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

Where will markets head this week?

Monday, December 01, 2014

By Shane Oliver

What to watch over the next week?

In the US, expect continued solid readings for the ISM manufacturing conditions index (Monday) and non-manufacturing conditions index (Wednesday), although the former might fall a bit from the very high reading seen in October, and another solid gain in November payrolls (Friday) of around 230,000 with unemployment unchanged at 5.8%. Signs that the stronger jobs market is feeding through to stronger wages growth will also be looked for in wage earnings data to be released Friday.

In Europe, all eyes will be on the ECB meeting (Thursday), where there is some chance that its QE asset purchase program will be widened to include corporate bonds. Recent comments from President Draghi suggest this is likely but the timing of the announcement is unclear because the ECB may prefer to wait to see how its next Targeted Long-Term Refinancing Operations (TLTRO) auction of cheap bank financing goes on December 11. Either way it’s just a matter of timing. Final PMI readings for December (due Monday and Wednesday) will be watched for any signs of upwards revision after the soft readings initially reported.

China's official manufacturing PMI for November is likely to soften a bit consistent with the softer HSBC flash PMI already reported. Note though it’s just gyrating up and down in the same range it’s been in for a few years now.

In Australia, the Reserve Bank (Tuesday) is likely to yet again leave interest rates on hold at 2.5%. Speeches by various RBA officials, including Governor Stevens, since the last meeting indicate a high degree of comfort with rates remaining at current low levels as the $A is still too high, growth remains sub-par and inflation benign. The accompanying statement is likely to repeat that a "period of stability" remains prudent for interest rates. This will mark the 17th month of rates at 2.5%, which is still less than the previous record of 20 months when rates were flat at 7.5% between December 1994 and July 1996, However, the record is likely to be surpassed early next year. Our assessment is that rates will be on hold well into the second half of 2015, and that in the near term the risks are skewed towards another rate cut.

On the data front, the highlight is likely to be September quarter GDP growth (Wednesday) which is likely to show that growth remains just below trend at 0.7% quarter on quarter (or 3.1% year on year) supported by solid contributions from consumer spending and trade, but weak readings for construction activity. Meanwhile, expect modest gains to be reported in November house prices (Monday), a bounce back in building approvals for October (Tuesday), a weak gain in October retail sales (Thursday) and another sizeable trade deficit (Thursday).

Outlook for markets
Shares are well placed to see gains into year end and through next year as the cyclical bull market that started in 2011 remains alive and well. November and December are both seasonally strong months for US and global shares as we run into the “Santa rally”, and seasonal strength in Australian shares usually commences in December. More fundamentally: valuations particularly against the reality of low bond yields are good; monetary policy is set to remain easy with QE in Europe and Japan and rate cuts in China replacing QE in the US, and rate hikes in the US and Australia being a long way off; and investor sentiment is far from euphoric. Australian shares are likely to remain a relative laggard though as commodity price weakness continues to impact, but the positive global lead, Chinese monetary easing and the lower Aussie dollar should help push the ASX 200 up into year end and through next year.

Low bond yields will likely mean soft medium term returns from government bonds. That said, in a world of too much saving, spare capacity and low inflation it’s hard to get too bearish on bonds.

The Australian dollar is likely to head even lower over the year ahead with the US dollar trending up, weak commodity prices and the Aussie dollar still too high given Australia’s high cost base. $US 0.75-0.80 is likely to be seen in the next year or so. A relatively greater fall in the Aussie/US dollar rate is necessary as the Aussie is unlikely to fall much against the Yen and Euro given their monetary stimulus programs.

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Investment markets and key developments

Monday, November 10, 2014

Shares were mixed over the last week with US shares up 0.7%, Japanese shares up 2.8% and Australian shares up 0.4% helped along by continuing reaction to the increased stimulus out of Japan, good profit results in the US, the Republican win in the US Congress and very dovish comments from the ECB but European shares fell 1.1% and Chinese shares fell 0.1%. Bond yields were little changed. Meanwhile, the $US had another leg up and this weighed on commodity prices and the $A which fell to its lowest level since 2010.

Republican control of the US House and now the Senate following the midterm elections is a positive for the US and US assets. While the knee jerk reaction has been that this means "gridlock" in Washington, our view is the exact opposite given that: the Senate Democrats who had actually been a road block for Obama are now side lined, the Tea Party influence on the Republicans was weakened last year (as they were seen as to blame for the Government shutdown), both sides will want to appear constructive ahead of the 2016 Presidential election and President Obama will want to leave a positive legacy.

This all points to Washington being less of a negative ahead with deals likely on government funding, the debt ceiling (necessary early next year), corporate tax reform and trade. On the debt ceiling (which currently needs to be raised by March next year) Mitch McConnell the new Senate leader has said there will be "no government shutdowns and no default".

No doubt in the ongoing search for something to worry about the rising trend in the $US and its implications for US shares will soon be on the list. The direct impact from a rising $US is negative for US company earnings as something like 40% of US earnings are sourced offshore. A rising $US will also be a source of ongoing downwards pressure on commodity prices and it has the potential to create problems for some emerging countries given the risk of capital flight with South America being most at risk here.

However, there are several counters. First, after a 30% or so fall since 2002, so far the $US has really just had a flick off the bottom. Second, to the extent a rising $US is a defacto monetary tightening it could delay the timing of the first Fed rate hike and/or the amount by which rates go up. And thirdly, it’s largely going up because the US is relatively strong and this strength is boosting US earnings (much like the rise in the $A last decade was associated with relative strength in Australia and the Australian share market at the time, until of course the $A ultimately ended up going too far). So I don’t see a rising $US as being a major problem, at least not until it goes a lot further.

In Australia, there were no surprises from the RBA which left interest rates at a record low for the 16th month in a row and provided no early warning of any imminent change by retaining its comments that a "period of stability in interest rates" remains prudent. Given that the RBA continues to project sub-trend growth and benign inflation in its quarterly Statement of Monetary Policy a rate hike remains a long way off, probably not till mid next year at the earliest. This is particularly so if the RBA proceeds with credit controls to slow lending to investors for housing as it will remove the one argument supporting a rate hike, ie house price strength.

A risk worth keeping an eye on is Ukraine, where escalating clashes indicate the ceasefire is unravelling.

Major global economic events and implications

US economic data continues to paint a picture of solid, but not booming growth. On the one hand, September data shows a wider than expected trade deficit and weak construction activity pointing to a downwards revision to September quarter GDP growth from 3.5% to 3%.

On the other hand, various business conditions PMIs and ISM indexes for October remain consistent with solid growth and October payroll data showed good but not booming jobs growth. While unemployment fell slightly to 5.8% indicating the labour market is continuing to tighten, wages growth remains low with hourly earnings up just 0.1% in the month or 2% year on year. The October jobs data does nothing to change expectations the Fed won’t start raising rates till mid 2015.

September quarter earnings results for US companies have been impressive. The reporting season is now 90% done with 80% of companies beating on earnings (compared to a norm of 63%) and 60% beating on sales. Earnings growth is running around 10% year on year, which is 5% better than expected a month ago.

In the Eurozone, the clear message from the Eurozone is that it is unanimously behind President Draghi’s target of boosting the ECB’s balance sheet to its 2012 high which implies QE to the tune of €1 trillion and that it is looking into further measures to be implemented if necessary.

Going by President Draghi’s comments the latter will be deployed if current measures are not enough (eg, to meet the QE target) or if the risk of deflation continues to rise. Either would likely mean an expansion in its asset purchases to include corporate debt and maybe public debt. The bottom line is that the ECB is serious about its QE program and the ongoing tension between Draghi and the Bundesbank looks to have been smoothed over.

Chinese economic data for October was mixed but remains consistent with growth around 7% to 7.5%. Official PMIs eased fractionally and import growth slowed to around 5% year on year, but the latter was in line with expectations and export growth came in a bit stronger than expected at 11.6% year on year. House prices continued to fall in October but at a slower rate.

Australian economic events and implications

Australian economic data painted a mixed picture. On the weak side the AIG's services sector conditions PMI fell in October and September building approvals fell, although the latter was due to normally volatile unit approvals. But against this the AIG's manufacturing conditions PMI rose in October, retail sales rose strongly in September and national house prices rose strongly in October albeit with gains concentrated in Sydney and Melbourne and several cities seeing price falls.

October jobs data provided a messy read with decent jobs growth after two weak months but not enough to stop a continued rising trend in unemployment to now 6.2%. The good news for the jobs market though is that forward looking labour market indicators like ANZ job ads point to somewhat stronger jobs growth ahead consistent with a possible peak in the unemployment rate in the first half of 2015.

The September trade data was also a bit confusing with another blowout in the deficit not helped by strong imports and weak commodity prices, but strong export volumes point to a strong 0.7 percentage point contribution to September quarter GDP growth from trade. Finally the TD Securities Inflation Gauge for October shows that inflation remains low. Overall the Australian economy continues to muddle along. Certainly not the disaster that some have long been predicting.

What to watch over the next week?

In the US, expect to see retail sales for October (Friday) bounce back from soft sales in the previous month. Consumer sentiment (also Friday) and data for small business optimism will also be released (Tuesday).

