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Shane Oliver
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Shane Oliver is head of investment strategy at chief economist at AMP Capital.

What to watch over the week

Monday, August 22, 2016

By Shane Oliver

Shares were mostly flat to down over the last week. While Chinese shares gained 2.2%, US shares were flat, Eurozone shares lost 2% reversing some of the gains of the previous week, Japanese shares fell 2.2% and Australian shares dipped 0.1%. Except in Australia, bond yields rose as some Fed officials indicated a September Fed rate hike was “possible” but the $US fell back to near where it was prior to the Brexit vote, which in turn, saw commodity prices rise, with oil helped by optimism of a supply cutback. The $A fell slightly.

The Olympics, US elections and shares in August

Its well-known that August is a seasonally tough month for US shares, with an average decline of -0.6% in the S&P 500 for all Augusts since 1985. Interestingly though, in US presidential election years/Olympic years (they are the same) since 1985, US shares have seen an average 0.7% gain in August. Maybe the feel-good feeling of the Olympics offsets the uncertainty around the election. For Australian shares, average August gains have been 0.4% over the same period for all Augusts and for Augusts in US election/Olympic years.

A big positive this year has been the fall back in the $US after several years of strong gains. From its high late last year, it has now fallen nearly 6%. This has taken pressure off US manufacturers and multinationals, helped commodity prices to stabilise and pick up (as they are priced in US dollars), reduced the downwards pressure on the Chinese Renminbi and the risk of capital flight out of China, and alleviated fears about a dollar funding crisis in the emerging world – all of which has been positive for global growth prospects and hence, risk assets. Of course, the downside has been for Japan and Australia which would prefer a lower Yen and $A respectively, but this is a minor issue in a global context.

Rethinking monetary policy, or just back to the past?

For the last two decades, central banks have been focussed on price stability (using inflation targets) and have played the first line of defence in stabilising the economic cycle, whereas fiscal policy has played back up, focussing more on fairness and efficiency for much of the time. But we are starting to see increasing discussion about whether a new approach is needed to manage macro-economic stability in a world of slower trend growth. Key aspects of this debate are about inflation targeting – that is, whether inflation targets need to be set higher or turned into price level or nominal GDP targets – and whether fiscal policy should play a greater role.

The debate is arguably not as big an issue for countries like the US and Australia, but it is a big one for countries where deflation is or risks becoming entrenched, such as Japan and maybe Europe. Ideally, Japan needs to combine monetary stimulus and fiscal stimulus – via some form of helicopter money - to have a greater chance of meeting its inflation and growth targets without further blowing out its already huge public debt to GDP ratio. The week ahead is likely to see a heightened focus on some of these issues, as the title of the US Federal Reserve’s annual economic policy symposium in Jackson Hole, Wyoming over Thursday to Saturday is “Designing Resilient Monetary Policy Frameworks for the Future.”

The Australian June-half earnings results improved in tone over the last week. While there was no real surprise from BHP’s profit slump, there have been some excellent results from stocks like JB Hi-Fi and Treasury Wine Estates. Key themes are: improving conditions for resources companies following a stabilisation in commodity prices; constrained revenue growth for industrials; ongoing cost cutting; continuing headwinds for the banks; and an ongoing focus on dividends. So far, 51% of companies have reported, with 46% exceeding expectations which is around the norm of 45%. 68% have seen their earnings rise on a year ago, 56% have seen their share price outperform the market the day results were released and 92% have either maintained or increased their dividends. While overall profits look to have fallen 8% in 2015-16 thanks to the slump in resource profits, they are on track for a return to growth in 2016-17 as the slump in resources profits reverses and non-resource stocks see growth.



Source: AMP Capital

Major global economic events and implications


US economic data was mostly good, with solid home builder conditions and another unexpected rise in housing starts, strong leading indicators and a fall in jobless claims but mixed readings from the New York and Philadelphia regional manufacturing conditions indexes. Meanwhile, there were a few gyrations around expectations for when the Fed will next raise interest rates, with the minutes from the July Fed meeting presenting a relatively dovish picture, but regional Fed President’s Williams and Dudley pushing back against market expectations that look to be too dovish. While I don’t see a Fed hike in September, I think it’s possible if we see another really good jobs report for August, and I remain of the view that the Fed will hike in December. Against this backdrop, the US money market’s probabilities of just a 22% chance of a hike in September and 51% in December, albeit up from a week ago, are still too low.

UK real retail sales surged 1.4% in July or 5.9% year-on-year, far stronger than expected. What happened to post-Brexit gloom? I can understand Brexiteers feeling happy, but they were only 37% of those of voting age!

Chinese home prices rose again in July, but with slower growth for Tier-1 cities, and to confuse the China bears, electricity consumption rose 9.6% year-on-year in July, the fastest in 3 years.

The Japanese economy barely grew in the March quarter, as poor net exports and capex offset consumer spending and housing construction. Poor growth, core inflation sliding back towards deflation and the Yen having risen 20% from last year’s low point are piling pressure on the BoJ and PM Abe to do something. With the US dollar around the 100 Yen “line in the sand” a point of action could be getting near.

Australian economic events and implications

While jobs growth was much better than expected in July, and unemployment fell back to 5.7%, the quality of jobs growth remains poor with another surge in part time jobs at the expense of weak full time jobs. And this, in turn, is keeping the combination of unemployment and underemployment very high at over 14% and driving wages growth (including bonuses) to a record low of just 2% year-on-year in the June quarter. Given this, and the ongoing downside risks it implies for inflation, we remain of the view that the RBA will cut the cash rate again in November to 1.25%. In this regard, the minutes from the RBA’s last Board meeting offered nothing really new.

Speaking of interest rates, the Sydney and Melbourne housing markets are looking to be a bit more of a challenge. The perk up in finance commitments to investors, HIA new home sales and weekly auction clearance rates in Sydney and Melbourne (see chart) despite mixed readings on what home prices are doing suggest that the Sydney and Melbourne property markets may be getting a bit too hot again (at least in parts - I hear that western Sydney isn't so strong). Returning to rapid house price gains at a time when the supply of apartments is starting to surge would not be a good thing. But interest rates need to be set on the basis of what is right for the average of Australia - not just house prices in two cities - so the RBA has been right to cut as the average of Australia needed it. However, pressure is likely shifting back to APRA to further tighten lending standards.



Source: Australian Property Monitors/Domain, AMP Capital

What to watch over the next week?

In the US, the focus is likely to be on Fed Chair Janet Yellen’s address to the Jackson Hole symposium for any clues on the interest rate outlook if she even decides to discuss current monetary policy. The likelihood is that if she does, she will reiterate that the process of raising interest rates to more normal levels is likely to remain cautious and gradual, but leave the impression that the Fed is on track to raise interest rates again this year. On the data front in the US, expect the manufacturing conditions PMI (Tuesday) to remain around 52.9, a fall back in new home sales (Tuesday) and in existing home sales (Wednesday), a further rise in home prices (Wednesday), a rise in core durable goods orders (Thursday) and a slight further downgrade to June quarter GDP growth (Friday) to 1% annualised from 1.2%.

In the Eurozone, business conditions PMIs will be released (Tuesday) but are expected to remain around an okay 53.

Japanese consumer price data (Friday) is expected to show continued deflation of around -0.4% year-on-year at a headline level and core inflation of just 0.4% year-on-year.

In Australia, expect June quarter construction data (Wednesday) to show continued weakness in mining related investment but strength in dwelling construction. Skilled vacancy data for July will also be released.

The Australian June quarter earnings reporting season will see its biggest week, with 87 major companies due to report in the week ahead including Fortescue, Oil Search, Westfield and Woolworths.

Outlook for markets


After a period of strong gains, shares are due to take a breather and weak seasonals for the next couple of months along with risks around Italian banks, the Italian Senate referendum, the Fed and global growth generally could be the drivers. However, after a 1-2 month correction or consolidation, we anticipate shares to trend higher over the next 12 months, helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth.

Ultra-low bond yields point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels, leaving them at risk of a snapback.

Commercial property and infrastructure are likely to continue, benefitting from the ongoing search for yield by investors.

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment prices get hit by oversupply.

Cash and bank deposits offer poor returns.

With the Fed continuing to delay rate hikes, a break of April’s high of $US0.78 and a push up to $US0.80 is likely for the $A. Beyond the short term though, we see the longer term downtrend in the $A ultimately resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value.

Eurozone shares fell 0.8% on Friday as worries about Italian banks, the upcoming Italian Senate referendum and the risk of another Spanish election weighed and the US S&P 500 fell 0.1%. Reflecting the soft global lead ASX 200 futures fell 6 points or 0.1% on Friday night pointing to a soft start to trade for the Australian share market on Monday.

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Another rate cut in November?

Monday, August 15, 2016

By Shane Oliver

Shares moved higher again over the last week with US shares hitting new record highs, albeit up just 0.1% for the week, Eurozone shares rising 2.4% to their highest since May, Japanese shares up 4.1%, Chinese shares up 2.8% and Australian shares up 0.6%. Bond yields mostly fell as investors remain unconvinced that the Fed is any closer to raising interest rates again. Commodity prices were mixed with oil up but metals down and a lower $US generally saw the $A briefly make it above $US0.77.

It’s now one year since China devalued its currency (by 3% August 11, 2015) and broke the link to the US - and the sky hasn’t fallen! At the time there, was much fear that this would drive massive capital outflow from China causing the Renminbi to plunge and de-stabilise the emerging world. Here we are one year later and while the Renminbi is now down 7% from its pre-devaluation level, it has not crashed, there has been no avalanche of capital outflows from China, there has been little lasting impact on the emerging world and investors now seem more comfortable with a more flexible and volatile Chinese currency. So another disaster that didn’t happen.

In a wide ranging speech, RBA Governor Glenn Stevens provided a useful reminder of just how well the Australian economy has performed over the last decade – with no recession and relative stability despite the worst global slump since the 1930s and the collapse of the mining boom. While lots of factors have played a role in this good performance, the RBA under Glenn Stevens has played a huge role in this outcome. And I have no reason to believe that the contribution to the Australian economy from the RBA under Governor Steven’s successor Philip Lowe will be any less successful in the years ahead.

Governor Stevens also provided useful insights on a range of other issues: that we are “kidding ourselves” if we think the debate about budgetary adjustment won’t have to become more “hard-nosed”; that there is only so much that monetary policy can do, and that thinking about ways to maximise potential growth is not just about debate amongst “elites”; that Australia cannot but be affected by the whole developed world having ultra-low interest rates (with the obvious implication that we have to follow suit to some degree if we want the $A to continue to help in the rebalancing of the economy); and that the inflation targeting framework is rightly flexible enough to allow for the current undershooting of the inflation target. The big takeout for me is that, while it would be nice to get more help from other areas of economic policy, if inflation looks like remaining below target for an unacceptable period and a strong $A is contributing to this, then the RBA will likely cut rates again. We continue to allow for another rate cut in November.

Speaking of rates and the currency, the Reserve Bank of New Zealand has exactly the same problem as the RBA: it cut rates, but because a cut was factored in and maybe because it didn’t sound bearish enough, the $NZ rose just as the $A did a week earlier. The solution will be more cuts and more dovishness from both the RBA and RBNZ.

What about the big Australian banks? The next chart shows the cash rate, the average one year bank term deposit rate and the standard variable mortgage since 1990.


