The global economy: June quarter 2014 review and outlook
Summary
After a volatile start to the year, global financial markets calmed down over the second quarter of 2014 with low volatility recorded, allowing global equity markets to rally and sovereign bond yields to fall. Financial markets were buoyed by expectations that the US Federal Reserve (‘the Fed’) would remain on the sidelines for a longer period of time before the first interest rate hike, while the European Central Bank (‘ECB’) cut interest rates and employed further unconventional monetary policy measures to boost growth and prevent deflation. Geopolitical risks stemming from the Middle East and Ukraine did add some volatility to markets, particularly the oil price, but tensions eased somewhat prior to quarter-end.
Overall, however, financial markets traded with very little volatility over Q2 2014, seemingly paying little attention to the potential risks, particularly emerging evidence of rising inflation and the impact on the timing of future tightening by the US Fed. The Chicago Board Options Exchange Volatility Index (‘the VIX’) averaged 12.76 over Q2 2014, compared to 14.81 in Q1 2014 and 14.25 in 2013. The US Dow Jones also recorded 51 days of moves less than 1% till the end of June in a unique period of low volatility.
The US Fed continued its reduction of ‘tapering’ of the QE3 bond asset purchase program over Q2 2014. At both its May and June meeting the Fed tapered by $US10bn, with bond buying down to $US35bn per month in June. At the current rate the Fed will finish its tapering program in either October or December 2014.
At this stage there has been no communication on the potential exit strategy by the Fed and markets appears complacent as to the risks of higher interest rates in the US. Instead Fed Chair, Janet Yellen, reiterated there was no urgency to step back from the highly accommodative monetary policy.
The largest revision in US GDP since 1976 was recorded for Q1 2014 GDP. Initially growth of 0.1% on a seasonally-adjusted-annualised-rate was recorded, before being initially revised to -1% in the second estimate before the third estimate was released at -2.9% (the weakest in five years). The overall weakness in GDP was driven by the extreme winter weather, however the biggest source of the revision was a slowdown in health care spending with a change in assumptions post introduction of Obamacare.
Global developed equity markets rose steadily over the quarter, with the strongest gains coming in May and June. Signs of an improving US economy post the weather related fall in Q1 2014 assisted the gains globally. The labour market continues to improve with the unemployment rate down at 6.1% in July, with job gains accelerating. Also assisting global equity markets were signs of stabilisation in China post the fine tuning policy measures announced by the government, as well as a reasonable earnings season in the US. Overall, the MSCI World Developed Markets Index increased by 4.2% to return a robust 21.6% over 12 months.
In the US, the S&P500 Index (+4.7%) reached a new all-time high in June, as investors rode on the belief the Fed was still a ways off tightening monetary policy, with lower bond yields also boosting the attractiveness of equities. High frequency US economic data also showed an improvement after a very weak first quarter, while company earning season and mergers and acquisition activity also boosted equity market returns. The energy (+11.2%) sector was the strongest performer given the gains in the oil price on supply concerns, while financials (+2.0%) underperformed.
European equities (Euro Stoxx 50 Index, +2.1%) were supported by some stabilisation in economic data, falling sovereign bond yields and further unconventional monetary policy measures announced by the ECB. The ECB lowered its Main Refinancing Rate from 0.25% to 0.15%, the lowest on record and the deposit rate was lowered into negative territory at -0.1% in an effort to fight deflation and a strong Euro. In the equity markets, Italy (-1.9%) fell after a strong performance in Q1 2014, while Spain rose (+5.6%) on improved macroeconomic data. UK (+2.2%) rose on strong labour market conditions and generally a more upbeat economic assessment.
The Japanese equity market (Nikkei 225 Index, +2.3%) rose after a weak Q1 2014, in the lead up to the consumption tax increase (from 5% to 8%) on 1 April 2014. At this stage the Japanese economy has handled the tax change reasonably well, with economic data released post this change showing reasonable economic momentum. Retail sales did fall in April and May as consumers brought forward consumption into March. Other economic data did improve, with both the Tankan Manufacturing Outlook and Non-Manufacturing Outlook Indices recording gains. Overall, financial markets continue to place faith in Prime Minister’s Abe growth strategy.
