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

Outlook for the markets

Monday, February 08, 2016

Investment markets and key developments over the past week

The past week has seen most share markets give up their gains of the previous week as some soft US data added to concerns about the US and global growth outlook and stronger US wage gains kept Fed rate hike fears alive. US shares lost 3.1%, Eurozone shares fell 5.1%, Japanese shares fell 4% and Australian shares lost 0.6%. Chinese shares rose 1% though.

Bond yields declined except in peripheral Eurozone countries. Commodity prices were mixed with metals up but oil down, as a weaker $US provided some help. While the $US fell against the Yen & Euro, the $A ended the week little changed.

Perhaps the big development over the last week was the decline in the $US, which fell 2.7% against major currencies. This was on the back of soft US economic data along with Fed Governor Brainard and NY Fed President Dudley reinforcing the view that the Fed is on hold.

The strengthening $US in recent times has played a role in market turmoil to the extent that it added to weakness in oil and commodity prices, put downwards pressure on emerging market currencies adding to the risk of a funding crisis, put pressure on China to depreciate the Renminbi and weighed on US profits.

So if the $US can stabilise then it could be positive for shares and commodities.

Against this, concerns around global growth, particularly about China and the US, are likely to linger so it remains premature to say we have seen the low for shares. In particular, a weaker $US will be of no help if it’s due to a slumping US economy.

The key therefore remains whether we will see a US/global recession. If we do then share markets have much further to fall (eg, another 20% plus). But if recession is avoided and global growth continues to muddle along around 3% pa then further downside in markets is likely to be limited and they are likely to stage a decent recovery by year end. We see a recession as being unlikely because we have not seen the normal excesses – massive debt growth, over investment or inflation – along with aggressive monetary tightening that invariably precede them. At this stage we see the probability of US/global recession as being around 25%.

While the RBA left interest rates on hold for the ninth month in a row the tone of its post meeting statement and its February Statement on Monetary Policy signals greater concern about the global growth outlook and a watching brief regrading recent financial turbulence suggesting that it has become a bit more dovish.

Our view remains the RBA will cut interest rates again this year reflecting the risks around the global economy, weaker than expected commodity prices, still subdued growth in Australia at a time when the contribution from housing construction is slowing, a more dovish Fed threatening a higher Australian dollar and continued low inflation.

However, this may not be till April or May.

Should investors worry about the Zika virus? No. While its implicated in birth defects, people usually don’t get sick enough to go to hospital and rarely die so it doesn’t compare to Bird Flu, Ebola or SARS for potential economic effects.

Major global economic events and implications

US economic news was a bit on the soft side. While the ISM manufacturing conditions remained weak, the ISM non-manufacturing conditions index fell, construction activity was weak and the Fed’s bank lending officer survey showed tightening lending standards for business loans and reduced loan demand.

However, all is not negative as the Markit manufacturing PMI is much stronger than the ISM, auto sales were stronger than expected, bank lending standards to households are not tightening and jobs data was okay.

While January payroll growth was weaker than expected this looks more like payback for several strong months as strong hours worked, stronger wages, falling unemployment and rising participation suggest the US labour market remains strong.

That said, the labour market is a lagging indicator so not the best guide to the US economy at present. More broadly the US economy could be going through just another soft patch of which there have been several in recent years.

Source: Thomson Reuters, AMP Capital

Sure there could be problems ahead for energy related debt and mining and energy related investment could fall further, but with the latter having already fallen from 0.8% of US GDP to just 0.4% the bulk of the damage is arguably already behind us.

So in the absence of a period of broad based excess and significant monetary tightening it remains hard to see a US recession.

At this stage I attach about a 25% probability to the risk of a US recession.

Source: Thomson Reuters, AMP Capital

So far the US December quarter earnings reporting season is about 63% complete.

While 77% of results have beat on earnings, the size of positive surprises has been lower than in prior quarters and so earnings are still down 5.6% year on year.

Sales revenue is down 4%, but up 0.9% if energy is excluded.

Eurozone unemployment fell 0.1% in December, but remains high at 10.4%.

Producer price inflation remains negative at -3%yoy highlighting the risk of broader deflation.

Japan’s final manufacturing conditions PMI for January fell slightly to 52.3 but its services conditions PMI rose 0.9 points to 52.4 all of which is consistent with continuing growth.

Chinese business conditions PMIs painted a mixed picture for January with the official and Caixin manufacturing PMIs little changed and averaging a still soft 48.9, but the average of the services PMIs rose 0.6 points to a solid 53.

Quite clearly manufacturing remains weak but services are solid.

Meanwhile further help was provided for the housing sectors with another cut in minimum down payment rates for some cities.

India is doing well with manufacturing and services conditions PMIs rising solidly in January.

Australian economic events and implications

Australian economic data was mixed. The AIG’s business conditions indicators continue to meander around average levels, building approvals rebounded in December but continue to look like they have seen the best pointing to a declining contribution to economic growth from housing this year, retail sales were flat in December but saw moderate real growth in the December quarter and the trade deficit blew out again in December due to weak commodity prices.

Home prices bounced back in January after falls in the December quarter but it continues to look like momentum is cooling in Sydney.

What to watch over the next week?

In the US, Congressional testimony by Fed Chair Yellen (Wednesday) will be watched for clues on how much the Fed has relaxed its intentions to hike interest rates this year. Retail sales (Friday) are likely to show modest growth.

Eurozone data is expected to show modest growth is continuing with December quarter GDP (Friday) expected to show growth of 0.4% quarter on quarter or 1.6% year on year.

Chinese credit data will be watched for signs that monetary easing is continuing to support credit growth.

In Australia, Parliamentary Testimony by RBA Governor Stevens (Friday) will be watched for clues on the interest rate outlook.

On the data front, the NAB business survey’s confidence reading (Tuesday) and consumer confidence (Wednesday) are vulnerable to slight falls reflecting ongoing share market turbulence and housing finance (Friday) is likely to show a slight pull back.

The Australian December half profit reporting season will start to ramp up in the week ahead with 27 major companies reporting including JB HiFi, Cochlear, Commonwealth Bank, RIO and the ASX. Key themes are likely to be: ongoing horrific conditions for resources companies (where 2015-16 earnings are expected to fall another 61%); continued modest profit growth for the rest of the market (of around 5%) led by healthcare, building materials, general industrials and discretionary retail; help from the lower $A; and an ongoing focus on cost control.

Given the significant downwards revision to earnings expectations and the fall in the share market so far this year there is some chance we will see upside surprise.

Outlook for markets

With global growth worries remaining it’s still premature to say that shares have bottomed.

However, with shares having become technically oversold at their recent lows, sentiment readings at bearish extremes and central banks becoming more dovish there is a good chance that the rebound that has recently got underway has further to go.

Beyond the near term uncertainties, we still see shares trending higher this year helped by a combination of relatively attractive valuations compared to bonds, further global monetary easing and continuing moderate economic growth. But expect volatility to remain high.

Very low bond yields point to a soft medium term return potential from sovereign bonds, but it’s hard to get bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation.

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

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne.

Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

New found dovishness from the Fed poses a short term upside risk for the $A to $US0.73-74. However, the broad trend is likely to remain down as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes it’s usual undershoot of fair value. Expect a fall to around $US0.60 by year end.

Eurozone shares fell 0.9% on Friday and US shares lost 1.9% as technology shares fell sharply on earnings worries and stronger wages growth in the US kept alive Fed rate hike fears.

While the $US rose on Friday in response to stronger US wages growth which pushed the $A back down to $US0.7060, against a basket of major currencies the $US only gained 0.5%, leaving it down 2.7% for the week.

The poor global lead saw ASX 200 futures lose 56 points or 1.1% pointing to a poor start for the Australian share market on Monday.

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Decent investment yield matters in volatile times

Friday, February 05, 2016

The renewed turmoil in global financial markets on worries about global growth has provided a reminder that we remain in an investment environment of constrained capital growth and high volatility. 

This has several implications for investors around interest rates and the yield investments provide.

First, interest rates are likely to remain low for longer: the Bank of Japan has cut interest rates on excess bank reserves to -0.1%, the ECB is likely to ease further, the Fed is backing away from rate hikes and the RBA is more likely to cut rates than increase them.

Second, it reminds us about the importance of the yield an investment provides as opposed to just relying on capital growth.

Third, while a fall in the capital value of an investment is unsettling, the cash flow it provides is generally a lot more stable and becomes relatively more attractive during periods of market declines. But what do we mean by yield? Why is it so important? And where can it be found?

What is investment yield?

The yield an investment provides is basically its annual cash flow divided by the value of the investment.

For bank deposits the yield is simply the interest rate, eg bank 1 year term deposit rates in Australia are around 2.4% and so this is the cash flow they will yield in the year ahead.

