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October 2016
McNaughton Report
The economic environment
Economics
Australia
Data – mixed
The Australian data in October was a mixed bag. The
employment report showed another weak headline fall of
9.8k for the month of September. The prior month’s read
was revised from -3.9k to -8.6k. The unemployment rate
edged down to 5.6% from an upwardly-revised 5.7%. The
details were soft. The participation rate fell to 64.5%, and
full-time jobs fell 53k. Part time work rose 43.2k, and the
underemployment rate has risen. The casualisation of the
work force helps explain the weakness in wages. The CPI
data was stronger than expected, in the weakest possible
way. The headline print of 0.7%q/q masked a 0.3%pt
contribution from flood effected fruit and vegies. The
annual rate of headline CPI of 1.3% was above expectations
of 1.1%. The core measures averaged just 0.35%q/q and
1.5%y/y, well short of the RBA’s 2.0-to-3.0% target inflation
range but not enough to convince the market further easing
was imminent.
United States
Data – mixed
US data was mixed. The key monthly employment report
disappointed, showing a 156k gain in payrolls and a lift in
the unemployment rate from 4.9% to 5.0% in September.
But that wasn’t enough to change the tone of resilience
in the labour market and gradually rising wages pressure
(hourly earnings up 2.6% y/y). GDP printed stronger at 2.9%
(saar) in Q3, up from 1.4% in GDP, while most other activity
and inflation indicators were largely as expected. The ISM
manufacturing index fell from 52.6 to 49.4 in August – the
first contraction in six months. Despite this, a lift in US
inflation added to the growing consensus of a December rate
hike. US consumer prices rose by 0.3% in September, in line
with expectations, to be up 1.5% on a year ago. Excluding
food and energy (core measure) prices rose by 0.1% (forecast
+0.2%) to be up 2.2% on the year.
China
Data – mixed
China’s manufacturing sector held steady last month: the
official manufacturing PMI for September was unchanged
Tracey McNaughton
Executive Director
Head of Investment Strategy
at 50.4 (consensus: 50.5, previous: 50.4) – remaining at a
two-year high. Exports for September fell a worse-thanexpected 10%y/y (consensus: -3.3%, previous: -2.8%).
CPI for September rose a stronger-than- expected 1.9%
y/y (consensus: 1.6%, 1.3%). The Producer Price Index for
September rose 0.1% y/y (consensus: -0.3%, previous:
-0.8%) – the first positive reading in 55 months. Industrial
production for September grew a weaker-than-expected
6.1%y/y (consensus: 6.4%, previous: 6.3%). Real GDP for Q3
grew 6.7%y/y (consensus: 6.7%, previous: 6.7%) – the third
quarter in a row of 6.7% growth.
Europe
Data – strong
Industrial production for August was stronger than expected:
German industrial production rose 2.5%m/m (consensus:
1.0%, previous: -1.5%), French rose 2.1%m/m (consensus:
0.6%, previous: -0.5%) and Spanish rose 1.4%m/m
(consensus: -0.1%, previous: 0.1%). Additionally, the
Eurozone composite PMI for October rose to a better-thanexpected 53.7 (consensus: 52.8, previous: 52.6) – a tenmonth high.
Other news
RBA Governor maiden speech
A speech by new RBA Governor Philip Lowe was perceived by
market participants as ruling out a near term rate cut. Lowe
emphasized Australia has a flexible medium term inflation
target of 2- 3% which serves Australian well and offers a
“degree of flexibility not available to some other central
banks”. The new Governor is perceived to be reluctant to
ease policy further after stressing the flexibility of the inflation
target in recent communications.
US Earnings Season
The US earnings season dominated attention. According
to Thomson Reuters I/B/E/S, nearly 73% of the S&P 500
companies that have reported, have issued profits above Wall
Street expectations, setting the stage for the benchmark index
to post earnings growth of 3% for the third quarter.
Out from the coal
The extraordinary bull market in coal continued: hard coking
coal once again rose sharply, up 20% during the month,
though this month it was outdone by thermal coal, which rose
33% during the month. The lift in thermal and coking coal
prices in October likely reflected a continued contraction in
Chinese domestic coal production.