The MSCI EM Index rose by 5.6% in Q2 2014 after falling in Q1 on the US Fed’s tapering program. India performed particularly well (MSCI India +12.9% in USD) post the conclusion of the world’s largest election. The National Democratic Alliance won, led by the Bharatiya Janata Party and Gujarat Chief Minister, Narenda Modi. Modi’s decisive victory and his record as Chief Minister of Gujarat excited market prospects for the outlook of India over the next five years. After the excitement of early in 2014, EM bond yields fell sharply in Q2 2014, with the JPMorgan EMBIG sovereign bond yield falling by 55bps to finish at 5.31% by June quarter-end, as EM FX also stabilised post the currency interventions in Q1.
In Australia, the ASX200 Accumulation Index returned +0.9% during the June quarter, underperforming global equity markets. Domestic investors had to continue to contend with concerns over China’s growth prospects, which weighed on the materials (-3.3%) sector. The iron ore price fell by 20% over the quarter, reaching a 22-month low of $US89 per metric tonne on 16 June 2014. Falls were driven by concerns over ongoing demand from China and as a large amount of supply from Australian entered the market. Energy stocks helped to support the market, buoyed by the rising oil price and reflecting the progress made with various liquefied natural gas (LNG) projects. Several ASX-listed companies are in the process of developing LNG projects, both within Australia and overseas.
There was a significant amount of corporate activity in the market, with a number of companies completing initial public offerings or requesting additional capital from shareholders. There was also an increase in merger and acquisition activity during the quarter. Several companies including David Jones and Treasury Wine Estates attracted takeover approaches, while Ramsay Health Care and Transurban Group made significant acquisitions of their own.
Longer-dated sovereign bond yields in the US, UK, Europe and Japan finished the June quarter lower. A combination of mixed global economic data (US, China, Japan and Eurozone), geo-political crises (Ukraine and Iraq), the continuation of ultra-accommodative monetary policy (led by European Central Bank policy easing and the US Federal Reserve’s lower terminal rates) and investor position ‘squaring’ (investors closed-out big short positions, which had been taken out in early 2014 to take advantage of the expected increase in interest rates) all contributed to the rally. US Treasury yields were also pulled lower by increasing foreign investor demand (foreigners had been on the sidelines post the QE3 ‘taper’ shocks of 2013) with their relatively attractive carry and yield compared with German and Japanese counterparts, in particular.
Overall, the 10-year US Treasury yield ended the quarter 22bps lower at 2.50%, while the 10-year German Bund yield fell by 37bps to 1.20%. The 10-year UK Gilt yield decreased by 7bps to 2.67% over the quarter, and the 10-year Japanese Government Bond yield fell by 10bps to 0.52%.
There was a solid bond rally in Australia during the June quarter, with CGS yields outperforming their global peers. The front-end of the curve remained anchored by the Reserve Bank of Australia’s (RBA) record low 2.5% cash rate and neutral policy bias with the three year CGS yield declining by 42bps to 2.69% in Q2 2014.
The longer-dated CGS yield finished the quarter at 3.54%, reaching its lowest level since June 2013, with the spread between the 10-year CGS and US Treasury dropping to around 100bps, near levels last seen in August 2013. The ECB’s policy easing and US Federal Reserve Chair Janet Yellen’s reiteration that US interest rates would remain low for a “considerable time” reinforced the impact of the US rally on Australia.
CGS also remained well-bid due to domestic factors. Yields rallied following the release of fairly ‘dovish’ RBA June meeting minutes, with the Board retaining its outlook for a “period of interest rate stability” over the quarter. Demand for CGS was also supported by a softer Australian growth outlook, with the cash rate hike market pricing expectations receding amid weaker economic data (retail sales, building approvals and housing price growth) outcomes. The Federal Budget weighed on consumer confidence, while diminishing bond supply (both CGS and semis) also contributed to the rally. The firm Australian dollar (AUD), which was up by 1.8% against the US dollar over Q2 2014, also likely attracted foreign buyers of CGS.