For 10-year Australian Government bonds, annual cash payments on the bonds (coupons) relative to the current price of the bonds provides a yield of 2.5% right now.

For residential property the yield is the annual value of rents as a percentage of the value of the property. On average in Australian capital cities it is about 4.2% for apartments and around 2.8% for houses. After allowing for costs, net rental yields are about 2 percentage points lower.

For unlisted commercial property, yields are around 6% or higher. For infrastructure investment it averages around 5%.

For a basket of Australian shares represented by the ASX 200 index, annual dividend payments are running around 5.3% of the value of the shares. Once franking credits are allowed for this pushes up to around 6.9%.

Yield and total return

The yield an investment provides forms the building block for its total return, which is essentially determined by the following.

Total return = yield + capital growth

For some investments like term deposits the yield is the only driver of return (assuming there is no default). For fixed interest investments it is the main driver – and the only driver if bond investments are held to maturity – but if the bond is sold before then there may be a capital gain or loss.

For shares, property and infrastructure, capital growth is a key component of return, but dividends or rental income form the base of the total return. Prior to the 1960s most investors focused on yield, particularly in the share market where most were long-term investors who bought stocks for dividend income.

This changed in the 1960s with the “cult of the equity”, as the focus shifted to capital growth. It was pushed further through the bull markets of the 1980s and 1990s.

Similarly at various points in the cycle real estate investors have only worried about price gains and not rents.

Why yield matters?

In times like the present a focus on the income an investment provides is important. First, with interest rates set to remain low or fall further, bank deposit rates – already at their lowest in Australia since the 1950s – are likely to remain low or go lower.

Our view is that further falls are likely as the RBA is likely to cut official interest rates to 1.75% in the next six months on the back of global uncertainties, sub-par growth and benign inflation. This in turn means an ongoing need to understand and consider alternative sources of yield on offer.

Second, a high and sustainable starting point yield for an investment provides some security during volatile times like the present. For example since 1900 dividends have provided more than half of the 11.6% total return from Australian shares and as can be seen in the next chart their contribution has been stable in contrast to the swings in the capital value of shares.

Dividends are relatively smooth over time. Companies hate having to cut them as they know it annoys shareholders so they prefer to keep them sustainable.

Finally, as baby boomers retire, investor demand for income will likely be high as the focus shifts to income generation.

Alternatives to term deposits for yield

The chart below shows the yield on a range of Australian investments. Yields on global investments tend to be lower.

All of these yields have fallen over the last few years as interest rates have fallen, but as can be seen several of the alternatives do offer much more attractive yields than term deposits.

Australian 10-year bond yields are now around 2.5%. This will be the return an investor will get if they hold these bonds to maturity. They can generate a higher return if yields continue to fall, but they are already very low. Global bond yields are lower, averaging around 1%.

After the house price boom of the past twenty years the rental yield on capital city houses is just 2.8% and that on apartments is around 4.2% and even lower after costs.

Corporate debt is an option for those who want higher yields than term deposits but don’t want the volatility of shares. For Australian corporates, investment grade yields are around 6.5% or less and lower quality corporate yields are higher.

Sub investment grade corporate bond yields in the US are actually now yielding around 9% as worries partly about loans to energy companies have pushed them higher.

Following the turmoil of the GFC Australian real estate investment trusts (A-REITs) have refocused on their core business of managing buildings, collecting rents and passing it on to their investors, with lower gearing. While their distribution yields have declined as rental growth has not kept up with total returns of 15% over the last 5 years, they are still reasonable at 4.8%.

Unlisted commercial property also offer attractive yields, around 6% for a high quality well diversified mix of buildings, but higher for smaller lower quality property. And it doesn’t suffer from the overvaluation of residential property.

Unlisted infrastructure offers yields of around 5%, underpinned by investments such as toll roads and utilities where demand is relatively stable.

Australian shares also fare well in the yield stakes. The grossed up dividend yield on Australian shares at around 6.9% is well above term deposit rates meaning shares actually provide a higher income than bank deposits. In fact the gap is now back to levels seen during the GFC.

Investing in shares of course entails the risk of capital loss.

But a way to minimise this risk is to focus on stocks that provide sustainable above average dividend yields as the higher yield provides greater certainty of return. The next chart 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 $3200 in interest (red bars).

By contrast the $100,000 invested in shares would have grown to $1.04 million (blue line) and would have paid $50,770 in dividends before franking credits (blue bars). The point is that dividends tend to grow over time (because an investment in shares tends to rise in value) and to be relatively stable compared to income from bank deposits which vary with interest rate settings.

Key issues for investors to consider

While there is a strong case for investors to focus on investments offering a decent yield there is no such thing as a free lunch.

All of the alternatives come with a risk of volatility in the value of the underlying investment. In the case of shares the key for an investor is to work out whether they want a stable value for their investment in which case bank deposits win hands down or a higher/more stable income flow in which case Australian shares win hands down.

More broadly, in searching for a higher yield investors need to keep their eyes open. It’s critical to focus on opportunities that have a track record of delivering reliable earnings and distribution growth and are not based on significant leverage.

In other words make sure the yields are sustainable. On this front it might be reasonable to avoid relying on some Australian resources stocks where current dividends look unsustainable unless there is a rapid recovery in commodity prices.

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Central banks more dovish

Monday, February 01, 2016

Investment markets and key developments over the past week

The past week has seen most global share markets continue to rally, as the Fed followed the ECB into dovishness and the Bank of Japan undertook more monetary easing. The latter in particular provided a strong boost at the end of the week for risk assets.

As a result Japanese shares gained 3.3% over the week, US shares rose 1.8%, Eurozone shares rose 1.1% and the Australian share market gained 2.9%.

Despite a rally on Friday, Chinese shares still lost 6.1%. Commodity prices also rose with oil up 4.7% and the $A gained. Japan’s further monetary easing pushed its 10 year bond yield to a record low of just 0.09% and this saw bond yields fall further globally.

The march towards more dovish central banks is gathering pace. They are concerned that the latest bout of global growth worries and commodity price falls will further delay the return of inflation to their targeted levels.

This renewed dovish tilt started with the ECB which is now expected to ease at its March meeting and became clear from the Fed following its January meeting where it was less positive on the growth outlook and indicated it was monitoring recent economic and financial developments.

The probability of a March Fed hike is now just 14% and rather than four Fed rate hikes this year as the Fed has been projecting in its “dot plot” I see only one or none. This should help reduce the upwards pressure on the $US which in turn should help oil and other commodity prices and relieve pressure on emerging countries.

Following on from the Fed, the Bank of Japan surprised the market by cutting the interest rate it pays on excess bank reserves that are held with it to -0.1%, in a move to induce banks to lend more.

The Bank of Japan’s rate cut, by putting downwards pressure on the value of the Yen versus other Asian currencies, is likely to force other central banks across Asia to ease too.

While the headlines will rave on about another round of “global currency wars”, easing wars are a better description and given the downside risks to global growth and inflation more global monetary easing is appropriate.

The Reserve Bank of NZ has also turned more dovish and I expect the RBA to do the same on Tuesday. An upbeat RBA and a dovish Fed would not be a good combination in terms of getting (& keeping) the $A down!

January has seen a terrible start to the year in share markets with the US S&P 500 down 5.1% and the Australian share market down 5.5%. It’s not the worst ever – we have seen it all before. But for US shares it has been the worst January since January 2009 (when shares lost 8.6%) and for Australian shares it’s the worst January decline since January 2010 (when shares lost 5.8%).

Obviously this will lead many to fear the old saying “as goes January so goes the year”, ie the so-called January barometer. But it’s worth noting that the track record of the January barometer is very mixed. For US shares the track record of a negative January going on to a negative year has been 43% since 1980.

Similarly for Australian shares the track record of a negative January going on to a negative year has been 33% since 1980.

Our high level view remains that if there is to be a US/global recession then share markets have much further to fall (eg another 20% plus), once the current bounce in shares has run its course. But if recession is avoided and global growth continues to muddle along around 3% pa then further downside in markets is likely to be limited and they are likely to stage a decent recovery by year end.

We see a recession as being unlikely because we have not seen the normal excesses – massive debt growth, over investment or inflation – along with aggressive monetary tightening that invariably precede them. In fact, we are still seeing aggressive global monetary easing.

Major global economic events and implications

US economic data over the past week was mixed with solid gains in home prices, a sharp rise in new home sales, an unexpected rise in consumer confidence, a fall in jobless claims and a sharp rebound in the Chicago PMI, but against this the Markit services sector PMI fell in January – albeit it remains reasonably solid at 53.7, December durable goods orders were much weaker than expected and December quarter GDP growth slowed to just 0.7% annualised.