Source: RBA, AMP Capital

Several things are worth noting. First, the period of one for one moves in the standard variable rate and the cash rate over 1997 to 2007 was a bit of an oddity. Banks do not get the bulk of their funding overnight at the cash rate but from a whole bunch of other sources. Movements in these were sort of consistent with the cash rate over the 1997-2007 period so the cash rate was the key driver. Second, since the GFC banks have been trying to get more of their funding from bank deposits as it’s a more stable source of funding than say, short-term money markets. But it’s also more expensive. And to keep depositors on side, banks have had to pay them more. So for example, the deposit rate line in the chart is now above the cash rate when prior to 2008 it was mostly below. Thirdly, banks have also been under pressure from regulators to raise more equity from their shareholders and this is also more expensive (eg they have to pay a 6% or so dividend).

All of which has pushed up the average cost of money the banks borrow relative to the cash rate, so mortgage rates have not come down fully with the cash rate. At the end of the day it is a highly competitive banking market, so those with a mortgage are free to call up their banks, threaten to refinance with someone else and ask for a better deal (who actually pays the standard variable rate of 5.2-5.3% now anyway?). Returning to the days where bank lending rates are regulated and banks resort to rationing the amount they lend based on useful things like “who the customer knows at the bank” would not be a bright move. The danger is that all the bank bashing leads to a weaker banking system in which we all end up worse off. Finally, the argument that monetary policy is no longer effective because of banks partial and out of cycle rate moves is ridiculous. As can be seen in the chart, the main driver of bank mortgage rates through the cycle remains the RBA via its cash rate.

Major global economic events and implications


US economic data was mixed, with a slight rise in small business optimism and continued strength in job openings and hiring but weak July retail sales, albeit this followed very strong and upwardly revised June retail sales growth. Producer price inflation also fell in July. A big negative though was continued weakness in productivity growth which is an obvious outworking of strong jobs growth and soft GDP growth.

Putting aside issues about whether growth is being understated on the back of cheap or even “free” technologies that are significantly enhancing our lives, low productivity growth adds to concerns that potential growth is lower than currently thought and flowing from this that “normal” interest rate levels are also lower. However, I suspect GDP growth and productivity will move higher in the year ahead as the detraction from US growth flowing from a rundown in inventories and energy investment have likely run their course. In terms of the Fed, the soft July retail sales data make a September rate hike even less likely (market probabilities are currently just 16%) but our base case remains for a December hike.

The US June quarter reporting season is now more than 90% done and indicates a clear rebound in earnings from their March quarter low. 78% of companies have beat on earnings and 56% have beat on sales, both of which are above normal levels. More importantly, while earnings are down 2.5% yoy, they have come in around 3% better than expected and are up about 9.5% on the March quarter low.

Japanese data was a bit better with solid gains in machine orders and economic sentiment.

Chinese economic data for July was weaker than expected with a slight slowing in industrial production (from 6.2% yoy to 6%), retail sales and fixed asset investment, continued weakness in exports and imports and weak credit and money supply growth. It's early days yet and recent floods may be impacting, but so far, the data suggests that Chinese growth in the current quarter may be edging down to around 6.5-6.6% yoy. Expect continued policy easing in China, including more interest rate cuts. Meanwhile, although a fall in food price inflation saw CPI inflation fall slightly, producer price deflation is continuing to fade which is good news for nominal GDP growth in China.

Australian economic events and implications


Australian data was a mixed bag with business conditions and confidence down slightly in July but remaining relatively resilient despite the political uncertainty at the time, consumer confidence up slightly in August to be around its long term average helped by the latest rate cut and housing finance up solidly again in June. The okay level of consumer and business confidence point to okay but not spectacular growth in the economy and the rise in housing finance tells us that overall the housing sector is still solid. In terms of the latter, it looks like investor lending is having a bit of a bounce after growth in the total bank book of lending to investors fell way below the APRA 10% limit, but it’s doubtful that investor lending will be allowed to pick up too far as there is a good chance that APRA will lower the 10% limit to around 7-8%.

The Australian June-half earnings reporting season has kicked off on a relatively ordinary note with so far only 37% of companies exceeding expectations (compared to a norm of 45%). However, 71% have seen their earnings rise on a year ago, 52% have seen their share price outperform the market the day results were released and 93% have either maintained or increased their dividends. It’s also still early days with less than 20% of results out so far.



What to watch over the next week?


In the US, expect the minutes from the July Fed meeting (Wednesday) to confirm that at the time it remained dovish and cautious but bear in mind that since then we have seen another strong US jobs report and a further strengthening in financial markets. Meanwhile, expect the August home builders conditions index (Monday) to strengthen slightly to a solid index reading of 60, housing starts to fall slightly after a very strong rise in June but permits to rise further, headline CPI inflation to fall slightly to  0.9% year on year but core inflation to remain unchanged at 2.3% yoy and industrial production to rise modestly (all due Tuesday).

In Europe the minutes from the ECB's last meeting (Thursday) are likely to confirm it remains dovish but in wait and see mode.

Japanese June quarter GDP growth (Monday) is likely to show growth slowing to just 0.2% quarter on quarter, after 0.5% qoq in the March quarter.

In Australia, expect June quarter wages data (Wednesday) to show wages growth at a new record low of 2% year on year reinforcing the downwards pressure on inflation. Employment data for July (Thursday) is expected to show flat employment after a high employment sample rotates out and given that recent forward looking job indicators have been more mixed lately. Unemployment is likely to rise slightly to 5.9%. Meanwhile, the minutes from the last RBA board meeting (Tuesday) are likely to confirm the dovish tone evident in the August Statement on Monetary Policy.

The June quarter earnings reporting season will ramp up in Australia as we move into the two busiest weeks for reports with 66 major companies due to report in the week ahead including JB HiFi, BHP, Wesfarmers, CSL, QBE, Origin, AMP, IAG, DUET, Lend Lease and Woodside Petroleum. After the downgrades since the last reporting season back in February the hurdle to avoid disappointment is now relatively low. Consensus expectations for 2015-16 earnings are for an 8% decline in profits driven by a 50% fall in resources earnings and a 2% fall in bank profits leaving profits in the rest of the market up just 1%. Key themes are likely to be: improved conditions for resources companies following a stabilisation in commodity prices; constrained revenue growth for industrials; ongoing cost cutting; continuing headwinds for the banks; and an ongoing focus on dividends. Sectors likely to see good profit growth are discretionary retail, industrials, gaming and healthcare. Expect disappointers to be punished severely.

Outlook for markets


After a period of strong gains, shares are due to take a breather and weak seasonals for August and September along with risks around Italian banks, the Fed and global growth generally could be the drivers. However, after a 1-2 month correction or consolidation, we anticipate shares to trend higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth.

Ultra-low bond yields point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment prices get hit by oversupply.

Cash and bank deposits offer poor returns.

With the Fed continuing to delay rate hikes and the $A pushing up to around $US0.77, a break of April’s high of $US0.78 and a push up to $US0.80 is now looking likely for the $A. Beyond the short term though, we see the longer term downtrend in the $A ultimately resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value.

Eurozone shares and the US S&P 500 both fell 0.1% on Friday not helped by soft US retail sales data. Reflecting the soft global lead, ASX 200 futures fell 11 points or 0.2% on Friday night pointing to a soft open for the Australian share market on Monday.

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Reporting season ramps up

Monday, August 08, 2016

By Shane Oliver

Shares were mixed over the last week. A bit of profit taking after the strong gains seen in July, Japan’s disappointing stimulus plans, and continuing worries about Eurozone banks saw Japanese shares fall 1.9%, Australian shares fall 1.2% and Eurozone shares fall 0.4%. But a strong US payroll report on Friday pushed the US share market up 0.4% for the week to a new record high and UK shares rose 1% helped by aggressive monetary easing from the Bank of England. Chinese shares were flat for the week. Commodity prices were mixed, with oil up slightly after bouncing off technical support after a 23% fall since their June high, but metal prices fell. While the $US rose, mainly after the strong jobs report, the $A was little changed. Bond yields rose sharply in the US and Japan, but were little changed in Australia.

While shares could go through a consolidation through the seasonally tough August-October period with various risks remaining, the broad trend is likely to remain up, helped by indications that global growth is not collapsing (while upside data surprises in the US are starting to roll over they are moving up in Europe, Australia and emerging countries), the worst is likely over for profits and economic policy is likely to remain easy (or easier) for longer. In terms of the latter, there have been another three easing moves over the last week with Japan disappointing, but the UK doing more than expected and the RBA easing and dovish.

After the previous week’s underwhelming monetary easing, Japan has followed up with an underwhelming fiscal stimulus. Actual fiscal stimulus this fiscal year will only amount to ¥4.5 trillion – or 0.9% of GDP – a fraction of what had been alluded to over the last few weeks. It's a little improvement on last year’s 0.7% of GDP stimulus. Having not seen the “helicopter money drop” that some thought was about to be delivered, sentiment on Japan has turned very negative again and the Yen is at risk of resuming its upswing. On the one hand it’s hard to keep making excuses and hanging out for something decisive out of Japan. On the other, it’s hard to believe that PM Abe and BoJ Governor Kuroda have given up and are joining the ranks of past indecisive Japanese policy makers of the last twenty five years. Time will tell, but it does seem clear that the sharp back up in Japanese 10-year bond yields seen over the last two weeks (from -0.3% to -0.1%!) won’t go too far, unless Japanese inflation starts turning back up and that seems unlikely in the short term. 

In contrast to Japan, the Bank of England overwhelmed with a rate cut, more quantitative easing focussed on government and corporate bonds, a 4-year cheap funding scheme for the banks and signalled that more is likely. And more is likely, given the short term confidence hit to the UK economy. But I suspect that this easing, and more significantly, the boost to trade from the 15% or so slump in the British pound from its average 2010-14 level, should help minimise the damage. Fortunately, the UK has a decisive central bank able to help patch it up after it shot itself in the foot in June!

The RBA eased and remains dovish, with another easing likely in November. Economic growth is not the major problem. Rather, the RBA’s move was all about making sure that sub-target inflation does not become entrenched and (while it won’t directly say it) trying to offset upwards pressure on the $A in the face of ongoing Fed rate hike delays. While the RBA’s August Statement on Monetary Policy saw no significant changes to the RBA’s forecasts for roughly 3%, GDP growth and 1.5-2.5% inflation over the next two years, the tone of the Statement is actually quite dovish with the RBA saying that “inflation is likely to remain below 2% over most of the forecast period”, that “there is room for even stronger growth”, that the risks around household debt and “rapid gains in housing prices” have diminished and that “forward looking indicators of the labour market have been mixed”. These comments, and in particular, that the RBA does not see inflation coming decisively back into the centre of its target range of 2-3% suggests to us that it retains an easing bias. If September quarter inflation rate remains very low as we expect and the Fed remains in ultra-gradual mode regarding rate hikes as we also expect, then the RBA will cut again in November.

Major global economic events and implications

US data was good with the ISM manufacturing conditions index adding to evidence that the slump in US manufacturing is over, services sector PMIs remaining consistent with good growth, auto sales rising strongly, personal spending also up solidly and employment reports remaining strong. The July jobs report was particularly good, with payrolls up by a more than expected 255,000 coming on the back of a 292,000 gain in June. While unemployment remained at 4.9%, this was because participation rose. Wages growth remains relatively subdued at 2.6% year-on-year, but is still tracing out a gradual uptrend. Since the GFC, unemployment has fallen from around 10% to now 4.9% and unemployment plus underemployment has fallen from around 18% to 9.7%, highlighting the massive improvement in the US economy. The strong July jobs report means the September Fed meeting is “live” for a hike, but given the Fed’s risk management approach and low inflation giving them plenty of flexibility, they are more likely to wait to December. 