Details of key events during the June quarter for the G4 major economies, Australia and China are:
United States
Taper time: The US Fed continued its ‘tapering’ of its QE3 bond purchase program by $US10bn in both its May and June meeting. By July 2014, the Fed’s monthly asset purchases are $US35bn per month, down from $US85bn per month at the end of 2013. In addition, the Fed is expected to reduce the pace of bond purchases further “in measured steps at future meetings” with a complete QE exit expected by either October or December 2014. At this stage no guidance has been provided as to the timing or method of the Fed’s exit strategy, although expectations are rising that the first interest rate hike is likely in Q3 2015 and the Fed could continue to reinvest coupons to maintain the size of its balance sheet after the first rate hike. This is contrary to the June 2011 exit principles.
New forecasts: At its June meeting, the FOMC members updated their key economic and interest rate forecasts. The ‘central tendency’ forecasts for the economy have been revised marginally lower for 2014 – mainly due to the poor-weather effected Q1 2014 GDP report. US real GDP growth in 2014 is projected to be between 2.1% and 2.3%, down from the 2.8% to 3.0% projection made in March. This still implies GDP growth will average roughly 3.0% at an annualised pace over the final three quarters of this year. Fed officials continue to anticipate real GDP growth of about 3.0% in 2015. The FOMC did also marginally lower its estimate of longer-run growth to 2.1% to 2.3% from 2.2% to 2.3%. As widely expected, given the significant improvement in the US labour market, the FOMC has lowered its 2014 unemployment rate forecast to 6.0% to 6.1% from 6.1% to 6.3%. In response to the faster drop in the unemployment rate, the Committee increased modestly the projected pace of policy tightening in 2015 and 2016. The median Fed funds rate projection for 2015 rose to 1.13% from 1.0%, and in 2016 increased to 2.5% from 2.25%. However, the median long-run Fed funds rate projection fell to 3.75% from 4.0%, suggesting that the neutral long-run policy rate is now lower than it was prior to the Global Financial Crisis (GFC).
Employment reaches pre-GFC level after 77 months: In a sign of the overall improvement in the US economy, the employment level finally reached its pre-GFC level, taking 77 months to do so, the longest reversion in recent history. Over Q2 2014, 816,000 jobs were added, the fastest pace since Q1 2012 and the unemployment rate fell to 6.1%, the lowest since September 2008. Importantly with the unemployment rate now at 6.1%, it has reached the Fed’s end of 2014 projection, six months earlier, and once again raises discussion of the Fed’s exit strategy. Jobs growth has been broad based among industries and recent falls in the unemployment rate have been driven by employment gains, with the participation rate holding steady over the quarter at 62.8%.
Economic data recovers after weather impacted Q1: After a weak Q1 2014 due to a cold winter, there were signs of a recovery during the second quarter outside of the strong employment growth detailed above. The housing market improved, with housing starts moving back through the 1 million level in May, existing home sales also recovered in April and May. New home sales in May recorded their strongest pace at 504,000 since May 2008. Consumer confidence improved over the quarter, with the University of Michigan measure rising to 82.5 in June, compared to 80.0 in March. The ISM Manufacturing Index also rose over the quarter, 55.3 in June versus 53.7 in March, as did the ISM Non-Manufacturing Index, which rose to 56 in June versus 53.1 in March.
Europe
Further policy measures announced by the ECB: The ECB cut all three of its key interest rates in a widely expected move at its 5 June meeting. The ECB lowered its main refinancing rate from 0.25% to 0.15% and in a historic move lowered its deposit rate into negative territory at -0.1%. The Marginal Lending Facility rate was lowered to 0.4% from 0.75%. It is unlikely any further rate cuts will occur with ECB President, Mario Draghi saying that rates are now at the lower bound. In the biggest surprise, the ECB announced a more generous Targeted Long Term Refinancing Operation (TLTRO) than the market expected. Banks will initially be able to borrow up to 7% of their current loan book to corporates and households (ex-mortgages), currently estimated at €400bn, as long as certain lending measures are met. In further information released at the 3 July meeting, Mario Draghi did suggest the total figure could be as high as €1trn. Banks will be able to borrow these funds over four years at 0.25%. All these measures are an attempt to stave off deflation and promote growth. Latest inflation figures show Europe is heading close to deflation, with CPI rising 0.5% per year in June, compared to 1.6% 12 months ago. GDP growth was recorded at 0.2% per quarter for March and 0.9% per year.
