Weekly Market Update – 8th August 2014

Investment markets and key developments over the past week

• The share market correction continued over the last week with a whole range of issues weighing on confidence including Russian retaliatory sanctions, increased fears of a Russian invasion of Ukraine, US air strikes on northern Iraq, poor data in Europe, strong data in the US continuing to feed Fed tightening fears and even the latest Ebola virus outbreak. Through the week European shares fell 2.5%, Japanese shares fell 4.8% and Australian shares fell 2.2%, but the Chinese share market rose another 0.4% and the US share market had a bounce on Friday on some signs of a de-escalation of the Ukrainian crisis leaving it up 0.3% for the week. From their recent highs US shares have now had a fall of 4%, Eurozone shares 10%, global shares 4% and Australian shares 3.5%. The risk off tone saw bond yields and metal prices fall and the gold price rise. The $A also fell helped along by a sharp rise in unemployment in Australia and a dovish statement from the RBA.

• Trying to time market turning points is hard but there is a good chance we have seen or are close to the lows in this correction, with the bounce in US shares on Friday off good support levels being a positive sign. To be sure, the combination of factors roiling markets is scary. But this is always the case during periods of market volatility. However, some of the factors floating around continue to look like an excuse for a correction:- Russia’s ban on various agricultural imports will hurt but needs to be put in perspective – Russia only takes 0.3% of Australia’s exports (the same as Turkey), 0.7% of America’s and 4% of the European Union’s where it trade sanctions could knock 0.2-0.3% off growth but not wipe out the recovery;- US airstrikes on northern Iraq have been on the cards since June and do not signal a return of US ground forces and its worth noting that in 1991 and 2003 shares bottomed just before or when the first missiles dropped on Iraq. The muted response in the oil price to the air strikes suggests they might help protect oil supplies;- several pandemic scares have arisen in recent years (SARs, bird flu & swine flu) only to fade reasonably quickly;

  – if Europe does weaken anew it will be met by more aggressive easing by the ECB; and

  – even if these considerations further dampen global growth they will just have the effect of further pushing out any Fed tightening, removing what is probably the biggest source of nervousness for investors at present.

• More fundamentally, the absence of investor euphoria and reasonable valuations at recent share market highs, continuing easy monetary conditions and the improving economic outlook are not consistent with the start of a major bear market. So while the correction could yet go a bit further, the broad trend in shares is likely to remain up with new share market highs likely in the months ahead. The key is to look for signs of the selling exhausting itself in the days/weeks ahead. Rising levels of investor pessimism tell us the complacency seen last month is getting washed out, which in turn will help set up a base for shares to start heading up again.

• Interest rates to remain on hold in Australia. There were no surprises from the RBA which continues to indicate that a period of interest rate stability remains prudent. While the RBA’s quarterly Statement on Monetary Policy had a more dovish tone with growth forecasts revised down by 0.25% pa and growth not seen rising above 3% until 2016, it doesn’ t appear to regard these changes as “material” enough to justify another rate cut. The improvement in housing indicators, business confidence and forward looking labour market indicators tells us that rates are low enough, but with unemployment still rising, the $A still strong and uncertainty remaining about the speed of the mining investment slowdown it’s hard to justify a hike either. So while the dovish tone in the RBA’s SOMP implies a greater risk of a rate cut than a hike in the short term, the most likely outcome is an extended period on hold into next year. The first rate hike is unlikely to come until after the Fed starts to raise rates.

Major global economic events and implications

• US economic data was mostly solid with the Fed’s latest survey of banks revealing a further easing in lending standards and increased demand for credit, a stronger than expected rise in factory orders, a rise in the ISM non manufacturing conditions index to its highest since 2005, another fall in jobless claims, a smaller trade deficit for June and the mortgage delinquency rate falling to its lowest since 2007.

• Meanwhile, US June quarter earnings results remain strong. 90% of the S&P 500 has now reported with 75% beating on earnings (against a norm of 63%) and earnings growth for the quarter now running around 11% year on year, which is about 6 percentage points above expectations at the end of June. The big improvement has been on sales with 64% beating expectations compared to an average of just 41% over the last three years.

