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Weekly Market Update – 27th June 2014
Investment markets and key developments over the past week
- Despite mostly good economic data, global share markets fell over the last week amidst ongoing uncertainty regarding Iraq and Ukraine. US shares fell 0.1%, Eurozone shares declined 2.2% and the Japanese share market fell 1.7%. However, Chinese shares gained 0.5% and Australian shares also gained 0.5% helped by an improvement in the iron ore price. Bond yields fell with investors punting that US rate hikes are still a long way off. While the oil price fell as OPEC indicated it would raise production if Iraqi supplies are disrupted, metal prices rose and the iron ore price continued its gradual recovery from the $US89/tonne low point seen in mid-June. The Australian dollar rose further as US interest rate expectations were reduced.
- The US energy boom on the back of shale oil fracking and horizontal drilling is a huge game changer in the US, but the impact is likely to become even more apparent with the US soon to start exporting condensates (or ultra-light oil), of which there could be more than one million barrels a day. American refineries are not geared to processing such ultra-light oil (the production of which has surged from shale fields) so it makes sense to export it. The impact will be to push down the price of light global oil grades like Brent and Tapis and it may also push down the price of US West Texas Intermediate as the processing of heavier US crudes can speed up. This is an important offset to the impact on global oil prices that may flow from Iraq.
- Japan’s third arrow reforms may seem more like a thousand needles but they are starting to add up and should not be ignored. A range of third arrow reforms have been announced in recent months, for example, easing visa requirements for Asian tourists, cuts to rice subsidies and eased factory regulations. On top of this the Government has now released its “New Growth Strategy” which includes a range of measures including a plan to incrementally cut the corporate tax rate from currently 36% to in the 20-30% range, measures to boost female workforce participation including a change in the tax system and measures to allow more foreign workers in certain sectors. These are all in the right direction and while one “big bang” reform should not be expected the gradualist “thousand needle” approach is still very positive. For example, depending on how far it goes the cut to Japan’s corporate tax rate could boost Japanese earnings per share by between 10 to 30 percentage points over the next four years. So while the boost to Japan’s economy and share market last year was driven more by monetary easing – and this remains important in ensuring that there is no return to deflation – economic reform looks increasingly likely to be a major driver over the longer term. After a 15% correction that took Japanese shares from expensive at the end of 2013 to now cheap, this augurs well for Japanese shares going forward.
Major global economic events and implications
- US forward looking economic data was pretty good. But first the bad news: the contraction in March quarter GDP was revised bigger yet again to now -2.9% annualised. However, it should be noted that the slump reflects a bunch of temporary factors that came together all at once, notably bad weather, a late Easter, difficulties in measuring healthcare reforms, an inventory adjustment and weak exports. However, these won’t be repeated and forward looking data point to a rebound in growth. Consistent with this consumer confidence rose to its highest level since January 2008, home sales rose very strongly in May, core capital goods orders are trending up nicely and the Markit manufacturing and services sector PMIs both rose strongly in June. The poor start to the year though does set back the narrowing in the output gap and other measures of spare capacity, which in turn has arguably pushed out the timing of the US Federal Reserve’s (Fed’s) first interest rate hike which partly explains why bonds have rallied. The US share market has not been too fussed though as the March quarter growth set back looks to be temporary, forward looking economic indicators are okay and low bond yields are good for valuations.
- Eurozone data was a bit disappointing with June manufacturing and services conditions PMIs unexpectedly falling slightly. They are at levels consistent with a continuing recovery in Europe, but a sluggish one which partly explains why the European Central Bank (ECB) announced further stimulus measures earlier this month. Furthermore, the June PMIs were not all bad news with the new orders component actually rising to a 37-month high.
- The HSBC manufacturing PMI in China surprised on the upside with the second solid monthly gain in a row adding to evidence that growth in China has stabilised after slowing earlier this year.
- Japanese data for May added to confidence that it has come through the April sales tax hike pretty well. Retail sales rose a lot more than expected after their slump in April, the jobless rate fell to 3.5% – its lowest since 1997 – the ratio of job vacancies to applicants rose to its highest since 1992 and the manufacturing PMI continued to recover. Meanwhile, inflation excluding the impact of the tax hike is running around 2% at a headline level and 0.7% at a core level adding to confidence that deflation is over.
Australian economic events and implications
- It was another light week on the economic news front in Australia with a further rise in the ANZ Roy Morgan consumer confidence index resulting in it having recovered nearly 40% of its Federal Budget related slump and mixed readings on job vacancies with skilled vacancies falling in May but the Australian Bureau of Statistics’ broader job vacancy index rising 2.6% over the three months to May and pointing to stronger jobs growth ahead.
- On the housing front we agree with comments by the Reserve Bank of Australia’s (RBA’s) Assistant Governor Christopher Kent that the rise in Australian house prices largely reflects buying by Australians on the back of low interest rates against a backdrop of lagging supply. Foreign buying has risen but based on approvals it’s around 12% of purchases by value and half that by number. Foreign buying is also concentrated in above average price brackets so is unlikely to have much impact on first home buyers. In other words, the importance of foreign buying in explaining high Australian house prices is exaggerated.
What to watch over the next week?
- In the US, expect a rise in the June ISM manufacturing conditions index to a solid reading of 56(Tuesday) and a fifth month of payroll jobs growth above 200,000 (Thursday) to add to confidence that the pace of growth is picking up. June payroll growth is expected to be 210,000 with the unemployment rate remaining at 6.3%. In other data expect 1% growth in May pending home sales (Monday), a slight improvement in the trade balance (Thursday) and a strong reading for the June ISM non-manufacturing index (Thursday).
- The ECB meets Thursday, but is unlikely to make any changes to monetary policy given the easing moves announced in June. However, it may provide more information as to how close it is to implementing a quantitative easing program around the purchase of asset backed securities. Eurozone inflation (Monday) is likely to have remained low in June and data for unemployment (Tuesday) and retail sales (Thursday) will also be released.
- In Japan, the Tankan business survey (Tuesday) is likely to show some improvement in the outlook after the impending sales tax hike depressed confidence three months ago.
- The official Chinese manufacturing conditions PMI (Tuesday) is expected to show a further gain in line with the flash HSBC PMI already reported.
- In Australia, the RBA (Tuesday) is certain to yet again leave interest rates on hold as it has continued to indicate is likely to be appropriate for some time yet. With a significant degree of monetary stimulus already in place and March quarter GDP growth coming in stronger than expected there is little case to cut interest rates. But with consumer confidence remaining depressed as a result of the Federal Budget, anecdotal evidence pointing to a flow on to retail sales, inflation remaining benign and the Australian dollar being uncomfortably high there is no case to raise rates either. In fact, interest rates now look like being on hold into next year.
- Meanwhile on the data front expect another gain in new home sales (Monday), continued modest growth in private credit (also Monday), a return to a small trade surplus (Wednesday), a Budget driven fall in May retail sales (Thursday) and a bounce back in May building approvals (also Thursday) after three months of falls. The TD Inflation Gauge, the RP Data house price index and the AIG’s business conditions PMIs will also be released.
Outlook for markets
- While shares remain vulnerable to a correction, particularly if talk of an earlier than expected Fed rate hike hots up in the months ahead, 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 short term dip in shares should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.
- Bond yields are likely to resume 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 dovishnessfrom the Fed rate rise risk pushing the Australian dollar higher in the near term (potentially up to $US0.97 if resistance just above $US0.94 can be cleared) 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 over the medium term. RBA jawboning is likely to return if the Australian dollar goes up too much further.