European Parliamentary elections show further polarisation amongst electorate: European Parliamentary elections were held from 22 to 25 May. Anti-establishment and Euroskeptic parties had their strongest showing in the 35 year history of EU elections, particularly in France and the UK. However the European People’s Party (the coalition of centre-right parties) still won the majority of votes and the Socialists/Social Democrats polled second. One clear positive out of the election was in Italy, where Prime Minister Renzi's position was strengthened as his party came in first, while the Euro critical party, Five Star Movement came in second. This result will help support Renzi’s structural reform plans and position as Prime Minister. Jean-Claude Juncker was nominated as European Commission President during June. The former Prime Minister of Luxembourg was appointed despite attempts by the UK to block his nomination.
United Kingdom
Change of tact by BoE Governor: The Monetary Policy Committee (MPC) of the Bank of England (BoE) maintained policy on hold throughout the June quarter. The Bank Rate was unchanged at 0.5% and the stock of asset purchases at £375bn. However BoE Governor Mark Carney warned that the first Bank Rate hike “could happen sooner than the markets currently expect” at his annual Mansion House speech on 12 June 2014. The market reaction was quick with expectations of the first hike brought forward from May 2015 to January 2015. The speech provided an important shift in BoE communication. Prior to this speech, Governor Carney had been keen to cool market expectations, putting forward an argument in favour of retaining the current ultra-accommodative policy due to the persistent slack in the economy. In his statement, the Governor appeared more ‘hawkish’ than the market, adding that the decision on the first rate hike “is becoming more balanced”. That said, Governor Carney later highlighted that “the MPC has no pre-set course”, and the decision will highly depend on data developments, with wages and prices being among the most crucial and closely monitored indicators.
UK economy continues to rebound: GDP growth increased by 0.8% in Q1 2014, slightly below the consensus of +0.9%. The annual growth rate accelerated to 3.1%, the strongest pace since late 2007. All sectors experienced growth in the quarter. House prices are still in a decisive uptrend and led to the Financial Policy Committee of the BoE to announce macro-prudential measures to help cool the market. House prices rose by 8.7% per year in May according to Halifax, matching a 7-year high The unemployment rate dropped to 6.6% in the 3 months to April, as 345,000 jobs were added, outstripping expectations of +270,000 in another strong show for the UK labour market.. UK retail sales fell by 0.5% in May to 3.9% per year, still the third highest pace in more than 6 years. The GfK reported consumer confidence rising from -5pts in March to 1pt in June, its equal highest reading since 2002.
Japan
No change from the Bank of Japan: The Bank of Japan (BoJ) maintained its record monetary easing at an annual pace of ¥60 trillion to ¥70 trillion ($US677bn) during the March quarter. It also reiterated its assessment of the economy (“has continued to recover moderately as a trend”) and its outlook for prices (“the year-on-year rate of increase in the CPI is likely to be around 1.25% for some time”).
Japanese economy appears to be weathering consumption tax increase: There are some good signs that Japan is weathering its April consumption tax hike, despite Q2 2014 GDP expecting to show a fall in growth. Q1 2014 GDP was 6.7% per year due to stronger business investment and as consumers brought forward spending before the consumption tax increase. In addition, other data (predominantly for May, but released in June) was largely stronger-than-expected, rebounding after the demand shock caused by the tax hike: machine orders (+17.6% per year); bank lending (2.4% per year); unemployment rate (3.5% per year), retail sales (+4.6% per month), consumer confidence (39.3pts); composite PMIs (49.2pts, up from 46.3pts); and a continuing recovery in the Economy Watchers Outlook (45.1pts). Japanese inflation spiked to the highest level since 1991, reflecting the impact of the April consumption tax hike. In May, core CPI was 2.2% per year, and +0.5% per year excluding the impact of the consumption tax hike.
