Weekly Market Update – 30th May 2014

Investment markets and key developments over the past week

• Global share markets rose over the past week helped by relief at the conclusion of the European and Ukrainian elections, mostly good economic data and more signs that easing is on the way in Europe. US shares gained 1.2%, Eurozone shares were up 1.5%, Japanese shares rose 1.2% and Chinese shares rose 0.2%. Signs that non-mining and housing investment are starting to offset the slump in mining investment also helped support the Australian share market despite the fall in the iron ore price, albeit the ASX 200 was flat over the week. Despite the gains in global shares, bond yields fell again as expectations for future interest rate levels are getting revised down. Commodity prices, including the iron ore price, fell but the Australian dollar rose a bit as the latest business investment data saw investment plans for the year ahead revised up. It’s hard to see the rise in the Australian dollar being sustained given the fall in the iron ore price and the risk that Reserve Bank of Australia (RBA) interest rate hikes will be pushed into 2015.
• The win by various “Euroskeptic” parties in the European Parliament (EP) elections is unlikely to have much impact. Sure they got 30% or so of the vote, but it represents a protest vote as voters know that its national elections that matter. Euroskeptic parties tend to represent the extreme left and right and don’t vote together and the vote is well short of a majority anyway. The increase in support for the extreme right in France and extreme left in Greece may concern governments in those countries but they know it’s a protest vote and governing parties did well in Germany and Italy. So it’s hard to see any real change in policy direction in Europe.
• The victory of Boris Poroshenko in Ukraine without the need for a run-off election is also a good outcome. While conflict remains in the east he is someone who can work with both Russia and the west.
• Policy fine tuning announcements in China continue to mount up, adding to confidence that growth will be supported around 7.5% this year. These amount to various spending measures (on shanty towns, railways, etc.) and monetary easings including the latest measure which involves cutting reserve ratio requirements for banks that meet lending levels to rural borrowers and small businesses. The importance of the fine tuning easing measures has been underlined by Premier Li stating that downside risks to the economy should be taken seriously and that policies should be fine-tuned appropriately, so more easing measures are likely.
• In Australia, the Australian Prudential Regulation Authority (APRA) announced draft qualitative guidelines aimed at encouraging lenders to appropriately manage high risk mortgages. This is very different to the quantitative restrictions on high loan to valuation ratio mortgages seen in New Zealand and reflects Australian regulators’ scepticism about the distortions such approaches result in. But quite clearly APRA does not want to see any deterioration in lending standards. To the extent this has an impact it is likely to add to the loss of momentum already seen in house prices this year and provide further room for the RBA to keep interest rates low.

Major global economic events and implications

• US economic data was mostly good. The bad news was that March quarter growth was revised to -1% annualised. However, this reflects a bunch of temporary factors including the impact of adverse weather on construction activity which will reverse. More importantly, forward looking indicators continue to improve with solid durable goods orders, continuing gains in home prices and house sales, a rise in consumer confidence, a strong rise in the Markit services conditions index and in various regional business surveys and a fall in jobless claims. So the US economy remains on track to expand strongly this quarter.
• Eurozone data was a bit more mixed, with sentiment readings up across the board in May, but money supply growth remaining weak and bank lending still down on a year ago. Meanwhile, European Central Bank (ECB) officials continue to reinforce expectations for a combination of ECB easing measures to be announced at its meeting next week.
• Japanese data showed the expected fall back in household spending and industrial production in April associated with the sales tax hike and the related surge in inflation. My inclination remains that with the underlying economy and policy stimulus both stronger than was the case around the time of the 1997 sales tax hike, the impact on growth is just temporary and Abenomics will continue to work. It is notable that the unemployment rate at a low 3.6% and the rising trend in the ratio of job vacancies to applicants have both been unaffected by the tax hike, adding to confidence that its effect is temporary.

Australian economic events and implications

• Australian data was actually pretty good, relative to fears. Sure mining investment fell another 8.7% in the March quarter and business intentions point to a further 15 to 20% fall over the financial year ahead. But against this the latest capital spending plans point to a less negative outlook for 2014-15 than previously foreshadowed with mining investment set to fall more slowly and investment in other industries now looking like it will see a solid rise. On top of this residential investment rose 6.8% in the March quarter, a further rise in new home sales in April points to more to come and credit growth continued its modest acceleration in April.
• The bottom line is that the rebalancing away from mining investment as a source of growth is starting to occur. The problem though is that it’s still tentative, so it’s critical that the blow to confidence from the Budget proves temporary. It’s obvious the Government will have to compromise to get aspects of its Budget through the Senate and this may lead to some softening of the harsher measures. Something else might have to give though given the need to see the budget still heading towards surplus, and paid parental leave is a logical candidate.

What to watch over the next week?

• In the US, expect the ISM manufacturing and services conditions indexes (due Monday and Wednesday respectively) to have remained around solid readings of 55 and May payroll employment (Friday) to show a gain of 220,000. The ISM and payroll reports are likely to confirm that growth is picking up after the first quarter slump.
• In Europe, the focus will be on the ECB (Thursday) which is expected to finally act on its easing bias again and announce more monetary stimulus. This is likely to take the form of interest rate cuts but there is some chance it will also include a form of quantitative easing.
• In Australia, it will be a busy week. The RBA (Tuesday) is certain to leave interest rates on hold for the ninth month in a row as it has previously indicated is likely to be appropriate for some time yet. Since the last meeting, the Budget has clearly had a negative impact on confidence and consumer spending too according to various anecdotes, but it’s unclear how long this will last and the stimulatory effect of record low rates is still working through the economy. At the same time inflation remains benign, there are tentative signs of cooling in the housing market and APRA’s qualitative crackdown on high risk mortgages means the RBA has plenty of scope to continue with low interest rates.
• On the data front, March quarter GDP growth (Wednesday) is expected to show that growth remains below trend with soft business investment but support from dwelling construction, consumer spending and trade likely to see GDP up 0.5% quarter on quarter, or 2.8% year on year. Expect to see a further slowing in house price growth but a 3% bounce in building approvals (both Monday), a slight setback in April retail sales (Tuesday) after 11 months of gains and a continuing trade surplus (Thursday). The AIG’s business conditions PMIs for May will provide a good indication of the impact of the Budget on business confidence.

Outlook for markets

• Shares remain vulnerable to a mid-year correction, just as we have seen in each of the last four years now. However, with shares having been in a bit of a stealth correction all year, any pull back may well be mild and in any case the broad trend in shares is expected 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 dip 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 it becomes 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.
• With Australian dollar short positions now largely unwound, it’s likely that the broad downtrend in the Australian dollar is resuming. Commodity prices including the iron ore price remain relatively soft, RBA interest rate hikes are getting pushed out and the Australian dollar is likely to revert to levels that offset Australia’s relatively high cost base.

Source: AMP CAPITAL ‘Weekly Market Update’

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