Shane Oliver's Insights

Investment markets and key developments over the past week

• While Australian shares push higher over the last week, other major share markets declined. US shares fell as oil prices declined, Eurozone shares fell with nervousness ahead of bank stress test results, Japanese shares fell after an underwhelming easing by the Bank of Japan and Chinese shares fell on the back of the banking regulator increasing measures to reduce financial risks. Bond yields also fell, but commodities were mixed with oil down and iron ore up and the US Dollar (AX:USD)declined which saw the AUD/USD rise above $US0.75.
• Overall July has been a good month for shares with the Australian share market up around 6.2%, leaving it on track for its best month since February last year. Key drivers have been good global economic data, good profit news out of the US, talk of easier for longer monetary policy and in Australia’s case a further rise in the iron ore price. As can be seen in the chart below economic data has been coming in better than expected lately with economic surprise indices (which measure data releases against market expectations) looking better for the US and major economies.

• As expected the Fed is more upbeat on the US economy, sees the near term risks as having diminished but still sees only gradual interest rate increases ahead. US money market probabilities of a Fed hike of 28% for September and 45% for December still look too low, but the basic message is that the Fed is not going to do anything to knowingly put the global and US economies at risk given the fragile nature of growth and the fact that inflation remains low.
• After much anticipation Japan has announced more monetary and fiscal stimulus. However, the Bank of Japan has underwhelmed with just a doubling of its of ETF buying program (to ¥6 trillion pa) but no increase in its bond buying program or monetary base target suggesting no real further easing of monetary policy. Rather the focus now shifts to fiscal stimulus with PM Shinzo Abe announcing plans for a ¥28 trillion economic stimulus, which may be detailed in the next week or so. While this is a big number (6% of GDP) much uncertainty remains around the detail of the stimulus – in terms of how much is real new stimulus (with some indications it will be just ¥7trn) and how many years it will be spread over. It’s doubtful that any of this will be enough to break the stop/start recession pattern and achieve the 2% inflation target so ultimately some form of helicopter money (ie, financing of government stimulus by the BoJ) will be required, but we are not there yet. In the mean-time there is a risk of further Yen strength.
• What's wrong with Italian banks? Put simply after years of poor growth and low interest rates Italy's banks have seen their non-performing loans rise to the point that two of them need to be recapitalised or else they will have to slow lending which will be bad for Italian growth. The trouble is that their share prices have collapsed making it hard to raise capital from the equity market and European rules on bank recapitalisation require private bond holders in banks to take losses ahead of the injection of public money. After the political furore that followed when an elderly retail investor committed suicide last November after having to take a €100,000 loss on a bond holding in a small bank, the Italian Government cannot afford to have a wider “bail-in” of ordinary bank investors as it will damage its prospects of winning a referendum on reducing the Italian Senate's power, which in turn could lead to the fall of the Renzi Government. So there is a stand-off between PM Matteo Renzi and the European Commission, but ultimately a compromise is likely as the rest of Europe realises that failure to do so could see the Eurosceptic Five Star Movement attain power in Italy. The European Banking Authority's bank stress tests could help clear the way for such a compromise.
• While June quarter inflation in Australia was in line with expectations including those of the Reserve Bank it showed that inflation has fallen further below target and that underlying inflationary pressures are very weak. Ongoing signs of very weak pricing power are evident in a range of areas including for supermarket items, clothing, rents, household equipment, car prices, communication and recreation. The basic message is the global deflationary forces, high levels of competition and weak wages growth are keeping inflation ultra-low with the risk inflationary expectations will be pushed down and make it harder to get inflation back to target. As such, pressure on the RBA remains intense.