Abe announces new growth strategy: on 24 June Prime Minister official announced Japan’s new growth strategy. This new strategy aims to achieve growth by focusing on three areas: (i) active participation of women in the workplace (ii) agriculture and (iii) medical and nursing care services. This is hoped to lift the potential growth rate of the Japanese economy from the current rate, estimated at around 0.75%. These new growth measures are expected to impact over the medium term and it could take decades for rewards to be delivered.
China
Mini-stimulus announcements add up: China is committed to its 7.5% growth target with Premier Li Keqiang stating “The Chinese government is adjusting its economic operations to ensure the minimum growth rate is 7.5%, the level to ensure job creation” in a speech at Mansion House in London in June. This follows a number of new policy measures announced over the quarter, including: infrastructure and housing investments (including five rail projects with total capex of 142bn yuan) unveiled on 2 April 2014, the Ministry of Finance urging government bodies to step up budget spending on projects that have fallen behind schedule and two targeted Reserve Requirement Ratio cuts over the quarter.
Exchange rate liberalisation: China continues to make changes to its exchange rate with the announcement that the yuan can now be exchanged directly for British pounds. The pound becomes the fifth major currency to trade directly against the yuan, joining the Australian and New Zealand dollars, the Japanese yen and the U.S. dollar.
Economic activity improves following a weak first quarter: : The HSBC manufacturing PMI rose in June to its highest level since November 2013, rising to 50.7 from 48.0 in March, confirming the trend of improvement in economic activity. The output index rose to a seven month high of 51.8 and new orders rose to a 15 month high of 51.8. The official PMI rose to 51.0 in June from 50.3 in March. Other economic indicators also showed signs of improvement. Inflation pressures remain well contained, with CPI data for June recorded at 2.3% per year, compared to 2.4% per year in March. Concerns do remain over the property sector, with house price gains softening. New home prices across 70 cities in China rose 5.6% per year in May, this compared to a 6.7% rise in April. Prices rose in only 15 cities, versus 57 cities three months prior.
Australia
The RBA on hold: The RBA left the cash rate unchanged at 2.5% at its Board meetings during the June quarter. There was no change to the Board’s neutral policy ‘guidance’ and signal that there is likely to be “a period of stability in interest rates”. The strength in the Australian dollar does remain a concern for the RBA, with recent gains reducing the assistance the Australian dollar was providing to help rebalance the economy, especially given recent falls in commodity prices (particularly the iron ore price). At a speech on 3 July 2014, Governor Stevens stated that “the exchange rate remains high by historical standards…..most measures would say it is overvalued, and not just by a few cents.”
Economy started 2014 with a bang but softened in Q2: GDP increased by 1.1% per quarter to 3.5% per year, the best quarterly growth since Q1 2012. Net exports contributed 1.4% per quarter and household spending contributed 0.3%, while inventories were the main drag (-0.6%). However, the Federal Budget weighed on consumer sentiment with the Westpac-Melbourne Institute index of consumer confidence plunging to a 3 year low of 93pts in May before recovering slightly to 93.2pts in June (vs. 99.5 in March) and then to 94.9 in early July. Retail sales were negatively impacted, falling 0.5% in May, taking the annual pace to 4.6%, compared to 5.6% per year at end of March. Business confidence fared better with the NAB Business confidence survey increasing to +8pts in June from +5pts in March. The economy added just 5,400 jobs in April and May, compared to +72,100 in the two months prior. However, the unemployment rate was unchanged at 5.8%. Building approvals were volatile on a month to month basis, finishing May up 14.3% per year.
Commonwealth Budget includes some tough measures: Australia’s 2014/15 Commonwealth Budget was released in May and estimated a deficit of $A29.8bn, or 1.8% of GDP. This is a solid improvement on the $A49.9bn 3.1% of GDP, deficit estimated for 2013/14. Australia’s net debt is now expected to peak at 14.6% of GDP at June 2017, up from 12.5% at June 2014 and a low of -3.8% of GDP (i.e. net assets) at June 2008. The impact on the economy from the fiscal contraction in the Budget is estimated at around 0.5% points for both 2014/15 and 2015/16. While this is not insignificant, it is unlikely to be enough to alter the RBA’s views on monetary policy. With the exception of a tax levy on high income earners, the Budget focused on spending cuts. However, a number of key Budget measures are facing opposition from the Australian Labor Party and smaller parties in the Senate and the government may need to make some changes to its announced policies to ensure they pass the Senate.
