By Shane Oliver

While Japanese shares (up 0.2%) and Chinese shares (up 0.1%) managed small gains over the last week, a further rise in bond yields on Friday on the back of more hawkish comments from the Fed and following the absence of further easing by the ECB saw Eurozone shares fall 1% and US shares fall 2.4% for the week. A sharp rise in Australian bond yields also helped drag down Australian shares by 0.6%. Despite falls on Friday, commodity prices rose, particularly oil on the back of a sharp Gulf of Mexico storm related fall in US crude inventories. Fed rate hike expectations pushed the Aussie dollar down, but only by 0.4%.

Bond yields have been driven higher by a range of things lately, including perceptions that central banks have become less interested in using negative interest rates, talk of a refocus from monetary to fiscal policy, receding deflationary pressure from commodity prices, perhaps the realisation that bonds are poor value and heightened expectation of Fed rate hikes. And in Australia, a perception that we are at, or close to, the end of the RBA’s easing cycle has added to upwards pressure on local bond yields. The rise in bond yields in the last few days was triggered by the ECB leaving monetary policy unchanged and comments by the normally dovish Fed regional President Rosengren warning of the risks of waiting too long to raise rates.

Shares have been vulnerable to a correction for a while (as has been noted in the Outlook section of this note). We have seen very strong gains from the February and post Brexit lows that left markets overbought with short term measures of volatility suggesting a degree of complacency. We are now in a seasonally weak period of the year and there is significant event risk ahead with the Fed, Italy, the US election and of course, South China Sea tensions and North Korean missile/bomb tests don’t help. So the correction could have further to run in the short term, but we see it as just that.

Bonds have likely seen the best – with central banks becoming less enamoured of negative interest rates (not their best move!), a shift in focus away from monetary stimulus towards fiscal stimulus and a stabilisation in commodity prices leading to lessening deflation risk. But it’s hard to see a sharp back up in bond yields as global growth remains subdued, uneven and fragile and core inflation remains well below inflation targets. While the Fed is likely edging towards another rate hike, mixed data recently makes a December move more likely than a September move and the ECB and Bank of Japan are more likely to continue or add to stimulus as opposed to curtail it.

The European Central Bank left monetary policy unchanged, there was no significant change to the ECB's economic forecasts, and President Draghi commented that an extension of the current quantitative easing program was not discussed. However, with inflation remaining well below target, the ECB's own economic forecasts assuming a continuation of the current QE program and various dovish comments from Draghi around the lack of upward inflation pressures indicate that an extension of the QE program beyond its March 2017 expiry at its December meeting is likely. The ECB also looks likely to announce a technical widening of the assets than can be purchased under the QE program in order to ensure that the ECB does not run into problems in implementing its program.

Having just cut rates last month, it was no surprise to see the Reserve Bank of Australia leave rates on hold at 1.5% at its September meeting. We remain of the view that the RBA will cut rates again at its November meeting when it reviews its economic forecasts after the release of the September quarter inflation data in late October. The risks to inflation are on the downside, thanks to weak inflation globally and record low wages growth domestically and the Aussie dollar is too high and at risk of breaking beyond the April high of $US 0.78 if the Fed continues to delay rate hikes. However, with economic growth holding up very well, another rate cut is a close call and is now critically dependent on seeing a lower-than-expected September quarter inflation result. A cut in the cash rate to 1% or below, and the adoption of quantitative easing, looks very unlikely in Australia.

Major global economic events and implications

US economic data painted a mixed picture – not one supporting an imminent Fed rate hike. Labour market indicators remain very strong, with the rate of job openings, hirings and people quitting for new jobs all at high levels, and jobless claims remain ultra-low, but a slump in the non-manufacturing conditions ISM index on top of the fall in the manufacturing conditions ISM adds to worries that growth may have slowed. The Fed's Beige Book did nothing to clear the picture, talking of modest growth (with a slight downgrade in conditions across states), a tight labour market, but little sign of inflation. While the slump in the ISM indexes could just be noise, the mixed readings on the US economy and continuing low inflation indicate that the Fed would be wise to hold off on raising rates in September. The market's probability of a September rate hike is 30% and that for December is 60%. Our base case remains for a December hike, but this “will they or won't they” soap opera looks like dragging on for a while yet.

Eurozone retail sales rose more than expected in July and are up 2.9% year on year, but German industrial production and factory orders were weaker than expected.

Japanese data continued the more positive tone of the previous week, with an upwards revision to June quarter GDP growth, stronger than expected wages growth, a rise in Japan’s leading index, a rise in overall economic sentiment and Tokyo’s office vacancy rate falling to just 3.9%.