In the Eurozone, September quarter GDP growth (Friday) is expected to be around 0.2% quarter on quarter after flat June quarter growth. This would be more in line with PMIs and confidence readings but is still very subdued. Data for industrial production (Wednesday) will also be released.

Chinese data for October is expected to show that CPI inflation (Monday) remains weak at around 1.6% year on year and that industrial production, retail sales and fixed asset investment (all due Thursday) are yet to show any acceleration in growth but rather remain consistent with GDP growth of around 7% to 7.5%. The case for further monetary easing in China remains strong.

In Australia, expect to see a modest rise in September housing finance (Monday), another solid rise in the ABS house price index (Tuesday) of around 2% for the September quarter but with Sydney and Melbourne remaining the key drivers, continued relatively subdued reads for the NAB survey’s business conditions and confidence measures (also Tuesday) and for consumer confidence (Wednesday) and wages growth remaining very weak (Wednesday) at around 2.6% year on year. Given RBA concerns that the housing market has become to frothy, the proportion of loans going to investors will be the main focus in Monday’s housing finance data.

Outlook for markets

With the September/October correction letting off a bit of steam, shares are well placed to see gains into year-end as the cyclical bull market that started in 2011 remains alive and well. Valuations particularly against the reality of low bond yields are good, monetary policy is set to remain easy with QE in Europe and Japan replacing that in the US and rate hikes in the US and Australia being a long way off, and investor sentiment remains cautious, which is positive from a contrarian perspective.

Australian shares will benefit from the positive global lead and will also benefit from the lower Australian dollar. My year end guesstimate of 5800 for the ASX 200 remains a bit of a stretch but it’s not out of the ball park.

Low bond yields will likely mean soft medium term returns from government bonds. That said, in a world of too much saving, spare capacity and low inflation it’s hard to get too bearish on bonds.

After a brief consolidation around the $US0.87-88 level the $A has broken through support at $US0.8640, resuming its downtrend. With the $US on the up, commodity prices on the slide and the $A still too high given Australia’s relative high cost base the trend remains down.

My target for the next year or so has been $US0.80 but I am considering revising that down to $US0.75 which is right where purchasing power parity would put it at present. A relatively greater fall in the $A/$US rate is also necessary to get the trade weighted $A down given weakness also being seen in the Yen and Euro.

European shares fell 1% on Friday, but the US S&P 500 was unchanged in the face of a fairly neutral October jobs report that showed a further fall in unemployment but less than expected jobs growth and continued low wages growth. As a result, ASX 200 futures were little changed on Friday night with just a 3 point, or 0.1% fall, pointing to a flat to slightly down start to trade for the Australian share market on Monday.

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Weekly economic and market update

Monday, October 20, 2014

by Shane Oliver

Investment markets and key developments over the past week

Global shares had another rough week on worries about global growth and as the Ebola scare continued to build. Despite a rally in US and European shares on Friday most share markets fell with US shares down 1 per cent for the week, European shares down 0.8 per cent, Japanese shares down 6.1 per cent and Chinese shares down 1.4 per cent. However, Australian shares having led on the way down managed to rise over the last week as investors started to look for bargains. 8 per cent yields on Australian banks are hard to resist. Global shares are now down 7.4 per cent from their September high and Australian shares are down 6.8 per cent, although this has been pared from an 8.9 per cent decline to the low on Monday. Bond yields continued to slide on global growth fears and on the back of safe haven buying. Commodity prices remained under selling pressure but the Australian dollar rose slightly as the US dollar pulled back a bit on talk that the Fed may delay the end of QE and/or rate hikes.

While doom and gloom is now rife, there are some signs that shares may be at or close to a low: the 8.4 per cent (September top to recent low) correction in global shares is around the size of the average correction seen since the current bull market began in 2011; in fact US and Australian shares have had a healthy correction of nearly 10 per cent top to bottom using intraday data; markets that led on the way down like Australian shares and US small caps have been clawing back in the last few days; the last few sessions have seen US and Australian shares rebound from intraday lows suggesting that bulls may be starting to get the upper hand; investor sentiment is now so bad that its good – with our composite measure of investor sentiment in the US having fallen to levels often associated with share market lows (see chart below at left); and the month of October is known for seeing shares start to turn back up after seasonal weakness ahead of a rally into year-end (chart at right). And from a fundamental perspective the fall in share markets has seen shares move well into cheap territory (with the forward PE on Australian shares at around 13.7 times being well below its long term average) and lower bond yields also adding to the relative cheapness of shares.
 


 

The Fed may delay ending QE and rate hikes. Various Fed officials have added to the message that the Fed will allow for the impact of softer global growth and the stronger US dollar and that it may result in a delay to rate hikes. I suspect that they might now get pushed into the September quarter next year. Two Fed officials even referred to possibility of more quantitative easing or a delay to the end of the current program if needed to head off falling inflation expectations. Fed President Bullard’s comments regarding extending QE are particularly significant because he often provides a lead on where the Fed is heading. The key is that the Fed is not on a pre-set path towards monetary tightening and there is now a good chance that QE will not end this month.

In Australia, RBA Assistant Governor Guy Debelle reiterated the view that the Australian dollar is still too high and the RBA’s concerns about the potential for financial market volatility and in particular warning of a potential “violent” sell off in fixed income markets if the outlook for low interest rates changes. Of course the latter was taken out of context by the media in referring to financial markets generally - as they say bad news sells! At this stage though there is no sign of any end to the low interest rate environment. Yes we are getting the volatility, but bonds are rallying as global growth is yet again disappointing pushing out any eventual global monetary tightening/higher interest rates. More broadly central banks and the IMF need to be very careful in what they wish for here. In providing monetary stimulus a key aim was that investors take on more risk thereby spreading easier monetary conditions through the economy and facilitating economic recovery. Warnings to the effect that we are now seeing unsustainable bubbles (I don’t see many), frothy markets and the risk of violent sell-offs to the extent it adds to investor panic risks undoing all they have sought to achieve over the last few years.

The risk around Ebola is clearly continuing to increase with more cases in the US after botched medical protocols. Our base case remains that it should be easier to control its spread in the US and in other western countries given modern medical facilities and higher hygiene standards and as such it will remain largely contained to Africa but with short term bouts of share market volatility around Ebola scares. But recent events in the US suggest that the risks have gone up. As we saw in Hong Kong and Singapore with SARS the main threat is to consumer confidence and hence to spending. So far US consumer confidence appears to have been little affected but it’s worth keeping an eye on.

Major global economic events and implications

US economic data was mixed with retail sales falling more than expected in September, albeit after a strong August, manufacturing conditions deteriorating in the New York region, small business confidence down slightly and home builder conditions falling, but against this jobless claims fell, industrial production rose strongly, manufacturing conditions in the Philadelphia region remained strong, housing starts and permits rose and consumer confidence rose despite share market falls and Ebola fears. Weak producer price inflation highlighted the risk that US inflation will continue to undershoot the Fed’s 2 per cent inflation objective. There was some very good news with the budget deficit in fiscal 2014 falling to 2.8 per cent of GDP (lower than Australia’s budget deficit!) which is well down from its 10 per cent peak in 2009. It’s also noteworthy that falling mortgage rates and gasoline prices are set to provide a boost to household finances.

It’s still early days in the US reporting season for September quarter profits but so far so good. Of the 82 S&P 500 companies to have reported so far, 77 per cent have beaten earnings expectations (against a norm of 63 per cent) and 58 per cent have beaten on sales. Profit growth for the quarter is likely to come in at 10 per cent year on year, roughly double current market expectations.

Eurozone data was mostly soft with industrial production down in August and the ZEW survey of investment analyst confidence falling sharply in October. German unemployment fell to 6 per cent though providing some positive news along with a rise in car sales in September.

Chinese credit growth continued to slow, albeit remaining solid, but money supply growth picked up marginally and trade data provided positive news with much stronger than expected growth in exports and imports for September. Inflation data was also weaker than expected with CPI inflation at its lowest in more than four years and the annual rate of decline in producer prices accelerating. Quite clearly China is operating well below its potential adding to global deflationary risks and there’s significant potential for rate cuts.

India also saw good news on the inflation front with both consumer and whole sale price inflation falling sharply suggesting the next move by the Reserve Bank of India will be a rate cut. That global interest rates are still going down, not up was highlighted by a cut in Korea’s policy rate to 2 per cent from 2.25 per cent.

Australian economic events and implications

Australian economic data was somewhat subdued with a fall back in business conditions and confidence to below average levels (albeit at least up on last year’s lows) and only a modest rise in consumer confidence in October leaving it below average levels too. Dwelling commencements also fell in the June quarter but after two very strong quarters and with building approvals pointing to a rebound in the September quarter. Dwelling starts are running around 180,000 pa which is in line with underlying demand after many years of shortfalls.

What to watch over the next week?

In the US, September inflation data (Wednesday) is likely to remain benign with inflation falling to 1.6 per cent year on year adding to the lack of pressure on the Fed to eventually raise interest rates. Meanwhile existing home sales (Tuesday) and house prices (Thursday) are expected to show modest gains, but expect new home sales (Friday) to reverse some of the 18 per cent gain seen in August. Markit’s manufacturing conditions PMI (Thursday) is expected to have remained strong, albeit falling slightly from 57.5. The flow of September quarter earnings results will ramp up.

