The beat goes on
The Australian market stumbled just twice during the month after the minutes of the recent FOMC meeting were published, and after the inconclusive result in the Italian election.
That says it all the major market-moving events were offshore.
The concern over the FOMC minutes came about because market analysts thought they perceived that so-called quantitative easing (ultra-easy monetary policy by means of an explicit programme of bond purchases by the Federal Reserve) may come to an end earlier than anticipated. This is a stretch. The problem is that the minutes reflect the views of all 19 members of the Committee. Only 12 members vote, however, and the recent public pronouncements of the voters have been decidedly more dovish than the Committee as a whole. In any case, a surprisingly early end to quantitative easing would only come about if the US economy does surprisingly well, so how is that a negative for the share market?
I claim no expertise whatsoever in the matter of the Italian election. At time of writing, it is not clear which parties if any are going to be able to stitch together a coalition, raising the prospect of another election. This brings back memories of Greece last year, and Italy is a lot bigger - and hence more important - than Greece. But no-one is talking of Italy leaving the euro zone, and when did it become news that Italian politics are unstable?
The Australian economy
We are about to receive an avalanche of data concerning the state of the Australian economy late last year, so I may be pre-empted before you get a chance even to read this. News already received on the labour market suggests that it is still sluggish, with year-to growth in employment just 0.9% and the unemployment rate still at 5.4%.
Yesterday, the capital spending expectations data, including a first look at 2013-14, saw the light of day. They were awaited eagerly, for the light that they may shed on the likely timing of the peak of the capital spending boom, and on what the other side of the boom may look like.
So what did they show? Take your pick. These data need to be interpreted carefully, and different analysts do this differently. As a general rule, over the long run of history, firms generally underestimate how much they are going to spend in future, so analysts generally adjust these figures upwards. But by how much?
The ratio between the actual result for a given year and the expectation is called the realisation ratio. For mining, over the past five years, this ratio has averaged 1.14 the actual figure has come in 14% on average above the first expectations estimate. If you apply this ratio, mining investment looks set to rise by about 20% next year. But given that the industry is cancelling plans rather than coming up with new projects, how likely is it that the current estimate is understated? This realisation ratio has been as low as 0.85, which would imply a fall of about 10% next year. Perhaps all we can say is that the new figures suggest the peak in mining investment is close but that there is no indication to date that the downside will be precipitous.
This will feed into the Reserve Bank's view of the economy. The Bank opted not to cut rates further in early-February, and also took the opportunity - in both the Quarterly Statement on Monetary Policy and the Governor's testimony - to suggest that the easing cycle may be at or close to an end, although there was nothing precluding a further rate cut should one prove desirable. The bank believes that the rate cuts already made are still making their way through the system. My suspicion is that the Bank may still cut again, but it is unlikely to be in early-March.
Bear in mind that financial markets (and the consensus of economists) generally continue to expect more cuts after (as it turns out eventually) the bottom of the cycle has been reached.
Where are we going?
I have made the point in the past that the rise in the Australian market to date (24.7% in the past 8 months) has been primarily driven not by an improvement in earnings expectations but by a lessening of fear. It has gone from dirt-cheap to only slightly cheap, so further substantial gains are likely to be made only if earnings expectations improve. The good news is that earnings expectations usually do improve in rate-cutting cycles. And the earnings season to date has been at least moderately encouraging.
In January, I published an end-2013 forecast for the ASX 200 of 5100 points. I pointed out that this was much stronger than the very pessimistic mean forecast (4557) of a panel of equity analysts polled by the AFR. The share market reached my end-of-year forecast, albeit temporarily, on 20 February, and closed above it on 28 February. While I have more than once in the past changed a forecast and lived to regret it when my previous view turned out to be closer, I have decided to lift my end-of-year target to 5300 points. Let's hope this doesn't wake up Jeff!
Chris Caton
Chief Economist
The views expressed in this article are the author's alone. They should not be otherwise attributed.
Frequently Asked Questions about this Article…
The article says the Australian market’s moves were driven mainly by offshore events — notably the publication of the FOMC minutes and an inconclusive Italian election. Locally the market only stumbled twice during the month because most market‑moving news came from overseas, and a broader lessening of fear has helped lift domestic prices.
Investors worried the FOMC minutes suggested quantitative easing might end sooner than expected, but the article points out the minutes record views of all 19 committee members while only 12 vote. Recent public comments from actual voters have been more dovish, and an early end to QE would likely require a surprisingly strong US economy — which is not inherently negative for share markets.
The piece notes the Italian result was inconclusive and could lead to another election, which recalls past European political instability. However, the author emphasizes no one was talking about Italy leaving the euro zone and that Italian political instability is a familiar story, so while it’s worth watching, it wasn’t presented as an immediate crisis for markets.
Recent labour data described in the article show a still‑sluggish labour market, with year‑to‑year employment growth around 0.9% and the unemployment rate near 5.4%. For investors, that suggests domestic demand may be soft and is one reason the economy and policy settings remain under close scrutiny.
The article explains capital spending expectations give a first look at future business investment and must be interpreted carefully. It introduces the 'realisation ratio' (actual spending divided by initial expectations): mining has averaged about 1.14 over five years (implying roughly +20% if applied) but could be as low as 0.85 (implying about −10%). Overall, the new figures suggest the peak in mining investment is close but not necessarily followed by a steep fall.
According to the article, the RBA opted not to cut rates again in early February and signaled that the easing cycle may be at or close to an end, while not ruling out future cuts if needed. The Bank also noted previous cuts are still working through the system — meaning investors should expect the possibility of more easing later, but not necessarily immediately.
The article argues that the recent 24.7% rise in the Australian market over eight months was driven more by a lessening of fear than by stronger earnings. It suggests further substantial gains are likely only if earnings expectations improve — and historically earnings do tend to brighten during rate‑cutting cycles. The current earnings season was described as at least moderately encouraging.
Chris Caton, the article’s author and Chief Economist, says he published an end‑2013 ASX 200 forecast of 5,100 in January but has lifted his end‑of‑year target to 5,300. He cites the market’s move higher (reaching his prior target in February), the reduction in investor fear, and the potential for improving earnings expectations during a rate‑cutting cycle as reasons for the upgrade.
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