Politics to become a focus: The Senate (upper house) that Australians elected in the September 2013 general election (plus the re-election in WA in April 2014) took their seats in early July. With a total of 33 seats the Coalition government will need 6 extra votes to pass any Legislation, i.e. a Senate majority is 39 votes, half of 76 plus 1.Without the support of the ALP or the Greens, the Coalition will need 6 of the remaining 8 Senators to pass Legislation. The Palmer United Party (PUP) holds 3 of these seats and has an agreement with the Motoring Enthusiasts party to vote as a block. This will give the PUP a voting block of 4. In addition, there are 4 other independent Senators. The government must, therefore, get the PUP block of 4 plus at least 2 of the other Senators to agree to vote on Legislation. The other alternative may be to get the 4 non-PUP Senators and then try and split up the 4 Senators from the PUP block. The other alternative is, of course, the get either the ALP or the Greens to support Legislation. Either way, the government faces a difficult negotiation challenge to implement their Budget strategy and other policies. It is also perhaps worth noting that number of crossbench Senators in the new Senate is a record high at 18. The previous record high was 13 in 2002-2005.
Economic and financial markets outlook: H2 2014
Global economic growth is broadening and improving and will likely to continue to increase in the second-half of 2014. The IMF is forecasting growth of 3.6% in 2014, up from 3.0% in 2013. This view is underpinned by a diminishing fiscal drag, a consumer recovery and tailwinds from improving financial conditions in the advanced economies, where growth is projected to accelerate from 1.3% in 2013 to 2.2% in 2014. The global business cycle continues to be de-synchronised, although the overall momentum is still gathering pace with the support of accommodative monetary policy. The major developed economies, such as the US and UK, remain at the forefront of the recovery, while the major emerging economies continue to grow at stabilising activity levels. Emerging market and developing economies’ output will increase by just 0.2%/pts to 4.9% this year according to the IMF.
The major central banks are likely to follow divergent paths. We expect further monetary policy easing from the Bank of Japan (‘BoJ’) and the European Central Bank (‘ECB’) in response to softer economic data (especially for Japan) and low inflation (especially for the ECB). However, rising capacity use is likely to prompt the BoE to hike rates late 2014 or early 2015, with the US Federal Reserve (‘the Fed’) continuing to ‘taper’ QE3 ending in October 2014 and then hiking interest rates around mid-2015.
United States
In the US, the likely path of ‘tapering’ and how qualitative forward guidance will continue to be implemented under the leadership of new Fed Chair Janet Yellen remains one of the hottest topics for markets this year. We expect the Fed to continue to reduce, or ‘taper’, asset purchases by around $US10bn per month through 2014 finishing in October, though this is data-dependent. We are already seeing some evidence of increasing wages, health care services and rent inflation in response to strengthening domestic demand, which could potentially lead to an upside surprise closer to the Fed’s 2% inflation target by year-end. Of greater concern, however, is whether the Fed will eventually surprise markets with a faster hiking cycle than the market is currently pricing and the exact process they will undertake to tighten monetary policy. We see policy rates remaining near zero until mid-2015, when we expect the Fed funds rate to be hiked gradually and the end to re-investments of securities on their balance sheet.
The timing and communication of these policy changes will impact financial markets. It is expected that US government bond yields will move higher and equity markets could trade with volatility over this period. The key factor for equity markets going forward will be sustained economic growth, which will boost earnings growth.