In the Eurozone, Markit’s business conditions PMIs are expected to remain down on the highs seen in July continuing to raise concerns about a loss of momentum in growth. The main focus though will likely be on the start of ECB quantitative easing and the October 26th release of the ECB’s much anticipated bank Asset Quality Review and Stress Tests. This will assess the adequacy of 130 Eurozone banks’ capital levels against both baseline and adverse scenarios and those that fail will be given 6 to 9 months to boost their capital ratios. Some failures are possible but mainly for unlisted and mutual banks, but not many of the major listed banks are likely to fail given pre-emptive capital raisings (€75bn since 2013) and conservative lending practices in the lead up to this review. In fact, just as occurred with the Fed’s stress test of US banks in 2009 it could prove to be a watershed event that helps restore confidence in Eurozone banks and clears the way for more bank lending.

Chinese activity data for September (Tuesday) is expected to show a bounce in industrial production to 7.5 per cent year on year growth from 6.9 per cent, but a further slight loss of momentum for retail sales and fixed asset investment. Stronger exports are likely to have helped support GDP growth but not enough to prevent a further slight slowing to around 7.2 per cent year on year. The HSBC flash manufacturing PMI for October (Thursday) is likely to have remained around the 50 suggesting relatively stable growth.

In Australia, the focus will be on September quarter inflation data (Wednesday) and a speech by RBA Governor Stevens (Thursday). September quarter inflation is likely to be benign helped by lower petrol and fruit & vegetable prices and the removal of the carbon tax. Expect headline inflation of 0.4 per cent quarter on quarter and 2.2 per cent year on year and underlying inflation of 0.5 per cent quarter on quarter and 2.6 per cent year on year. RBA Governor Steven’s speech will be watched for any updated comments on the outlook for interest rates but he is likely to retain the on hold with a dovish tone evident in the RBA’s last post meeting statement. The minutes from the last meeting (Tuesday) and speeches by RBA officials Kent and Lowe will also be watched closely but are all unlikely to signal any deviation from the RBA’s “period of stability” stance on interest rates.

Outlook for markets

Our assessment remains that recent falls in shares represent a correction and not the start of a new bear market. Share valuations have now pushed well into cheap territory (the forward PE on Australian shares has fallen from 14.8 times to 13.7 times), the global growth outlook remains for okay growth (“not too hot, but not too cold”), monetary conditions globally and in Australia look like they will remain very easy with Europe and Japan filling the quantitative easing gap that will be left by the US and US rate hikes looking even further away and investor sentiment is now very bearish again which is positive from a contrarian perspective.

The lower Australian dollar will also help boost growth in Australia and eventually profits. So for these reasons the correction should be seen as providing a buying opportunity.

October is often a month where market falls come to an end ahead of a Santa Claus rally into year end and I expect to see the same happen this year. Seeing the ECB’s bank stress test results and the ECB start up its QE program (both of which will occur in the next week) are likely to help in this regard.

Low bond yields will likely mean soft medium term returns from government bonds. That said, in a world of too much saving, spare capacity and low inflation it’s hard to get too bearish on bonds.

In the short term the Australian dollar has fallen too far too fast (just as the US dollar has risen too far to fast), so a short covering bounce could well emerge. That said the broad trend in the Australian dollar is likely to remain down reflecting soft commodity prices, the likelihood the Fed hikes interest rates before the RBA and the relatively high cost base in Australia. Expect to see it fall to around US dollar0.80 in the next year or so.

Eurozone shares gained 3.1 per cent on Friday and the US S&P 500 rose 1.3 per cent helped by a combination of good economic data, solid US earnings reports and confirmation that the ECB will soon start up its program of buying asset backed securities, or private QE, within days. The positive global lead saw ASX futures rise 68 points or 1.3 per cent suggesting that the rebound in Australian shares will continue on Monday.


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Global currency gyrations and the Australian dollar

Thursday, October 16, 2014

by Shane Oliver

The past month has seen a sharp fall in the value of the Australian dollar from around US dollar 0.94 to a low of near US dollar 0.86. While there will be short term gyrations, the broad trend in the Australian dollar likely remains down. This is part of a bigger global shift involving a stronger US dollar.

A secular upswing in the US dollar

Not only has the Australian dollar fallen sharply against the US dollar recently but so too have currencies such as the Euro and Yen. The chart below shows the value of the US dollar against a trade weighted basket of major currencies.

The US dollar has been tracing out a broad bottom since 2008.

This is likely part of a broader long term or secular pattern:

During the second half of the 1990s the US dollar surged in value as the US was seen as a global growth and innovation leader.

During last decade from 2002 the US dollar traced out a broad decline as emerging market countries were much stronger.

But since the GFC the US dollar seems to be bottoming. Our assessment is that the secular downtrend in the US dollar since 2002 is now over and that it will now trend higher.

Because the US was proactive in dealing with the GFC its economy is now on a sounder footing globally and, like in the 1990s, it’s becoming something of a growth locomotive again.

The Fed will soon end its quantitative easing program and may start to raise interest rates next year.

But there is no end in sight for the Bank of Japan’s bigger money printing program and the European Central Bank is about to embark on its own QE program this month. Neither is even contemplating raising interest rates.

While China is still strong its pace of growth has slowed with its own structural issues and pressure on the

People’s Bank of China to ease monetary policy. What’s more the bulk of the rise in the Renminbi is likely behind us.

The emerging world is now beset by various structural problems which will possibly constrain their growth. All of this points to a longer term upswing in the US dollar. This has a number of implications including less pressure on the Fed to raise rates as a rising US dollar is a de-facto monetary tightening (so lower US interest rates for even longer) and downwards pressure on commodity prices. In many ways it looks like we could be seeing a re-run of the second half of the 1990s which saw the US as the world’s locomotive, a strong US dollar, weak commodity prices, benign inflation, relatively low interest rates and strong gains in US shares

A secular downswing in commodity prices

Just as the US dollar appears to be embarking on a long term upswing, commodity prices look to be in a long term down swing. In fact they are related as there are two drivers of the trend in commodity prices:

Supply and demand. Last decade demand for industrial commodities was surging led by industrialisation in China as supply (after years of commodity weakness) struggled to catch up. Now it’s the other way around as demand growth in China while still strong has slowed (accentuated by a cyclical downturn in property related demand) and supply is surging after record investment in in sources for everything from coal and iron ore to gas.

The value of the US dollar. Since commodities are priced in US dollars they move with it. They rose last decade when the US dollar was in decline and are now heading down as the US dollar is on the way up. As can be seen in the next chart raw material prices trace out roughly 10 year long term upswings followed by 10 to 20 year long term bear markets. After an upswing last decade, they now look to be embarking on a secular downtrend.

..and a secular downswing in the Australian dollar

Against this backdrop the big picture outlook for the Australian dollar is not flash. First, it’s best to start with what economists call purchasing power parity, according to which exchange rates should equilibrate the price of a basket of goods and services across countries. A guide to this is shown below which shows the Australian dollar/US dollar rate (against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia since 1900.

Purchasing power parity doesn’t work for extended periods. But, it does provide a guide to where exchange rates are headed over long periods of time. Right now on this measure the Australian dollar is still 15-20 per cent overvalued, with fair value around US dollar 0.75. This also lines up with anecdotes of high prices and labour costs in Australia compared to other countries.

Second, as already noted, commodity prices are in a secular downswing. This is highlighted by the iron ore price which a decade ago was around $US 20/tonne rose to $US 180/tonne in 2011 and has since fallen back to around $US 80/tonne.

Third, while Australian interest rates are still above those in the US and elsewhere the gap has narrowed. Moreover the Fed in the US is soon to end its monetary stimulus program and is likely to start raising interest rates well ahead of the RBA.

Fourthly, perceptions of global investors about the Australian dollar appear to be changing. Over much of the last decade it was positive reflecting Australia’s favourable fundamentals tied to growth in the emerging world and more latterly as an AAA rated safe haven. Now there is a bit more wariness as emerging markets have gone out of favour and if Australia fails to get its budget deficit under control (with Senate blockages and the fall in the iron ore price likely to result in another deterioration in the next MYEFO budget outlook due later this year) foreign perceptions could deteriorate further.

Finally, as already discussed the trend in the US dollar is likely to be up.

In the short term, the Australian dollar has fallen a bit too far too fast (just as the US dollar has risen too far to fast), so a short covering bounce could well emerge over the next month or so. Indeed the Australian dollar seems to be finding support around US dollar 0.8640.

However, for the reasons noted above the broad trend in the Australian dollar is likely to remain down. I remain of the view that it will fall to around US dollar0.80 in the next year or so as the Fed eventually starts to raise interest rates, with the risk of an overshoot on the downside.

Of course it’s worth noting that the fall in the Australian dollar on a trade weighted basis won’t be as pronounced as against the US dollar as major currencies like the Yen and Euro are also likely to fall against the US dollar.

