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Shane Oliver
Financial markets
+ About Shane Oliver

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

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.

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The power of compound interest - an investor's best friend

Thursday, July 17, 2014

by Shane Oliver

Key points

  • Compound interest is an investor’s best friend. 
  • The higher the return, the greater the investment contribution and the longer the time period the more it works. 
  • To reap maximum advantage from it, ensure an adequate exposure to growth assets, contribute early and often to your investment portfolio and find a way to avoid being thrown off by the investment cycle. 

Introduction

I reckon the first wonder of the investment world is the power of compound interest. My good friend Dr Don Stammer even goes so far to refer to it as the “magic” of compound interest because it almost is magical. Compound interest can be the worst nightmare of a borrower as interest gets charged on interest if it is not regularly serviced. But it’s the best friend of investors. Unfortunately for a variety of reasons some miss out on it. 

Compound interest – what is it? 

But what is it and why is it so powerful? Compound interest is simply the concept of earning interest on interest. Or more broadly, getting a return on past returns. In other words any interest or return earned in one period is added to the original investment so that it all earns interest or a return in the next period. And so on. Its best demonstrated by some examples. 

  • Suppose an investor invests $500 at the start of each year for 20 years and receives a 3 per cent annual return. See Case A in the next table. After 20 years the investment will have increased to $13,838, for a total outlay (or $ Flow in the table) of $10,000. Nice, but hardly exciting as the return was only low at 3 per cent pa. 
  • But if the investor put the same flow of money in an asset returning 7 per cent a year, after 20 years it will have grown to $21,933. See Case B. Not bad given the same total outlay of $10,000. And in year 20, annual investment earnings are now $1435, more than three and a half times the investment earnings in the same year in Case A of $403. 
  • Finally, if the whole process was kicked off by a $2000 investment at the start of the first year, with $500 each year thereafter and still earning 7 per cent per annum then after 20 years it will have grown to $27,737. Case C. By year 20 in this case the annual investment earnings will have increased to $1815. 

These examples have been kept relatively simple in order to illustrate how compounding works. Obviously all sorts of complications can affect the final outcome including inflation (which would boost the results as the table uses relatively low returns for both the low and high risk asset), allowance for the more frequent compounding which actually occurs in investment markets as opposed to annual compounding in the table (which would also boost the final outcome) and the timing of the return from the high growth asset through time in that it won’t be a steady 7 per cent year after year.

However, the power of compound interest is clear. From these examples, it is evident that it has three key drivers:

  • The rate of return – the higher the better. 
  • The contribution – the bigger the better because it means there is more for returns to compound on. The $2000 upfront contribution in Case C boosted the outcome after 20 years by an extra $5804 compared to Case B. Not bad for just an extra $1500 investment. 
  • Time – the longer the better because it means the longer the compounding process of earning returns on returns has to run. Time will also help smooth out any year to year volatility in returns. After 40 years the investment strategy in Case A will have grown to $38,832 but Case B will have grown to $106,805 and Case C will have grown to $129,267.

Compound interest in practice

This all sounds fine in theory, but does it really work in practice? It’s well-known that growth assets like shares and property provide higher returns than defensive assets like cash and bonds over long periods of time. This is because their growth potential results in higher returns over long periods of time which compensates for their higher volatility compared to more stable and less risky assets. 

The next chart is my favourite demonstration of the power of compound interest in action for investors. It shows the value of $1 invested in 1900 in Australian cash, bonds and shares with earnings on each asset reinvested along the way. Since 1900 cash has returned 4.8 per cent per annum, bonds have returned 6 per cent pa and shares returned 11.9 per cent pa.

Shares are clearly more volatile than cash and bonds. The arrows in the chart show periodic, often long bear markets in shares. However, the compounding effect of their higher returns over time results in much higher wealth accumulation from them. Although the return from shares is only double that of bonds, over 114 years the $1 invested in 1900 will have grown to $398,420 today, whereas the $1 investment in bonds will only be worth $750 and that in cash just $204.

Now of course, investors don’t (usually) have 114 years. But the next chart shows rolling 20 year returns from Australian shares, bonds and cash and it’s evident that shares have invariably outperformed cash and bonds over such a period.

Note that while the return gap between shares on the one hand and bonds and cash on the other has narrowed over the last 20 years this reflects the relatively high interest rates and bond yields of 20-30 years ago, which provided a springboard to relatively high returns from such assets. With bond yields and interest rates now very low such bond and cash returns are very unlikely to be repeated in the decade or so ahead.

Some issues

What about property? Over long periods of time Australian residential property has generated similar total returns (ie capital growth plus income) for Australian investors as Australian equities. For example since 1926 Australian residential property has returned 11.1 per cent pa, which is similar to the 11.5 per cent pa return from shares over the same period.

What about fees? Fees on managed investment products will clearly reduce returns over time, but less so for cash and fixed income products and for equities the fee impact will be offset by the impact of franking credits in the case of Australian shares (which amount to around 1.3 per cent pa) and which has not been allowed for in the last two charts.