Evidence continues to build that US profits are turning up. 433 S&P 500 companies have reported June quarter earnings, with 78% beating on earnings and 56% beating on sales, both of which are above normal levels. More importantly, while earnings are down 3% year-on-year, they have come in around 2% better than expected and are up about 8% on the March quarter low. 

Final business conditions PMIs for July confirmed that Europe remains on track for ongoing moderate growth, while those for the UK collapsed post Brexit. Fortunately, the UK is only 2.5% of the global economy.

China saw some good news with manufacturing and services conditions PMIs moving slightly higher on average in July, pointing to an ongoing stabilisation in growth. 

Reform is getting back on track in India. In a very positive move, India’s Upper House passed a Goods and Services Tax (GST) Constitutional amendment bill. There is a long way to go before the GST kicks in, but when it does, it will be a huge leap forward for India replacing a myriad of silly taxes. Productivity gains from a simpler and more efficient tax system are likely to be significant. This is a positive sign for further reforms in India to the extent that the Modi Government has been able to reach a consensus with the opposition parties on reform. Meanwhile, the Government has formally locked into an inflation target of 4% with a 2% range for the Reserve Bank of India locking the once inflation prone country into international best practice regarding inflation targeting.

Australian economic events and implications

Australian data over the last week presented a mixed picture. On the one hand, the trade deficit worsened in June, retail sales continue to lose momentum and building approvals are trending down. But on the other, net exports look like they will be a neutral contributor to GDP growth in the June quarter, which is pretty good after a huge contribution in the March quarter, the level of building approvals is still high, the pipeline of dwellings to be completed is huge, new home sales remain strong, non-residential approvals appear to be improving and business conditions PMIs for both the manufacturing and services sectors are well above those seen in major developed countries. All of which suggests that growth continues. Meanwhile, the Melbourne Institute’s Inflation Gauge indicates that inflation remained weak in July and CoreLogic data indicated a continued softening in national home price growth.

What to watch over the next week?

In the US, the focus is likely to be on July retail sales (Friday) which are likely to show continued reasonable growth. Data will also be released on small business confidence, productivity, job openings and hiring and producer prices.

In China, July data is expected to show a slight improvement in momentum in exports and imports (Monday), a further fading in producer price deflation but a fall in consumer price inflation to 1.7% year-on-year (Tuesday) mainly due to slower food prices, a fall back in money supply and credit growth after a surge in June, steady growth in retail sales (of around 10.6% year-on-year) and industrial production (around 6.2% year-on-year) but a further slowing in fixed asset investment (all due Friday).

In Australia, expect the NAB business survey (Tuesday) to show business conditions and confidence holding up reasonably well and consumer confidence (Wednesday) to bounce back a bit helped by the latest RBA rate cut and a settling of political uncertainty in Canberra. Housing finance data for June (Wednesday) is expected to bounce back as the May rate cut feeds through. A speech by RBA Governor Glen Stevens on Wednesday will be watched for any clues on interest rates.

The Australian June half profit reporting season will also start to ramp up with 23 major companies reporting including News Corp, CBA, Fairfax and Telstra.  

After the downgrades since the last reporting season back in February, the hurdle to avoid disappointment is now relatively low.

Consensus expectations for 2015-16 earnings are for an 8% decline in profits driven by a 50% fall in resources earnings and a 2% fall in bank profits, leaving profits in the rest of the market up just 1%.

Key themes are likely to be: improved conditions for resources companies following a stabilisation in the iron ore and oil price; constrained revenue growth for industrials although improved business conditions according the NAB business survey may help; ongoing cost cutting; continuing headwinds for the banks; and an ongoing focus on dividends.

Sectors likely to see good profit growth are: discretionary retail, industrials, gaming, and healthcare. Expect disappointers to be punished severely, with sharp share price falls.

Outlook for markets

Seasonal September quarter weakness along with risks around Italian banks, the Fed and global growth generally could still see more volatility in shares in the short-term. However, beyond near-term uncertainties, we anticipate shares to trend higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Ultra-low bond yields point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to tougher lending standards and as apartment prices get hit by oversupply in some areas.

Cash and bank deposits offer poor returns. 

With the Fed continuing to delay rate hikes and the $A pushing up to around $US0.76, there remains a real risk that it will re-test April’s high of $US0.78 and maybe push on to $US0.80. Beyond the short term, we see the longer term downtrend in the $A continuing as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead. 

Thanks to the strong July jobs report in the US, Eurozone shares gained 1.4% on Friday and the US S&P 500 rose 0.9%. Reflecting the positive global lead ASX 200 futures rose 31 points or 0.6% pointing to a positive start to trade on Monday for the Australian share market. 

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What to watch this week: Reporting season

Monday, August 01, 2016

By Shane Oliver

The past week was mixed for share markets. While Australian shares rose 1.2% and Eurozone shares rose 1%, US shares fell 0.1% as oil prices declined, Japanese shares lost 0.4% not helped by an underwhelming easing by the Bank of Japan and Chinese shares fell 0.7% on the back of the banking regulator increasing measures to reduce financial risks. Bond yields also fell, but commodities were mixed with oil down and iron ore up and the $US declined which saw the $A rise. 

More broadly, July was a good month for shares, with strong gains in global shares (US shares +3.6%, Eurozone shares +5.1%, Japanese shares +6.4% and Chinese shares +1.6%) and the Australian share market up around 6.3%, its best month since October 2011. Key drivers included good global economic data, good profit news out of the US, talk of easier for longer monetary policy and in Australia’s case, a further rise in the iron ore price. As can be seen in the chart below, economic data has been coming in better than expected lately, with economic surprise indices (which measure data releases against market expectations) looking better.

Source: Bloomberg, AMP Capital

As expected, the Fed is more upbeat on the US economy, sees the near term risks as having diminished but still sees only gradual interest rate increases ahead. The basic message is that the Fed is not going to do anything to knowingly put the global and US economies at risk given the fragile nature of growth and the fact that inflation remains low. Weaker-than-expected US June quarter GDP growth of just 1.2% annualised and soft June quarter employment cost growth of 2.3% year-on year-will further delay the Fed, but another hike is still likely by year end.

After much anticipation, Japan has announced more monetary and fiscal stimulus. However, the Bank of Japan has underwhelmed with just a doubling of its of ETF buying program (to ¥6 trillion pa) but no increase in its bond buying program or monetary base target and no further cut in interest rates, suggesting no real further easing of monetary policy. However, it’s not all negative, as the ETF buying is positive for shares, the absence of more negative interest rates is positive for banks and the BoJ will review policy more broadly at its next meeting. The focus now shifts to fiscal stimulus, with PM Shinzo Abe announcing plans for a ¥28 trillion economic stimulus. While this is a big number (6% of GDP) much uncertainty remains around how much is real new stimulus and how many years it will be spread over. It’s doubtful that any of this will be enough to break the stop/start recession pattern and achieve the 2% inflation target, so ultimately, some form of helicopter money will be required, but we are not there yet. In the mean-time, there is a risk of further Yen strength.  

The results of the latest European large bank stress tests were better than expected with only Italy’s Monte Paschi and Allied Irish “failing” the tests in that their capital ratio would fall below 4.5% under stress. Allied Irish only failed marginally, but Monte Paschi would see its capital wiped out. The problems at Monte Paschi are no surprise though. 

What's wrong with Italian banks? Put simply, after years of poor growth and low interest rates Italy's banks have seen their non-performing loans rise to the point that one of them – Monte Paschi - needs to be recapitalised or else it will have to slow lending which will be bad for Italian growth. The trouble is that bank share prices have collapsed, making it hard to raise capital from the equity market and European rules on bank recapitalisation require private bond holders in banks to take losses ahead of the injection of public money. After the political furore that followed when an elderly retail investor committed suicide last November after having to take a €100,000 loss on a bond holding in a small bank, the Italian Government cannot afford to have a wider “bail-in” of ordinary bank investors as it will damage its prospects of winning a referendum on reducing the Italian Senate's power, which in turn could lead to the fall of the Renzi Government. So there is a stand-off between PM Matteo Renzi and the European Commission, but ultimately, a compromise is likely as the rest of Europe realises that failure to do so could see the Eurosceptic Five Star Movement attain power in Italy. The European Banking Authority's bank stress tests could help clear the way for such a compromise.

While June quarter inflation in Australia was in line with expectations including those of the Reserve Bank, it showed that inflation has fallen further below target and that underlying inflationary pressures are very weak. Ongoing signs of very weak pricing power are evident in a range of areas including for supermarket items, clothing, rents, household equipment, car prices, communication and recreation. The basic message is the global deflationary forces, high levels of competition and weak wages growth are keeping inflation ultra-low with the risk inflationary expectations will be pushed down and make it harder to get inflation back to target. As such, pressure on the RBA remains intense.

Major global economic events and implications

US data was a bit mixed over the last week with stronger-than-expected consumer confidence and new home sales and continuing low jobless claims, but soft durable goods orders, pending home sales, GDP growth and employment cost growth. June quarter GDP growth disappointed at just 1.2% annualised after just 0.8% in the March quarter. However, final demand growth was solid at 2.4% and the detraction from inventories (which was -1.2 percentage points) is likely to have largely run its course. 

Evidence is continuing to build that US profits have bottomed. 316 S&P 500 companies have now reported June quarter earnings to date and the results show an 8% plus pick-up in profits on the March quarter with 81% beating on earnings and 58% beating on sales.

While confidence readings in the UK continue to come in very weak post Brexit, they are holding up reasonably well in the Eurozone with economic confidence actually rising slightly in July. Eurozone bank lending growth also picked up a notch in June, pointing to continued moderate growth. June quarter GDP growth slowed to 0.3% quarter-on-quarter or 1.6% year-on-year from 1.7% year-on-year and July core inflation was unchanged at 0.9% year-on-year.

Although Japanese jobs data in June remained solid and industrial production rose, household spending remains very weak, deflation remains evident in a fall in the CPI of -0.4% year-on-year and core inflation fell further to just 0.4% year-on-year. What’s more, the jobs data is being flattered by a falling workforce and while industrial production bounced it followed a weak May and is down -1.9% year-on-year. All of which explains the need for more aggressive stimulus in Japan.

Australian economic events and implications

Apart from continuing low consumer price inflation in the June quarter, producer price and import price inflation was also weak. Private sector credit data showed weak growth with growth in the stock of lending to property investors slowing.

What to watch over the next week?

In the US, jobs data (Friday) is likely to remain consistent with solid US economic growth. Expect a 180,000 gain in payroll employment, unemployment remaining around 4.9% and a slight edging up in wages growth. Meanwhile the manufacturing conditions ISM index (Monday) is likely to remain around 53, the core private consumption deflator (Tuesday) is expected to hang around 2.6% year-on-year and the non-manufacturing conditions ISM (Wednesday) is expected to remain solid. June quarter corporate earnings will also remain a focus.

The true stimulus flowing from Japan’s ¥28 trillion plus stimulus package will be assessed when details are released Tuesday. 

The Bank of England (Thursday) is likely to ease policy, responding to the post Brexit confidence slump.

Chinese manufacturing conditions PMIs (Monday) are expected to show a modest improvement, but nothing to excite.