Chinese data for August showed a welcome improvement, with exports and imports suggesting stronger global demand and stronger domestic demand respectively and a small rise in the Caixin services sector conditions PMI adding to confidence that Chinese growth has stabilised. What's more, producer price deflation continued to fade in August, which is invariably a pointer to stronger Chinese nominal growth. Meanwhile, China's State Council (or cabinet) indicated it would step up fiscal stimulus and investment in weak areas of the economy, adding to confidence that Chinese growth is not about to fall out of bed any time soon.

Australian economic events and implications

A good week for the optimists on Australia. June quarter GDP data showed solid growth of 0.5% quarter on quarter or 3.3% year on year. To be sure, the quarterly pace of 0.5% was down on 1% in the March quarter and were it not for a surge in lumpy public spending (notably in defence) growth would have been negative as the slump in mining investment continues to detract from growth. However, some slowing in the quarterly growth rate of 1% quarter on quarter seen in the March quarter was inevitable. Going forward, net exports are likely to remain solid, as new resource projects come on stream, underlying public investment is on the rise thanks to infrastructure projects in NSW and Victoria, mining investment is getting close to more normal levels so the huge growth detraction from its unwind over the last few years will start to abate next year, reasonable growth in consumer spending is likely to be underpinned by a still high household savings rate and the completion of new homes, a stabilisation in commodity prices and our terms of trade suggests that the big hit to national income is over and productivity growth is very strong at 2.9% year on year. What's more, 3.3% growth for the year to the June quarter is way above the US at 1.2%, the Eurozone at 1.6% and Japan at just 0.6% and the diversity of growth drivers of the Australian economy (from mining to housing to public capex, etc) in part highlights why the economy has now gone 25 consecutive years without a recession.

In other data, housing finance fell in July and AIG services and construction conditions PMIs followed the manufacturing PMI lower in August, but these series can be quite volatile. Meanwhile, ANZ job ads were strong in August (pointing to continued solid jobs growth) and the trade deficit improved sharply in July (although this was driven by volatile gold exports so is not quite as good as it looks), but the Melbourne Institute's Inflation Gauge showed that inflation remained weak in August.

What to watch over the next week?

In the US, the main focus is likely to be on August retail sales (Thursday) which are expected to show a rebound in underlying retail sales growth to around 0.3% month on month after a soft July. Note that the retail sales are now only 43% of total consumer spending in the US. Meanwhile, expect a fall in industrial production, but slight improvements in the Philadelphia and New York manufacturing conditions indexes (also Thursday) and core CPI inflation for August have remained around 2.2% year on year (Friday).

The Bank of England (Thursday) is expected to leave monetary policy on hold, being in “wait and see” mode after last month’s easing.

Chinese August activity data (Tuesday) is expected to show a slight improvement for industrial production to 6.1% year on year, no change in retail sales at 10.2% year on year and a slight fall in fixed asset investment.

In Australia, expect the August NAB business conditions and confidence surveys (Tuesday) to hang around the okay levels seen in July, consumer confidence (Wednesday) to be little changed and August jobs data (Thursday) to show a 15,000 gain, with unemployment rising back to 5.8%.

Outlook for markets

After a period of strong gains into July/early, August shares remain vulnerable to a further correction in the next few months. Australian shares have already fallen 4% from their August high, but global shares have only just started to come off. September and October are often rough months seasonally, and various event risks loom in the months ahead including around the Fed, Italian banks, the Italian Senate referendum, the US election and global growth generally. However, after a short term correction, we anticipate shares to trend higher over the next 12 months helped by okay valuations, very easy global monetary conditions and continuing moderate global economic growth.

Ultra-low bond yields point to a soft medium term return potential from them, but it’s hard to get too bearish in a world of fragile growth, spare capacity, low inflation and ongoing shocks. That said the bond rally this year had taken yields to pathetic levels leaving them at risk of a snapback, which we are now seeing.

Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors.

Dwelling price gains are expected to slow to around 3% over the year ahead, as the heat comes out of Sydney and Melbourne thanks to poor affordability, tougher lending standards and as apartment prices get hit by oversupply.

Cash and bank deposits offer poor returns.

There is a high risk that the $A will re-test its April high of $US0.78 if the Fed continues to delay, presenting challenges for the RBA. Beyond the short term though, we see the longer term downtrend in the $A ultimately resuming as the interest rate differential in favour of Australia narrows as the RBA continues cutting and the Fed eventually resumes hiking, the risk of a sovereign ratings downgrade continues to increase, commodity prices remain low and the $A sees its usual undershoot of fair value.

Eurozone shares fell 1.1% on Friday and the US S&P 500 lost 2.5% as bond yields rose further in response to Fed President Rosengren’s warning about waiting too long to raise interest rates coming on the back of the ECB leaving monetary policy unchanged at its Thursday meeting. The weak global lead saw ASX 200 futures fall 79 points or 1.5% pointing to a poor start to trade for the Australian share market on Monday.