• Eurozone data was soft with a sharp fall in German factory orders, mixed readings on industrial production and a fall in Italian GDP adding to growth concerns. As expected the ECB left policy on hold, clearly preferring to give the June easing measures a chance to work. However, ECB President Draghi clearly recognises the downside risks and reaffirmed the ECB’s commitment to use quantitative easing if necessary.

• In China, soft July services PMIs and continued benign inflation leave the door open for further policy stimulus measures. Meanwhile trade data provided mixed signals with weaker imports but a double digit gain in exports.

Australian economic events and implications

• A bad run of Australian data, but not that bad. The past week saw a bad combination of Australian data with the unemployment rate spiking to 6.4%, the trade deficit remaining large in June and June quarter real retail sales falling 0.2%. Australia’s official unemployment rate is now above that in the US and as a result of the June quarter trade and real retail sales data there is a possibility that June quarter GDP growth will be negative. However, there are several reasons not to be too alarmed. First, just as he jobs figures at the start of the year looked unbelievably strong, they now look too soft. In particular the rise in the unemployment rate looks to have been exaggerated by a rotation in the ABS sample and a change in the ABS survey questions. Second, forward looking jobs indicators – such as ANZ job ads, skilled vacancies and the employment component of the NAB business survey – all point to stronger jobs growth. Third, the June quarter trade data looks to be payback for the strength seen in the March quarter. Fo rth, June retail sales showed a solid bounce back from the Budget related hit in May. Fifthly, it’s worth noting that the AIG’s services, construction and manufacturing conditions indexes all rose in July. Finally, housing finance remained strong in June telling us the housing recovery remains on track.

• It’s way too early to draw any conclusions from the June half profit reporting season in Australia as only a few companies have reported. But so far so good with more companies seeing profits up than down and dividends continuing to increase with Rio being a standout on this front. The big miners are clearly responding to investor demand for dividends with Rio’s dividend yield now being 4.8% and BHP’s 4.9%.

What to watch over the next week?

• In the US, expect a 0.3% gain in July retail sales (Wednesday), a 0.3% rise in July industrial production, another solid reading in the Fed’s New York regional manufacturing index and a benign July PPI reading (all Friday).

• Eurozone June quarter GDP data (Thursday) is expected to show flat growth.

• Japanese June quarter GDP (Wednesday) is expected to fall by 1.8%, reflecting payback for the pull forward of demand ahead of the sales tax hike. This was expected and does not represent the start of another recession.

• Chinese July activity data (Wednesday) is expected to hold around the improved pace seen in June. Money supply and credit growth is expected to have slowed back a bit from the strong June pace.

• In Australia, expect to see July business confidence hold around June’s reasonable levels according to the NAB business survey (Tuesday), a 1% rise in June quarter house prices (Tuesday), a further recovery in consumer sentiment (Wednesday) reflecting the gains already seen in weekly consumer sentiment surveys and continued modest wages growth in the June quarter (also Wednesday) of just 2.5% year on year.

• The Australian June half profit reporting season will ramp up with 36 major companies reporting. Consensus earnings estimates for 2013-14 are for 12% growth led by resources with +28%. The combination of the lower iron ore price, the higher $A and the hit to confidence from the Budget suggest a bit of downside risk to consensus estimates. Given relatively elevated PEs compared to a few years ago underperformers will be hit hard. Most interest is likely to be on outlook statements with a bit of upside potential for companies exposed to housing, non-mining construction & retailing. Consensus 2014-15 earnings growth estimates are modest at +5%.

Outlook for markets

• The correction seen in shares over the last few weeks is a healthy development serving to relieve a bit of investor complacency that had started to build up during the first half. More broadly the trend in shares is likely to remain up. Valuations were not onerous at recent highs, 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. As a result the current pullback should be seen as providing a buying opportunity. 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 as the US economy continues to strengthen. This and low yields is likely to mean pretty soft returns from government bonds.

• The combination of soft commodity prices, an increasing likelihood 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 $A remain down.

Source: AMP CAPITAL ‘Weekly Market Update’

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