Weekly Market Update – 21st March 2014

Investment markets and key developments over the past week

• The past week has seen worries about Ukraine fade but concerns the United States Federal Reserve (Fed) will raise rates earlier than expected has taken centre stage. This saw bond yields push higher, but despite a few gyrations most equity markets rose helped by a combination of relief regarding Ukraine, better economic data and European agreement on a banking union. Shares in the US rose +1.4%, Eurozone shares gained +2.6%, Chinese shares rose +2.2% and Australian shares rose +0.2%. Japanese shares bucked the trend and fell -0.7%. The renewed focus on expectations of a Fed rate hike pushed the US$ higher against the yen and euro, but the A$ bucked the trend and rose in value helped by a continuing reduction in prospects for further rate cuts in Australia and talk of policy stimulus in China.

• The risks regarding Ukraine seem to be receding. Russia does not appear to be interested in moving into other parts of Ukraine, and Ukraine seems to have accepted the Crimea as a part of Russia (for now). Ukraine is pulling its military out of the region. The sanctions from the US and European Union (EU) and some tit-for-tat moves from Russia appear to have no economic impact and comments from the Ukrainian Prime Minster appear more conciliatory towards Russia with commitments to not join NATO and to decentralise power to its regions. Key issues to watch will be: any escalation in ethnic violence in eastern Ukraine as it could still lead to civil war, increased Russian intervention on the grounds of ‘protecting Russians’; more substantial sanctions from the US and Europe; and, the Ukrainian elections outcome in May. The risks within the region are high. However, I remain of the view that the crisis in Ukraine is just another distraction for investors. It will not derail the European or global economic recoveries or the bull market in shares.

• The Ukraine crisis will be far worse for Russia than the West. The EU is looking to cut its reliance on Russian energy and while Fitch affirmed the US’ AAA rating, it and S&P cut Russia’s rating outlook.

• 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. There were no surprises from the Fed’s decision to continue tapering. The Fed’s commented that it will be appropriate to maintain the current rate for a considerable time after quantitative easing (QE) ends and that once full employment and 2% inflation are reached it will be appropriate to keep interest rates below normal levels. This is a ‘dovish’ approach. However, financial markets latched on to upwards revisions to Fed meeting participants’ interest rate expectations, the so-called ‘dot plot’, along with Yellen’s comment that the first rate hike may come six months after QE ends and this led to fears of an earlier and sharper tightening by the Fed. It is increasingly likely that, just as last year taper talk caused volatility in financial markets, this year it will be debate about when the Fed will first start to tighten that will cause volatility. However, I would not be too fussed. First, Yellen’s six month comment has probably been taken too literally and based on comments by the Fed’s James Bullard, President and Chief Executive Officer (CEO) of the St. Louis Fed, Yellen probably thought she was just affirming market expectations for the first rate hike rather than signalling an earlier move. Second, as Yellen and Richard Fisher, President and CEO of the Dallas Fed, have indicated it is inappropriate to read too much into changes in the ‘dot plot’. Third, and most importantly, 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 supports a stronger outlook for corporate profits. It will be a long time before US interest rates reach levels that really threaten profit growth and the share market outlook. Finally, by the time US rates do start to go up – probably not till around next year – investors will have become well and truly used to the idea.

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. However, better-than-expected growth in industrial production and good gains in manufacturing conditions, according to surveys in the New York and Philadelphia regions, are 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 Gross Domestic Product (GDP) was helped by falling oil imports and benign core inflation, at +1.6% year-on-year (yoy) in February. This highlighted there is 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 is worth putting it in context though. First, the default was due to illegal activities with both the Chairman and his son being arrested. This has nothing to do with property related stress. Second, 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 is about to burst. However, there are pockets of oversupply and many property developers have taken on too much debt which leaves them vulnerable as house price growth slows. More defaults are likely among property developers as well as in industries with excess capacity such as cement, coal, steel, solar cells and ship building. This should not be a major problem, unless the Government keeps its foot on the brakes for too long. As China’s savings rate is huge – savings which mostly have to be recycled via debt – allowing a deleveraging cycle would be very dangerous. The Chinese authorities realise this. As result, slowing growth appears to be driving a gradual policy easing evident in a -3% decline in the renminbi and with the Government announcing a speeding up in construction activity. The authorities have already indicated 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. This means ongoing strong growth in demand for urban property, infrastructure and consumer services. Notwithstanding short-term cyclical swings – like the inventory cycle now affecting iron ore demand – Chinese raw material demand is likely to remain strong in the long term.

Australian economic events and implications

• The minutes from the last Reserve Bank of Australia (RBA) Board meeting offered little that was new with the Bank repeating that “a period of stability in interest rates” remains prudent. 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 – 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. There is little sign of relaxing lending standards, no risk at present to financial system stability and little sign of speculative behaviour. I suspect that the impositions 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 purchasing managers index (PMI) day, with a great deal of reading due. A bounce in Chinese business sentiment (MNI) survey points to a bounce in China’s flash HSBC manufacturing conditions PMI. Europe’s PMIs are likely to confirm ongoing economic recovery, although it will be interesting to see whether the uncertainty regarding the Ukraine has had any impact and the Markit PMI. The PMI in the US expected to remain around an expansion oriented reading of 57.

• In the US, expect to see further gains in house prices, a fall back in new home sales after a +10% bounce in February, 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 Goods and Services Tax (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 Glenn Stevens and Deputy Governor Philip Lowe will be watched for any clues regarding the outlook for interest rates.

Outlook for markets

• The combination of emerging market worries – notably China and Ukraine– along with growing uncertainty as to when the Fed will start to raise interest rates will likely 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. 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 5,800.

• 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 US$0.95 on the back of excessive short positions, the broad trend in the A$ 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.

 

Important note: While every care has been taken in the preparation of this article, 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 article 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 article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.