Implications for investors

There are a several implications for investors. First, the fall in the Australian dollar back towards more fundamentally justified levels is good for the Australian economy and ultimately the local share market. When the Australian dollar is in free-fall it is often bad news for the Australian share market as foreign investors retreat to the sidelines for fear of losing more of their money. But after a while the lower Australian dollar will become a source of support for the market as it flows through to upwards revisions to earnings expectations. A rough rule of thumb is that each 10 per cent fall in the value of the Australian dollar boosts company earnings by 3 per cent. Providing the downtrend in the Australian dollar remains gradual the negative impact from the boost to inflation flowing from higher import prices should remain modest.

Second, and perhaps more significantly, the outlook for a continuing downtrend in the value of the Australian dollar highlights the case for Australian based investors to have a relatively greater exposure to offshore assets that are not hedged back to Australian dollars (ie remain exposed to foreign currencies) than was the case say a decade ago when the Australian dollar was in a strong rising trend. Put simply, a declining Australian dollar boosts the value of an investment in offshore asset denominated in foreign currency 1 for 1. Eg a 10 per cent fall in the value of the Australian dollar will boost a foreign share portfolio by 10 per cent in value in Australian dollar terms.

Finally, the longer term downtrend in commodity prices also works in favour of having a relatively greater exposure to traditional global shares as the US, Europe and Japan are commodity users and tend to benefit from softer commodity prices whereas it’s a headwind for the Australian economy.

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Australian house prices – a bit too hot in parts

Thursday, September 25, 2014

Key points

  • The Australian housing sector is doing its part in helping the economy rebalance as mining investment slows.
  • Thanks largely to a persistent undersupply of new homes, Australian housing remains overvalued. Negative gearing, foreign and SMSF buying are just a sideshow to the supply shortage.
  • The home buyer market is still not seeing the bubble conditions of a decade ago, but the market is too hot in parts and the risks have grown. Expect increasing jawboning from the RBA with a rising likelihood of credit growth restrictions for investors if it doesn’t slow soon.
  • The medium term return outlook for residential property is likely to be very constrained.

Introduction

As the mining investment boom deflates, in order for Australia to rebalance its economy, a pick-up in demand for homes and house prices in response to lower interest rates, sending a signal to home builders to build more homes was essential. Fortunately, it’s occurred. The RBA (belatedly in my view) got rates down, home buyers returned, home prices rose and we are now in the midst of a dwelling construction boom. The housing sector is doing its part!

But it seems that there is nothing that gets Australians going more than what’s happening with house prices. Are they in a bubble? Is negative gearing to blame? Or is it foreign buying? Will it burst? Should the Reserve Bank slow it down? Is housing a good investment? This note looks at the current state of play in the Australian residential property market.

Australian housing remains overvalued

Australian housing remains overvalued on most measures. But then again this has been an issue for more than a decade. For example, while a bit more extreme than my own view at the time, the OECD estimated that Australian house prices in 2004 were 51.8 per cent overvalued. This compared to just 1.8 per cent for US housing and 32.8 per cent for the UK. While real house price weakness through 2010 to 2012 saw the degree of overvaluation diminish, the problem is returning with a vengeance:

According to the 2014 Demographia Housing Affordability Survey the median multiple of house prices to household income in Australia is 5.5 times versus 3.4 in the US.

On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average, Australian houses are 30 per cent overvalued and units 17 per cent overvalued.

The ratios of house prices to incomes and rents in Australia are 23.5 per cent and 40.9 per cent above their long term averages respectively, which is at the higher end of OECD countries. This contrasts with the US, which is near the lower end in the OECD.

What’s to blame for high house prices?

There are two main drivers of the surge in house prices over the last two decades. The first was the shift to low interest rates. Lower rates enabled Australian’s to borrow more for a given level of income and so pay each other more for homes. As can be seen the shift in house prices from below trend to above (as derived from the last chart) has gone hand in hand with an increase in the ratio of household debt to income.

The trouble is that the shift to low interest rates occurred in many other countries and most did not have anywhere near the surge in house prices or household debt Australia had, implying a heavy speculative element in driving prices higher as well. I have long thought this surge in household debt and relative house prices represents Australia’s Achilles’ heal. Should anything go wrong with the ability of households toservice their debt Australia would be at risk. Fortunately it’s hard to see the trigger for this in anything but a small way.

The second reason is a lack of supply. While the US saw a property price surge into 2006 matched by a supply surge, supply in Australia has been subdued due to restrictive land supply policies and high stamp duty and infrastructure charges. The National Housing Supply Council estimated a few years ago that since 2001 Australia had a cumulative net shortfall of over 200,000 dwellings. Reflecting this, residential vacancy rates remain relatively low.

Given the supply shortfall, most of the scapegoats that various commentators have come up with to explain high home prices are a sideshow. Foreign and SMSF buying is no doubt playing a role in some areas but looks to be small. Negative gearing is more contentious, but it’s likely that curtailing access to it when stamp duty remains very high will have a negative impact on the supply of property to the extent that it will have the effect of reducing the after tax return to property investment. Restricting negative gearing for property would also distort the investment market as it would still be available for other investments.

Rising risks

Our assessment is that the Australian property market is not at the bubble extreme it was at a decade ago: the overvaluation is a bit more modest; annual housing credit growth for owner occupiers and investors is running at around one third the pace seen in 2003; Australians don’t seem to be using their houses as ATMs against which debt can be drawn suggesting they are less comfortable regarding the outlook and debt; and the home price gains now have been over a shorter period and are concentrated in just Sydney & Melbourne. However, danger signs are emerging:

After a cooler period during the first half of the year the property market seems to be hotting up again. National average home prices rose at an annualised 16.8 per cent pace over the 3 months to August according to RP Data and auction clearance rates are at or above last year’s highs.

The proportion of housing finance commitments going to investors is now back to around the 50 per cent high seen a decade ago, suggesting that the market is becoming more speculative. And there are signs that home buyers are starting to extrapolate recent strong price gains into the future which is very dangerous.

Finally, The Block is back on top as the most watched show on TV highlighting a return to very strong community interest in the property market. Taken together these indicators warn that the housing market is getting a bit too hot.

Policy implications

The heat in the home buyer market is clearly starting to concern the Reserve Bank with its Financial Stability Review indicating that it’s becoming concerned about speculative activity in the property market and the risks this poses to the broader economy when the property cycle eventually turns down.

Normally with the property market hotting up the RBA would start to think about raising interest rates but right now it’s loath to do this given uncertainty regarding the rest of the economy and the risk a rate hike would put upwards pressure on the still too high $A.

As a result APRA is more closely monitoring the banks and the RBA and APRA are now discussing steps that could be taken to ensure sound lending practices are maintained with a focus on investors. The latter would involve the use of macro-prudential controls to slow the housing market – which is really just a fancy term for the old fashioned credit rationing that used to be applied prior to the 1980s.

This could involve limits on loan to valuation ratios, forcing banks to put aside more capital or forcing banks to impose tougher tests when granting loans. Such approaches all have problems: they tend to work against first home buyers; if they target investors as looks likely they work against a group of lower risk borrowers; people can start to find their way around them; and their impact is hard to gauge.

The best approach is for the RBA to first ramp up its efforts to warn home buyers of the need to be cautious. But if that fails in quickly cooling the property market, expect an announcement from APRA and the RBA on lending restrictions likely targeting investors in the next few months.

Housing as an investment

Notwithstanding the rising risk of macro prudential controls, in the short term further gains in house prices are likely until the RBA starts to raise interest rates probably around mid next year, soon after which another 5 to 10 per cent property price down cycle is likely to start.

Beyond the short term it’s worth noting residential property has provided a similar long term return as Australian shares, with both returning around 11 to 11.5 per cent pa since the 1920s.

They are also complimentary to each in terms of risk and liquidity and are lowly correlated. All of which means there is a case for investors to have exposure to both.

At present though, housing looks somewhat less attractive as a medium term investment. The gross rental yield on housing is around 3.2 per cent and for units is around 4.4 per cent giving an average of just 3.8 per cent. After costs this is just below 2 per cent. Shares and commercial property both offer much higher yields.

Medium term capital growth is also likely to be limited, with the overvaluation likely to see real house prices stuck in a 10 per cent or so range around a broadly flat trend. This is consistent with the 10-20 year pattern of alternating secular bull and bear phases evident in the second chart in this note. Taken together this suggests that a realistic expectation for total returns from residential property over the medium term is just around 4 to 5 per cent pa.

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The latest Ebola outbreak – implications for investors

Tuesday, August 19, 2014

by Shane Oliver

  • The worst Ebola outbreak to date in Africa and fears it will spread is leading to some concerns of a global pandemic. 
  • So far there has been little impact on global share markets but if the number of cases continues to rise with more signs of transmission to western countries then nervousness could increase. 
  • While there is reason for concern, the experience with SARS, bird flu and swine flu highlight that worst case pandemic fears don’t usually come to pass. The key for investors is to be alert, but not alarmed. 

Introduction

The last few weeks have seen a range of factors causing volatility in investment markets including concerns that the Fed might start to raise interest rates earlier than expected, worries about the lack of strength in Europe, Russian trade sanctions and the conflicts in Ukraine, Iraq and the Middle East. In the background have also been concerns about the worsening Ebola outbreak in West Africa with the risk it could cause a global pandemic. This has been heightened after the World Health Organisation (WHO) declared the outbreak an “international public health emergency”.

