Weekly Market Update – 12th September 2014

Investment markets and key developments over the past week

• Share markets mostly pulled back over the last week as worries about the US Federal Reserve (Fed), talk of tougher capital requirements for US banks and new trade sanctions over the Ukraine weighed. Japanese shares were an exception globally with the fall in the yen to a six-year low boosting confidence. US shares fell 1.1%, Eurozone shares fell 1.2%, Chinese shares rose 0.2% and Japanese shares rose 1.8%. Australian shares fell 1.2% on the back of the weak US lead and the ongoing fall in the iron ore price. Bond yields rose though on the back of Fed concerns and commodities were soft not helped by a stronger US dollar.

• After being wrong on the Australian dollar all year (we expected a fall, but it went up), it’s now going in the right direction again thanks to a combination of a resurgent US dollar as the Fed edges closer to an eventual rate hike and continuing weakness in commodity prices as highlighted by the plunging iron ore price. This is being reinforced as the Australian dollar has broken through technical support including its 200-day moving average. The unwinding of net long speculative positions in the Australian dollar is likely to add to its downwards momentum. Our view remains that it’s on its way ultimately to around US$0.80 or even a bit below which is a level that would neutralise the relatively high cost and price base in Australia compared to the US. The resumption of the downtrend in the Australian dollar may not be so good for us as consumers (as import prices will have another leg up), but it will provide a great shot in the arm for trade exposed industries, such as manufacturers, tourist operators and higher education institutions, which is just what the economy needs. For investors, it means having a greater exposure to foreign currencies (notably the US dollar) via e.g. unhedged global shares or short Australian dollar positions.

• Scottish independence – On the geopolitical risk front attention is turning to the Scottish independence vote to be held on 18 September. While most polls favour the ‘No’ vote it’s a close call. A move to independence for Scotland (which is 9% of UK gross domestic product (GDP), 8% of UK population) would ultimately see it worse off than staying in the UK as North Sea revenues are in decline, its population growth is weak, its budget deficit would be larger and the transition would involve huge risks for its large financial sector (which accounts for 16% of Scottish employment) as it may not retain the protection of the Bank of England. For these reasons a ‘No’ vote makes sense and is our base case, but of course this is about more than just economics.

• A ‘Yes’ vote would have two significant implications. First it would raise the level of uncertainty around UK and particularly Scottish assets. This is because it would raise a whole bunch of issues around North Sea oil and gas revenue, whether Scotland would take its share of the UK’s public debt, whether it will be able to retain sterling as its currency and the Bank of England as its central bank and lender of last resort. But of course the UK is no longer a major driver of global growth so don’t expect a major threat globally here. The second and more significant implication is that it could encourage Catalonia’s push for independence from Spain (with a vote on this scheduled for 4 November, although this is not officially recognised by the Spanish Government) which could frighten investors in Spanish bonds and raise fears, albeit we think short-lived, regarding the euro. This is the bigger issue to keep an eye on.

• While shares are vulnerable to a correction over the seasonally-weak September/October period,the latest Westpac/Melbourne Institute consumer sentiment survey for September provided a reminder that we are still a long way away from the sort of optimism towards shares that we normally see at major share market tops. Bank deposits and paying down debt continue to be seen as the wisest place for savings with less than 10% of those surveyed seeing shares as the wisest place. In 2000 just before the tech wreck the latter peaked at 34%.

Major global economic events and implications

• US economic data was strong, adding to concerns about an earlier-than-expected Fed rate hike. July retail sales rose strongly with upwards revisions to prior months, consumer sentiment rose and consumer credit is in a solid rising trend. In addition, small business optimism rose, and although job openings and hiring rates did not rise further they remained at high levels. Various indications also point to an upwards revision to June quarter GDP growth. That said, as has been the case for a while, it’s not all strong with the rate at which people are quitting jobs (a favourite indicator of Janet Yellen) remaining subpar and applications for mortgages to purchase properties remaining weak. Meanwhile the US budget deficit continues to shrink – down 22% for the first 11 months of the current financial year on 7% plus revenue growth and weak spending growth.

• Japanese data presented a mixed picture but one still consistent with a return to growth in the current quarter. Consumer confidence dipped and an index of tertiary activity was flat. Against this, the Ministry of Finance’s business survey rose to near pre sales tax hike levels, machinery orders rose strongly and the Manpower employment index rose further. What’s more the yen fell to 107.3 (per US dollar) it’s lowest in six years.