In Australia, we expect the Reserve Bank (Tuesday) to cut the cash rate again by another 0.25% taking it to a new record low of 1.5%. The June quarter inflation data is not low enough to make an RBA rate cut certain, particularly given that recent economic data has been reasonably good. However, on balance we expect that the RBA will cut again to help ensure that inflation expectations do not become entrenched below 2%, so that there is reasonable confidence that inflation will move back into the target zone in a reasonable time frame and to head off a rebound in the $A. Alternatively, if the RBA does not cut again on Tuesday, then expect an easing in November. The RBA’s Statement on Monetary Policy (Friday) will likely make minimal changes to its growth and inflation forecasts.

On the data front in Australia, expect July CoreLogic data to show a further loss of momentum in Sydney and Melbourne home prices, a 1% bounce in June building approvals and a slight improvement in the June trade deficit (all Tuesday) and a 0.3% gain in retail sales (Thursday).

The Australian June-half profit reporting season will also start to get underway in the week ahead, with a handful of companies due to report (including Rio, Tabcorp and Suncorp). After the downgrades since the last reporting season back in February the hurdle to avoid disappointment is now relatively low. Consensus expectations for 2015-16 earnings are now for an 8% decline in profits driven by a 50% fall in resources earnings and a 2% fall in bank profits leaving profits in the rest of the market up just 1%. Key themes are likely to be: improved conditions for resources companies following a stabilisation in the iron ore and oil price; constrained revenue growth for industrials although improved business conditions according the NAB business survey may help; ongoing cost cutting; continuing headwinds for the banks; and an ongoing focus on dividends. Sectors likely to see good profit growth are discretionary retail, industrials, gaming and healthcare.

Outlook for markets

Brexit related risks, Italian bank risks, renewed $US strength and seasonal September quarter weakness could still see more volatility in shares in the short term. However, beyond near-term uncertainties, we anticipate shares trending higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Ultra-low bond yields point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to tougher lending standards and as apartment prices get hit by oversupply in some areas.

Cash and bank deposits offer poor returns. 

With the Fed continuing to delay rate hikes and the Aussie dollar pushing up to around $US0.76, there is a real risk that it will re-test April’s high of $US0.78 and maybe push on to $US0.80 if the RBA does not cut rates on Tuesday. Beyond the short term, we see the longer term downtrend in the Aussie dollar continuing as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the dollar sees its usual undershoot of fair value. The dollar is still likely to fall to around $US0.60 in the years ahead. 

Eurozone shares rose 0.8% on Friday and the US S&P 500 gained 0.2% helped by good earnings results and as soft US GDP growth added to expectations that the Fed would delay hiking rates again. Following the positive global lead ASX 200 futures rose 17 points, or 0.3%, pointing to a positive start to trade Monday.

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Signs are pointing to an August rate cut

Monday, July 25, 2016

By Shane Oliver

It’s now four weeks since the Brexit panic on June 24 and since then US shares are up 7%, Eurozone shares are up 6%, British shares are up 10%, Australian shares are up 7% and Japanese shares are up 11%. Fears around Brexit’s global impact look to have been wildly exaggerated. The only really lasting impact (so far) has been on the British pound which is down another 4% leaving it down 11% from June 23rd, which reflects the negative impact of Brexit on the UK economy.

Over the past week, the rally in shares generally continued with US shares up 0.6%, Eurozone and Japanese shares up 0.8% and Australian shares up 1.3% but Chinese shares down 1.6%. A combination of good economic data, good US profit results, the absence of a major negative impact outside the UK from Brexit and talk of more policy stimulus in parts of the world are continuing to help. Bond yields were generally flat to down, commodity prices fell and the $A fell partly in sympathy with NZ moves towards another monetary easing. 

The talk around Japan’s planned fiscal stimulus is continuing to get ramped up with the size of the package supposedly going from ¥10trillion, to ¥20trillion to maybe even ¥30trillion which is around 6% of GDP, albeit it depends how many years it is spread over. If, as we expect, it’s focussed on encouraging consumers to spend more then it should have a reasonable chance of success. 

In maybe a sign of things to come in Australia – NZ looks to be heading for another rate cut. After a low inflation outcome, a further tightening in restrictions on residential mortgage lending and the Reserve Bank of New Zealand stating that “a decline in the [$NZ] is needed”, the RBNZ has set the scene for a rate cut next month. In fact, it said that “it seems likely that further policy easing will be required”.

The IMF downgraded it's global growth forecasts to 3.1% for 2016 (from 3.2%) and to 3.4% for 2017 (from 3.5%) on Brexit risks - but hardly a surprise. It must often strike the ordinary investor as weird that much fanfare is given to the IMF downgrading its growth forecasts, but share markets seem to largely ignore it. There are several reasons for this but in essence it’s because the market (and most economists) have already moved ahead of the IMF and the IMF global growth forecasts have been starting out too optimistic for years now. Since early this decade, they have been starting out forecasting 4% global growth for the year ahead, only to end around 3%. This is not great – but it’s not bad either! Just more of the same. 

One positive from the last week – we learned that Trumps can say thoughtful things. Not to worry that they were Michelle Obama’s. In the week ahead, it’s on to the Democrat convention which may be a lot calmer!

Major global economic events and implications

US data was on a roll. Housing data was strong (with solid readings for home builder conditions, starts, sales and home prices), jobless claims remain very low, leading indicators rose more than expected and the Markit manufacturing PMI rose solidly in July. So much for all the waffle about a US recession! The US housing recovery likely has a long way to go as housing starts at 1.2 million continue to run below underlying demand of 1.5 million with the overbuilding of last decade having been more than worked off. Buying a house in Detroit still looks like a good proposition! 

Evidence is continuing to build that US profits bottomed in the March quarter. 125 S&P 500 companies have now reported June quarter earnings to date, and so far so good, with 82% beating on earnings and 60% beating on sales. While the market expects profits to fall 3% from a year ago, this will translate into a rise in profits of 8% from the March quarter.

As expected, the ECB remained in wait and see mode at its July meeting. However, President Draghi referred to greater uncertainties in reference to Brexit and reiterated the ECB’s “readiness, willingness and ability to act” if necessary. We remain of the view that its QE program will be extended beyond its current expiry of March 2017. Eurozone business conditions PMIs and consumer confidence fell slightly in July, suggesting little impact on confidence and conditions from Brexit. They remain at levels consistent with moderate growth. Interestingly, the ECB’s bank lending survey showed an increase in demand for loans and a further easing in lending standards which is also a good sign as the survey was conducted before and after the Brexit vote.

It’s not so good for the UK where its PMI fell sharply in July as Brexit hit, adding to evidence it may be heading into recession. Just remember though that the UK is only 2.5% of world GDP.

Japan’s manufacturing conditions PMI showed a welcome improvement in July albeit it’s still weak.

The Chinese property market recovery remains a positive for growth – with residential property prices up another 0.8% in June or 7.8% year-on-year. Meanwhile, the MNI Chinese business sentiment index rose in July and significant flooding in parts of China could have a short-term positive impact on GDP from rebuilding and may temporarily boost food prices.

Australian economic events and implications

In Australia, the minutes from the RBA’s last Board meeting confirmed that the door is wide open for another rate cut at its August 2 meeting. While not as direct as the Reserve Bank of New Zealand, the RBA indicated that it was waiting on further information on inflation, the labour market and the housing market and the next update of the RBA’s economic forecasts. Since it has described the labour market and the housing market as “mixed”, and recent data on both suggest no reason to change that assessment, the implication from the RBA is that should we see another low inflation reading when the June quarter CPI numbers are released on Wednesday. And then it’s likely that the RBA will cut the cash rate from 1.75% to 1.5% on August 2. A CPI outcome of 0.4% quarter-on-quarter for headline and underlying – which is what we expect - would likely be enough to see the RBA cut again.

What to watch over the next week?

The focus in the week ahead will be on monetary policy - with June quarter inflation data in Australia providing a guide to whether the RBA will cut rates again next month and both the Fed and Bank of Japan meeting – and European banks with another round of stress tests.

In the US, we expect the Fed (Wednesday) to leave rates on hold as it seeks to gain more confidence that US growth is back on track and that the impact from Brexit will be minimal, but to indicate that it still expects to raise rates in a gradual and cautious fashion. The US money market is only implying a 10% chance of a hike in the week ahead, but the Fed may try and push up the market’s probability of a hike going forward, which is currently at just 24% for September and 45% for December. With US growth averaging around 2%, the labour market continuing to tighten with wages growth edging higher and inflation heading up towards target, we see more like a 65% chance of a hike in December. The main brake on the Fed will be if the $US rises too strongly as it amounts to a de facto monetary tightening. On the data front in the US, expect to see continuing gains in US home prices, a rise in new home sales but a fall in consumer confidence (all Tuesday), softish durable goods orders and a rise in pending home sales (Wednesday), a slight edging up wages growth (according to the June quarter employment cost index) and a bounce back in annualised GDP growth to 2.6% in the June quarter (both Friday) after just 1.1% growth in the March quarter. Earnings will also remain a focus, with over 180 S&P 500 companies to report June quarter earnings.

In the Eurozone, the focus will be on the latest ECB bank stress tests (Friday) which will indicate whether banks are sufficiently capitalised or not. Italian banks of course will be the main focus, and the stress tests should help clear the way for some of them to be recapitalised. On the data front, expect June quarter GDP (Friday) to show moderate economic growth of around 1.5% year-on-year and confidence readings (Thursday) will provide a further guide to the impact of Brexit on business confidence. Data will also be released for bank lending (Wednesday) and core inflation (Friday) is likely to have remained around 0.9% year-on-year on July.

The Bank of Japan (Friday) is likely to announce further monetary easing as the Japanese government prepares to unveil its much talked about fiscal stimulus package. While it’s doubtful this will involve “helicopter money” (ie direct BoJ financing of government spending), it is getting close. Rather, it's likely to involve further monetary easing through some combination of increased ETF and corporate debt purchases and another cut in the negative deposit rate. While Bank of Japan Governor Kuroda rejected the idea of helicopter money in June, he also rejected negative interest rates shortly before announcing them. Japanese data due Friday is expected to show continued labour market strength and a bounce in industrial production but soft household spending and inflation.

In Australia, expect another low inflation reading on Wednesday for the June quarter to clear the way for an August RBA rate cut. While headline inflation is expected to rise 0.4% quarter-on-quarter thanks to higher petrol prices and a seasonal rise in health costs, this is likely to see annual inflation drop to 1.1% year-on-year and low wages growth and competitive pressures are likely to have seen underlying inflation rise just 0.4% qoq or 1.4% yoy, which is down from 1.6% yoy in the March quarter. June credit data (Friday) is likely to show that credit growth remains moderate with the stock of lending to property investors continuing to show slower growth.

Outlook for markets

Brexit related risks, Italian bank risks, renewed $US strength as the Fed heads back towards tightening and seasonal September quarter weakness could still see more volatility in shares in the short term. However, beyond near-term uncertainties, we anticipate shares trending higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Ultra-low bond yields (with one third of the global bond index in negative yield territory) point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback. Renewed expectations of a Fed hike may be the driver.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to tougher lending standards and as apartment prices get hit by oversupply in some areas. Prices are likely to continue to fall in Perth and Darwin. 

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue, as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares gained 0.1% on Friday and the US S&P 500 rose 0.5%, helped by good earnings results and better-than-expected business conditions PMIs. As a result of the positive global lead, the ASX 200 futures contract rose but only by 4 points or 0.1%, pointing to a mild positive start to trade for the Australian share market on Monday. Gains are likely to be tempered by softer commodity prices, including a fall in the iron ore price, which will weigh on resources stocks.