The slowdown in GDP growth was mainly due to inventories and net exports, but business investment also fell. GDP growth is likely to stay down in the current quarter as the fall in durable goods orders points to more capex weakness and the blizzard in the north east will impact spending.

So the US economy is going through yet another soft patch which along with another soft reading on wages growth – as the December quarter employment cost index rose just 2% year on year – adds to the pressure on the Fed not to hike rates anymore.

So far the US December quarter earnings reporting season is about 40% complete. While 80% of results have beat on earnings, its only 48% for sales and earnings are still down 5.6% year on year.

Eurozone confidence readings slipped in January, on the back of all the news around global growth worries and share market turbulence, but remain at levels consistent with okay growth. Core inflation remained low at 1% year on year.

The Japanese labour market remained strong in December but household spending and industrial production were very weak and core inflation fell to 0.8% year on year.

Chinese industrial profits fell over the year to December, but consumer confidence rose in January.

Australian economic events and implications

Australian December quarter inflation data indicate that pricing power and inflationary pressures remain very weak, but probably not weak enough to trigger another RBA rate cut just yet. But with underlying inflation running at the bottom of the 2-3% inflation target it leaves plenty of room for another rate cut and helps reinforce the RBA’s easing bias.

Meanwhile another sharp slump in December quarter export prices means that the hit to national income is continuing, but that net export volumes will have continued to help real GDP growth.

The NAB business survey indicated that business conditions and confidence slipped in December, but remain above average, albeit this was before the intensification of global growth worries seen so far this year.

Finally, credit data for December shows continued moderate growth overall with an ongoing slowing in lending to property investors relative to owner occupiers – no doubt APRA will be happy!

What to watch over the next two weeks?

In the US, expect a slight improvement in the ISM manufacturing conditions index (Monday) but a slowing in jobs growth (Friday) to around 190,000 consistent with a slight rise in jobless claims lately with unemployment remaining unchanged at 5%.

Wages growth is likely to remain relatively subdued but with a slight rising trend. The non-manufacturing conditions ISM (Wednesday) is likely to remain solid and the Fed’s preferred inflation indicator will be released Monday.

In China, the official and Caixin manufacturing conditions PMIs for January (Monday) are likely to remain subdued but services conditions PMIs should remain a bit stronger.

In Australia, the RBA on Tuesday is expected to leave interest rates on hold but it’s likely to strengthen its easing bias. December quarter inflation was low but in line with RBA expectations, recent Australian economic data has been okay and it’s doubtful that the latest bout of financial and commodity market turmoil has been enough to move the RBA out of its “chilled out” state.

However, the latest round of worries about global growth coming at a time when domestic growth remains sluggish, national income is being hit by the continuing slump in commodity prices, the housing sector is losing momentum and inflation is low are likely to see the RBA strengthen its easing bias. We remain of the view that the RBA will cut the cash rate again in the months ahead.

The RBA’s Statement on Monetary Policy (Friday) is likely to show a further delay in the return of economic growth to around 3% from end 2016 into 2017.

On the data front in Australia expect to see continued softness in the January Core Logic RP Data home price indexes and ongoing benign inflation in the TD Securities Inflation Gauge for January (both Monday), the December trade deficit come in around $3bn and a 7% rebound in December building approvals (both Wednesday) and solid retail sales data (Friday). AIG business conditions PMIs will also be released.

The Australian December half profit reporting season will start to get underway in the week ahead but with only a handful of companies reporting (including Tabcorp and Downer).

Key themes are likely to be: ongoing horrific conditions for resources companies (where 2015-16 earnings are expected to fall another 52%); continued reasonable profit growth for the rest of the market (of around 6%) led by healthcare, building materials, general industrials and discretionary retail; and an ongoing focus on cost control. Given the significant downwards revision to earnings expectations (-5% over the last 3 months) and the fall in the share market so far this year which has taken it to a slightly below average PE there is some chance we will see upside surprise.

Outlook for markets

With global growth worries remaining it’s still premature to say that shares have bottomed. However, with shares having become technically oversold at their recent lows, sentiment readings at bearish extremes and central banks becoming more dovish there is a good chance that the rebound that has recently got underway has further to go.

Beyond the near term uncertainties, we still see shares trending higher this year helped by a combination of relatively attractive valuations compared to bonds, further global monetary easing and continuing moderate economic growth. But expect volatility to remain high.

Very low bond yields point to a soft medium term return potential from sovereign bonds, but it’s hard to get bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation.

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

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes it’s usual undershoot of fair value. Expect a fall to around $US0.60 by year end.

Friday saw Eurozone shares rise 2.3% and the US S&P 500 gain 2.5% thanks to further monetary easing from the Bank of Japan, some good US earnings results and an unexpected sharp rebound in the Chicago region manufacturing conditions PMI for January.

As a result of the positive global lead, ASX 200 futures rose 37 points or 0.7% pointing to a solid start to trading for the Australian share market on Monday.

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Good chance of a short-term bounce

Monday, January 25, 2016

By Shane Oliver

Investment markets and key developments over the past week

It’s been another volatile week in financial markets as investors continue to fret about the global growth outlook, but strong signs from the ECB of further monetary easing helped shares and other risk assets rebound after falling earlier in the week. As a result despite earlier sharp falls US shares rose 1.4% over the week, Eurozone shares gained 2.3% and Australian shares rose 0.5%. Chinese shares also rose 0.9%, but despite a late surge Japanese shares still ended down 1.1%. After plunging to a new low of $US26.6/barrel the oil price managed a 9% gain over the week and metal prices also rose. The ECB inspired bounce in risk assets later in the week also helped push the $A back up to around $US0.70, and saw bond yields mostly rise over the week.

From their highs last year to their lows in the past week many global share markets have already fallen into bear market territory (defined as a 20% decline from the high – which this time around was last year). Asian shares (down 28% from last year’s high) and emerging market shares (down 27%) entered bear market territory last year. Japanese shares have had a fall of 23% and Eurozone shares have lost 22%. Australian shares have come close with a fall of 19% from the high in April last year but US shares have only had a decline of 13% from last year’s high.

With global growth worries likely to linger and US shares having only had a 13% fall despite having more valuation concerns than other markets it’s too early to say that we have seen the low. So the Australian share market could yet be tipped into bear market territory.

However, there were some more positive signs over the past week. First, Chinese economic data over the last week was much better than feared and the Chinese Renminbi has remained relatively stable.

Second, share markets have become very oversold with some technical indicators (RSI’s for example) at levels often associated with at least short term lows and a bounce, which we may be starting to see.

Third, signs of extreme pessimism and investor capitulation are continuing to build, with our investor sentiment index for US shares nearing levels associated with bounces (see next chart).

Finally, central banks are turning dovish. This started with the Fed’s Bullard last week and now the ECB is signalling more easing at its March 10 meeting and the BoJ is reported to be considering doing more easing too. More easing from the ECB is likely to take the form of a €10-15bn/month increase to its quantitative easing program and another deposit rate cut. 

In the week ahead the Fed is likely to signal a pause in raising interest rates to allow it to reassess the outlook and the Bank of Japan is expected to at least signal that it has become more dovish.

Our high level view remains that if there is to be a US/global recession then share markets have much further to fall (eg another 20% plus), but if recession is avoided and global growth continues to muddle along around 3% pa then further downside in markets is likely to be limited and they are likely to stage a decent recovery by year end. We see a recession as being unlikely because we have not seen the normal excesses – massive debt growth, over investment or inflation – along with aggressive monetary tightening that invariably precede them.

While on global growth, the IMF downgraded its global growth forecasts for 2016 to 3.4% (from 3.6%) and for 2017 to 3.6% (from 3.8%). This was largely due to growth downgrades in the emerging world and the US. 

It’s worth noting that though that IMF growth downgrades have been the norm for the last five years now with the IMF typically starting off with a growth forecast of close to 4% for each year and then having to downgrade it to usually end up around 3%. On one level its negative as it highlights the fragile and constrained nature of global growth since the GFC. But it should also mean that the days of rising inflation and much higher interest rates leading to a sharp economic downturn is a still long way off.

 

Major global economic events and implications

In the US, home builder conditions and housing starts were a bit weaker than expected but remain solid and should be supported by rising household formation, existing home sales rebounded strongly and the Markit manufacturing conditions PMI rose 1.5 points to 52.7 in January providing a possible sign that the inventory correction in manufacturing may be over. Meanwhile headline and core inflation was weaker than expected in December. So far only 73 S&P 500 companies have reported December quarter earnings with 78% beating on earnings but only 48% beating on sales.

Eurozone business conditions PMIs slipped in January but remain at solid levels pointing to continued okay growth.