• Chinese data for August indicates the latest soft patch is continuing with slower growth in industrial production, retail sales, investment and credit and a fall in imports. However, continued strength in exports will help GDP growth and Premier Li indicated that growth remains on track for “about 7.5%” this year and that the Government will continue with “targeted easing”. Benign inflation readings for August, with non-food inflation at 1.5% year-on-year, suggest China has plenty of scope for further easing, which we expect in the months ahead.

Australian economic events and implications

• Australian data provided a rather confusing picture. A fall back in the Westpac-Melbourne Institute consumer sentiment index in September was disappointing, although it’s worth noting that this contrasts with the weekly ANZ Roy Morgan consumer sentiment index which is much stronger. While the National Australia Bank’s survey of business confidence and conditions readings fell in August, confidence remained reasonably high and both are well up on first half 2013 levels. Housing finance data for July showed continuing strength with construction finance up but with the investor share back to 2003-04 peak levels providing cause for concern. Finally the Australian Bureau of Statistics still seems to be having statistical problems with its monthly labour force data highlighted by an unbelievable 121,000 gain in new jobs in August, a big bounce in the labour force participation rate and a sharp fall in unemployment back to 6.1%, from the equally unbelievable 6.4% reported in July. The trend in unemployment suggests it’s still rising but not rapidly. Moreover, while the jobs gain is not believable the trend improvement in ANZ job ads, the National Australia Bank’s survey of employment intentions and the Manpower Employment Outlook survey continue to point to better jobs growth ahead.

What to watch over the next week?

• In the US, the main event will be the Federal Open Market Committee meeting (Wednesday) which is expected to see the Fed taper its quantitative easing program by another US$10 billion a month, leaving it on track to end in October. Most interest will be on how the Fed sees the state of the US economy and guidance regarding the timing of the first interest rate hike. Currently, the Fed states that it anticipates a “considerable time” between the ending of quantitative easing and the first rate hike, with this taken to mean six months or more. While still-low inflation and wages growth and excess capacity in the labour market suggest it may want to retain this characterisation for now it may try to soften it putting a greater focus on economic data to give them more flexibility if needed. Such a move is unlikely to change the timing of the first rate hike though which is likely to be in the June quarter, but may cause a bit of market volatility.

• On the data front in the US expect to see modest growth in industrial production (Monday), continued solid readings for the New York and Philadelphia regional manufacturing surveys (Monday and Thursday), benign consumer price index readings (Wednesday) leaving inflation running at 1.9% year-on-year, a further slight rise in the National Association of Home Builders index (Wednesday) and a slight pullback in housing starts (Thursday) after a very strong July.

• In Europe, the degree of bank interest in the European Central Bank’s cheap funding operation (the targeted longer-term refinancing operation, or TLTRO) will be watched Thursday.

• In Australia, the minutes from the Reserve Bank of Australia’s (RBA) last meeting (Tuesday) are likely to repeat the “period of stability” on rates mantra and unlikely to add anything new given that Governor Stevens has already delivered a speech on the economy since the last meeting. A speech by Assistant Governor Kent also on Tuesday will be watched for any clues though.

Outlook for markets

• The correction season consistent with the old adage “sell in May, go away and come back on St Leger’s Day” is still upon us with September historically being the weakest month of the year for US shares and the September-October period often being tough in Australia. Relatively high short-term optimism readings in the US also warn of the risk of a correction and worries about an earlier-than-expected Fed rate hike, the likely ending of the Fed’s third round of quantitative easing (QE3) next month and the Ukraine are potential triggers.

• However, a correction would be healthy in allowing shares to let off a bit of steam and should be seen as a buying opportunity as the cyclical bull market in shares likely has further to go as we still don’t see the signs of shares being overvalued, over-loved and overbought normally seen at major market tops. Valuations remain okay, global earnings are continuing to improve on the back of gradually-improving economic growth, global monetary conditions are set to remain easy and there is no sign of investor euphoria.

• Low bond yields will likely mean soft returns from government bonds.

• The combination of soft commodity prices, the 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 Australian dollar remain down. Expect to see it fall to around US$0.80 in the next year or so.

Source: AMP CAPITAL ‘Weekly Market Update’

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