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8 reasons for the market rebound

Monday, July 18, 2016

By Shane Oliver

It has been “risk on” again over the last week in investment markets, helped by a combination of good economic data in the US and China, good US earnings news and firming expectations of more policy stimulus in Japan. US shares rose 1.5% to a new record high, European shares (up 3.9%) and Japanese shares (up 9.2%) have recovered much or all of their Brexit losses, global shares have broken their down trend from last year’s high and Australian shares rose 3.8% to their highest for the year. Chinese shares also gained 2.6%. On top of this, commodity prices are doing okay, credit spreads have narrowed and bond yields have increased with the US 10-year yield rising 19 basis points. The Aussie dollar was little changed. 

So markets generally have moved on from the initial panic reaction seen in the days after the Brexit vote. What gives? Eight factors explain the rebound in investment markets: 

  • Global policy makers have signalled easier global monetary policy for longer post Brexit; 
  • The decline in bond yields has further improved the relative attractiveness of shares; 
  • There doesn’t seem to have been a surge in support for exiting the EU or Eurozone in other European countries post Brexit. In fact, as highlighted by the Spanish election, it may be the opposite. Note of course the rest of Europe always saw itself as far more “European” than the UK ever did; 
  • Global economic data has generally been good – there has been no sign of the much feared global recession; 
  • US profits are showing signs of bottoming, helped by a stabilisation in the $US and the oil price;
  • Investors have been more relaxed about the latest decline the value of the Chinese Renminbi or RMB - perhaps reflecting slowing capital outflows from China, foreign demand for Chinese assets, reassurance from Chinese officials that a collapse in the RMB is unlikely and a growing relaxation about fluctuations in the value of the RMB; 
  • Investors have realised that Brexit may be a long time coming and may be a Brexit lite; and
  • All the talk seems to have been bearish lately – Brexit disaster, Chinese debt, US slowing, messy Australian election - which provides an ideal springboard for market gains!

Japanese PM Shinzo Abe’s coalition’s big upper house election victory on Sunday looks to have cleared the way for more stimulus in Japan with Abe commenting “I think this means I am being told to accelerate Abenomics..” A large fiscal stimulus package looks to be on the way and expectations of more monetary easing (probably at the BoJ’s July 29 meeting) have seen the Yen fall. Japan looks to be getting close to using “helicopter money” – where the central bank directly finances public spending or tax cuts, with no implication that it has to be paid back – but it may not be used initially. 

While the Bank of England did not ease monetary policy at its July meeting, it clearly signalled easing ahead with the minutes, noting that “most members of the Committee expect monetary policy to be loosened in August.”

Meanwhile, new UK PM Theresa May’s decision to give prominent Brexit Leave campaigners the task of seeing the job through has effectively put them on the hook to explain any compromises (e.g. around immigration to maintain free trade access) or to take some of the blame if it goes wrong. There is also a long way to as Article 50 of the Lisbon treaty may not be triggered until next year and by then a weaker UK economy (owing to negative Brexit confidence effects) could have dimmed support for it. So there is still plenty of room for Brexit lite or even no Brexit. Either way, Brexit will be an ongoing issue, but I suspect markets will just learn to live with it along with all the other noise that surrounds them. The key is that if Brexit is demonstrated to be more trouble than remaining in the EU, then the risk of a domino effect of exits across the Eurozone will be much reduced.

Perhaps more fundamentally, PM May has signalled a focus on reducing the perceived injustices that helped drive the Brexit vote in the first place. While it’s clear that governments need to respond to rising inequality – particularly in the US and UK where its most evident – or face longer term risks, the danger is that a shift away from economic rationalist policies will ultimately threaten productivity and growth and hence investment returns much as it did in the 1970s.

Geopolitical risk reared its head again in the last week in relation to South China Sea tensions, another terrorist attack in France, and a coup attempt in Turkey: 

  • The decision by UN’s Permanent Court of Arbitration in favour of the Philippines in relation to disputed “islands” in the South China Sea signals a step up in geopolitical risks in the region. This was particularly so after China’s Foreign Ministry declared the decision “null and void” and there was talk of China having the right to declare an Air Defence Identification Zone (ADIZ) in the area. But an ADIZ was declared by China over disputed islands with Japan in 2013 and not enforced. Also, China’s Foreign Minister indicated a willingness to peacefully resolve the dispute through negotiations which the new more pro-China president of the Philippines may be amenable to. There are lots of risks in the South China Sea, but this could drag on for years and come to nothing despite occasional flare ups.
  • The latest horrible terrorist attack in France had a muted impact on the French share market on Friday (-0.3%) and on travel shares, but it is noteworthy that financial markets seem to be getting used to such attacks with the impact of recent past terror attacks being short lived.
  • News of an attempted coup in Turkey (with the army saying it’s taking power to restore democracy and freedom) adds further to geopolitical risks given the regional hot spot Turkey sits in. But it’s at least the fourth coup in Turkey since 1960, and I suspect no lasting impact on global markets. It’s not good for Turkey though.

Major global economic events and implications

US economic data was good with stronger than expected gains in retail sales and industrial production, a slight rise in small business optimism and continued strong data on job openings (albeit down slightly) and hiring and ultra-low jobless claims. Core CPI inflation rose 2.3% over the year to June, adding to evidence that deflationary risks are receding and implying a 1.6% year-on-year increase in the core private consumption deflator. Fed officials have been sounding more relaxed about the US economy after the jobs data and regarding the impact of Brexit, with the implication that the Fed is still on track for one rate hike this year. The US money market’s probability of a hike this year has now increased to 45% up from just 12% pre payrolls but still looks too low. That said, the reality or threat of a rising US dollar will act as a strong constraint on how much the Fed will tighten.

Weak Japanese machine orders and wages growth highlight the pressure for further policy stimulus in Japan.

Chinese growth has stabilised. June quarter GDP growth was unchanged at 6.7% and while June data showed that investment and imports slowed, growth in industrial production, retail sales, credit and money supply all came in better than expected and mostly picked up. So, after a long period of deceleration, Chinese growth looks to be stabilising just above 6.5%, which is good for commodity prices and hence Australia. Meanwhile, producer price deflation continues to recede which is a good sign, but CPI inflation remains very low (just 1.2% year-on-year for non-food inflation) indicating plenty of scope for ongoing policy stimulus.

Australian economic events and implications

Australian economic data was okay. While consumer confidence fell presumably in response to the messy election result, Brexit, etc, the fall was only 3% and leaves confidence at the high end of the range of the last few years. Meanwhile, business conditions in June (albeit pre-election) were solid, home loans rose in May leaving in place just a moderately slowing trend, housing starts rose to a record in the March quarter and jobs growth continued in June. Our assessment remains that the RBA will cut rates again next month but with okay economic data it’s dependent on another low June quarter inflation reading due on July 27th. Falling retail prices in the June NAB survey certainly point in this direction.

What to watch over the next week?

In the US, expect another solid reading for the NAHB home builders’ conditions index (due Monday), gains in housing starts and permits to build new homes (Tuesday), a further rise in home prices but a slight fall in existing home sales (both Thursday) and a slight increase in the Markit manufacturing conditions index for July to around 51.5 (Friday). The Republican convention (July 18-21) in Cleveland will see the focus on the November presidential election ramp up.

The US June quarter earnings reporting season will also start to ramp up, with over 100 S&P 500 companies due to report. While the consensus sees a 4% decline in earnings from the June quarter a year ago, this will mark roughly a 7% gain in earnings from the March quarter, with a more stable US dollar and oil price helping. In other words, the US earnings recession could be over.

The European Central Bank is expected to make no changes to monetary policy when it meets Thursday as it’s still in “wait and see” mode after the further easing it announced earlier this year. However, it’s likely to remain dovish and indicate that it is closely monitoring the risks flowing from Brexit and around Italian banks. An extension to its quantitative easing (beyond March 2017) and bank liquidity assistance programs (TLTRO) is likely at some point. Meanwhile, July business conditions PMIs (Friday) will be watched for any impact from the Brexit vote, but are expected to remain reasonable.

Japan’s manufacturing PMI for July (Friday) will be watched for an improvement from the low reading of 48.1 in June.

In Australia, the minutes from the last RBA Board meeting are likely to imply that the door is open to another rate cut should June quarter CPI data due on July 27 confirm that inflation remains lower than desired. Data on skilled vacancies will also be released.

Outlook for markets

Brexit related risks, Italian bank risks, renewed US dollar strength as the Fed heads back towards tightening, and seasonal September quarter weakness could still see more volatility in shares in the short term. However, beyond near term uncertainties, we anticipate shares trending higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Ultra-low bond yields (with one third of the global bond index in negative yield territory) point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback. Renewed expectations of a Fed hike may be the driver.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and as apartment prices get hit by oversupply in some areas. Prices are likely to continue to fall in Perth and Darwin. 

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows; as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the Aussie dollar sees its usual undershoot of fair value. The Aussie dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares fell 0.2% on Friday and the US S&P 500 lost 0.1% despite good US economic data, possibly reflecting a bit of profit taking after recent gains. Reflecting the soft global lead, the ASX 200 futures fell 11 points or 0.2% pointing to a soft start to trade on Monday. This may be accentuated a bit by news of a Turkish coup attempt which broke after the US share market closed, but did see US S&P 500 futures slip 0.4%. 

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Will Brexit ever happen?

Monday, July 11, 2016

By Shane Oliver

Wariness returned to investment markets in the past week, led in part by worries about Italian banks, but this was reversed to some degree on Friday by strong US jobs data. As a result share markets were mixed over the week with Eurozone shares down 1.6%, Japanese shares down 3.7% (not helped by the rising Yen) and Australian shares down 0.3%. But US shares rose 1.3% (to around a record high) and Chinese shares rose 1.2%. Worries about Australian banks - on the back of global bank weakness, APRA indications further capital raising may be required, and the shift in Australia’s and banks’ credit rating outlook to “negative” by Standard and Poors - weighed on the Australian share market.

Bond yields continued to fall and a rising $US weighed on oil and metal prices and saw the Chinese Renminbi fall to its lowest level since 2010. Despite the rising $US and S&P placing Australia’s credit rating on negative outlook, the $A rose.

Fears around a recession in the UK following the Brexit decision continue to build, with business confidence falling sharply. Clearly UK business is concerned about their continued access to EU markets. These concerns have also hit the UK commercial property market with several unlisted property funds halting redemptions as investors anticipate a bleak outlook for the UK property market if businesses decide to relocate operations to Europe. While the Bank of England cut banks’ capital requirements and the continuing plunge in the value of the British pound should help, it’s doubtful this will be enough to stop a recession later this year. Bear in mind though that the UK economy is only 2.5% of global GDP. It’s also worth noting that the problem with British property funds are reflective of a specific problem in the UK post Brexit. It’s not indicative of a problem with global commercial property markets generally.

But will Brexit even happen? Given the Bregret and mayhem in the UK there is some chance that Article 50 of the Lisbon treaty, which governs exits from the EU will never be triggered. This could happen say if the new conservative leader waits till next year to trigger Article 50, by which time a recession could have moved popular opinion against Brexit, or alternatively, if a new election is called which becomes another defacto referendum on Brexit. It’s also possible that the UK does trigger Article 50, but then in negotiating with the rest of the EU concludes it doesn’t want to go.

While once triggered Article 50 supposedly means no going back, it’s likely that in this circumstance the EU will find a way to keep the UK in. All of this has a long way to play out though. Of course, the real issue for the global economy and investment markets is the impact on Europe and the risk of a domino effect of exiting Eurozone countries. But if Britain ultimately doesn’t leave, or leaving is demonstrated to be more trouble than remaining, then the risk of a domino effect will be much reduced.