Chinese December quarter GDP growth at 6.8% year on year and December activity data were fractionally weaker than expected but not dramatically so. It tells us that growth is still soft but it’s not collapsing. Policy stimulus measures are helping but more is needed to help the economy as it transitions from a reliance on manufacturing and investment to services and consumption. This transition is evident in industrial production growth of 5.9% over the year to December (which is down from 10% plus up until about four years ago) in contrast to retail sales growth of 11.1% year on year.  That Chinese shares were able to rally on the news tells us that a much worse outcome had been “feared”. This year I expect Chinese growth to edge down to a 6.5% pace with policy stimulus measures helping avoid a sharper slowing. Continued gains in Chinese property prices for December highlight that the risks from a property collapse are continuing to recede.

Australian economic events and implications

Australian economic data releases were but generally on the soft side. Consumer confidence fell in January, presumably in response to news of market turmoil, leaving it a bit below average and new home sales fell in again in November. While housing starts rose to a record high in the September quarter, the softening trend in building approvals and new home sales suggest they are likely to have peaked. Meanwhile the TD Securities Inflation Gauge for December points to continued low inflation. 

What to watch over the next two weeks?

In the US the big one to watch will be the Fed meeting on Wednesday. The Fed won’t be making any changes to monetary policy but is likely to be dovish in acknowledging the latest downside risks to inflation and support the view that a March hike is now unlikely. The US money market puts the probability of a March high at just 22% and the way things are going the Fed its increasingly likely that the Fed will struggle to put through even one 0.25% rate hike this year.

After the Fed the focus in the US will shift to the December quarter employment cost index which is likely show that wages growth remains benign at 2.1% year on year and December quarter GDP growth which is likely to show growth slowing to just 0.8% annualised due to a large detraction from inventories (both due Friday). In other data expect to see further gains in home prices and little change in consumer confidence (both Tuesday), modest gains in December new and pending home sales and soft December durable goods orders (Thursday).

Eurozone inflation for January (Friday) is likely to remain very low helped by the latest plunge in oil prices.

Expect Japanese data for December on Friday to show continued labour market strength but softness in household spending and industrial production. Core inflation is likely to slip to around 0.8% year on year from 0.9% in November. The Bank of Japan (Friday) is likely to be at least more dovish.

In Australia expect a 6% drop in petrol prices to result in December quarter inflation of 0.3% quarter on quarter or 1.6% year on year (Wednesday). Despite the lower $A, ongoing discounting is expected to keep underlying inflation low at 0.5% quarter on quarter or 2.1% year on year. Inflation is not likely to be low enough to trigger another RBA rate cut in February by it will be no barrier either. The December NAB business survey will also be released Monday, December quarter export and import prices (Thursday) are likely to show a further fall in the terms of trade and credit growth (Friday) will likely show a further slowing in lending to property investors.

Outlook for markets

It’s still too early to say that shares have bottomed, but given increasing pessimism, indications that shares are oversold and more dovish central banks there is a good chance we will see at least a short term bounce. In fact as seen over the last few days this may be already getting underway. Beyond the near term uncertainties we still see shares trending higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. But expect volatility to remain high.

Very low bond yields point to a soft medium term return potential from sovereign bonds, but it’s hard to get too bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation.

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

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of Sydney and Melbourne. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes it’s usual undershoot of fair value. Expect a fall to around $US0.60 by year end.

Friday saw Eurozone share markets continue to rebound with a 2.7% gain and the US S&P 500 rise 2% as signs of more easing ahead from the ECB continued to impact along with some better manufacturing data in the US. Reflecting the positive global lead ASX 200 futures rose 55 points or 1.1%, pointing to a solid start for the Australian share market on Monday.

 

 

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Another volatile week ahead

Monday, January 18, 2016

By Shane Oliver 

Investment markets and key developments over the past week

So share markets have remained under pressure, commodity prices have continued to slump with oil falling to $US29.6/barrel for the first time since 2003 and bond yields falling further helped by safe haven buying and falling inflation expectations. While there were a few up days US shares lost 2.2%, Eurozone shares fell 2.9%, Japanese shares fell 3.5%, Chinese shares lost 9% and Australian shares fell 2%. Having broken below last year’s lows the $A looks like it is heading much lower – my view remains $US0.60 by year end.

With worries about global growth likely to linger we could still see more downside in share markets in the short term that could see developed markets including Australian shares follow emerging markets into a bear market (defined as a 20% decline – as measured against last year’s highs). Eurozone shares have already slipped into bear market territory with a decline of 20.4% from last year’s high, whereas Australian shares and Japanese shares are down 18% and US shares down 12% compared to their 2015 highs.

However, there are some positive signs:

First, economic data over the last week has been mostly okay, although the softness in US December retail sales is a concern.

Second, the Chinese Renminbi appears to have stabilised for now albeit helped by jawboning by Chinese officials and People’s Bank of China intervention.

Third, sentiment is starting to get very negative as highlighted by all the coverage given to the “RBS tells investors to sell everything” story. This is a sign we may be getting closer to the capitulation that usually presages market bottoms. 

Fourth, while the ongoing plunge in commodity prices, and particularly oil prices is bad news for producers its great news for consumers. I don’t normally do cut and paste jobs here but ran out of time and this chart from Deutsche Bank, highlighting that normal lags suggest that the bulk of the boost to G7 GDP growth from lower oil prices is ahead of us, caught my eye. I am not in the 4% growth camp for the G7, but it is a significant growth boost operating in the other direction to all the gloom and doom now building up.

Finally, I suspect we are getting close to the point where developed central banks start to act, not necessarily by easing but by sounding more dovish. This may already be starting at the Fed with St Louis Fed President Bullard expressing concern that the latest fall in oil prices will delay a return in inflation to target at a time when inflation expectations are falling.

Bullard is often seen as a bellwether at the Fed so his new found dovishness may soon show up in similar views from other Fed officials. A March Fed rate hike is looking unlikely and I remain of the view that the Fed will struggle to put through the four rate hikes for this year shown in its “dot plot”. Two at best but the risk is one or none - a bit like last year.

The Bank of Japan is also likely to be under renewed pressure to step up its easing as the rising Yen and plunging oil will make it even harder to head towards its inflation target. Watch the ECB for its thoughts in the week ahead.

For those worried that the fall in China’s foreign exchange reserves will push up US bond yields – don’t. At least not now anyway. Despite a $US500bn fall in China’s FX reserves last year, US bond yields were little change and so far this year they are falling. Clearly other investors are filling any gap. The time to worry would be when global investors are confident (so not buying bonds) and China is still selling FX reserves.

Major global economic events and implications

US economic data was mixed with a slight rise in small business optimism and consumer confidence, solid readings for job openings and hiring and the Fed’s Beige Book of anecdotal evidence pointing to “modest” to “moderate” growth but disappointing retail sales and industrial production data.

Japanese data was mixed with stronger economic confidence but weaker machinery orders.

Chinese data for exports and imports surprised on the upside in December, vehicle sales continued to surge helped by tax incentives and credit growth accelerated suggesting stimulus measures are helping. While strong trade with Hong Kong may warn of over invoicing and disguised capital outflows the overall picture is consistent with Chinese growth stabilising as opposed to collapsing.

Australian economic events and implications

Australian jobs data yet again surprised on the upside with employment falling just fractionally after two exceptionally strong months of jobs growth and unemployment remained down at 5.8%. It’s hard to believe that jobs growth is really running at 2.6% year on year – or a whopping 4.6% year on year in NSW – at a time when economic growth is just 2.5%. Statistical distortions appear to be at work here rather than an economic boom. By the same token underlying jobs growth is still likely to be solid as low wages growth and growth in low wage jobs in industries like retail and construction in NSW and Victoria make up for the slump in mining related jobs in WA.

Incidentally, various labour surveys (eg, ANZ job ads, ABS job vacancies and the NAB business survey employment component) are all at levels consistent with reasonable jobs growth. Maybe not just as strong as the official figures show. While we still see the case for more RBA rate cuts and a lower $A, the bottom line though is that the economy is a long way from the collapse many fear.

Housing finance rose more than expected in November, but mainly due to owner occupiers. Finance to property investors rose slightly but this followed sharp falls in previous months indicating that APRA measures designed to cool lending to property investors are still working.

Meanwhile back to petrol prices (a favourite topic given my car). Given the crash in oil prices including Asian Tapis grade oil in Australian dollars, petrol prices in Australian cities should be pushing down to 90 cents a litre. High refinery margins based on Singapore refined petrol prices seem to be the main issue here.

Source: Bloomberg, AMP Capital.


What to watch over the next two weeks?