Markets
Bonds and Credit
Yields higher
Whispers of inflation and a turn in the long interest rate
cycle played through to all markets in October. Most major
markets' long bond yields rose steadily through the month,
with the U.S. 10-year Treasury yield reaching its highest level
since May.
With US data still reasonable and Fed officials warning that
monetary tightening will soon be required, bond yields came
under intense pressure. On October 14, The US Federal
Reserve Chair, Janet Yellen, said that the country may need
to temporarily run a "high-pressure economy, with robust
aggregate demand and a tight labor market " in order to lift
the growth potential of the economy. The US 10-year yield
rose in October, ending 23bp higher at 1.83%. The US 2-year
yield rose by 8bp to 0.84% as prospects for a December
tightening by the Fed grew. Pricing for December has lifted to
80% for December. The market is assuming the FOMC won’t
move before the Presidential election has been decided.
Treasuries were in fact one of the more resilient bond
markets. The sell-off in long-end bonds was global, with the
10-year German bund yield up 28bp amid talk of QE tapering
in 2017 by the ECB. In the UK, 10-year gilts rose 50bp as signs
emerge that the plunge in the GBP (which extended further
in October) is fuelling an inflation pulse. The Japanese 10-year
yield rose 4bp, having increased sharply back in August.
Australian bond yields rose in line with these other markets,
and thus under-performed against Treasuries. The 3-year
bond sold-off 18bp to an implied yield of 1.70% while
the 10-year sold-off 44bp to 2.35%. The 3/10yr curve
accordingly steepened 26bp.
The RBA left the cash rate unchanged in October at 1.5%.
Overnight indexed swap (OIS) rates subsequently drifted
higher. The terminal cash rate drifted from 1.32% to 1.40%.
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Market participants scaled back the probability of cut in
November to 4% (from 40%), and implied cuts thereafter
where mostly removed.
Global macro themes and the technical backdrop continue
to influence credit performance. Despite risk around the US
presidential election, unknown Brexit fallout, particularly
EU fragmentation, credit spreads remain stable. Bond yields
however sold off in October, from Bunds to Treasuries
to ACGBs, taking us slightly higher than historic lows.
Continued extraordinary monetary support, and modest
expectations in terms of interest rate rises (globally) continue
to fuel the hunt for yield.
Equities
Global sharemarkets mixed and volatile
Investors had a lot to digest with concerns about the health
of the European financial sector dominating focus and
weighing on risk assets in the early part of the month. In
addition the US earnings season dominated investor flow
throughout the month. A stronger US dollar hurt commodity
prices with gold losing US$65 in the first week of October
to close at US$1251 a tonne on October 7 – a four-month
low. And global bond yields rose, weighing on investor
sentiment. Also prominent during the month was a pick-up
in M&A activity and increasing focus on the upcoming U.S.
Presidential election.
The ASX 200 lost 2.2% in the fourth week of October.
Over October one of the worst performing sectors was the
S&P/ASX 200 A-REIT sector – down 7.7%. The Healthcare
sector lost 8.3%, and the Industrials sector gave back 4.2%.
The utilities sector lost 3.0% while the energy sector lost
2.3%. The best performing sectors across the ASX 200 over
October was Materials (up 1.3%).
The US the S&P 500 lost 1.9%, while the Dow Jones fell by
0.9%, and the Nasdaq lost 2.3%. The Japanese Nikkei rose
by 5.9% – helped by a weaker yen. The German Dax rose
by 1.5% while the UK FTSE rose by 0.8%. MSCI emerging
markets rose 0.2% while MSCI World fell 2.0%.
Commodities and Currencies
Taking a pounding
AUD depreciated 0.7% against the USD but appreciated
against all other currencies. The biggest currency story of the
month was the British pound, which fell heavily against most
major currencies on fears over a 'hard' exit from the European
Union, hitting a 31-year low against the U.S. Dollar. The
Chinese yuan continued to weaken, hitting its weakest level
against the U.S. Dollar since September 2010. Gold was down
3.3%, oil fell 4.0% while iron ore rose 8.0% to be up 43.7%
year-to-date.
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