is likely to be reasonable. The further increase in the June MNI business indicator in China points to a further slight rise in the flash HSBC PMI, the Eurozone PMI’s are expected to stay around the 52-53 level with some possibility of a boost from the European Central Bank’s (ECB’s) latest easing measures and the Markit PMI in the US is expected to remain around 56.

• In addition, in the US expect to see further gains in existing home sales (Monday), new home sales and house prices (both Tuesday), a slight rise in consumer confidence (Tuesday), solid underlying durable goods orders (Wednesday) and a rise in the Fed’s preferred inflation indicator (i.e. the core private consumption deflator) to 1.6% year-on-year for May (Thursday). March quarter GDP growth (Wednesday) is expected to be revised down further to -1.8% annualised, but this should be seen as old news given the improvement seen in a range of indicators in recent months.

• Japanese data to be released Friday will be watched for a bounce back in consumer spending after the tax related slump in April and for continued strength in the jobs market. National inflation is expected to have increased to 3.7% year-on-year but this has also been affected by the sales tax hike.

• In Australia it will be a light week on the data front with only data for skilled job vacancies (Wednesday) and overall job vacancies (Thursday) due for release. Both will be watched closely for Budget related impacts.

Outlook for markets

• Shares remain vulnerable to a mid-year correction, just as we have seen in each of the last four years now. Iraq, Ukraine and the risk of an inflation/Fed rate hike scare in the US at some point are all risks. However, in the absence of a global monetary shock as we saw in each of mid-2010, 2011 and 2013 and with shares having been in a bit of a stealth correction through the first part of this year, any pull back may well be mild. In any case the broad trend in shares is likely to remain up. Share market fundamentals remain favourable with reasonable valuations, global earnings improving on the back of rising economic growth and monetary conditions set to remain easy for some time. So any dip should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.

• Bond yields are likely resuming their gradual rising trend as its becoming increasingly clear that US inflation has bottomed and 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 boost to the carry trade from the ECB and continued dovishness from the Fed risk pushing the Australian dollar higher in the short term, the combination of soft commodity prices and relatively high costs in Australia are expected to see the broad trend in the Australian dollar remain down over the medium term. RBA jawboning is likely to return if the Australian dollar goes up too much further.

 

Source: AMP CAPITAL ‘Weekly Market Update’

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