Perhaps the main focus in the week ahead will be on Chinese economic activity data and GDP for December which will be released Tuesday. Expect December quarter growth to come in around 6.9% year on year and 6.9% for 2015 as a whole as strength in consumer spending helps offset slower growth in investment. December data is expected to show a slowdown in industrial production to 6.1% year on year (from 6.2%), but unchanged growth in fixed asset investment and a slight acceleration in retail sales to 11.3% year on year from 11.2%. The overall impression is expected to be one of stable as opposed to collapsing growth.

In the US, expect the home builders’ conditions index (Tuesday) to remain solid, December housing starts (Wednesday) to show further strength, a rebound in existing home sales after a regulatory distortion in November and a slight gain in the US Markit manufacturing conditions PMI to 51.8 from 51.2 (all Friday). Headline CPI inflation (Wednesday) is expected to remain close to zero, with core inflation running around 2%. The December quarter profit reporting season will also start to ramp up. With analysts expecting a 6.7% decline in profits and downgrades to upgrades running at high levels there is scope for upside surprise.

The ECB (Thursday) is not expected to make any changes to monetary policy, but President Draghi is likely to sound dovish following the continuing fall in commodity prices. Eurozone business conditions PMIs (Friday) are expected to have remained solid, although recently renewed global growth worries may have impacted. Japan will also release its manufacturing conditions PMI on Friday.

In Australia, the main focus is likely to be on the Westpac consumer sentiment reading for January (Wednesday) to see whether it has been affected by the latest bout of turmoil in share markets.  The TD Securities Inflation Gauge (Monday) is likely to confirm that inflation remains low and the HIA’s New Home sales data (Thursday) will also be released.

Outlook for markets

Worries about China, the Fed and global growth are likely to drive continued share market weakness and volatility in the short term. More Renminbi stability and a more dovish Fed would certainly help. Beyond the short term we still see shares trending higher again helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. But expect volatility to remain high.

Very low bond yields point to a soft medium term return potential from sovereign bonds, but it’s hard to get too bearish in a world of fragile growth, spare capacity, weak commodity prices and low inflation.

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

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of the Sydney and Melbourne markets. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes it’s usual undershoot of fair value. Expect a fall to around $US0.60 by year end.

The slide in global share markets continued on Friday with Eurozone shares down 2.4% and US shares down 2.2% as US retail sales for December disappointed and the oil price fell below $US30/barrel. Reflecting the poor global lead ASX 200 futures fell 87 points or 1.8% pointing to a weak start for the Australian share market on Monday.

 

 

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7 reasons not to be too concerned

Thursday, January 14, 2016

By Shane Oliver 

2016 has started much where 2015 left off with basically the same worries driving another bout of share market falls.

Geopolitical concerns have played a role but the main issues are uncertainty regarding the Chinese economy, wariness about the Fed raising interest rates and the impact of a rising US dollar and falling Chinese Renminbi. 

Share markets have seen sharp declines so far this year (with US shares -5.2%, Eurozone shares -6.2%, Japanese shares -9.5%, Chinese shares -14.6% and Australian shares -6.8%) taking them back to around the lows seen during the second half of last year, commodity prices are down further with the oil price falling to its lowest since 2009 and bonds have rallied with safe haven buying. This note looks at the key issues.

Drivers behind of recent falls could linger for a while 

The weakness seen so far this year started with declines in the Chinese share market and currency, sparking renewed concerns about the Chinese economy, not helped by some soft manufacturing data in the US and geopolitical concerns in the Middle East and around North Korea.

The renewed depreciation in the value of the Renminbi is a key issue at present as its decline has helped drive upwards pressure in the $US by pushing down the value of other emerging market currencies, adding to weakness in oil and other commodity prices and keeping alive fears of some sort of emerging market crisis. Geopolitical issues have played a role – notably an intensification of tensions between Saudi Arabia and Iran along with a claimed H bomb test in North Korea.

There could still be more share market weakness to come in the short term: global growth worries centred on China and the US may linger; until the Fed starts to soften its stance on interest rate hikes market nervousness is likely to remain; it is not clear that the dynamic of a weaker Renminbi and tightening Fed putting upwards pressure on the $US and downwards pressure on commodities and hence emerging countries, is over; finally, some technical indicators can be interpreted as warning of further weakness. 

Emerging markets have already fallen into a bear market, defined as a 20% decline. Further short term weakness could see more mainstream share markets fall into bear market territory as European and Australian shares are already down 18% from last year’s lows, Japanese shares down 17% and US shares  down 10% from their 2015 highs

Seven reasons not to be too concerned 

While risks remain high in the short term there are several reasons not to be too concerned. In other words, if we do go into a bear market in developed market shares it is likely to be relatively shallow unlike say the GFC falls of 50% plus and we continue to see shares having a better year this year than last.

First, the latest fall in Chinese shares arguably tells us more about regulatory issues and fears around the share market and currency rather than much about the economy. Recent economic data out of China has been mixed rather than outright negative.

Rather the main drivers have been worries about new share supply following the end to a ban on selling by major shareholders, a new share market circuit breaker which perversely encouraged investors to bring forward selling, and a continuing depreciation of the Renminbi against the $US. 

In terms of each of these: Chinese regulators have since announced a restrictive limit on the size of stakes that major investors can sell; the circuit breaker has now been suspended; and after a 6% plus depreciation in the value of the RMB since July the PBOC appears to be stepping up its effort to stabilise it and indeed some stability has returned in the last few days. Our view remains that Chinese growth this year will come in around 6.5% and ongoing stimulus measures appear to be gaining some traction in helping ensure this.

Second, a US recession is unlikely. This is critically important as the US share market sets the direction for global shares and the historical experience tells us that slumps in US shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is (eg the tech wreck and GFC).

See the next table. Sure US manufacturing is soft thanks to the strong $US and softening resource investment.

But against this we have seen none of the excesses that precede recessions – like excessive growth in private debt, over investment in housing or capital good, high inflation or a speculative bubble. And most economic indicators in the US are okay highlighted by continuing strong jobs data which is serving to keep consumer spending firing even though the strong $US has damped US manufacturing. Nor have we seen 17 Fed interest rate hikes or the move to an inverted yield curve as we saw prior to the GFC.

Third, the combination of okay economic data in China and the US along with good Eurozone indicators lately indicate the global economy is unlikely to plunge into recession. Sure while manufacturing conditions PMIs globally have been a bit softer lately, services conditions indicators remain reasonably solid.

Fourth, the current dynamic is very different to say the GFC as lower oil prices and commodity prices are providing a huge boost to consumers and most businesses. This is unlike the US housing slump at the time of the GFC that froze credit markets and led to a huge loss of household wealth or the surge in oil prices that preceded the GFC.

Fifth, monetary policy remains ultra easy. The Fed is very unlikely to undertake the four rate hikes it’s signalling for this year and other countries are still easing. This is very different to prior to the GFC when monetary tightening was the norm.  

Sixth, renewed sharp falls have seen share market valuations become quite attractive. Our valuation measures for global and Australian shares have fallen back into very cheap territory. The gap between the grossed up dividend yield on Australian shares which is now nearly 7% and term deposit rates around 2.5% is back to around its highest level since the GFC.

While confidence in Chinese shares is being tested again, it’s worth noting that Chinese companies listed in HK provide particularly attractive long term value trading on forward PEs close to 6 times, less than half that of Australian shares.

Finally, there is a lot of pessimism around. This is evident in headlines screaming “RBS tells investors to sell everything” to “Collapse 2016”. Then again you might say such extreme views always exist. True. But they are suddenly all landing in my inbox telling me that such headlines are getting much more interest and belief. In some ways this is a negative as it is creating more fear amongst investors, but the flipside though is that when everyone fears the worst, often the surprise is that things turn out to be better. 

Implications for Australia

The latest bout of global growth worries warns that the global environment Australia faces remains messy. So while rebalancing away from mining will continue to help we may face another year with growth stuck around 2.5%. Ongoing commodity price weakness means ongoing pressure on the budget deficit, points to more downwards pressure on the $A and more pressure on the RBA to cut interest rates again. Expect the $A to fall to around $US0.60 by year end and the RBA to cut the cash rate to 1.75%.

 

 

 

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A poor start to the year

Monday, January 11, 2016

By Shane Oliver

Investment markets and key developments over the past week

Shares have got off to a rather bad start for the year triggered by many of the same worries seen last year: a fall in Chinese shares and the value of the Renminbi, which in turn has triggered renewed worries about the Chinese economy; the weaker Renminbi triggering more commodity price weakness and fears of an emerging market crisis; some soft US manufacturing data; and geopolitical risks this time regarding tensions between Saudi Arabia and Iran and an H bomb test in North Korea. Consequently all share markets have seen sharp declines so far this year (with US shares -6%, Eurozone shares -7.2%, Japanese shares -7.0%, Chinese shares -9.7% and Australian shares -5.8%), commodity prices are down further with the oil price falling to its lowest since 2009 and bonds have rallied with safe haven buying.