But back to the present, in the Eurozone the main focus regarding post-Brexit risks in the past week relates to European – mostly Italian - banks. These have been weakened by years of slow growth, ultra-low interest rates and tighter regulatory conditions. These risks preceded Brexit, but the Brexit scare has refocused attention on them by pushing down bank share prices, which in turn, makes it harder for banks to raise capital. Italian banks are arguably most at risk with the Italian government wanting to recapitalise some of them, but the European Commission preferring a bail-in from creditors. Not recapitalising them risks slower bank lending, slower growth and higher unemployment and hence a greater risk of support for a move out of the Eurozone in countries like Italy. At this stage, we are a long way from this and some sort of muddle through solution will likely be found. But of course it won't stop investors worrying about it in the interim.

On the positive side of the equation, it's notable that Italian and Spanish bond yields remain around record lows, suggesting the threat of ECB intervention is working, the latest rise in the value of the $US and associated fall in the Chinese Renminbi has not been associated with the panic around capital outflows from China that we saw earlier this year, and commodity prices continue to hold up reasonably well which may be a good sign for global growth. But again, it's early days yet, and one risk worth keeping an eye on is that of a further rise in the $US. Ongoing upwards pressure on the $US is a real risk, given the risk of safe haven flows out of Europe at the same time that the US economy looks to be doing okay (as confirmed by strong June employment gains which suggests a much greater chance of a Fed hike this year than the 21% probability that the US money market is assigning). Another break higher in the $US would be bad for oil and other commodities, the emerging world, and the Chinese Renminbi.

In Australia, the Coalition will be returned to government. The issue of course is that the Senate is likely to be less friendly than over the last three years, which will mean the Coalition Government will have little chance of passing key aspects of this year’s Federal Budget including its company tax cuts (at least not for large companies), some of its superannuation changes and the still to be passed savings from the 2014 budget. The likelihood would be more slippage in the return to budget surplus. Serious economic reform looks off the agenda. 

Reflecting the risk of yet more budget slippage, its little surprise to see the ratings agencies getting tetchy, with Standard and Poors putting Australia’s sovereign rating on negative outlook. This of course does not mean a downgrade is inevitable, but with the new parliament “unlikely to legislate savings or revenue measures sufficient….for the budget deficit to narrow materially” [in the words of S&P], I would say that it’s probable. So far the financial markets have taken the move to negative outlook calmly perhaps because it has long been talked about. In theory, a ratings downgrade should mean higher interest rates as foreigners demand a higher yield on Federal debt and this flows through to state debt, banks, corporates and potentially to out of cycle mortgage rate hikes for households. In reality, this impact may be muted. The US in 2011 and the UK last week actually saw bond yields fall after ratings downgrades and many lower rated countries borrow more cheaply than Australia (eg, Italy and Spain). And in any case the RBA can still offset higher mortgage rates with another interest rate cut.

Rather the biggest concern about the threat to our AAA rating is what it tells us about policy making in Australia today. Australia worked hard reforming the economy after last being downgraded in 1986 and won a AAA rating back in 2002. Losing it again would signal we have become unable to control public spending, that we have lost our way to some degree after the hard work of the Hawke/Keating & Howard/Costello years.

Major global economic events and implications

US economic data was good, with a very strong rebound in June payroll employment, continuing low jobless claims and the ISM non-manufacturing index rising to a solid 56.5 in June. The June payroll employment gain of 287,000 more than makes up for the weak May gain. Abstracting from monthly noise, jobs growth averaged a solid 147,000 a month over the last three months telling us that the US economy is doing well. The Fed will probably still want to see more evidence that US growth has picked up sustainably and that global risks post Brexit are settling down, and so won’t be rushing to raise rates soon, particularly with wages growth remaining low. However, given the solid June payroll report, we remain of the view that the Fed will raise rates again this year, probably in December. The US money markets’ assessment of just a 21% chance of a Fed hike this year (up from 12% pre payrolls) is way too pessimistic and will likely move up, which in turn, will place upwards pressure on bond yields at some point by year end. 

Japan’s poor PMI readings, falling wages and a 20% rise in the Yen since last year’s high, add to pressure on the Bank of Japan. Expect BoJ easing and intervention to push the Yen down soon.

China’s services PMI improved in June, consistent with okay growth with services continuing to lead over manufacturing.

Australian economic events and implications

In Australia, the RBA opened the door to another rate cut, indicating that it was awaiting “further information” which is presumably a reference to June quarter inflation data later this month. We remain of the view that the RBA will cut rates again as the risks to inflation are on the downside, the risks to global and Australian growth are still on the downside (with Brexit and the messy Australian election not helping) and the $A is still too high. We are continuing to allow for two more 0.25% rate cuts this year, the first in August.

Australian data was on the soft side with a fall in building approvals and slowing momentum in retail sales, but ANZ job ads still pointing to reasonable jobs growth. National house price momentum slowed in June, but remains lopsided with strength in Sydney and Melbourne but four capitals seeing falls.

What to watch over the next week?

In the US, expect a modest gain in June retail sales, a slight improvement in industrial production and core CPI inflation around 2.2% year on year (all Friday). Alcoa will kick off June quarter earnings reports on Monday. The consensus sees a 5% decline in earnings year-on-year, but this will mark a rise on the March quarter, with a more stable $US and oil price helping.

Expect the Bank of England to ease monetary policy on Thursday.

In China, June quarter GDP is likely to show a softening in growth to 6.6% from 6.7% (Friday). However, the quarterly rate of growth is expected to perk up. Export and import data will also be released and data for industrial production, retail sales and investment may show a slight slowing.

In Australia, expect a fall in housing finance (Monday), little change in business conditions in the June NAB business survey (Tuesday), a small fall in consumer confidence (Wednesday) on the back of Brexit and election noise and a 10,000 gain in jobs, but a slight rise in unemployment to 5.8% (Thursday).

Outlook for markets

Brexit uncertainty, Italian bank risks, renewed $US strength and seasonal September quarter weakness could see more volatility in shares in the short term. However, beyond near-term uncertainties, we still see shares trending higher this year, helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Lower and lower bond yields point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks like Brexit. That said, the recent bond rally has taken bond yields to ridiculously low levels, leaving them at risk of a sharp snapback at some point. Renewed expectations for Fed tightening may be the driver.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and apartment prices get hit by oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane. 

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead. 

Eurozone shares gained 2.1% on Friday and the US S&P 500 rose 1.5% to around its record high. As a result of the strong global lead, ASX 200 futures rose 61 points or 1.2% pointing to a solid gain for the Australian share market when it opens on Monday.

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Will we see a post-election rally?

Monday, July 04, 2016

By Shane Oliver

Share markets rebounded over the past week as worries about Brexit leading to global financial and economic chaos faded. US shares rose 5.1%, Eurozone shares gained 3.9%, Japanese shares rose 4.9%, Chinese shares rose 2.5% and the Australian share market gained 2.6%. Despite ongoing political turmoil in the UK, the British share market surged 7.2% to its highest for the year helped by the plunging British pound and talk of Bank of England monetary easing. Bond yields continued to decline on lower for longer interest rate expectations but currency markets were a bit more stable (apart from the pound), credit spreads narrowed and commodity prices rose.

There have been several positive developments over the last week with respect to Brexit. Well maybe not for the UK, but in terms of the issue that really matters and that is the threat it poses to the rest of Europe and the global economy. First, the Spanish election actually saw support for the governing People’s Party increase with no gain for anti-establishment Podemos suggesting that the Brexit mayhem may have seen voters opt for stability. Of course, PM Rajoy’s People’s Party still has to form a coalition government but the prospects are much higher than after the December election.

Second, two clear messages emerged from the European Union leader’s summit in the last week: it is looking to learn the lessons from the UK’s exit to better serve its citizens and strengthen the EU; and it is taking a firm stance with the UK – there can be no access to the benefits of free trade with the EU without meeting the obligations (the free movement of people, adoption of EU rules and regulations and contributing to its budget). In other words, the UK will not be let off lightly which will send a strong signal to other potential exiteers. 

Third, policy makers around the world have continued to swing into action with the Bank of England foreshadowing monetary easing, talk that the ECB is considering expanding its bond purchases, fresh stimulus in Korea, another rate cut in Taiwan and more moves towards stimulus in Japan.

Fourth, bond yields in Spain and Italy have fallen sharply to new record lows indicating that so far investors are not demanding a higher premium to invest in such countries. The threat of ECB “whatever it takes” intervention to preserve the Euro is helping.

Finally, assets vulnerable to a rising $US have not crashed. In fact, oil has hung around $US50, copper is up and emerging market shares are OK. Credit spreads have not blown out. We don’t seem to be seeing a re-run of the January-February panic. 

Of course, the ride will remain rough for UK assets, although the British pound appears to be wearing the worst of that and it should be borne in mind that the UK is only 2.5% of global GDP. And uncertainty will remain regarding the risk of a domino effect of exits in the Eurozone - with the Italian Senate referendum in October and a re-run of the Austrian presidential election in September or October following a ruling by the Austrian Constitutional Court being the next big events to watch. But so far at least, the threat from Brexit to the Eurozone and the rest of the world looks to be constrained.

In Australia, the election is finally over but it looks like another three years of de facto minority government which is not a great outcome for the economy and investment markets. While the Coalition looks to be slightly ahead in the seat count so far, it looks very close and the outcome may not be known till Tuesday at the earliest. Even if the Coalition does win government, it won’t have control of the Senate with the balance of power remaining with the Greens and minority “parties” which will act as a huge constraint on the government, which means another de facto minority government, ie, more of the same. The end result will be poor prospects for getting government spending and the budget deficit under control over the next three years and for the Coalition implementing its policy to cut corporate taxes let alone undertaking serious productivity enhancing economic reforms. It looks next to impossible for a Coalition government to get enough votes to reinstate the Australian Building and Construction Commission.

Alternatively, if Labor wins it will likely mean faster public spending growth via more spending on health and education, partly funded by tax increases on higher income earners (retention of the budget deficit levy and cutbacks in access to negative gearing and the capital gains tax discount and superannuation savings similar to those of the Coalition, although the details haven’t been spelt out) but a higher budget deficit in the next few years, a royal commission into banking, and greater intervention in the economy.

The prospect of another three years of de facto minority government coming on the back of the minority Gillard/Rudd government over 2010-13 and the 2013-16 Coalition government’s inability to pass much of its economic and budget reform agenda through the Senate is not a good outcome for the Australian economy. Whoever wins, it means that the risk of a sovereign credit rating downgrade has increased further.

More broadly, the success of Labor's campaign offering more spending and higher taxes coming on the back of the Brexit outcome in the UK and the success of Trump and Sanders in the US adds to evidence that median voters are shifting to the left and away from the economic rationalist policies of deregulation, smaller government and globalisation. This is a negative for long-term growth prospects and an additional constraint on investment returns.

Over the 8 weeks since the election was called, Australian shares fell 0.6%. The next table shows that shares rose an average 4.8% over the 3 months after the last 12 Federal elections with 8 out of 12 seeing gains. Will we see a post-election rally over the next 3 months this time around? Relief at getting the election out of the way may help, but the unclear outcome with the likelihood of minority government and the failure of the new government to have control of the Senate, September quarter seasonal weakness in shares and Brexit uncertainty are likely to weigh in the short term, even though I see shares being higher by year end.