While this is first and foremost a human crisis, understandably there is some concern this could turn into a global pandemic scare first affecting travel related stocks but then having a broader economic impact. That said, recent experiences with SARS, bird flu and swine flu highlight that worst case pandemic fears don’t always eventuate.

Some background on Ebola

Here is a summary of information regarding Ebola: 

  • Ebola virus disease affects humans and other primates. Flu like symptoms appear two days to three weeks after infection and then move on to nausea, vomiting and diarrhoea and reduced function of the liver and kidneys and bleeding. The mortality rate is around 60 to 65%. 
  • Since the disease was first identified in 1976, there have been several outbreaks which usually start with human contact with an infected animal’s body fluids. Transmission between humans occurs via contact with an infected person’s body fluids. Airborne transmission has not been observed. As a result the potential for widespread transmission is considered to be low. 
  • Large scale epidemics have mainly taken place in poor isolated areas of Africa lacking in modern medical support and poor hygiene. 
  • No vaccine is available and treatment usually involves supporting the patient and the administration of medications to control bleeding and prevent secondary infections but the scale of the latest outbreak appears to have helped clear the way of use of unproven drugs. 

  • Prevention includes wearing protective clothing around patients, isolating them and quarantining affected areas. 
  • The 2014 outbreak is the worst to date affecting Guinea, Sierra Leone, Liberia and Nigeria. As of August 13 there were 2127 cases and 1145 deaths although this likely understates the true position.
  • On August 8 WHO declared the latest Ebola epidemic to be an “international public health emergency” which has the effect of mobilising global resources to combat it. 
  • Cordoning off affected areas and border closures (eg, Liberia) and screening measures are now becoming common. Flights to affected areas are being suspended. 

Past experiences

To provide some context it is worth reviewing past pandemics – both real and feared. There were three influenza pandemics in the last century: 1918-19, 1957 and 1968. The 1957 and 1968 pandemics are estimated to have killed up to 4 million people. However, the 1918 Spanish flu pandemic was the most severe. While the mortality rate was low, up to 50 million people died worldwide. With a big proportion of the population staying at home, economic activity was severely disrupted, although this was compounded by the ending of World War I. US industrial production slumped 18% between March 1918 and March 1919. Australian real GDP slumped 5.5% in 1919-20 (but then rebounded 13.6% in 1920-21). The share market impact is hard to discern given the volatility associated with the ending of WWI, however US and Australian share markets rose through much of the pandemic period.

The SARS outbreak of 2003 is perhaps a more useful guide. After emerging in China around February 2003, SARS infected about 8000 people (mostly in Asia) in 30 countries over a five month period and had a mortality rate of about 10%. While the number infected was not that great, SARS had a big negative impact on the countries most affected as people stayed home for fear of catching it. GDP in Hong Kong and Singapore slumped by over 2% in the June quarter of 2003 as retail sales fell, workers stayed home and travel dried up. Growth then subsequently rebounded. 

Reflecting SARS, Asian shares fell in April 2003, even though global shares started to move out of a three year bear market from March. The April 2003 low in Asian shares coincided with signs the number of new cases was peaking, and this was well ahead of the economic recovery.

Most pandemics have taken six to 18 months to run their course and usually peter out as measures are taken to slow their spread (eg, hygiene, quarantining, banning gatherings, preventing travel). SARS ended quicker due to the nature of the virus and rapid action by authorities.

In 2005 and early 2006, there was significant concern that a severe strain of bird flu (called H5N1), which was resulting in human casualties, mainly in parts of Asia where people had contact with chickens, would mutate into a form that was readily transmissible between humans. However, this didn’t really eventuate and as such the economic impact was modest although it did cause bouts of volatility in share markets in 2005 and early 2006.

Similarly concern that the spread of swine flu would become a global pandemic rattled share markets for a while around April 2009 but quickly faded. The WHO was subsequently criticised for becoming too alarmist as it had declared the outbreak a “public health emergency.”

The economic and financial impact

The severity of the latest Ebola outbreak tells us there is reason for concern, but history tells us it might all come to nothing. Given the range of possibilities, the best way to get a handle on the economic and investment market impact of Ebola is to consider several scenarios. We suggest three.

1. Containment to Africa – the number of cases continues to rise for a few months but it remains mainly contained to West Africa.

  • The global economic impact would be minor as the affected countries are of minor global economic significance. 
  • There might be bouts of share market nervousness (particularly airline stocks), but these would be limited. 

2. Spread globally but contained – a significant number of Ebola cases appear in western countries from travellers returning from Africa but quick action by health authorities contains the outbreak to, say, a few thousand cases and there is no widespread transmission in western countries. 

  • News of cases popping up in western countries would cause significant uncertainty which might have a small negative impact on economic activity. The travel industry is most likely to be affected (much as occurred with SARS) as people stop travelling and there may also be some effect on economic activity as people avoid crowds. But the impact should be small and short-lived. 
  • Share markets are likely to fall on news of a spread to western countries but the fall is likely to be limited to a normal correction after which markets would rebound. 

3. Global pandemic – Ebola spreads globally turning into a global pandemic, against which available medicine has little initial impact and attempts at containment are unsuccessful resulting in millions of deaths. 

  • This scenario would see a major negative impact on economic activity. Global travel would virtually cease. Many would simply not come into work – a reasonable estimate is around 20% of workers, although this might be spread over time. This would see a sharp slump in GDP and the onset of a global recession. Australia would not be immune. 
  • Share markets would likely fall sharply – maybe by 20% or so - reflecting the huge economic and profit uncertainty. Cash would be the place to be for investors. 
  • However, if history is any guide economic activity would rebound quickly once it’s clear the pandemic is under control. Share markets are likely to anticipate this and rebound even as economic conditions remain bleak. 

Conclusion

While there is reason for concern and it is easy to dream up nightmare scenarios, the experience with SARS, the pandemonium over bird flu with “predictions” it could kill as many as 150 million people and the mini panic regarding swine flu (for a while I always packed Tamiflu when travelling overseas!) tell us that the worst case fears of pandemics usually don’t come to pass. Hopefully the same will apply to the latest Ebola outbreak. It is not easily transmissible and should be more easy to contain if it makes its way to western countries with modern medical facilities and higher standards (and ease of) hygiene.

As such, our base case scenario (with 90% probability) is that Ebola remains essentially contained to Africa. This suggests that while there might be a bit of short term volatility around Ebola scares there is unlikely to be a major impact on share markets. However, since the risk is not insignificant it will be necessary for investors to keep a close eye on how the latest outbreak develops. The key for investors at this stage is to be alert, but not alarmed.

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Why I love dividends and you should too

Wednesday, August 13, 2014

by Shane Oliver

  • Dividends are great for investors as decent dividends augur well for earnings growth, they provide a degree of security in uncertain and volatile times, they are likely to comprise a relatively high proportion of returns going forward and they provide a relatively stable and attractive source of income. 
  • If dividends are allowed for the value of an investment in Australian shares has surpassed its 2007 record high. 
  • It’s important that dividend imputation is retained in Australia to ensure dividends are not taxed twice and companies continue to pay out decent dividends. 

Introduction

Up until the 1950s most share investors were long term investors who bought stocks for their dividend income. This changed in the 1960s as bond yields rose on the back of inflation and investors started to shift focus to capital growth. However, thanks to the volatility seen over the last decade or so, and an increased focus on investment income as baby boomers retire, interest in dividends has been on the rise. Investor demand for dividends is clearly evident in Australia with even the big resource stocks starting to heed the call. This is a good thing because dividends are good for investors in more ways than just the income they provide. 

It’s well-known Australian companies pay out a high proportion of earnings as dividends. This is currently 75 per cent, and it’s averaged around this since the late 1980s. Banks, telcos, consumer stocks and utilities are the big dividend payers. By contrast in the major global markets dividend payout ratios range from 31 per cent in Japan to 49 per cent in the UK. 

However, some argue that dividends are irrelevant and simply don’t matter as investors should be indifferent as to whether an investment pays a dividend, or whether the company retains earnings that are reinvested to drive earnings growth. Or worse still, some argue that high dividend pay outs are a sign of poor long term growth prospects or that they are not sustainable. And of course, some just see dividends as boring relative to the excitement that can come from speculating on moves in share values. My assessment is far more favourable.

Dividends are cool

There are lots of reasons to love dividends and here they are. First, dividends do matter in terms of returns from shares. For the US share market it has been found that higher dividend pay outs lead to higher (not lower) earnings growth*. This is illustrated in the next chart which shows that for the period since 1946 whenever US companies have paid out a high proportion of earnings as dividends (the horizontal axis) this has tended to be associated with higher growth in corporate profits (after inflation) over the subsequent 10 years (vertical axis).

And of course higher growth in company profits contributes to higher returns from shares over the long term. This all suggests dividends do matter & the higher the better (within reason). There are several reasons why this is the case:

  • when companies retain a high proportion of earnings there is a tendency for poor investments which subsequently leads to poor earnings growth; 
  • high dividend pay outs are indicative of corporate confidence about future earnings (otherwise companies would not feel comfortable in paying them); 
  • high dividend pay outs are a positive sign as they indicate earnings are real, ie backed by cash flow. 

