Weekly Market Update – 25th July 2014

Investment markets and key developments over the past week

• While US shares were flat, most share markets rose over the last week on generally good economic data, continued solid earnings results and an absence of additional bad news regarding either Ukraine or the Middle East. European shares rose 0.5%, Japanese shares gained 1.6%, Chinese shares rose 3.2% and Australian shares gained 0.9%. In fact Australian shares rose to their highest since June 2008. Bond yields were little changed as was the Australian dollar. Commodity prices were mixed with oil down, gold flat and copper up.

• The July round of business conditions purchasing managers’ indexes (PMIs) provided confidence that the global recovery is on track with the US manufacturing PMI remaining strong at 56.3, the Eurozone composite PMI rising to its equal highest reading for the recovery and China’s HSBC PMI rising to 52, its highest in 18 months. Japan’ s manufacturing PMI disappointed though falling back to 50.8. The overall impression is of continued solid global growth, but not so strong as to invite generalised inflation or rate hike worries.

• The Chinese share market was perhaps the most interesting over the last week with the continuing run of good economic news resulting in a technical break higher. We have seen a few false breaks in Chinese shares before so it’s premature to get too excited, but with China A shares amongst the world’s cheapest and economic indicators looking better, we continue to see significant medium term return potential from Chinese shares.

• Victory for business friendly Joko Widodo in the Indonesian election is a great outcome for Indonesia, but he lacks the winning margin Modi attained in India and a challenge to the results by the defeated candidate, former General Subianto Prabowo, will prolong political uncertainty. So the outcome does not warrant the sort of re-rating of the Indonesian share market that Indian shares have seen. At least not yet.

• Reserve Bank of Australia (RBA) Governor Glenn Stevens provided a reminder of just how important the global policy response to the global financial crisis (GFC) was in heading off a re-run of the Great Depression. Thankfully policy makers had learned the lessons of the 1930s well and weren’t to be distracted by the disciples of Austrian economics who advocated a do nothing approach. Steven’s also rightly points out that the search for yield and risk taking is “the whole point” to quantitative easing. While this has yet to flow on to risk taking by US businesses (i.e. investment) – with Governor Stevens suggesting this owes much to subdued confidence – We think there are enough indicators to provide confidence it will. This includes the rising trend in US durable goods orders and its strengthening jobs market.

• Comments that Australian home owners with a mortgage will struggle if mortgage rates rise are a bit overblown. We heard similar warnings at the bottom of the last rate cycle in 2009 but didn’t see major problems through the 2009-10 tightening cycle. There are several reasons to expect the same when rates eventually start moving up again. First, just as Australians have sped up principal repayments as rates have come down they will likely slow them as rates go up. In fact debt interest payments are at a ten year low. Second, the household debt to income ratio has been basically flat since the GFC so it’s not the case that Australians have been rapidly taking on more debt. Third, interest rates won’t rise unless household income is also on the rise and this will provide some offset to higher interest rates. Finally, we agree that the rise in household debt ratios over the last twenty years has left households a lot more sensitive to higher interest rates. But this is not new and it explains why the peak in the cycle for interest rates has been trending down. The RBA is well aware of the issue and knows that it doesn’t need to raise rates as much as in times past to have the same impact. So just as the 2010 cash rate peak of 4.75% was below the 2008 peak of 7.25%, the next peak will likely be lower again. Maybe around 4%. At this stage it’s still a bit academic though as the first rate hike is still a way off. But for those home buyers looking for another opportunity to lock in low mortgage rates, the cut in five year fixed rate mortgages to below 5% by major banks on the back of reduced borrowing costs and competitive pressure is good news.

Major global economic events and implications

• US data was mostly good. New home sales disappointed but existing home sales rose solidly, house prices continue to rise, the Markit manufacturing PMI remains strong, jobless claims fell to their lowest since early 2006, durable goods orders remained in a gradual rising trend and core inflation was benign at 1.9%. The US economy is on the mend, but the benign inflation result gives the US Federal Reserve (Fed) breathing space on interest rates.