The poor start to the year clearly warns that global growth concerns remain, that commodity prices are still under downwards pressure and that volatility in investment markets will likely remain high. However, it is worth putting these developments in some perspective.

The latest fall in Chinese shares may have a bit further to go but looks to have been exaggerated and driven more by fears and regulatory issues around the share market and currency rather than a renewed deterioration in economic indicators. While the Caixin business conditions PMIs were weaker in the last week official PMIs for December were stronger. Rather the main drivers were worries about new share supply following the scheduled end to a ban on selling by major shareholders, a new share market circuit breaker that commenced on Monday which appears to have added to market volatility rather than calmed it down because the 7% threshold for a market fall to trigger a shutdown was too tight and encouraged investors to bring forward selling in an effort to beat the shutdown and a continuing depreciation of the Renminbi.

Looking at each of these: Chinese regulators have since announced a restrictive limit on the size of stakes that major investors can sell; the circuit breaker has now been suspended after the experience of the last week; and after a 6% plus depreciation in the value of the RMB since July the PBOC is now likely to step up efforts to try and stabilise it again much as it did through September and October. The depreciation of the Renminbi is the key issue at present as its decline is helping fuel upwards pressure on the $US, adding to weakness in oil and other commodity prices and keeping alive fears of some sort of emerging market crisis. Fortunately, Friday did see some stability return to the Chinese share market and currency but it needs to be sustained.

While the US ISM manufacturing index has been softer lately and is a concern most US data points to stable underlying growth of around 2% or so. This includes employment in the US which rose by a much stronger than expected 292,000 in December.

Signs that global growth remains fragile and constrained will have the effect of ensuring that global monetary policy remains easy this year, with Fed tightening likely to be very gradual with maybe just two 0.25% rate hikes this year, Japan and Europe continuing with quantitative easing and China continuing to cut interest rates. The continuing global weakness also adds to the case for the RBA to cut interest rates again.

The tensions between Sunni Saudi Arabia and Shia Iran have been building for a while and partly flow from the US’ shift in military focus away from the Middle East. However, while they will continue to show up in wars in the region, eg in Syria and Iraq, they are unlikely to result in outright direct conflict in a way that dramatically pushes up oil prices. In fact in the short term the tension ensures that OPEC will remain paralysed with Saudi Arabia focussed on maintaining high production to inflict pain on Iran and Iraq, which will serve to keep oil prices low (or lower) for now.

North Korea’s H bomb test is a big concern but there is some debate as to whether it was really an H bomb and it has already had three nuclear tests since 2006.

So overall, while it’s been a poor start to the year for equity markets and risks remain high in the short term our expectation remains for better returns this year than we saw in 2015 as share market valuations are reasonable being cheap relative to bonds and bank deposits, global monetary conditions are likely to remain very easy and this should in turn help ensure a rising trend in share markets, albeit with bouts of volatility along the way. While confidence in Chinese shares is being tested again, it’s worth noting that Chinese companies listed in HK provide particularly attractive long term value trading on forward PEs close to 6 times, less than half that of Australian shares.

What about the January barometer? There is an old saying in relation to the US share market that “as goes January, so goes the year”. Sometimes this is narrowed down to the first five days of the year. This year the US S&P 500 with a fall of 6% for the first five days is off to its worst start at least back to 1950. However, the track record of this barometer is rather mixed. In fact the hit rate of negative first five days going on to negative years for the US share market has been 45% since 1950 and just 29% since 1980.

Major global economic events and implications

While the US ISM manufacturing conditions index softened further in December other data has been more favourable with the non-manufacturing conditions index remaining solid, gains in home prices, higher consumer confidence and labour market data remaining solid. The December jobs report was particularly positive with payroll employment up much more than expected at 292,000 and employment in the prior two months being revised up but increasing participation keeping the unemployment rate unchanged at 5% and wages growth coming in weaker than expected at 2.5% year on year. The strength in jobs tells us that the US economy remains solid, but rising labour market participation and soft wages growth gives the Fed plenty of breathing space on interest rates. Meanwhile the minutes from the Fed’s last meeting reinforced the focus on “actual and expected inflation” moving closer to target when considering future rate hikes, so it’s hard to see the Fed being anything but gradual in raising rates as weak commodity prices will continue to constrain inflation. The next Fed hike is unlikely till March but this could be delayed if global growth concerns, market volatility and falling commodity prices continue.

Eurozone bank loans accelerated further in November, German factory orders gained more than expected in November and confidence readings rose to their highest since 2011 in December and are at levels consistent with reasonable economic growth.

Chinese economic data has been mixed with better December readings for the official manufacturing and non-manufacturing PMIs but softer readings for the Caixin PMIs. Meanwhile, inflationary pressures remained low in December with non-food inflation of just 1.1% year on year and producer prices continuing to fall at the rate of 5.9% year on year, indicating that there are no constraints to further monetary easing here.

Australian economic events and implications

Australian economic data releases over the last two weeks were mostly soft. November retail sales were solid and the trade deficit fell slightly, but remains high. Meanwhile, the services sector PMI softened significantly in December, building approvals for November provided further evidence that the contribution to economic growth from home construction will slow this year, December home prices showed a further loss of momentum and lending to investors continued to slow in November. Our view remains that with global growth remaining fragile, commodity prices weak, mining investment still falling and housing’s contribution to growth set to slow that the RBA will have to cut interest rates further this year.

What to watch over the next two weeks?

In terms of recent market turmoil the key things to watch out for are stabilisation in the Chinese share market and currency.

In the US, the main focus will be on the December quarter earnings reporting season which will kick off today with Alcoa. The strong $US and weak oil prices are a drag, but as the consensus is for a 6% year on year decline in earnings there is a bit of scope for upside surprise. On the data front expect to see a modest 0.1% gain in December retail sales, a slight fall in industrial production and weak core producer price inflation (all Friday). Data for small business optimism and manufacturing conditions in the Philadelphia and New York regions will also be released.

In China, December data is likely to show continued strength in credit flows but ongoing softness in exports and imports (Wednesday).

In Australia, December jobs data (Thursday) is expected to show some reversal of the unbelievable 71,000 jobs surge seen in November. We expect a 10,000 decline in employment and unemployment to rise to 5.9% but the reality is that trying to pick the jobs numbers is a bit like forecasting a random number generator. November housing finance data (Friday) is likely to show a further decline in lending to investors.

Outlook for markets

Worries about China and the Fed are likely to drive continued volatility in the short term until some stability returns to the Renminbi and $US and hence in commodity prices. Beyond the short term we still see shares trending higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. But expect volatility to remain high.

Very low bond yields point to a soft medium term return potential from sovereign bonds, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation.

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

National capital city residential property price gains are expected to slow to around 3% this year, as the heat comes out of the Sydney and Melbourne markets. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes it’s usual undershoot of fair value. Expect a fall to around $US0.60 by year end.

While the Chinese share market and currency stabilised a bit on Friday and US jobs data was positive, investor nervousness remained pushing Eurozone shares down another 1.7% and the US S&P 500 down another 1.1%. As a result of the poor global lead ASX 200 futures fell 80 points signalling a poor start to trade for the Australian share market today.

 

 

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What to watch over the next two weeks

Thursday, December 24, 2015

By Shane Oliver

Major global economic events and implications

US economic data was mostly good. While durable goods orders for November were on the soft side and existing home sales plunged in response to slower property closings due to regulatory changes, consumer spending in November was solid, consumer confidence edged higher, new home sales rose and September quarter GDP growth was little changed at 2% annualised with strong growth in private demand. Meanwhile, inflation as measured by the core private consumption deflator remains stuck at 1.3% year on year in November which is well below the Fed’s 2% target and supports the case for Fed rate hikes to be gradual.

More economic stimulus on the way for China in 2016, with the Central Economic Work Conference signalling: more fiscal easing; “prudent” monetary policy which if 2015’s “prudent” is any guide means more PBOC easing; and measures to lower costs for companies and reduce the housing inventory. With Chinese real interest rates still too high for small and medium businesses we expect the PBOC’s benchmark interest rate to be cut towards 3%. The required reserve ratio for banks is still too high for an environment where the PBOC is no longer looking to sterilise capital inflows and is likely to fall to around 10% over the next few years.

What to watch over the next two weeks?