The bottom line is that strong dividend pay outs are more likely to be consistent with strong, not weak, earnings growth. The higher dividend yield and pay out ratios for Australian companies, compared to mainstream global share markets, is a positive sign for relative returns from the Australian share market on a medium term basis – particularly at a time when the boost to national income from the terms of trade is going in reverse.

Secondly, concerns about the sustainability of dividends fly in the face of all the evidence that companies like to manage dividend expectations smoothly. They rarely raise the level of dividends if they think it will be unsustainable. As can be seen below, dividends move roughly in line with earnings but are a bit smoother. For an investor this means the flow of dividend income is relatively smooth. 

Thirdly, decent dividend yields provide security during uncertain times. As can be seen in the next chart dividends provide a stable contribution to the total return from shares over time, compared to the year-to-year volatility in capital gains. Of the 11.8 per cent p.a. total return from Australian shares since 1900, just over half has been from dividends.

Fourthly, investor demand for stocks paying decent dividends will be supported over the years ahead as more baby boomers retire and focus on income generation.

Fifthly, with the scope for capital growth from shares diminished thanks to relatively high price to earnings ratios compared to 30 years ago, dividends will comprise a much higher proportion of total equity returns than was the case in the 1980s and 1990s globally and in Australian shares up until 2007. Around half of the total return from Australian shares over the next 5 to 10 years is likely to come from dividends, once allowance is made for franking credits.

Finally, and for some most importantly, dividends provide good income. Grossed up for franking credits the annual income flow from dividends on Australian shares is currently around 5.7 per cent. That’s $5700 a year on a $100,000 investment in shares compared to $3500 a year on the same investment in term deposits (assuming a term deposit rate of 3.5 per cent).

Another angle on dividend income

The next chart illustrates just how powerful investing for dividend income (without even really trying) can be relative to investing for income from bank term deposits. It compares initial $100,000 investments in Australian shares and one year term deposits in December 1979. The term deposit would still be worth $100,000 (red line) and last year would have paid $4,150 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1,054,000 (blue line) and would have paid $45,000 in dividends before franking credits (blue bars). This would translate to around $59,650 if franking credits are allowed for. The reason for the difference is over time an investment in shares tends to rise in value, whereas an investment in term deposits is fixed.

 

New highs

Finally, while we all bemoan the fact that Australian shares are still trading around 20 per cent below their 2007 all-time high, once reinvested dividends are allowed for (ie looking at the ASX 200 accumulation index) the Australian share market is now above its all-time high. In other words an investor who (god forbid) put all their money into the market at the peak in 2007 would now be in the black if they had reinvested dividends along the way.

 

Why dividend imputation is important

Which brings us to the topic of dividend imputation. This arrangement was introduced in the 1980s and allows Australians to claim a credit for tax already paid on their dividends in the hands of companies as corporate earnings and effectively boosts the average dividend yield on Australian shares by around 1.5 percentage points. However, in recent times it has been subject to some questioning with the interim report of the Financial System Inquiry questioning whether dividend imputation was creating a bias to invest in domestic equities and adversely affecting the development of the corporate bond market. Meanwhile, some such as Treasury argue that it along with other tax concessions (like negative gearing) primarily benefit the rich.

The trouble is that dividend imputation actually corrects a bias by removing the double taxation of earnings – once in the hands of companies and again in the hands of investors. It also encourages corporates to give decent dividends to shareholders as opposed to irrationally hoarding earnings. Interest on corporate debt never suffered from double taxation as it is paid out of pre-tax corporate earnings. And all such concessions encourage savings in the face of Australia’s relatively high marginal tax rates. The removal of dividend imputation would not only reintroduce a bias against equities but substantially cut into the retirement savings and income of Australian investors, discourage savings and lead to lower returns from Australian shares. So hopefully common sense will prevail and dividend imputation will not be tampered with.

Concluding comments

Dividends are often overlooked. But they provide a great contribution to returns, a degree of protection during bear markets and a great income flow. Investors should always allow for them in their investment decisions.

See R.D.Arnott and C.S.Asness, “Surprise! Higher Dividends = Higher Earnings Growth”, Financial Analysts Journal, Jan/Feb 2003. Of course it’s become a bit complicated for US shares in recent times as the tax system effectively encourages companies to return capital to investors as buy backs as opposed to dividends, which might be argued to be the same thing.

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Investment markets and key developments over the past week

Friday, August 01, 2014

by Shane Oliver

Global shares had a poor week with a range of issues reportedly weighing with more sanctions on Russia and worries about the Fed, earnings, Banco Espírito Santo and Argentina's "default”. This dragged down global shares for July by 1 per cent. While Australian shares got hit on Friday it came after a very strong month with the ASX 200 up 4.4%. The risk off move by investors weighed on the euro and $A, commodities were mixed with oil down but metals up and bond yields actually rose in the US and Australia.

Many of the reasons reportedly unnerving investors look to reflect isolated instances rather than systemic problems, ie more like an excuse for a correction: Banco Espirito Santo’s situation is not indicative of other Eurozone banks; Argentina’s problems are well known and its “default” reflects a problem with a hedge fund rather than broader emerging market debt problems; tougher sanctions for Russia will harm it a lot more than the West with Russia unlikely to cut off gas supplies to Europe given the long term damage it will do to what is a key export earner for it; and overall US earnings reports have been very strong.

That said, having not had a decent pullback since January/February US shares (and hence global shares) have become vulnerable to a correction and this may be it. We are also in the weakest quarter of the year for shares seasonally and worries regarding the Fed may be with us for a while yet. However, the absence of investor euphoria, reasonable valuations, easy global monetary conditions and the improving economic outlook suggest that what we are seeing is just a correction, not the start of a major bear market.

While the Fed will remain an ongoing source of investor nervousness as the case for a rate hike gradually builds, there were no surprises from the Fed’s latest meeting. As expected the Fed announced another $US10bn cut its in quantitative easing program and it now sees less risk of too low inflation and recognises the stronger labour market. However, it still sees significant labour market slack and has not changed its assessment that the Fed Funds rate will remain in its current range for a considerable period after the end of QE. Expect to see a gradual hawkish shift over time, but no rate hike till around mid-2015.

The justification for tax concessions in Australia - such as negative gearing, the capital gains tax discount, dividend imputation, superannuation - seems to be a hot topic these days. The often put arguments for their removal/curtailment are that the rich get the greatest advantage from them and it would help balance the Budget. Such views are frequently put by Treasury, which, according to Paul Keating, has long hated them. However, the arguments working the other way are more powerful. First, many of the tax concessions are fundamentally justified: negative gearing just allows for the legitimate costs of investing; dividend imputation removes the double taxation of dividends and puts shares on an equal footing with other Australian assets; and superannuation concessions encourage savings for retirement and helps provide patient capital. Second, that they are used so much by the rich is a reflection of Australia's very high marginal tax rate and the fact that it cuts in at a relatively low income level. Cut the reliance on income tax for revenue and the top marginal tax rates, and the desire to minimise tax via concessions will fall. Removing or curtailing the concessions without cutting income tax rates will just reduce savings and incentive which will work against Australia's long term growth potential.

Major global economic events and implications

US economic data confirmed growth has rebounded. June quarter GDP growth rose at a stronger than expected 4 per cent annualised pace after a 2.1 per cent contraction in the March quarter, consumer confidence rose to its highest since October 2007, the Markit services sector PMI remained very strong and jobs data remains solid. However, the US economy is a long way from booming – inventory accumulation contributed 1.7 percentage points to June quarter GDP growth and housing indicators have been a bit mixed. So the recovery continues but I can understand why the Fed is a bit reticent about getting too hawkish. While employment costs rose more than expected in the June quarter, they are still up just 2 per cent year on year which is stuck in the same range as the last few years. So not a lot of inflation pressure here.

Meanwhile, US June quarter earnings results remain strong. 75 per cent of the S&P 500 has now reported with 76 per cent beating on earnings (against a norm of 63 per cent), 66 per cent beating on sales and earnings growth for the quarter now running around 10 per cent year on year, which is about 5 percentage points above expectations.

In the Eurozone, economic confidence drifted slightly higher in July consistent with ongoing economic recovery and the unemployment rate continued to drift down to 11.5 per cent, from a high of 12 per cent. That said inflation has fallen to a new cyclical low of just 0.4 per cent year on year highlighting the need for easy monetary policy.

Japanese data was mixed. Industrial production fell much more than expected in June and the unemployment rate rose slightly but against this real household spending rose more than expected in June, small business confidence rose and the ratio of job openings to applicants rose to its highest since 2002.

China’s official manufacturing PMI rose further in July adding to confidence that growth is improving.