Major global economic events and implications

• US data was a bit mixed over the last week with stronger than expected consumer confidence and new home sales and continuing low jobless claims, but soft durable goods orders, pending home sales and home prices and a worse than expected goods trade deficit.
• Evidence is continuing to build that US profits have bottomed. 299 S&P 500 companies have now reported June quarter earnings to date and the results show an 8% plus pick-up in profits on the March quarter with 81% beating on earnings and 59% beating on sales.
• While confidence readings in the UK continue to come in very weak post Brexit, they are holding up reasonably well in the Eurozone with economic confidence actually rising slightly in July. Eurozone bank lending growth also picked up a notch in June pointing to continued moderate growth.
• Although Japanese jobs data in June remained solid and industrial production rose, household spending remains very weak, deflation remains evident in a fall in the CPI of -0.4% year on year and core inflation fell further to just 0.4% yoy. What’s more the jobs data is being flattered by a falling workforce and while industrial production bounced it followed a weak May and is down -1.9% yoy. All of which explains the need for more aggressive stimulus in Japan.

Australian economic events and implications

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

What to watch over the next week?

• In the US, jobs data (Friday) is likely to remain consistent with solid US economic growth. Expect a 180,000 gain in payroll employment, unemployment remaining around 4.9% and a slight edging up in wages growth from 2.6% year on year. Meanwhile the manufacturing conditions ISM index (Monday) is likely to remain ok at around 53, the core private consumption deflator inflation (Tuesday) is expected to hang around 2.6% yoy and the non-manufacturing conditions ISM (Wednesday) is expected to remain solid. June quarter corporate earnings will also remain a focus.
• The Japanese Government will be watched for any more details regarding its ¥28 trillion plus stimulus package. The July services sector PMI will also be released (Wednesday).
• Chinese manufacturing conditions PMIs (Monday) are expected to show a modest improvement, but nothing to excite.
• In Australia, we expect the Reserve Bank (Tuesday) to cut the cash rate again by another 0.25% taking it to a new record low of 1.5%. The June quarter inflation data is not low enough to make an RBA rate cut certain particularly given that recent economic data has been reasonably good. However, on balance we expect that the RBA will cut again to help ensure that inflation expectations do not become entrenched below 2%, so that there is reasonable confidence that inflation will move back into the target zone in a reasonable time frame and to head off a rebound in the $A. Alternatively if the RBA does not cut again on Tuesday, then expect an easing in November. The RBA’s Statement on Monetary Policy (Friday) will likely make minimal changes to its growth and inflation forecasts.
• On the data front in Australia, expect July CoreLogic data to show a further loss of momentum in Sydney and Melbourne home prices, a 1% bounce in June building approvals and a slight improvement in the June trade deficit (all Tuesday) and a 0.3% gain in retail sales (Thursday).
• The Australian June half profit reporting season will also start to get underway in the week ahead with a handful of companies due to report (including Rio, Tabcorp and Suncorp). After the downgrades since the last reporting season back in February the hurdle to avoid disappointment is now relatively low. Consensus expectations for 2015-16 earnings are now for an 8% decline in profits driven by a 50% fall in resources earnings and a 2% fall in bank profits leaving profits in the rest of the market up just 1%. Key themes are likely to be: improved conditions for resources companies following a stabilisation in the iron ore and oil price; constrained revenue growth for industrials although improved business conditions according the NAB business survey may help; ongoing cost cutting; continuing headwinds for the banks; and an ongoing focus on dividends. Sectors likely to see good profit growth are discretionary retail, industrials, gaming and healthcare.

Outlook for markets

• Brexit related risks, Italian bank risks, renewed $US strength and seasonal September quarter weakness could still see more volatility in shares in the short term. However, beyond near term uncertainties, we anticipate shares trending higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth.
• Ultra-low bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said, the recent bond rally has taken yields to pathetic levels leaving them at risk of a snapback.
• Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.
• Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to tougher lending standards and as apartment prices get hit by oversupply in some areas.
• Cash and bank deposits offer poor returns.
• The Australian dollar is still higher than it should be and the longer term downtrend looks likely to continue as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain in a secular downswing and the $A sees its usual undershoot of fair value. The $A is still likely to fall to around $US0.60 in the years ahead.