In the US, the focus will likely be on the minutes from the Fed’s last meeting (January 6), which are likely to reinforce the message that future interest rate hikes will be dependent on actual and expected progress towards meeting the Fed’s inflation objective and that they are likely to be gradual, and December’s jobs report (January 8). Expect December payroll employment to have increased by another 200,000, unemployment to remain at 5% and wages growth to rise to around 2.8% year on year. In other data releases, expect further gains in home prices and a rise in consumer confidence (December 29), a solid gain in pending home sales (December 30), a slight improvement in the ISM manufacturing conditions index (January 5) and continued strength in the ISM non-manufacturing conditions index (January 6). Apart from all this, the main event will be January 8th which will be Elvis’ 81st birthday.

In the Eurozone, expect December core inflation (January 5)  to have remained low at around 0.9% year on year and unemployment in November (January 7) to fall slightly to 10.6% from 10.7%. Money supply and credit data (December 30) will be watched for a further improvement in momentum.

In Japan, November industrial production data (December 28) and the Nikkei manufacturing conditions PMI (January 4) will be released.

China’s official manufacturing conditions PMI (January 1) and the Caixin PMI (January 4) are both expected to show modest improvements.

In Australia, expect credit data (December 31) to show continued moderate growth with an ongoing slowdown in lending to property investors, Core Logic/RP Data home price data for December (January 4) to provide further evidence that the Sydney and Melbourne property boom is slowing, November trade deficit to show a slight improvement, building approvals to fall (both January 7) and November retail sales (January 8) to show a 0.4% gain.

Outlook for markets

Shares are likely to see their traditional Santa Claus rally over the Christmas/New Year period as investors take advantage of improved valuations, monetary conditions remain easy and new issuance dries up into year end. However, worries about the Fed and a rising $US possibly weighing on commodity prices and emerging countries may mean that volatility will remain high.

For 2016, our key themes are as follows:

The combination of okay global growth, still low inflation and easy money remains positive for growth assets. But ongoing emerging market uncertainties combined with Fed rate hikes and geopolitical flare ups are likely to cause volatility.

Global shares are likely to trend higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth.

For shares we favour Europe (which is still unambiguously cheap and seeing continued monetary easing), Japan (which will see continued monetary easing) and China (which will also see more monetary easing) over the US (which may be constrained by the Fed and relatively high profit margins) and emerging markets generally (which remain cheap but suffer from structural problems).

Australian shares are likely to improve as the drag from slumping resources profits abates, interest rates remain low and growth rebalances away from resources. But they will probably continue to lag global shares as the commodity price headwind remains. Expect the ASX 200 to rise to around 5700 by end 2016.

Commodity prices may see a bounce from very oversold conditions and as the $US stabilises or slows, but excess supply for many commodities is expected to see them remain in a long term downtrend.

Very low bond yields point to a soft return potential from sovereign bonds, but it’s hard to get too bearish in a world of too much saving, spare capacity & low inflation.

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

National capital city residential property price gains are expected to slow to around 3-4%, as the heat comes out of the Sydney and Melbourne markets. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes it’s usual undershoot of fair value. Expect a fall to around $US0.6

I hope you have a transcendent Christmas and a pristine 2016.

 

 

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Shares poised for Santa Claus rally

Monday, December 21, 2015

By Shane Oliver

Investment markets and key developments over the past week

The past week has seen more volatility with shares initially falling then rallying into and immediately after the Fed’s decision to raise interest rates before then giving back some or all of their gains as commodity price weakness and global growth worries continued. This left share markets mixed for the week with eurozone shares up 1.8%, Australian shares up 1.5% and Chinese shares up 4.2%, but US shares down 0.3% and Japanese shares down 1.3%. Japanese shares were dragged lower by disappointment that an enhancement to the Bank of Japan’s monetary easing program didn’t go further. Oil and gold prices fell not helped by a rise in the value of the $US. The stronger $US saw the $A fall. Bond yields rose in the US but fell in Australia.

At last the Fed raises rates, but expect future moves to be gradual. The Fed's rate hike was hardly a surprise to anyone. It has been warning of such a move all year and markets have been in fear of it all year. There are four key points to note. First, the hike after seven years at zero is a vote of confidence in the US economy. Second, by starting to move ahead of inflation picking up the Fed is hoping to prolong the business cycle rather than end it. Third, future rate hikes are conditional on further improvement in the US economy, with the Fed's commentary highlighting a greater focus on achieving progress towards its inflation goal as a condition for further rate hikes. 

Fourth, future hikes are likely to be gradual as inflationary pressure remains low, probably more gradual than the Fed's "dot plot" projections for four 0.25% rate hikes next year. Finally, the Fed has indicated that it does not plan to start reversing its quantitative easing - the next big move - until interest rates get much closer to normal – so this is likely to be a 2017 issue at the earliest and when it does start it will probably just be with the Fed no longer rolling over maturing bonds on its balance sheet. With the Fed out of the way for now, monetary conditions likely to remain easy for a long time to come and the Fed not likely to do anything to upset the growth outlook, shares should see their normal Santa Claus rally into year-end. But as we have seen in the last few days it’s likely to be a bumpy ride.

But, how big a threat are the redemption freezes imposed by some US mutual funds that invest in junk bonds? There is clearly a risk here with energy debt at risk due to the continuing plunge in oil prices and the risk that some investors not used to the risk of corporate debt may panic. Against this, some of the funds freezing redemptions had very concentrated investments in risky and illiquid bonds, broader US corporate health is good and junk bond yields around 9% are attractive. In short, it’s an issue to keep an eye on - be alert but not alarmed.

The move by the US to remove its ban on oil exports will add to negative sentiment around oil. First, it will likely further close the gap between global and US oil prices (which is currently around $US2/barrel between Brent and US West Texas Intermediate). Second, it will reinforce Saudi Arabia’s disinclination to help balance the global oil market as it knows that it will just lose long term market share if it does. Finally, while it may not result in a further sharp fall in oil prices as the US is still a net oil importer, it will help cap upside in oil prices, to the extent that higher prices will drive stronger US production and potentially exports. 

In Australia it was a case of another budget update, another deficit blowout. The Mid-Year Economic and Fiscal Outlook projects the four year deficit outlook to be a cumulative $26bn worse than projected at the time of the May Budget thanks to a combination of weaker commodity prices and lower economic growth. While this is only 0.5% or less of GDP a year, it’s still yet another deterioration pushing the return to surplus out by another year to now 2020-21. Given this slippage has been an going phenomenon for several years now (see the next chart) it’s reasonable to ask to as to whether we will ever get to surplus. This is particularly so given that history warns of an economic downturn sometime in the next five years and that the aging population will start making a return to surplus even harder next decade. 

While Australia’s public debt levels relative to GDP are modest by Japanese, US and European standards our ongoing failure to bring the deficit under control warns that we could find ourselves slipping into a debt problem. In the interest of avoiding this and providing flexibility to undertake fiscal stimulus through the next economic downturn it is imperative that our politicians find ways to stabilise revenue growth and limit spending.

 

Source: Australian Treasury, AMP Capital

Major global economic events and implications

US economic data was mixed with weak industrial production, a fall in the Markit manufacturing PMI for December (although it’s still well above the ISM) and weak readings for manufacturing conditions in the NY and Philadelphia regions, a slight fall in the NAHB's home builders' conditions index albeit to still strong levels but very strong gains in housing starts and permits, strong leading indicators and a larger than expected fall in jobless claims. US inflation rose in November on an annual basis but mostly due to low numbers a year ago dropping out.

Eurozone industrial production rose more than expected in October, and while business conditions PMI's slipped in November their continued strength points to improved growth ahead.

While the Bank of Japan enhanced its quantitative easing program to buy longer dated bonds and expand the purchase of ETFs by ¥300bn annually it’s a trivial move relative to the size of the current program. In fact, it may have backfired to the extent that it added to investor fears that the BoJ is not really prepared to do more.

Chinese property prices continued to rise in November indicating that the gradual property market recovery is continuing.

Australian economic events and implications

Australian house prices were confirmed by the ABS as seeing solid gains in the September quarter – up 2% quarter on quarter of 10.7% year on year, led by Sydney and Melbourne. This is old news though as more recent private sector home price data series point to a sharp softening in recent months. Meanwhile, skilled vacancies rose further in November indicating that labour market strength may be continuing – albeit not quite as strong as recent ABS data suggests. 

The minutes from the RBA’s last Board meeting offered nothing new – with the RBA reasonably positive on recent data but still retaining a mild easing bias. At this stage the RBA remains quite happy to “chill out” over the Christmas period, but our assessment remains that with the mining investment boom still unwinding, commodity prices still weak, the contribution from housing to growth starting to slow next year and inflation remaining very low that the RBA is still likely to ease again next year.

Oil prices at new lows yet petrol prices remain high – how come? As can be seen in the next chart the Asian Tapis oil price in Australian dollars has fallen well below its January low but Australian capital city petrol prices are averaging well above their January lows. Someone is making a higher margin.

