Weekly Market Update – 15th May 2015

• While the bond sell off initially continued into the last week it showed signs of stabilising with yields falling later in the week and this helped shares a bit. In fact, while Eurozone shares fell 1.2%, US shares rose 0.3% to a new record closing high, Australian and Japanese shares both rose 1.8% and Chinese shares rose 2.4%. Meanwhile, the $US continued to fall on some soft US data and this saw most commodity prices edge higher and the $A push back above $US0.80, which must be a concern for the RBA.

• Have we seen the end of the bond sell off? In the short term it’s too early to say that the bond sell-off is over as positions that built up on the back of deflation fears earlier this year could continue to unwind. However, bond yields are unlikely to back-up too far for several reasons and we may have already seen the worst. First, in Europe – which is the epicentre of the bond sell-off the European Central Bank (ECB) bond buying program has a long way to go with ECB President Draghi reminding the market that “we will implement in full our (quantitative easing) purchase program”. In fact the ECB is likely to appreciate the fact that it can now buy bonds on more attractive yields and that there seems to be plenty of investors willing to now sell them to it. Second, global growth remains below trend and underlying inflation remains very low. Finally, flowing on from this, central banks are unlikely to ratify the back-up in bond yields with sharp rate hikes like occurred in the 1994 bond crash. Soft data in the US if anything is pushing out the timing of the Fed’s first rate hike (again), rate hikes are not even on the horizon in Europe, Japan and Australia and in China rates are set to fall a lot further. So while it’s hard to be bullish on bonds – because yields remain very low pointing to low medium term returns – it’s hard to be too bearish either as the world remains awash in savings and spare capacity.

• Similarly, the pull-back in shares could have further to run if bond yields remain under short term pressure and as we proceed through a seasonally weak part of the year for shares. However, our view remains that in the absence of unambiguous and broad based share market overvaluation, investor euphoria in favour of shares and excessively tight monetary conditions that will drive bond yields rapidly higher or slow growth significantly, what we are seeing in shares is more likely to be a correction rather than the start of a new bear market. Corrections are quite normal and healthy for shares in that they help prevent markets from overheating and provide opportunities for investors. In anticipation of a correction in bonds and shares we have been running a higher than normal cash allocation and see recent moves as setting up investment opportunities.

• In Australia, the Federal Government’s Budget was a far a more boring and moderate affair than last year’s austerity debacle. Reflecting this, it’s likely to have a positive impact on confidence. The big positives are increased child care assistance and a tax cut & instant tax write-off for capital spending items up to $20,000 for small business. Both the child care and small business packages look to have been received very well and the tax write-off looks like providing a boost for retailers, car sales and capital goods providers. It would be dangerous to overstate the upside as the various “spending measures” are being fully offset by savings, including the decision not to proceed with the proposed Paid Parental Leave Scheme (PPL). However, the child care and small business measures look like generating a bigger bang for the buck than the expensive PPL would have. At the very least, this budget looks like providing a boost to confidence in contrast to last year’s confidence zapper. However, the downside is that the Government is still seeking to have the Senate pass many of last year’s savings so there could be another fight with the Senate, the revenue assumptions being based on a return to 3.5% growth from 2017-18 look at risk and the return to surplus looks as distant as ever.

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