Europe
The Eurozone is enjoying a modest but fragile recovery. However, the persistently strong Euro currency (albeit weaker post ECB meeting in June) and current account surpluses due to capital repatriation is impacting upon domestic demand and trade flows across the region – especially in the periphery. The output gap/excess capacity and strong Euro is contributing to deflationary price pressures across the Euro area. Deflation is being imported via lower energy costs while export costs are increasing, restraining competitiveness. Private sector credit growth remains anaemic while the pace of bank lending remains contractionary. The downshift in EM growth and geo-political risks in Ukraine also present some headwinds to the recovery. Overall, we see three key drivers of modest economic activity improvement in the Eurozone in 2014. First, domestic demand in Germany should be supported by very easy financial conditions relative to its point in the business cycle. Second, the Periphery should benefit from a decline in the fiscal drag. And third, exports for the area as a whole are likely to benefit as global growth improves, despite the elevated Euro.
China
We remain fairly optimistic on China, where recently announced economic and social reforms should enable the leadership to engineer a more sustainable domestic consumption-led growth path. We expect the overall policy environment to remain positive and, with recent policy measures to help support 7% plus growth for the remainder of the year. The government continues to try to rebalance the economy, with falls in investment growth offset by improvements in consumption growth. It is expected financial markets will remain very sensitive to any headlines out of China over the remainder of 2014.
Australia
Australian shares are likely to perform reasonably well as profits pick up and interest rates remain low, valuations look reasonable and given the strength in the earnings cycle. However, the earnings cycle does face some headwinds from lower commodity prices, weaker mining capex and an elevated Australian dollar. The Australian dollar is expected to remain well supported given the outlook for Australia and relative attractiveness in bond yields.
In Australia, economic growth was stronger than anticipated in early 2014. This is expected to slow as the transition in growth from the mining sector to non-mining sector continues and as the government budget cuts are introduced. There are signs that investment outside the mining sector has improved, especially in infrastructure, and this combined with housing construction are key growth drivers. This transition period in our economy should see the Reserve Bank of Australia on hold until early 2015 before the process of normalising the official cash rate begins.
We expect the Australian dollar (AUD) to remain well supported over the remainder of this year as it responds to important drivers, such as the stabilisation of China economic data, improving domestic activity and a still-elevated terms of trade. Foreign purchases of AUD-denominated bonds have also picked-up from offshore investors in search of higher yielding AAA-rated CGS. Persistent USD weakness despite the ‘taper’ has also been supportive of the AUD. However much of the direction in the AUD will depend on the timing of the exit strategy of the Federal Reserve and how they communicate this. It would be expected that the AUD will fall when the Fed announces its plan to raise interest rates for the first time.
Equities continue to re-rate upwards to record highs as volatility (the VIX) has fallen to pre-GFC levels. Despite rising concerns over asset bubbles, valuations remain around long-term averages and equities remain attractive relative to bonds. Ultimately, while accommodative central bank policies can continue to support prices in the near-term, sustained appreciation will require the stronger economic growth than we expect to materialise eventually and, in-turn, boost corporate earnings. Future returns will likely be positive but depend much more on stock-selection and earnings growth momentum. After rapid gains over the past 2 years, equities are no longer considered to be “cheap”, but closer to fair value, with returns likely to be more constrained this year with more ‘normal’ EPS growth and PEs of around 6% and 15x, respectively. Australian shares are likely to perform reasonably well as profits pick up and interest rates remain low and valuations look reasonable However, the earnings cycle does face some headwinds from lower commodity prices, weaker mining capex and an elevated AUD.
Global sovereign bonds have rallied on mixed US economic data, short covering, expectation of ECB easing and EM Central Bank accumulation of relatively cheap US rates, lower terminal Fed Funds rate expectations (than history) and corporate hoarding of US Treasuries over fears of a liquidity “squeeze”. Ultimately, US rates should rise (and have started to) back towards their most recent equilibrium level on the back of improving signals on inflation and economic momentum over the remainder of this year.
Key events to watch over the second half of this year include major central bank action; particularly the Federal Reserve who should fine tune their exit strategy and communicate to the market later this year and the Bank of England who could become the first major central bank to lift rates late this year. Political events will also be critical with the Scottish referendum vote due 18 September possibly having consequences for the outlook for UK and Europe markets and a succession vote in Catalonia, Spain. There is also a general election in Brazil on 4 October 2014 which could have a localised impact as well as Senate and House of Representative elections in the US on 4 October which could make President Obama’s late two years in government even more challenging to pass legislation.
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