Oliver's Week

Headline developments

• The main event, or the only event for many, was Australia making it through to the World Cup final 16.

• Sharemarkets had another volatile week. Similarly, commodity prices were pretty mixed with oil up slightly, gold little changed and metal prices down slightly.

• There was good news for Australia’s iron ore producers with Chinese steel producers agreeing to the 19% rise in iron ore contract prices for the year starting April this year that had earlier been agreed with European and Japanese steel mills. This is worth nearly $2 billion in extra annual earnings for Rio Tinto and BHP Billiton combined and will flow directly into reducing Australia’s trade deficit.

Major global economic releases and implications

US economic data was soft with more evidence that the housing market is weakening. The National Association of Home Builders’ latest confidence index slipped to an 11-year low, building permits continued to fall and mortgage applications remained week. Further, the US leading economic index continued to fall suggesting weaker growth ahead, and jobless claims rose consistent with a softening labour market. Mounting evidence that the US is slowing adds to confidence that inflation, which normally lags growth, won’t get out of hand and consequently points to less pressure on the Fed to raise interest rates in the second half of the year.

In Europe, the Euro-zone’s trade balance remained slightly in deficit, consumer spending in France picked up in May and producer prices in Germany rose on the back of higher energy costs. All of this supports the view that the European central bank will continue to raise interest rates, but a surprise fall in industrial orders suggests the process will remain very slow.

The Bank of Japan’s governor indicated that it was on track to raise interest rates but can do so gradually. A slip in business confidence in the June quarter certainly suggests that there is no need for any aggressive moves. Japanese interest rates are currently zero and we expect them to rise this year (possibly in July), but only to about 0.25%.

Major Australian economic releases and implications

In Australia, economic data was mixed. The Westpac/Melbourne Institute’s leading index of economic activity, which measures the likely pace of economic activity in the coming six to nine months, improved in April, and points to solid growth ahead. This view was supported by an increase in skilled vacancies in June. However, a survey of Australian manufacturing conditions in the June quarter remained subdued. June quarter dwelling commencements unexpectedly rose but with home building approvals remaining weak it looks like an aberration.

Major market moves

Global sharemarkets were pretty mixed '” down slightly in the US and Asia, but up slightly in Europe and Japan. Inflation and interest rate worries remained but some strong US company earnings reports provided support. Locally, the market rebounded from a slump earlier in the week helped by a positive lead from US shares and a rebound in resources stocks and banks.

Bond yields drifted higher on inflation worries. The US dollar strengthened against most currencies, including the Australian dollar, on expectations regarding relative interest rates. The $US also closed below 8 Renminbi for the first time, bringing the total revaluation in the Chinese currency to 3.5% since last July. The Chinese are likely to allow the Renminbi to appreciate further but it is likely to remain a slow process.

What to watch in the week ahead

The big event in the week ahead will be the US Fed’s interest rate setting meeting where another 0.25% interest rate increase to 5.25% is a dead cert. However, with a rate hike fully priced in by markets the focus will be on the statement that accompanies it. Our bet is that the Fed will indicate a potential softening in its stance, noting that recent inflation data is a concern but leaving open the possibility that interest rates may be at or very close to the top if the economy continues to moderate as it expects. On this it should be noted that inflation almost always lags a turn in economic growth and so interest rates normally peak well before inflation does. Also released will be data on home sales, consumer confidence and the Fed’s preferred measure of inflation, the private consumption deflator excluding food and energy, for May.

Locally, it’s another quiet week in terms of economic data, with job vacancies, private sector credit and new home sales figures due for release.

Outlook for markets

Global and Australian sharemarkets wobbled around a bit over the past week, but they remained above the previous week’s lows, and we remain of the view that they are on track to rally into July/August. Valuations are now very attractive with price/earnings (P/E) multiples back to around or below 2003 bear market lows. The July profit reporting season in the US and the August reporting season in Australia is yet again likely to see companies surprise on the upside, bad news from the Fed is already factored in and investor sentiment readings in the US have fallen back to levels normally seen at market bottoms.

However, while the worst may be behind us and we should have good gains over the next month or so, further weakness into the seasonally weak September/October period still appears likely, probably on the back of concerns about the global growth outlook. So investors should be prepared for a rough ride over the next four months.

Nevertheless, the current rough patch in sharemarkets is likely to be a correction and not the start of a bear market. The key will be how the economic cycle unfolds over the next year or so, and specifically what happens to economic and profit growth. In our view the conditions are not in place for a hard landing in terms of global or Australian growth '” the inflation and interest rate threat is simply not severe enough '” so we remain of the view that while economic global growth may slow it won’t collapse. This should underpin profit growth and commodity prices. The combination of good value indicates that shares will recover once the Fed is able to ease up on the interest rate brake, it becomes clear that global growth is in for a soft landing, and the Australian economy remains robust.

So despite the current rough patch, the trend in both global and Australian share prices is likely to remain up. By year end Australian shares are likely to be back at new highs.

US and Australian bond yields are likely to fall over the next few months as the US housing market slowdown feeds through into consumer spending resulting in an abatement of inflation paranoia. This should help the wider sharemarket, along with interest sensitive sectors such as listed property and infrastructure in particular.

In the very short term, the Australian dollar is vulnerable to any further correction in commodity prices and the continuing upwards drift in US interest rate expectations. But against this the still high level of commodity prices and the fact that Australian interest rates remain well above global rates provides a lot of support. So over the next few months the Australian dollar is likely to remain within its recent US70–78¢ range.