Are these returns sustainable going forward? This is really a separate topic, but the historical returns from the three assets likely all exaggerate their future medium term return potential. Cash rates and bank term deposit rates are likely to hover around 3-4 per cent, current ten year bond yields around 3.4 per cent suggest pretty low bond returns for the decade ahead (in fact just 3.4 per cent for an investor who buys a ten year bond and holds it to maturity). And the Australian equity return may be closer to 9 per cent pa, reflecting a dividend yield around 4.5 per cent and capital growth of around 4.5 per cent. But for shares this sort of return is still not bad and leaves in place significant potential for investors to reap rewards from the power of compounding over the long term.

Why investors often miss out

But if the power of compound interest is so obvious, what can cause investors to miss out. There are several reasons:

  • First investors may be too conservative in their investment strategy, opting for lower returning defensive assets like cash or bank term deposits. This may avoid short term volatility but won’t build wealth over the long term if that’s the objective.
  • Second, they leave it too late to start contributing to an investment portfolio or don’t contribute much initially. This makes it more difficult to catch up in later life and leaves investors more at the whim of financial market fluctuations during the catch up phase. Fortunately the Australian superannuation system forces Australian’s to start early in life, albeit the contribution rate is too low.
  • Third, they can adopt the right strategy to benefit from compound interest over the long term only to get thrown off during a bout of market volatility. This usually occurs after a steep slump in investment markets and sees the investor switch to cash only to return, if at all, after the market has already had a good recovery.
  • Finally, some investors have been sucked in over the years by promises of a “free lunch”, eg the 10 per cent pa yield funds that were floating around prior to the GFC which then ran into trouble once the GFC hit and proved to be more risky than equities.

Implications for investors

There are several implications for investors looking to take advantage of the power of compound interest.

First, if you can take a long term approach, focus on growth assets like shares and property with a long term track record.

Second, start contributing to your investment portfolio as much as you can as early as possible.

Third, find a way to manage cyclical swings. For example, invest a bit of time in understanding that the investment cycle is a normal part of investment markets and partly explains why growth assets have a higher return in the first place. Or invest in funds that undertake dynamic asset allocation to help manage the investment cycle. Or both.

Finally, if an investment sounds too good to be true – implying some sort of free lunch – and/or you can’t understand it, then stay away.

 

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Investment markets and recent key developments

Friday, July 11, 2014

by Shane Oliver

Share markets retreated over the last week on worries that problems at some European banks might spark a return of its debt crisis and nervousness about a possible correction in the US. Most share markets fell, including in Australia and China. Share market nervousness saw bonds rally, except in peripheral Eurozone countries where Portuguese bank problems weighed. Commodity prices were little changed but interestingly the oil price continued to drift down as worries about Iraq abated and Libyan and Saudi supplies rose. The $A saw a brief bounce higher, but it was short lived.

It seems there is always something to worry about. Just as investors were getting a little less concerned about oil supply disruptions from Iraq, along comes a scare about problems at European banks. A week ago Austria’s Erste Bank issued a profit downgrade and then the parent company of Portugal’s largest bank Banco Espirito Santo delayed a debt payment.

Investors fear this may be a sign of problems at other Eurozone banks, which might require public support leading to renewed budget blowouts. So far there is no evidence of this but the slow recovery in Europe does present risks as does the ECB’s bank stress tests this year.

It’s certainly worth keeping an eye on, but several considerations suggest we won’t see a return to the dim dark days of the Eurozone crisis. First, the problems at both Erste Bank and Banco Espirito Santo look to be partly specific to those organisations, eg issues in its Romanian and Hungarian businesses for Erste and a troubled parent and exposure to dodgy Angolan loans for Espirito Santo. Second, the backstop support for Eurozone banks is now huge compared to the situation three or four years ago, eg the ECB’s commitment to supply cheap funding to banks.

Third, the rally in Eurozone banks had arguably gotten ahead of itself. Eurozone banks are down 13 per cent from their high in April this year, but from the Eurozone crisis lows in 2011-12 to their April high they rallied 122 per cent, nearly double the 68 per cent gain in Eurozone shares generally. So a correction was inevitable.

Results from the Indonesian election may take a week or two to be finalised, but most exit polls suggest a win by Joko Widodo, who is the most market friendly and reform oriented of the two candidates, so if he has won it would be a positive for the Indonesian economy and assets. However, it would appear likely to be only a narrow win, so a strong reform mandate may be lacking, unlike in the case of the recent Indian elections.

The first Budget of the new Modi led Indian Government was a bit of a non-event in terms of announcing dramatic reforms. But it did present a sensible fiscal strategy in terms of reducing the deficit and focussing on productive spending. The Budget should be seen as just a start with significant reform still on the way in India.

The debacle in Canberra regarding the passage of the Budget and associated policy changes through the Senate is depressing, particularly given the optimism that had come with the demise of minority government last September. There is a risk that it starts to act as a broader drag on confidence in the economy.

