Headline developments of the past week.

Week ending Friday, 2 March 2007
Headline developments of the past week

·         Equity bull markets are characterised by steady advances with occasional sharp setbacks, and the latter was clearly evident over the last week with share markets falling sharply, “triggered” by a 9% one day fall in Chinese shares. The Chinese fall came amid uncertainty regarding moves by Chinese authorities to cool the share market down after a 135% gain over the past 12 months. This adversely affected US shares at a time when there was already concerns about problems in sub-prime (ie, mainly low-doc) mortgages and former Fed Chairman Alan Greenspan said there was a “possibility” that the US economy could slip into recession later this year (he also said it wasn’t “probable” but this was ignored) and the sell-off then reverberated around the world. However, most share markets had risen sharply in recent months and were vulnerable to anything which upset confidence. Furthermore, the fall in Chinese shares is not telling us anything about the Chinese economy where growth remains strong, inflation remains relatively low and credit growth is well behaved. Our assessment is that recent turbulence is nothing more than a correction and while it may have further to run the trend in share markets will remain up this year. One thing is clear – not only is the Chinese economy now having a huge impact on the global economy, but the Chinese share market is starting to have a big impact on investor sentiment too.

·         Crude oil prices rose on tensions with Iran, but base metal prices fell slightly on fears of slower economic growth.

Major global economic releases and implications

·         US economic data was generally soft. December quarter GDP growth was revised down to 2.2%, home sales remain weak, durable goods orders fell, construction fell and unemployment claims rose. But the ISM manufacturing conditions index rose slightly in February, suggesting that while manufacturing remains soft it is certainly not collapsing. Overall we remain of the view that the US economy is on track for a soft landing, but the growth slowdown and problems in the sub-prime mortgage industry are bringing a Fed interest rate cut back into focus. We see the Fed cutting from around May or June.

·         In Europe, inflation remained below the European Central Bank’s 2% ceiling in February, but solid growth readings suggest interest rates are likely to be increased again.  

·         Japanese economic was soft with falls in industrial production, housing starts and inflation and while retail sales rose in January it is still down 0.8% year on year. The next Japanese rate hike is looking a long way away.

Australian economic releases and implications

·         Australian economic data was robust with a bounce in new home sales, solid retail sales, a modest quickening in the pace of credit growth and a strong rise in construction activity. While business investment was surprisingly soft in the December quarter investment intentions were revised up. The main disappointment was that the current account deficit rose to around 5.9% of GDP in the December quarter with net exports set to knock 1.3% from December quarter GDP growth.

·         The December half profit reporting season is now essentially complete. Of the 165 major companies to have reported, 77 (or 47%) have exceeded expectations, as against only 29 (or 17% which have come in below) (see chart). 43 companies have upgraded their profit guidance relative to consensus or come out with very positive outlook comments as opposed to only 11 making negative outlook statements. Profit growth for the year to the December half has come in around 19% compared to our initial expectations for around 17% growth. Reflecting the flow of solid profit results, consensus earnings expectations have been revised up by around 1 to 2% for each of fiscal year 2007 and 2008. Resources shares remain the stand out performers in terms of earnings growth but most of the upside surprise was in industrials and financials. Other themes included solid growth in dividends for industrial stocks which suggests that companies are reasonably confident about the outlook, pretty good cost control and solid margins. Overall the profit reporting season has been pretty good and provides a strong base of support for the share market.

Source: AMP Capital Investors

Major market moves

·         As noted above, global shares fell and this contributed to a sharp fall in Australian shares. However, despite its strong out performance in recent times the fall in the Australian share market has been relatively mild compared to several global share markets possibly reflecting the strength of the recent profit reporting season and strong capital flows into the market.

What to watch in the week ahead?

·         In the US, data will be released for payroll employment, along with the ISM survey of conditions in the services sector and the Fed’s Beige Book of anecdotal evidence. The European Central Bank is expected to raise its key interest rate to 3.75%.

·         Locally, the Reserve Bank of Australia will meet to discuss interest rates. Recent statements from the Bank suggest it is much more relaxed about inflation so we expect rates to remain on hold. Recent turmoil in global share markets adds to the case for the RBA to take a relatively cautious stance. Our assessment remains that rates will be unchanged for the next few months ahead of cuts later this year in response to receding inflation worries and ongoing sub-par growth. Data for company profits, the trade deficit, building approvals and December quarter GDP growth are also due for release. We expect December quarter GDP growth of around 0.5% quarter on quarter resulting in annual growth of just 1.9%. This will mark the third quarter in a row of growth around the 2% mark making it harder to explain away as a statistical aberration.

Outlook for markets

·         Global and Australian share markets had become extended after very strong gains since last June (global shares had risen 23% and Australian shares had gained 25%) and so its quite likely that the correction in share markets has a bit further to run over the next few weeks. Possible contributors to further weakness include uncertainty about the depth of the slowdown in the US economy, tensions with Iran, continued uncertainty about Chinese shares and simple profit taking. Over the last two years there have been three major corrections in global and Australian share markets – in March/April 2005 when Australian shares fell 8% from top to bottom, in October 2005 when Australian shares fell 8% and in May/June last year when Australian shares fell 12%. Each of these corrections lasted about a month or so before the rising trend resumed and it is likely we have entered a similar pattern now. Having a periodic correction is far healthier than seeing share markets rise exponentially only to crash later on. In fact 10-20% corrections each year were the norm in the second half of the 1990s and yet annual share market gains were still reasonable.

·         More fundamentally we don’t see the current correction as the start of a major bear market. Overall share market valuations both globally and in Australia are not expensive, profit growth is likely to remain robust with recent profit results in Australia suggesting a solid outlook, the macroeconomic backdrop of reasonable growth and benign inflation and interest rates is likely to remain in place and there is lots of cash out there looking for a home. So notwithstanding a bit of short term weakness, global and Australian share markets are likely to provide solid gains over the remainder of the year.

·         It’s also possible that the correction in Chinese shares has further to run with the National People’s Congress over the next two weeks likely to be a source of rumours (and possible action) in terms of further measures to cool the share market. But it’s worth noting that the Chinese authorities don’t want to cause another bear market in shares after having put so much effort in just over a year ago to turn the market around after a four year bear market. While the correction in Chinese shares may have further to run in the short term, the trend is likely to remain up as profit growth is likely to remain strong, price to earnings ratios may be high but they are well below previous peaks and there is a huge potential for individual investors to allocate to shares from cash. Note that foreign investor exposure to the Chinese A share market is just around 1%.

·         With global growth slowing and investors temporarily seeking safe havens, bond yields may fall further in the short term. More broadly bond yields are likely to track sideways this year as growth and inflation prove benign.

·         The $A is likely to continue churning up and down around current levels with both interest rates and commodity prices providing mixed signals for the currency at present.

 

By Shane Oliver, chief economist with AMP Capital Investors.*