Market Outlook

Where’s the sharemarket heading in the next week, and over the longer term. Craig James, CommSec’s chief equities economist spells out the signposts for the week ahead. Then Michael Knox, an analyst with ABN-Amro Morgans, looks further into the future, at where the market will be going for the next year.
CRAIG JAMES

Australia
June 19: Imports of goods (May). One of the most up-to-date readings on the economy.
June 21: Skilled vacancies index (June). The trend index has lifted for the past five months.
June 22: Dwelling commencements (Mar qtr). Dwelling starts probably fell by 1.5%, adding to an already-tight rental market.
June 22: Car sales (May). We expect that car sales fell by 0.5% in the month.

Overseas
June 20: US Housing starts (May). Housing starts have fallen for the past three months.
June 22: US Leading index (May). The leading index probably fell by 0.4%, the third fall in four months.
June 23: US Durable goods orders (May). Orders probably rose 1% after sliding 4.8% in April.

The big picture

It is now all but certain that the US Federal Reserve will lift interest rates at the end of June. At face value the likelihood of another rate hike is negative for sharemarkets as it points to a slowdown in economic activity and corporate profits. But that's not the full picture. US monetary policy is still not overly restrictive while the global economy continues to motor above its longer-term averages. So US company profits will continue to grow, merely at a slightly slower pace. The other "positive" is that investors have now got greater certainty. The key economic data is out of the way and the Fed is poised to lift interest rates. Investors should now have increased confidence to make investment decisions, perhaps pointing to more settled conditions on global sharemarkets.

However what hasn't been resolved is what happens after the next Federal Reserve meeting on June 28 and 29. Underlying inflation is continuing to creep higher but US economic activity is slowing. At face value this looks like a major problem for the US central bank, and therefore for investors across the globe. But Federal Reserve officials are likely to soon start stressing the lags associated with monetary policy. Monetary policy is said to operate with "long and variable lags" '” meaning, in simple terms, that rate hikes today could affect the economy perhaps 9–12 months in the future. If the Federal Reserve believes the economy will continue to slow in coming months and that recent rate hikes will eventually restrain inflationary pressures, then it will retire to the interest rate sidelines after the June meeting.

For investors though, what matters most is the Federal Reserve's communication strategy. If the Fed stresses that it will remain vigilant in restraining inflationary forces but believes that it is appropriate to retire to the interest rate sidelines, then investors will embrace this certainty, and sharemarkets will resume their upward path.

Domestically, as we noted last week, one of the most positive developments has been the lift in productivity. In the March quarter, GDP per hours worked was up 4.7% per cent on a year ago '” the strongest growth pace in eight years. Stronger productivity growth boosts economic growth and restrains inflationary pressures. CommSec has also looked behind the data to find out what has been driving our good productivity performance. In the March quarter, the number of employees and hours worked were both lower than a year earlier while output was higher.

The week ahead

The economic calendar is again sparsely populated in the coming week, and not just in Australia. There is also little in the way of market-moving data in the US, while at the same time the Federal Reserve moves into its "black-out" period ahead of the June 28-29 policy-making committee meeting. The hope is that the absence of economic data can lead to more settled conditions on financial markets.

In Australia, dwelling commencements probably fell by 1.5% in the March quarter, adding to concerns about the tightening in rental markets. In Sydney, the rental vacancy rate stood at 2.2 per cent in May, well below the "comfort" level of 3.0%. Simply not enough new homes and apartments are being built, a development that should eventually lead to greater interest by investors.

Sharemarket

Investors should ignore so-called conventions about "corrections". If a sharemarket “correction” is regarded as a 10% fall from recent highs, then by definition the Australian sharemarket hasn't experienced a correction, falling by just over 9%. Clearly that isn't the case. The Australian sharemarket has been experiencing a correction after unsustainable gains recorded over the first 4½ months of the year. It has been an extremely welcome development and sets up the sharemarket for more sustainable gains in the second half of 2006. The global economy remains in great shape as evidenced by the super-strong 14.2% annual growth in Chinese retail sales. CommSec continues to favour the resources, banking and consumer discretionary sectors and expects the ASX200 to reach 5350 by end year.

MICHAEL KNOX

In April I said that I thought the fair value of the ASX200 was about 4770 points and that the market needed a breather. The market, however, continued to rise and in May I suggested that we would have a correction but I thought the correction would be in a seasonally weak period between July and September.

Well, the market obviously wanted to get the pain out of the way in a hurry. We have been down within touch of our estimate of fair value in the last couple of days. Since April, we have had earnings announcements and the result of those announcements in May is to slightly improve earnings growth. In April, earnings per share growth achieved a rate of 16.1%. By the end of May, earnings per share growth rose to a rate of 16.8%. The result was to increase estimate of fair value of our ASX200 model by 100 points to 4870 points. All this means is that in the past couple of days it is the first time that the Australian stockmarket has been cheap this year.

High returns with low volatility

One of the unusual things about the bull market that we have had for the last three years is that we have had very strong improving fundamentals and very low volatility. The reason is that as strong earnings growth has proceeded, we have had long-term interest rates that have been low and stayed low.

Indeed, last year when Alan Greenspan was talking about the Conundrum, it looked like long-term interest rates would never rise and that cheap money would continue to drive markets upwards.

We are now in a bear market for bonds. That bear market for bonds began at the end of September last year. Since that time, US treasury yields have risen 100 basis points. Our models tell us that by the middle of next year, the US 10-year bonds will rise through 6%. That means that we will suffer again in the next year what we suffered through in the last 6 months.

Low returns with high volatility

As most people know, rising bond yields means that the discount rate for the stockmarket will go up. That means that it will be harder and harder for the price of stocks to rise.

The other problem is that bond yields rise in a series of shocks, almost like small earthquakes. As those earthquakes happen, they transmit shocks through the market for equities. That generates an increased level of volatility. The equities market has been fighting rising bond yields and is suffering increased volatility. This scenario will be with us for the next year.

The other problem for the returns on equities is that the US economy is slowing down. The Federal Reserve has arguably gone too far in raising the real Fed Funds rate. We are now well above neutral in terms of the Fed Funds rate and the Fed Funds rate looks like going higher. The only possible
result is a growth recession in the US economy in 2007. That means earnings per share growth in the US equities market will decline. Earnings per share growth for the year to March rose 14.8% but for the year to June, already we have seen a slowdown of earnings per share growth to 7.6%.

The result of this combination of slowing earnings and rising bond yields is to flatten out our Dow model and flatten out our Australian equities model. What we can expect is very low but slightly positive returns over the year ahead and a much higher level of volatility. After having a long period of high returns and low risk we are now going to have to struggle through a period of low returns and high risk.