Australian economic events and implications

Australian data provided a mixed but ok picture. On the downside a sharp fall in export prices saw the terms of trade resume its slide in the June quarter, resulting in an ongoing headwind to nominal growth and national income. Against this though, while building approvals fell in June, the level remains strong, new home sales rose in June, house prices continue to rise albeit at a more moderate pace than through the last half of last year, the AIG’s manufacturing PMI rose again in July and a weekly Roy Morgan survey indicated that consumer confidence continues to recover from its Budget related hit. What’s more private credit growth picked up further in June driven by a rebound in personal and business borrowing. So while the resources boom continues to fade, evidence continues to build that the economy is rebalancing towards a greater reliance on other sectors.

What to watch over the next week?

In the US, the Fed’s loan officers survey (Monday) is expected to confirm that lending conditions are favourable, the ISM services index (Tuesday) is expected to show that services sector conditions remain solid and the trade deficit (Wednesday) is likely to be flat. Productivity growth (Friday) is expected to bounce back.

Having just eased again two months ago the ECB (Thursday) is unlikely to make any changes, but is likely to restate its easing bias and that it is continuing to look into a quantitative easing program.

Chinese inflation data for July (Saturday) is expected to be benign. Trade data will be released Friday.

In Australia, as nothing much has changed over the last month the RBA at its Board meeting on Tuesday is expected to leave rates on hold and repeat that a period of interest rate stability remains prudent. Its quarterly Statement on Monetary Policy (Friday) is also likely to express a neutral inclination on rates.

On the data front in Australia, expect to see June retail sales (Monday) bounce back 0.3 per cent after their fall in May, the June trade balance to remain in deficit (Tuesday), labour force data to show a 10,000 gain in employment leaving unemployment unchanged at 6 per cent and housing finance data (Friday) to show a slight bounce back.

The Australian June half profit reporting season will start to get underway in the week ahead with 8 major companies reporting including Downer and Rio. Consensus earnings estimates for 2013-14 are for 12 per cent growth led by resources with +28 per cent, banks at +10 per cent and industrials ex-financials at +3 per cent. The combination of the lower iron ore price, the higher $A and the hit to confidence from the Budget in the June quarter suggest a bit of downside risk to consensus estimates for resource and industrial stocks, although the banks are likely to remain strong. Given relatively elevated PEs compared to a few years ago underperformers are likely to be slammed. Most interest is likely to be on outlook statements with resources companies at risk but a bit of upside potential for companies exposed to housing and non-mining construction and retailing. Consensus 2014-15 earnings growth estimates are relatively modest at +5 per cent, with resources at 2 per cent, banks at 4 per cent and industrials at 10 per cent.

Outlook for markets

Shares have been vulnerable to a correction for a while and so the weakness seen over the last week may have a bit further go, but we continue to see little evidence suggesting we are at or near a major market top. Valuations remain reasonable, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In terms of the latter, if anything there is still a lot of scepticism which is a long way from the sort of confidence normally seen when bull markets end. Given all this, any short term dip in shares should be seen as a buying opportunity as the broad trend is likely to remain up. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely to resume their gradual rising trend over the next six months led by increasing evidence that US growth is picking up pace. This combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.

While the carry trade from ultra-easy money in the US, Europe and Japan risks pushing the $A higher, the combination of soft commodity prices, an increasing likelihood that the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down.

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Weekly market and economic update: 28 July 2014

Monday, July 28, 2014

by Shane Oliver

Investment markets and key developments over the past week

Share markets rose on mostly good economic data, continued solid earnings results in the US and an absence of additional bad news regarding either Ukraine or the Middle East. This saw Australian shares rise to their highest since June 2008. Bond yields rose but only slightly. Oil and metal prices rose too, but gold fell. The Australian dollar got a boost as Australian June quarter inflation data showing inflation at the top of the RBA’s target range was seen as curtailing the chance of another rate cut.

The July round of business conditions PMIs provided confidence that the global recovery is on track with the US manufacturing PMI remaining strong at 56.3, the Eurozone composite PMI rising to its equal highest reading for the recovery and China’s HSBC PMI rising to 52 its highest in 18 months. Japan’s manufacturing PMI disappointed though falling back to 50.8. The overall, impression is of continued solid global growth, but not so strong as to invite generalised inflation worries or rate hikes.

The Chinese share market was perhaps the most interesting over the last week with the continuing run of good economic news resulting in a technical break higher. We have seen a few false breaks in Chinese shares before so it’s premature to get too excited, but with China A shares amongst the world’s cheapest and economic indicators looking better, we continue to see significant medium term return potential from Chinese shares.

Victory for business friendly Joko Widodo in the Indonesian election is a great outcome for Indonesia, but he lacks the winning margin Modi attained in India and a challenge to the results by the defeated candidate former General Subianto Prabowo, will pro-long political uncertainty. So the outcome does not warrant the sort of re-rating of the Indonesian share market that Indian shares have seen. At least not yet.

RBA Governor Glenn Stevens provided a reminder of just how important the global policy response to the GFC was in heading off a re-run of the Great Depression. Thankfully policy makers had learned the lessons of the 1930s well and weren’t to be distracted by the disciples of Austrian economics who advocated a do nothing approach. Steven’s also rightly points out that the search for yield and risk taking is “the whole point” to quantitative easing. While this has yet to flow on to risk taking by US businesses, ie investment, with Governor Stevens suggesting this owes much to subdued confidence, I think there are enough indicators to provide confidence it will. This includes the rising trend in US durable goods orders and its strengthening jobs market.

Comments that Australian home owners with a mortgage will struggle if mortgage rates rise are a bit overblown. We heard similar warnings at the bottom of the last rate cycle in 2009 but didn’t see major problems through the 2009-10 tightening cycle. There are several reasons to expect the same when rates eventually start moving up again. First, just as Australians have sped up principle repayments as rates have come down they will likely slow them as rates go up. In fact debt interest payments are at a ten year low. Second, the household debt to income ratio has been basically flat since the GFC so it’s not the case that Australians have been rapidly taking on more debt. Third, interest rates won’t rise unless household income is also on the rise and this will provide some offset to higher interest rates. Finally, I agree that the rise in household debt ratios over the last twenty years has left households a lot more sensitive to higher interest rates. But this is not new and it explains why the peak in the cycle for interest rates has been trending down. The RBA is well aware of the issue and knows that it doesn’t need to raise rates as much as in times past to have the same impact. So just as the 2010 cash rate peak of 4.75% was below the 2008 peak of 7.25%, the next peak will likely be lower again. Maybe around 4%. At this stage it’s still a bit academic though as the first rate hike is still a way off. But for those home buyers looking for another opportunity to lock in low mortgage rates, the cut in five year fixed rate mortgages to below 5% by major banks on the back of reduced borrowing costs and competitive pressure is good news.

Major global economic events and implications

US data was mostly good. New home sales disappointed but existing home sales rose solidly, house prices continue to rise, the Markit manufacturing PMI remains strong, jobless claims fell to their lowest since early 2006 and core inflation remained benign at 1.9%. The US economy is on the mend, but the benign inflation result gives the Fed breathing space on interest rates.

Meanwhile, June quarter earnings remain solid. So far 45% of S&P 500 companies have reported with 77% beating on profits and 66% beating on sales.

Eurozone July PMIs rose and beat expectations. Services conditions were particularly strong and pushed the composite PMI to its equal strongest for the recovery so far, a level consistent with 1.5% annual growth.

The slight fall in Japan’s July PMI was disappointing. Meanwhile inflation data remains positive, even allowing for the impact of the sales tax hike.

The further rise in China’s HSBC manufacturing conditions PMI in July backs up the rise already reported in MNI’s business confidence indicator in telling us that growth has continued to improve. No hard landing here!

Australian economic events and implications

In Australia, the news that inflation has risen to 3% caused some consternation that there might be a rate hike around the corner. But while inflation at the top of the target range makes it harder for the RBA to cut interest rates again - not that they wanted to anyway - it doesn’t point to a rate hike. First, the rise in the annual rate of inflation reflected strong inflation during the second half of last year, but it has since slowed. Second, outside of housing costs, much of the rise in inflation owes to government decisions. Higher interest rates won’t stop this. Third, inflation is set to fall with the removal of the carbon tax and continuing very low wages growth. Fourth, underlying inflation at 2.8% is basically in line with the RBA’s forecast of 2.75%. And finally, a rate hike will only push the $A even higher. So rates are likely to remain on hold.

Meanwhile, there was good news on the economy with the weekly Roy Morgan consumer confidence survey rising to pre-Budget levels and a rise in skilled vacancies in June. The former suggests the hit to confidence from the Budget has faded and the latter adds to evidence that forward looking labour market indicators are improving.

What to watch over the next week?


In the US, the focus will be on the Fed (Wednesday) which is expected to taper its monthly asset purchases by another $US10bn taking them to $US25bn a month, consistent with continued solid economic data. However, most interest will likely be on the tone of the Fed’s post meeting statement which is likely to acknowledge the improvement in the economy but leave the impression the first rate hike is still some time away. My best guess for the first rate hike remains mid next year, but this doesn’t mean financial markets won’t start to worry about it earlier. On the data front, expect a further gain in June pending home sales (Monday), another increase in house prices (Tuesday), little change in consumer confidence (also Tuesday), June quarter GDP data (Wednesday) to show growth bouncing back but only to a 2.9% annualised pace, the July ISM (Friday) remaining solid at around 55.5 and July jobs data (Friday) showing a 225,000 gain in payrolls but unemployment unchanged at 6.1%.