Major global economic events and implications

US economic data was good with a surprisingly solid increase in the June manufacturing conditions ISM index, good growth in consumer spending for the second month in a row in May, a rise in consumer confidence, continued gains in home prices, the June services PMI flat at 51.3 and continuing low jobless claims. While pending home sales and trade data were weaker than expected, March quarter GDP growth was revised up to 1.1% annualised and June quarter growth looks to have rebounded to around 3% annualised.

Eurozone economic sentiment fell only slightly in June and remains consistent with moderate growth and a pick-up in bank lending growth is a positive sign. Inflation rose slightly in June but remains low at 0.1% year-on-year for headline and 0.9% year-on-year for core.

Japanese jobs data for May remained strong, housing starts rose and the June quarter Tankan business conditions survey was little changed, but May data for household spending and industrial production were soft and core inflation slipped further to just 0.6% year-on-year, adding to pressure for more stimulus.

Chinese business conditions PMIs for June were little changed consistent with growth running around 6.5% to 7%.

Australian economic events and implications

In Australia, early indications of the impact of the Brexit outcome on confidence suggest little impact with the ANZ/Roy Morgan weekly consumer sentiment reading falling just 1.7% to a level still above its long term average and auction clearance rates remaining solid. Meanwhile, job vacancies fell over the 3 months to May but on an annual basis still point to solid jobs growth, private credit growth slowed in May with credit to property investors continuing to lose momentum and business lending slowing, home price growth slowed in June with four capital cities seeing price declines but Sydney and Melbourne remaining strong, new home sales fell in May and the AIG’s manufacturing PMI improved to an okay 51.8.

What to watch over the next week?

The week ahead will no doubt see bouts of Brexit related nervousness but it may continue to settle down in the absence of any new developments in Europe. In Australia we will see reaction to the election result, but if its more of the same then the impact will be minor.

In the US, June payroll employment (Friday) is likely to bounce back by 180,000 jobs after the disappointing May gain of 38,000 with unemployment remaining at 4.7% and wages growth running around 2.6% year-on-year. But given the threat to confidence and growth from Brexit it won’t be enough to signal an imminent Fed rate hike in July. It will help ease fears regarding US growth though. Meanwhile, expect the non-manufacturing conditions ISM for July to remain around an OK 52.9 but the May trade deficit to deteriorate a bit given preliminary goods trade data (both Wednesday). The minutes from the last Fed meeting (also Wednesday) are likely to be very dovish but are dated given the Brexit outcome.

Chinese CPI inflation (Sunday July 10) for June is likely to have remained around 2% year-on-year, but producer price deflation is likely to show a continued abatement.

In Australia, expect the RBA (Tuesday) to leave interest rates on hold for the second month in a row. Following its last meeting the RBA expressed a degree of comfort with current interest rate settings and while Brexit and Australian election related risks have added to the case for another rate cut at this stage the RBA is likely in wait and see mode. That said we still expect further easing this year with the August meeting providing a better opportunity to move as by then the risks flowing from Brexit and the Australian election will be clearer and we will have seen the June quarter inflation data.

In the meantime expect a sharp fall in May building approvals (Monday) after several months of strength and continued moderate growth in retail sales (Tuesday). ANZ job ads, the May trade deficit and the services PMI will also be released.

Outlook for markets

Brexit uncertainty and seasonal September quarter weakness could see more volatility in shares in the short term. The messy Australian election outcome is also likely to weigh on Australian shares in the short term. However, beyond near term uncertainties, we still see shares trending higher this year helped by relatively attractive valuations, very easy global monetary conditions and continuing moderate global economic growth. 

Lower and lower bond yields point to a soft medium-term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks like Brexit. That said, the recent bond rally has taken bond yields to ridiculously low levels leaving them at risk of a sharp snapback at some point.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane. 

Cash and bank deposits offer poor returns. 

The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows (as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value). The dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares gained 0.6% on Friday and the US S&P 500 rose 0.2% as Brexit related fears continued to recede. While ASX 200 futures rose 32 points or 0.6% following the positive global lead and rising commodity prices, this is likely to be more than offset by the messy Australian election outcome suggesting that Australian shares could see a modest fall at the open. Put simpl,y markets don’t like policy uncertainty and the election has delivered that. The election outcome and the prospect of a ratings downgrade could also push the $A down. 

 

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Keeping Brexit in perspective

Monday, June 27, 2016

The past week has been dominated by first the anticipation that Britain would vote to Remain within the EU that saw “risk on” in financial markets and shares rally followed by an abrupt move to “risk off” as the referendum saw the Leave vote win by 52% to 48%.

The vote to Leave poses risks: to the UK economy which will also face a period of political instability with PM Cameron to step down by October and pro-EU Scotland pushing for another independence referendum; to Eurozone stability over fears that some Eurozone countries may seek to follow the UK; and hence to global growth. It also threatens to add momentum to a move away from economic rationalist policies in favour of populism and a reversal of globalisation, which would be a negative for long term global growth.

Reflecting the worries about the impact on the UK and more significantly Europe financial markets reacted sharply in “risk off” fashion on Friday with the British pound (-8.1%), British shares (-3.1%), the Euro (-2.4%) and Eurozone shares (-8.6%) down sharply and this seeing global share markets down generally along with the Australian dollar. Safe haven assets such as bonds, the $US, Yen and gold have all benefitted. This could have further to go in the short term until some of the dust settles. A concern is that a rising $US in response to safe haven demand will weigh on the Renminbi (sparking new fears of capital outflows from China), commodity prices and emerging countries taking us back to the global growth fears we saw earlier this year.

However, it’s worth putting all of this in perspective. First the moves in some markets seen on Friday were exaggerated because the moves that occurred during the first four days of the last week when markets thought Remain would win had to be reversed. So, for example, while Eurozone shares fell 8.6% on Friday they only fell 2.6% over the last week. Over the week as a whole US shares lost 1.6%, Japanese shares lost 4.2%, Chinese shares fell 1.1% and Australian shares fell 1%. Bad but not monumental. Believe it or not the British share market actually rose 2% over the last week. While the British pound fell 8.1% on Friday it only fell 4.7% over the week as a whole and the $A actually rose 1% last week. It was similar with bonds and oil – big moves on Friday but only modest moves over the week

Second, Britain has only started down a process to exit and has a long way to go yet. It will first need a new PM then later this year formally notify its intent to exit which will then kick off a negotiation process that will then take up to two years to complete. This will determine the ultimate impact on the UK economy – either it will retain free trade access to the EU but have to continue to allow the free movement of people, agree to EU rules and regulations and contribute to its budget or forgo free trade altogether. At this stage its hard to see which way this will go. But the point is that for some time the UK will still be in the EU. 

Third, while the Brexit vote will likely trigger a guessing game as to which Eurozone country will try and follow its lead and ask for a similar referendum it’s doubtful that Eurozone countries will actually seek to leave because the hurdle to leave the Eurozone is higher than Britain leaving the EU as it will mean adopting a new currency, paying higher interest rates, etc. Just think of Greece despite its woes over the last few years consistently deciding to stay in the Eurozone. Countries to watch though are Italy following the recent success in municipal elections of the Eurosceptic Five Star Movement and maybe Spain given the success of Podemos.

Fourth, the Brexit vote is unlikely to be akin to a Lehman moment because conditions are radically different. Lehman came after a long period of global strength and a credit boom where liabilities and exposures were opaque. That is not the case now and Brexit has been talked about endlessly so is not the surprise Lehman was.

Finally, central banks have quickly adopted a “whatever is necessary” stance to provide liquidity to markets and support their economies, notably the Bank of England which is already providing £250bn. The ECB is monitoring the situation but its liquidity measures (eg. TLTRO) are probably more than enough at present. The more important point is that global monetary policy will remain easier for longer. The Fed certainly will be slowed further in raising rates because it won’t want to put more upwards pressure on the $US which is being boosted by safe haven demand. A G7 Statement decrying excessive currency volatility has arguably given Japan close to a green light to intervene to stop the Yen rising much further. Expect more BoJ easing soon which should help Japanese shares.

I am not so confident about British assets given the long period of uncertainty the UK will now face both economically and politically. However, the global bout of “risk off” underway is likely to provide a buying opportunity as Europe is likely to hang together, global monetary policy is likely to be even easier than previously thought and the global economy is likely to continue to see modest growth.

Given that only 2.7% of Australian exports go to the UK and that the Leave victory is unlikely to plunge Europe into an immediate recession the main impact on Australia will be on financial markets. This could affect short term confidence and may add to the case for the RBA to cut interest rates again particularly if banks increase their mortgage rates out of cycle due to higher funding costs flowing from an increase in lender caution. That said we expect the RBA to cut rates again anyway and a falling $A will continue to provide a shock absorber for the Australian economy. Overall, Brexit barely changes the risk of recession in Australia which remains low.

The key for investors is to either look through the short term noise caused by the Brexit decision or look for investment opportunities that it throws up as investment markets become oversold.

Just finally on Europe, the last week saw the German constitutional court approve the validity of the ECB's Outright Monetary Transaction (OMT) program, which partly underpins Draghi's 2012 commitment to do "whatever it takes" to preserve the Euro. This is a big relief because its rejection would have put a cloud over the ECB’s ability to respond to any turmoil in peripheral bond markets that may flow from the Brexit vote.

Now on to other things!

In Australia, the big event in the week ahead will be the Federal election (Saturday). Each side of politics is offering very different visions for the size of government:

Labor is focused on spending more on health and education and in the process allowing the size of the public sector to increase, funded by tax increases on higher income earners (retention of the budget deficit levy and cutbacks in access to negative gearing, the capital gains tax discount and superannuation). The ALP would also undertake a royal commission into banking and intervention in the economy is likely to be higher than under a Coalition government.

By contrast the Coalition is focused more on containing spending, and encouraging economic growth via company tax cuts and mild reforms. Despite the Coalition’s tilt to “fairness” with its super reforms it’s committed to keeping taxes down. It does plan to reinstate the Australian Building & Construction Commission but even with the double dissolution election it’s unclear whether it will get enough votes to do this.

At this stage the polls suggest the Australian election is too close to call. But it’s a big ask to see the ALP become the first opposition in 85 years to regain government after just one term as it will need to win 19 seats. As such betting agencies have the Coalition as favourite. However, the big issue may be what happens in the Senate with there being a good chance that the Greens and minority “parties” control the balance of power again acting as a huge constraint on the government, which would mean another de facto minority government, ie more of the same. Which in turn mean poor prospects for getting government spending under control over the next three years and for implementing serious productivity enhancing economic reforms.

Over the 7 weeks since the election was called the Australian share market has fallen 3.1%. The next table shows that 8 out of 12 elections since 1983 saw shares up 3 months later with an average gain of 4.8%. This may partly reflect relief at getting the election out of the way.

Australian shares before and after elections

Major global economic events and implications

Fed Chair Janet Yellen’s congressional testimony didn’t really add much. The key is that the Fed is “proceeding cautiously” to give it time to assess whether the US economy and inflation is on track with its expectations and given global uncertainties. Uncertainty and market turmoil flowing from the Brexit outcome is likely to further delay the Fed in terms of raising rates again.

US economic data was mostly good. While durable goods orders were weak, the June manufacturing PMI rose, home prices rose, home sales were strong, jobless claims fell sharply and home prices continue to rise. And the US’s top 33 banks passed a Fed stress test indicating that they have enough capital to withstand a severe economic shock (involving unemployment doubling to 10%.) In other words they are in good shape to withstand any shock flowing from Brexit.

The Eurozone composite business conditions PMI fell slightly in June with a decline in services (on Brexit fears?) offsetting a gain in manufacturing. It remains at a level consistent with moderate growth though.