Source: Bloomberg, AMP Capital

What to watch over the next week?

In the US, expect to see gains in home prices and existing home sales (Tuesday), but a downwards revision to September quarter GDP growth to 1.9% annualised from 2.1% (also Tuesday), the core private consumption deflator for November remaining low at 1.4% year on year, a slight fall back in durable goods orders after a strong rise in October and a gain in new home sales (all Wednesday).

In Europe Spain's general election (Sunday) will be watched closely. Recent opinion polls show some increase in support for the left wing/anti-establishment Podemos party but the most likely outcome remains a coalition involving the ruling People's Party. Either way much of heavy lifting on reforms has already been done in Spain. So a Greek style existential crisis regarding the Euro is unlikely to be triggered.

Japanese data (Friday) is expected to show continued labour market strength, a slight improvement in household spending but still low inflation.

Outlook for markets

With the Fed out of the way for now, shares are likely to see their traditional year-end Santa Claus rally as investors take advantage of improved valuations, monetary conditions remain easy and new issuance dries up into year end. However, worries about a rising $US weighing on commodity prices and emerging countries mean that volatility will likely remain high.

More broadly the trend in shares is likely to remain up. Shares are cheap relative to bonds, monetary conditions are set to remain easy and the Fed is unlikely to do anything to threaten global growth, and this should help see the global economic recovery continue. Our end 2015 target of 5500 for the ASX 200 may be a bit of a stretch, but we see it rising to 5700 by end 2016.

Low yields point to soft medium term government bond returns, although they remain a great portfolio diversifier.

The $A could continue to bounce around the $US0.70-0.73 level in the short term, but the broad trend is likely to remain down as the interest rate differential in favour of Australia is set to narrow and the trend in commodity prices remains down. This is expected to see the $A fall to $US0.60 in the next year or so.

Eurozone shares fell 1.2% on Friday and the S&P 500 lost 1.8% as investors continue to fret about the risk of slowing global growth. As a result of the poor US lead, ASX 200 futures fell 40 points or 0.8% pointing to a weak start for the Australian share market.

 

 

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A constrained year for investors

Monday, December 14, 2015

By Shane Oliver 

2015 has seen another long worry list for investors. Some of these – such as terrorist attacks in Paris, the escalating war in Syria, refugee problems in Europe, Greece’s latest tantrum and tensions in the South China Sea – have not had a lasting impact on investment markets. However, worries about deflation, falling commodity prices, fears of an emerging market (EM) crisis led by China and uncertainty around the Fed’s first interest rate hike have had a more lasting impact. In Australia the focus remained on the rebalancing of the economy after the mining boom as well on property bubbles. While it has not been a bad year for investors, overall returns have been constrained.

Key themes have been:

Constrained global growth. This has been the story for the last few years. Global growth yet again failed to take off being constrained by a combination of a slowing manufacturing sector in the US, another downturn in Japan, a further slowing in China and deep recessions in Brazil and Russia. As a result global growth remained uneven and stuck around 3%. However, while this is causing ongoing skittishness amongst investors it’s not bad. Stronger growth would only bring inflation and interest rate worries.

Deflation fears linger. Inflation remained low or fell in developed countries as excess capacity and falling commodity prices continued to impact.

Falling commodity prices. The plunge in commodity prices continued as surging supply faced slower demand led by China. Bad news for commodity producers and related investments but good news for most developed countries.

Further global monetary easing, but with the Fed diverging. While the Fed moved towards its first rate hike after seven years at zero, lift off was continuously delayed as central banks in China, Europe and Japan continued to ease in the face of sub-par growth and the deflation threat.

More geopolitical threats. Terrorist attacks in Paris, the escalating war in Syria and tensions in the South China Sea all caused periodic fear, but without much lasting impact.

Subdued growth and more rate cuts in Australia. The mining slump continued to weigh seeing growth remain sub-par. This saw the RBA cut the cash rate to a record low of 2%. But thankfully recession remains elusive as the economy has rebalanced with NSW and Victoria doing well.

While global growth remains in a “sweet spot”, its fragility & the associated skittishness of investors – particularly around China, EMs and the Fed – made for a volatile and disparate ride in investment markets.

* Yr to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP Capital
 

Share markets started 2015 well, as falling inflation & bond yields saw shares revalued only to see them correct under the weight of China/EM/Fed worries, before rebounding somewhat into year-end as such fears faded a bit.

In the developed world US shares took a back seat relative to Japanese and European shares which benefitted from easier monetary policy and lower currencies.

While Chinese shares had a strong start, they fell back on bubble fears. Emerging market shares performed poorly.

Commodities had another bad year as supply surged, Chinese growth slowed and the $US rose.

Australian shares underperformed yet again as the slump in commodity prices weighed and as the big banks faced slower growth and higher capital requirements. While the utility, industrial and health sectors did well this was offset by resources, banks and consumer staples.

Global and Australian bonds had subdued returns reflecting low yields.

Real estate investment trusts and unlisted assets like commercial property and infrastructure had strong returns as investors sought decent sources of income yield.

Australian residential property had a good year, but mainly due to house price gains in Sydney and Melbourne. However, gains slowed significantly in the December quarter as official measures designed to slow property investor lending kicked in.

Cash rates and bank term deposit returns were poor reflecting record low RBA interest rates.

The $A fell another 10% and this helped boost the returns from global shares, once translated into Australian dollars.

Balanced superannuation funds still exceeded cash and inflation but are on track for their softest returns since 2011.

2016 – another year of constrained growth

No doubt those who were looking for economic mayhem to break out in 2015, will simply roll their expectations for disaster into 2016. However, there are good reasons to believe we will simply see a continuation of the constrained uneven global growth that we have been seeing over the last few years.

Major economic downturns are invariably preceded by either economic or financial overheating and there are no signs of that. There has been no major global bubble in real estate or business investment, inflation remains low, share markets are not unambiguously overvalued and global monetary conditions are easy. In terms of the latter while the Fed is likely to raise rates the process is likely to be gradual reflecting constrained US growth and still low inflation. And monetary easing is set to continue elsewhere, which in turn will also limit the extent of Fed tightening to the extent it puts upwards pressure on the value of the $US. As such, apart from a left field shock, it is hard to see what will drive a major global economic downturn at present.

At the same time, it is hard to see what will drive a sharp acceleration in economic growth either. Rather, the structural combination of slower population growth, a more cautious approach to debt and structural problems in the emerging world will keep a lid on global growth.

Consistent with this leading growth indicators point to steady growth. Not collapsing, but not booming either.

Source: IMF, AMP Capital


For Australia, the economy is likely to continue to rebalance away from mining. However, in the face of a further fall in mining investment, falling national income, a slowing contribution from housing and upwards pressure on bank mortgage rates from increasing capital requirements, further monetary stimulus in the form of more RBA interest rate cuts and a lower $A are likely to be needed. If this occurs then improving conditions in sectors like consumer spending, tourism, manufacturing and higher education should see GDP growth move up to around 3% by year end. At the same time

Implications for investors?

The combination of okay global growth, still low inflation and easy money remains positive for growth assets. But ongoing emerging market uncertainties combined with Fed rate hikes and geopolitical flare ups are likely to cause volatility.

Global shares are likely to trend higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth.

For shares we favour Europe (which is still unambiguously cheap and seeing continued monetary easing), Japan (which will see continued monetary easing) and China (which will also see more monetary easing) over the US (which may be constrained by the Fed and relatively high profit margins) and emerging markets generally (which remain cheap but suffer from structural problems).

Australian shares are likely to improve as the drag from slumping resources profits abates, interest rates remain low and growth rebalances away from resources, but will probably continue to lag global shares again as the commodity price headwind remains. Expect the ASX 200 to rise to around 5700 by end 2016.

Commodity prices may see a bounce from very oversold conditions, but excess supply for many commodities is expected to see them remain in a long term downtrend.

Very low bond yields point to a soft return potential from sovereign bonds, but it’s hard to get too bearish in a world of too much saving, spare capacity & low inflation.

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

National capital city residential property price gains are expected to slow to around 3-4%, as the heat comes out of the Sydney and Melbourne markets.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes its usual undershoot of fair value. Expect a fall to around $US0.60.

What to watch?

The main things to keep an eye on in 2016 are:

how aggressively the Fed raises rates – continued low inflation is likely to keep the Fed gradual (as we expect), but a surprise acceleration in inflation would speed it up;

whether China continues to avoid a hard landing;

whether non-mining investment picks up in Australia - a failure to do so could see more aggressive RBA rate cuts;

ongoing geopolitical flare ups, including in the South China Sea; and

whether the global economy can finally throw off the worry list and constraints seeing growth perk up.

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