That said, it would be dangerous to read too much into it at this stage. So far the Australian share market and the $A are rightly ignoring it. And if it results in a softening in some of the harsher measures in the Budget (perhaps funded by a “delay” in the paid parental leave scheme) then it could have a positive impact on confidence.

Major global economic events and implications

US data continues to point to stronger US growth. Job openings are at their highest since 2007, consumer credit continues to rise, weekly mortgage applications rose, jobless claims fell and a private survey of June retail sales pointed to solid gains.

Meanwhile, the minutes from the Fed’s last meeting offered little that was new with the Fed on track to end quantitative easing in October and nothing to change the view that the first rate hike is unlikely till around mid-next year. There was some discussion about whether investors had become too complacent on interest rates, but Janet Yellen’s recent comments suggest she was not that concerned. Finally, the June quarter profit reporting season kicked off with a solid result from Alcoa auguring well.

Japanese data was mostly okay with the June Economy Watchers outlook survey remaining solid, bank lending trending up, a rise in tertiary activity and higher consumer confidence but a sharp fall in machine orders.

Chinese import and export growth were a little weaker than expected in June, but continue to pick up consistent with better growth. On top of this inflation remains low, posing no constraint to further easing in China.

The divergence in the state of Asian economies was highlighted in the past week with Malaysia raising interest rates for the first time in three years citing strong growth and inflation risks, whereas the Bank of Korea left rates on hold but with a clear easing bias after revising its growth forecasts down. Korea seems to be more of a special case though with the ferry accident earlier this year having a negative impact on spending.

Australian economic events and implications

Australian data was rather messy. Consumer confidence rose in July but only slightly and is yet to fully recover its Budget related slide, but against this business confidence is running slightly above average. Employment also rose by more than expected in June but jobs growth is still not enough to bring unemployment down, with it bouncing back to the top of the 5.8 to six per cent range it has been in for the last nine months.

The good news though is that leading employment indicators such as ANZ job ads and the hiring component of the NAB survey are pointing to stronger jobs growth ahead. There was also good news for the construction sector with the AIG’s construction PMI rising strongly in June. While housing finance slipped in May adding to evidence of a welcome moderation in momentum in the home buying market, it remains at a high level.

With interest rates set to remain low and on hold probably into next year and the Budget likely to be softened to get it though the Senate, its likely that consumer confidence will gradually improve over the months ahead.
According to Australian Property Monitors capital city rental growth over the year to the June quarter ranged between -6.6 per cent (in Perth) and +5.6 per cent (in Melbourne. The point though is that with dwelling prices up around 10 per cent over the same period rental yields are continuing to fall.

What to watch over the next week?

In the US, a key focus will be Fed Chair Janet Yellen’s Congressional testimony starting Tuesday. It’s unlikely she will waver much from the message following the June Fed meeting which was basically that the economy is improving allowing continued tapering but that monetary tightening is still a considerable time away given slack in the economy.

She may elaborate a bit on the risks around inflation and rates and the Fed’s exit strategy. On the data front, expect a 0.6 per cent gain in June retail sales, a 0.3 per cent rise in June industrial production (Wednesday), a further rise in the NAHB homebuilders conditions index (Wednesday)  and gains in housing starts and permits (Thursday). Producer price inflation data will also be released.

The US June quarter earnings reporting season will start to hot up. The consensus is for earnings growth of 6 per cent year on year and sales growth of 3 per cent. Given the downgrade from 8 per cent three months ago and a high level of negative profit warnings it’s likely that earnings growth will come in stronger than this.

Chinese activity data released Wednesday is expected to confirm a pick-up in growth, after the slowdown in the March quarter. June quarter GDP growth is expected to grow 1.8 per cent quarter on quarter (after 1.4 per cent QOQ) in the March quarter, leaving annual growth at 7.4 per cent. June industrial production is expected to pick up to nine per cent year on year, with growth in retail sales expected to remain unchanged at 12.5 per cent.
In Australia, the minutes from the last RBA Board meeting (Tuesday) are likely to express a more dovish bias than seen in the post meeting statement consistent with the more dovish tone seen in the previous minutes and in

Governor Steven’s recent speech. Data for dwelling starts (Wednesday) will likely show a further rise.

Outlook for markets

Could shares have a correction? Yes. As always there is no shortage of possible triggers with Eurozone bank issues back in focus and the potential for a Fed rates scare as the US economy continues to hot up. Are we at a major share market top? No. Valuations are not stretched, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, global and Australian 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 – as evident in headlines about capital markets being out of step with reality (Financial Times) and markets being so high that the air is thin (Wall Street Journal) – which is a long way from the sort of confidence that is normally seen when bull markets come to an end. Given all, this any short term dip in shares should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely to resume their gradual rising trend 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 continuing carry trade from ultra easy money in the US, Europe and Japan risks pushing the $A higher in the near term (potentially up to $US0.97), 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. RBA jawboning is already making a bit of a comeback.

 

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