Japan’s manufacturing conditions PMI rose just 0.1pt to a still weak 47.8 in June indicating that growth in June quarter is still struggling.

A couple of Chinese business conditions surveys moved in opposite directions for June with one up solidly and a small business PMI weakening. So bit of a wash there.

Australian economic events and implications

In Australia, the minutes from the last RBA Board meeting added little that was new with the RBA neutral and on the sidelines for now. However, our view remains that lower inflation and a too high $A on ongoing Fed delays will still see more easing ahead with the next cut likely in August.

Meanwhile Australian economic data over the last week was uneventful. March quarter house prices fell slightly according to the ABS but more timely private sector data suggests a renewed pick up since then particularly in Sydney. While population growth has slowed from its 2% peak late last decade to 1.4% last year it’s still contributing to solid underlying demand for housing.

NSW and Victoria are the top states for population growth, and flowing partly from this house price growth. Which in turn partly explains the good state of their budgets. Finally, skilled vacancies continue to see reasonable growth telling us that the labour market remains solid.

What to watch over the next week?

The focus in the week ahead will no doubt see continued reaction to the Brexit referendum, particularly given an EU leaders’ summit on Tuesday and Wednesday.

In the US, expect to see a further gain in home prices and a slight rise in consumer confidence (Tuesday), solid growth in personal spending and a slight rise in the core private consumption deflator to 1.7% for the year to May, but a slight fall in pending home sales (all Wednesday) and a slight rise in the ISM manufacturing conditions index (Friday) to around 51.5 (Friday).

In the Eurozone expect bank lending (Monday) and economic confidence readings for June (Wednesday) to remain around levels consistent with continued moderate economic growth. Core inflation data for June (Thursday and unemployment data (both Friday) will also be released. The outcome of the Spanish election on Sunday may also add to short term uncertainties regarding the Eurozone.

In Japan, expect a slight fall in industrial production (Thursday), a deterioration in the June quarter Tankan survey reflecting the recent earthquake and continued softness in household spending but the jobs market (all Friday) is likely to remain solid helped by the falling workforce. Core inflation (also Friday) is expected to fall to 0.6% yoy in May.

In Australia, apart from Saturday’s election, expect the trend in new home sales (Wednesday) to remain modestly down, ABS job vacancies for the 3 months to May to rise consistent with monthly vacancy data and continued moderate credit growth (Thursday) and a slight softening in home price momentum in June (Friday) according to CoreLogic. The AIG’s manufacturing conditions PMI (Friday) will also be released.

Outlook for markets

The aftermath of the Brexit vote could see more volatility in shares in the short term. However, beyond near term uncertainties, we still see shares trending higher this year helped by relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth.

Lower and lower bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks like Brexit. That said, the recent bond rally has taken bond yields to ridiculously low levels leaving them at risk of a sharp snapback at some point.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane.

Cash and bank deposits offer poor returns.

While the Brexit outcome knocked the $A lower, it’s still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares lost 8.6% on Friday night and the US S&P 500 lost 3.6% in response to the Brexit vote. However, since the Australian share market largely responded to the Brexit outcome on Friday, ASX 200 futures actually rose 3 points or 0.1% indicating a basically flat start to trade for the Australian share market on Monday.

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Is the Brexit frenzy justified?

Monday, June 20, 2016

By Shane Oliver

The past week has been dominated by Brexit worries which pushed down most share markets and combined with a very dovish US Federal Reserve, pushed bond yields down as well. US shares fell 1.2%, Eurozone shares lost 2.4%, Japanese shares were also hit by the absence of further Bank of Japan monetary easing and fell 6%, Chinese shares lost 1.7% and Australian shares fell 3.7%. The fall in bond yields saw German 10-year yields fall briefly below zero for the first time and Australian 10-year bond yields fall briefly below 2% to a new record low. Commodity prices were mixed with oil down but metals up a bit. The Australian dollar was little changed.  

Source: Global Financial Data, AMP Capital

Why the Brexit frenzy and is it justified? The Brexit vote (Thursday) is fast approaching and nervousness in financial markets has been building over the last few weeks, particularly as the Leave campaign – focussing on the more emotive topic of immigration - has been showing a lead over Remain. The agitation in financial markets reflects two things. First, concern about the impact of Brexit on the UK economy via reduced trade access to the EU, its financial sector and labour mobility (which has been estimated at somewhere around -2% of UK GDP) and this has been weighing on UK assets, notably the British pound. But Britain ain’t what it used to be (eg it only takes 2.7% of Australia’s exports). The real concern globally is that a Brexit could lead to renewed worries about the durability of the Euro to the extent that it may encourage moves by Eurozone countries to exit the EU and Eurozone which in turn, could reignite concerns about the credit worthiness of debt issued by peripheral countries and lead to a flight to safety out of the Euro into the $US which could put renewed pressure on emerging market currencies, the Renminbi and commodity prices. And then we are back in the turmoil we saw earlier this year! 

However, with Eurozone shares falling 8% in the last few weeks, it could be getting overdone. If Remain wins then recent market moves should reverse with the British pound and Eurozone shares likely to bounce particularly sharply. If Brexit wins there could be more to go in the short term (ie shares down, bond yields down, British pound and Euro down and $US, Yen and gold up) but this will likely prove to be a buying opportunity in relation to European and global shares as Europe is likely to hang together as it did through its sovereign debt crisis. The hurdle for a Spain, an Italy or a France to leave the Eurozone is much higher than for the UK to leave the EU as they would end up with a depreciated currency and higher debt costs. Just think of Greece which despite all its woes consistently wants to stay in the Eurozone. In fact, support generally remains high for the Euro. It would probably also be the case that Europe would ultimately be better off without Britain as it would remove a brake on greater integration.

Will Brexit happen? While the polls have been moving in favour of the Leave campaign, I still lean to a Remain outcome: undecided voters are likely to favour the status quo, telephone polls which were more accurate in last year’s UK election still favour Remain and the murder of a pro Remain British politician by a mad Brexiteer may swing support back to Remain. 

Meanwhile, the Fed remains on hold and very dovish. It revised growth forecasts down fractionally to 2% for this year and next and slightly upgraded its inflation forecasts but it was a bit less positive on the US jobs market. More significantly the so-called "dot plot" showing expectations of the 17 Fed meeting participants for the Fed Funds rate still sees two hikes this year but six members now see only one hike this year (up from just one in March). The "dot plot" also lowered the profile for interest rates in the years ahead once again in the direction of already lower market expectations. See the next chart. Short of a big rebound in June payroll employment I can't see the Fed moving before September at the earliest. The key is that the Fed remains cautious and is allowing for global risks. Market expectations for a Fed rate hike this year now look too dovish (just 38% chance of a hike by December), but the key is that the Fed is not going to knowingly do anything that threatens the US or global growth outlook. 

Source: US Federal Reserve, AMP Capital

As if there isn’t enough to worry about, the terror threat loomed its head again with a horrible attack in Orlando. This appears to have more in common with the Sydney Lindt Café attack with another nutcase, but it doesn’t annul the horrible loss of life. Investment markets appear to be getting desensitised to terror attacks because if they don’t damage economic infrastructure, they are unlikely to have much financial impact. The Orlando attack has played into the hands of Donald Trump though.

Major global economic events and implications

US data remains consistent with a modest rebound in June quarter GDP growth. Industrial production was soft in May but manufacturing conditions in the New York and Philadelphia regions bounced back, the NAHB home builders’ conditions index rose and housing starts were stronger than expected, US retail sales rose strongly in May for the second month in a row and jobless claims remain low. The Atlanta Fed's GDPNow growth tracker is pointing to GDP growth of 2.8% annualised this quarter. Meanwhile, core CPI inflation was 2.2% year-on-year in May which is consistent with the Fed’s preferred measure of inflation slowly heading back to its 2% target.

The Bank of Japan disappointed yet again, but with inflation well below target, shaky growth and the Yen now rising to a 12-month high, pressure remains for additional quantitative easing which we still see being delivered, perhaps in July.

Chinese data for May was mixed with slowing growth in investment but stable growth in retail sales and industrialist production. Combined with stronger exports and stable business conditions PMIs growth looks to be tracking sideways at 6.5-7% but policy looks like it will have to remain stimulatory.

Australian economic events and implications

Australian data remains consistent with okay economic growth with business conditions remaining solid in May, consumer sentiment holding onto most of the rate cut related bounce in May and employment up solidly in May, with unemployment remaining unchanged at 5.7%. However, there are some concerns with business confidence down in May, full time employment growth remaining weak and labour market underutilisation as measured by unemployment and underemployment rising to a high 14.2% which will maintain downwards pressure on wages growth. So while growth looks okay, there is nothing here to prevent further monetary easing.

What to watch over the next week?

The focus in the week ahead will no doubt be on the Brexit vote (Thursday). Since polling stations won’t close until 10pm UK time on Thursday night, we may not get a clear indication as to the outcome until 7am the next day (around 4pm Friday in Sydney). If it’s a very close vote, it could take longer.  

The latest Spanish election (June 26) will also be watched closely. While opinion polls point to a stronger performance from left wing Podemos, following its alliance with a far left party, they also indicate neither a centre-left or centre-right coalition are likely to achieve a majority. The outcome may continue to be a minority centre-right government which won’t reverse the economic reforms of recent years, but will be constrained in what it can do. Fortunately most of the heavy lifting on Spanish economic reforms has already been done.

The German constitutional court will deliver its final ruling on the validity of the ECB's Outright Monetary Transaction program (Tuesday) which partly underpins Draghi's 2012 commitment to do "whatever it takes" to preserve the Euro.

In the US, the highlight will likely be Fed Chair Yellen’s Congressional Testimony (Wednesday) which is likely to repeat that the Fed remains dovish and cautious in raising rates. On the data front, expect a further gain in home prices and a rise in existing home sales (both Wednesday), but a fall back in new home sales and the June manufacturing conditions PMI to be around 50.5 (both Thursday) and underlying durable goods orders to show modest growth (Friday).

In the Eurozone, consumer confidence and business conditions PMIs (Thursday) will be released.

In Australia, the minutes from the RBA’s last meeting (Tuesday) will be watched for any guidance around the outlook for interest rates. On the data front expect ABS data to show a 1% gain in March quarter home prices (also Tuesday).

Outlook for markets

Short term event risk – the Brexit vote, Spanish election, Australian election, US Republican and Democrat party conventions - could drive continued short-term share market volatility. However, beyond near-term uncertainties, we still see shares trending higher this year, helped by relatively attractive valuations, ultra easy global monetary conditions and continuing moderate global economic growth. 

Lower and lower bond yields point to a soft to medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation. That said, the recent bond rally has taken bond yields to ridiculously low levels, leaving them at risk of a sharp snapback.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

Capital city dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to toughening lending standards and pockets of oversupply. Prices are likely to continue to fall in Perth and Darwin, but price growth may be picking up in Brisbane. 

Cash and bank deposits offer poor returns. 

A bounce from oversold levels and Fed rate hike delays are clearly supporting the Aussie dollar in the short term. But the longer term downtrend looks likely to continue, as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, commodity prices remain in a secular downswing and the dollar sees its usual undershoot of fair value. The dollar is still likely to fall to around $US0.60 in the years ahead.

Eurozone shares rose 1.2% on Friday as Brexit fears receded a bit, but the US S&P 500 fell 0.3% led down by technology and health care shares. ASX 200 futures were unchanged, pointing to a flat start to trade for Australian shares on Monday.

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