Eurozone economic confidence measures for July (Wednesday) are likely to remain consistent with continued gradual recovery and inflation (Thursday) is likely to have remained very low.

In Japan, June data for household spending (Tuesday) and industrial production (Wednesday) will be watched for signs of recovery after the April sales tax induced slump. Jobs data is likely to have remained solid.

In China, expect to see a further improvement in the official Chinese manufacturing PMI (Friday) for July. 

In Australia, expect to see flat building approvals after a strong rise in May and modest growth in credit (both Thursday). June quarter export prices (Thursday) will likely show a sharp fall reflecting the slump in the iron ore price. Data for new home sales, house prices, the manufacturing PMI and producer prices will also be released.

Outlook for markets

Shares remain vulnerable to a short term correction, with a potential Fed rates scare at some point being the most likely trigger, but we continue to see little evidence suggesting we are at or near a major market top. Valuations remain reasonable, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In terms of the latter if anything there is still a lot of scepticism which is a long way from the sort of confidence that is normally seen when bull markets end. Given all this, any short term dip in shares should be seen as a buying opportunity as the broad trend is likely to remain up. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely to resume their gradual rising trend over the next six months led by increasing evidence that US growth is picking up pace. This combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.

While the carry trade from ultra-easy money in the US, Europe and Japan risks pushing the $A higher, the combination of soft commodity prices, an increasing likelihood that the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down.

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Investment markets and key developments over the past week - 25 July 2014

Friday, July 25, 2014

by Shane Oliver

Share markets rose on mostly good economic data, continued solid earnings results in the US and an absence of additional bad news regarding either Ukraine or the Middle East. This saw Australian shares rise to their highest since June 2008. Bond yields rose but only slightly. Oil and metal prices rose too, but gold fell. The Australian dollar got a boost as Australian June quarter inflation data showing inflation at the top of the RBA’s target range was seen as curtailing the chance of another rate cut.

The July round of business conditions PMIs provided confidence that the global recovery is on track with the US manufacturing PMI remaining strong at 56.3, the Eurozone composite PMI rising to its equal highest reading for the recovery and China’s HSBC PMI rising to 52 its highest in 18 months. Japan’s manufacturing PMI disappointed though falling back to 50.8. The overall, impression is of continued solid global growth, but not so strong as to invite generalised inflation worries or rate hikes.

The Chinese share market was perhaps the most interesting over the last week with the continuing run of good economic news resulting in a technical break higher. We have seen a few false breaks in Chinese shares before so it’s premature to get too excited, but with China A shares amongst the world’s cheapest and economic indicators looking better, we continue to see significant medium term return potential from Chinese shares.

Victory for business friendly Joko Widodo in the Indonesian election is a great outcome for Indonesia, but he lacks the winning margin Modi attained in India and a challenge to the results by the defeated candidate former General Subianto Prabowo, will pro-long political uncertainty. So the outcome does not warrant the sort of re-rating of the Indonesian share market that Indian shares have seen. At least not yet.

RBA Governor Glenn Stevens provided a reminder of just how important the global policy response to the GFC was in heading off a re-run of the Great Depression. Thankfully policy makers had learned the lessons of the 1930s well and weren’t to be distracted by the disciples of Austrian economics who advocated a do nothing approach. Steven’s also rightly points out that the search for yield and risk taking is “the whole point” to quantitative easing. While this has yet to flow on to risk taking by US businesses, ie investment, with Governor Stevens suggesting this owes much to subdued confidence, I think there are enough indicators to provide confidence it will. This includes the rising trend in US durable goods orders and its strengthening jobs market.

Comments that Australian home owners with a mortgage will struggle if mortgage rates rise are a bit overblown. We heard similar warnings at the bottom of the last rate cycle in 2009 but didn’t see major problems through the 2009-10 tightening cycle. There are several reasons to expect the same when rates eventually start moving up again.

First, just as Australians have sped up principle repayments as rates have come down they will likely slow them as rates go up. In fact debt interest payments are at a ten year low.

Second, the household debt to income ratio has been basically flat since the GFC so it’s not the case that Australians have been rapidly taking on more debt.

Third, interest rates won’t rise unless household income is also on the rise and this will provide some offset to higher interest rates.

Finally, I agree that the rise in household debt ratios over the last twenty years has left households a lot more sensitive to higher interest rates. But this is not new and it explains why the peak in the cycle for interest rates has been trending down.

The RBA is well aware of the issue and knows that it doesn’t need to raise rates as much as in times past to have the same impact. So just as the 2010 cash rate peak of 4.75 per cent was below the 2008 peak of 7.25 per cent, the next peak will likely be lower again. Maybe around four per cent. At this stage it’s still a bit academic though as the first rate hike is still a way off. But for those home buyers looking for another opportunity to lock in low mortgage rates, the cut in five year fixed rate mortgages to below five per cent by major banks on the back of reduced borrowing costs and competitive pressure is good news.  

Major global economic events and implications

US data was mostly good. New home sales disappointed but existing home sales rose solidly, house prices continue to rise, the Markit manufacturing PMI remains strong, jobless claims fell to their lowest since early 2006 and core inflation remained benign at 1.9%. The US economy is on the mend, but the benign inflation result gives the Fed breathing space on interest rates.

Meanwhile, June quarter earnings remain solid. So far 45 per cent of S&P 500 companies have reported with 77 per cent beating on profits and 66 per cent beating on sales.

Eurozone July PMIs rose and beat expectations. Services conditions were particularly strong and pushed the composite PMI to its equal strongest for the recovery so far, a level consistent with 1.5 per cent annual growth.

The slight fall in Japan’s July PMI was disappointing. Meanwhile inflation data remains positive, even allowing for the impact of the sales tax hike.

The further rise in China’s HSBC manufacturing conditions PMI in July backs up the rise already reported in MNI’s business confidence indicator in telling us that growth has continued to improve. No hard landing here!

Australian economic events and implications

In Australia, the news that inflation has risen to three per cent caused some consternation that there might be a rate hike around the corner. But while inflation at the top of the target range makes it harder for the RBA to cut interest rates again - not that they wanted to anyway - it doesn’t point to a rate hike. First, the rise in the annual rate of inflation reflected strong inflation during the second half of last year, but it has since slowed. Second, outside of housing costs, much of the rise in inflation owes to government decisions. Higher interest rates won’t stop this. Third, inflation is set to fall with the removal of the carbon tax and continuing very low wages growth. Fourth, underlying inflation at 2.8 per cent is basically in line with the RBA’s forecast of 2.75 per cent. And finally, a rate hike will only push the $A even higher. So rates are likely to remain on hold.

Meanwhile, there was good news on the economy with the weekly Roy Morgan consumer confidence survey rising to pre-Budget levels and a rise in skilled vacancies in June. The former suggests the hit to confidence from the Budget has faded and the latter adds to evidence that forward looking labour market indicators are improving.

What to watch over the next week?

In the US, the focus will be on the Fed (Wednesday) which is expected to taper its monthly asset purchases by another $US10bn taking them to $US25bn a month, consistent with continued solid economic data. However, most interest will likely be on the tone of the Fed’s post meeting statement which is likely to acknowledge the improvement in the economy but leave the impression the first rate hike is still some time away. My best guess for the first rate hike remains mid next year, but this doesn’t mean financial markets won’t start to worry about it earlier. On the data front, expect a further gain in June pending home sales (Monday), another increase in house prices (Tuesday), little change in consumer confidence (also Tuesday), June quarter GDP data (Wednesday) to show growth bouncing back but only to a 2.9 per cent annualised pace, the July ISM (Friday) remaining solid at around 55.5 and July jobs data (Friday) showing a 225,000 gain in payrolls but unemployment unchanged at 6.1 per cent.

Eurozone economic confidence measures for July (Wednesday) are likely to remain consistent with continued gradual recovery and inflation (Thursday) is likely to have remained very low.

In Japan, June data for household spending (Tuesday) and industrial production (Wednesday) will be watched for signs of recovery after the April sales tax induced slump. Jobs data is likely to have remained solid.

In China, expect to see a further improvement in the official Chinese manufacturing PMI (Friday) for July. 

In Australia, expect to see flat building approvals after a strong rise in May and modest growth in credit (both Thursday). June quarter export prices (Thursday) will likely show a sharp fall reflecting the slump in the iron ore price. Data for new home sales, house prices, the manufacturing PMI and producer prices will also be released.

Outlook for markets


Shares remain vulnerable to a short term correction, with a potential Fed rates scare at some point being the most likely trigger, but we continue to see little evidence suggesting we are at or near a major market top. Valuations remain reasonable, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In terms of the latter if anything there is still a lot of scepticism which is a long way from the sort of confidence that is normally seen when bull markets end. Given all this, any short term dip in shares should be seen as a buying opportunity as the broad trend is likely to remain up. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely to resume their gradual rising trend over the next six months led by increasing evidence that US growth is picking up pace. This combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.

While the carry trade from ultra-easy money in the US, Europe and Japan risks pushing the $A higher, the combination of soft commodity prices, an increasing likelihood that the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down.

| More

 

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