• Meanwhile, June quarter earnings remain solid. So far 46% of S&P 500 companies have reported with 79% beating on profits and 66% beating on sales. These are both well above the norm.

• Eurozone July PMIs rose and beat expectations. Services conditions were particularly strong and pushed the composite PMI to its equal strongest for the recovery so far, a level consistent with 1.5% annual growth.

• The slight fall in Japan’s July PMI was disappointing. Meanwhile inflation data remains positive.

• In China, monetary conditions look to be continuing to ease and the further rise in China’s HSBC manufacturing conditions PMI in July backs up the rise already reported in MNI’s business confidence indicator in telling us that growth has continued to improve. No hard landing here!

Australian economic events and implications

• In Australia, the news that inflation has risen to 3% caused some consternation that there might be a rate hike around the corner. But while inflation at the top of the target range makes it harder for the RBA to cut interest rates again – not that they wanted to anyway – it doesn’ t point to a rate hike. First, the rise in the annual rate of inflation reflected strong inflation during the second half of last year, but it has since slowed. Second, outside of housing costs, much of the rise in inflation owes to government decisions. Higher interest rates won’t stop this. Third, inflation is set to fall with the removal of the carbon tax and continuing very low wages growth. Fourth, underlying inflation at 2.8% is basically in line with the RBA’s forecast of 2.75%. And finally, a rate hike will only push the Australian dollar even higher. So rates are likely to remain on hold.

• Meanwhile, there was good news on the economy with the weekly Roy Morgan consumer confidence survey rising to pre-Budget levels and a rise in skilled vacancies in June. The former suggests the hit to confidence from the Budget has faded and the latter adds to evidence that forward looking labour market indicators are improving.

What to watch over the next week?

In the US, the focus will be on the Fed

(Wednesday) which is expected to taper its monthly asset purchases by another $US10bn taking them to $US25bn a month, consistent with continued solid economic data. However, most interest will likely be on the tone of the Fed’s post meeting statement which is likely to acknowledge the improvement in the economy but leave the impression the first rate hike is still some time away. My best guess for the first rate hike remains mid next year, but this doesn’ t mean financial markets won’t start to worry about it earlier. On the data front, expect a further gain in June pending home sales (Monday), another increase in house prices (Tuesday), little change in consumer confidence (also Tuesday), June quarter GDP data (Wednesday) to show growth bouncing back but only to a 2.9% annualised pace, the July ISM manufacturing index (Friday) remaining solid at around 55.5 and July jobs data (Friday) showing a 225,000 gain in payrolls but unemployment unchanged at 6.1%. The Fed’s preferred wage growth measure (Thursday) and inflation measure (Friday) will also be released.

 

Eurozone economic confidence measures for July (Wednesday) are likely to remain consistent with continued gradual recovery and inflation (Thursday) is likely to have remained very low.

 

In Japan, June data for household spending (Tuesday) and industrial production (Wednesday) will be watched for signs of recovery after the April sales tax induced slump. Jobs data is likely to have remained solid.

 

In China, expect to see a further improvement in the official Chinese manufacturing PMI (Friday) for July.

 

In Australia, expect to see flat building approvals after a strong rise in May and modest growth in credit (both Thursday). June quarter export prices (Thursday) will likely show a sharp fall reflecting the slump in the iron ore price. Data for new home sales, house prices, the manufacturing PMI and producer prices will also be released.

 

Outlook for markets

Shares remain vulnerable to a short term correction, with a potential Fed rates scare at some point being the most likely trigger, but we continue to see little evidence suggesting we are at or near a major market top.

Valuations remain reasonable, particularly if low interest rates are allowed for, 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. In terms of the latter if anything there is still a lot of scepticism which is a long way from the sort of confidence that is normally seen when bull markets end. Given all this, any short term dip in shares should be seen as 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 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 carry trade from ultra-easy money in the US, Europe and Japan risks pushing the Australian dollar higher, 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 Australian dollar remain down.