The past week has seen a swing in investor sentiment from gloom at the start of the week after the release of disappointing US jobs data to a bit more optimism.

To be sure there has been some more bad news, such as another downgrade to Spain’s sovereign rating and more soft European economic data, but the mid week rebound in share markets was driven by several factors.

• Firstly, monetary easing in China and Australia and indications Europe and the US are heading towards more monetary easing.
• Second, Spanish banks are likely to be recapitalised by the European bailout fund, possibly in the week ahead following reports as to how much will be required.
• Third, signs Europe appears to be moving towards “more Europe” (with greater fiscal union and centralised banking controls) in return for greater support from Germany.
• Finally, share markets and currencies like the $A had become very oversold and were due for at least a bounce.
• However, while the global policy developments of the last week have been welcome, whether we have seen the bottom or not for share markets remains to be seen and at this stage is contingent upon sensible outcomes from the Greek and French elections and concrete policy moves from European leaders towards supporting banks (both in terms of recapitalisations and bank deposit insurance or guarantees) and reducing bond yields in troubled countries, along with easier monetary policy from the ECB and possibly the Fed.
• It’s ironic that over the last week it was China and Australia, with 8.1% and 4.3% economic growth respectively that eased monetary policy whereas the ECB and Bank of England with zero growth left policy on hold!

Major global economic releases and implications

• US economic data was mixed with a slight rise in the ISM non-manufacturing conditions index in May, a fall in weekly jobless claims, modest growth in weekly chain store sales and the Fed’s Beige Book suggesting the economy is growing at a moderate pace, but weekly mortgage applications falling for the fourth week in a row and factory orders coming in below expectations in April. Reflecting the softer conditions seen recently in the US various Fed officials have raised the prospects of more monetary stimulus. Fed Chairman Bernanke left the door open for more stimulus, but was predictably non-committal and this led to a bit of market disappointment with some investors clearly looking for a green light to QE3 at the Fed’s June 19-20 meeting. The most likely scenario though is that the Fed will extend Operation Twist (selling short term and buying long term bonds) before considering QE3. A rapid deterioration in Europe though would make QE3 more certain.
• European economic data was weak with greater than expected falls in industrial production, German factory orders & exports and retail sales. Despite this the ECB maintained its usual ‘head in the sand and wait for things to get worse’ stance and left rates on hold. Fortunately, some ECB council members supported the case for a rate cut suggesting the ECB may be getting ready to cut, probably at its next meeting. The Bank of England also left monetary policy unchanged, but more QE is likely going forward.
• In contrast to the dithering Europeans, China has moved to ease monetary conditions again by cutting interest rates by 0.25%, confirming a heightened focus on boosting growth. Importantly the central bank gave banks the flexibility to charge up to 20% below the benchmark lending rate, which will take the 1 year lending rate down to 5.05%, which is around or below previous cycle lows. Chinese May data for industrial production, retail sales and investment confirm a further mild growth slowdown. However, inflation fell more than expected to 3% and is likely to fall further in response to soft growth and falling producer prices indicating there is plenty of scope for further monetary easing. We expect another two 0.25% cuts in interest rates, another two or three 0.5% cuts in bank required reserve ratios and more fiscal stimulus ahead. This will help ensure Chinese economic growth bottoms out at soft landing levels, ie around 7.5%. China’s accelerated easing is ultimately very positive as monetary tightening from late 2009 through to last year drove a 38% bear market in Chinese shares, so an easing cycle is likely to help set the scene for a cyclical bull market.

Australian economic releases and implications

• In Australia, it was a good news week with the RBA cutting interest rates by 0.25%, shortly followed by news that the economy was booming with GDP growing a very strong 1.3% in the March quarter, or 4.3% year on year, and employment rising strongly in May. Trade data revealed a sharp reduction in the trade deficit as exports recovered after several weak months, and housing finance rose but the trend remains weak.
• While the strength in growth and employment questions whether an interest rate cut was needed, our inclination is to treat the GDP and employment figures with a bit of scepticism for several reasons. First, there are a number of oddities in the March quarter national accounts including: surging growth in consumer demand for food and a range of consumer services which sits uneasily with the general feeling of consumer caution; cost increases for engineering construction are a modest 2.1% year on year despite constant talk of surging mining costs; the financial and insurance sector in the economy is up a strong 5.4% in volume terms over the last year which doesn’t gel with the tough times in this sector and nominal GDP growth was less than real GDP growth partly explaining why things don’t feel that good and raising some questions about sustainability. In short, it’s doubtful that most Australian households and businesses can relate to the news of this sort of growth.
• Second, the strength of employment in recent months is mainly in NSW and Victoria and not in WA, which is hard to reconcile with sub trend growth in both states. Soft job ads suggest the jobs market remains subdued.
• Third, the boom in GDP doesn’t fit comfortably with most partial indicators on the performance of the economy including for retail sales, house prices, housing activity, business conditions indicators, profits, etc.
• So taken together with very soft readings for inflation our view is that the RBA was right to ease. While the strength in GDP and employment may see the RBA sit tight for the next month or so and an upbeat speech by Governor Stevens quite clearly highlights the RBA will not be cutting in order to try and reignite a boom in borrowing and asset prices, our assessment is that the combination of uncertain global conditions, a likely slowing in Australian growth and benign inflation will still see the RBA cut interest rates further by year end.

Major market moves

• After a poor start, share markets had strong mid week gains on hopes for policy stimulus and signs Spain is getting closer to a bailout to recapitalise its banks. However, Asian and Australian shares slipped later in the week as investors were disappointed Fed Chairman Ben Bernanke didn’t commit to more monetary stimulus. US & European shares rose strongly, Australian shares were flat and Asian shares were flat to down.
• It was a similar pattern for commodity prices and the Australian dollar, with the latter having a decent rise over the week on stronger than expected Australian economic data.
• Consistent with an improvement in confidence, bond yields rose from record lows. Yields fell in Spain.

What to watch over the week ahead?

• In the US, expect soft retail sales (Wednesday), a fall in headline inflation on lower gasoline prices and benign core inflation (Thursday), soft industrial production (Friday) after a strong gain in the previous month and slight falls in the New York region manufacturing conditions index and consumer sentiment (Friday).
• Euro-zone industrial production (Wednesday) and employment (Friday) are likely to be weak and inflation data (Thursday) are likely to be benign. French voters go to the polls on June 10 and 17 in National Assembly elections, where a strong showing by Nicholas Sarkozy’s party could help ensure President Hollande chooses a centrist for his prime minister which could help avert any leftward lurch in France.
• The Bank of Japan (Friday) is expected to leave monetary policy on hold, but should be easing.
• In Australia, the NAB’s business survey (Tuesday) and the Westpac consumer sentiment survey (Wednesday) will be watched for any boost from recent interest rate cuts. The consumer sentiment survey is likely to record some bounce with news of lower interest rates, strong economic growth and a strong labour market likely to have offset ongoing gloomy headlines coming out of Europe.

Outlook for markets

• It’s too early to say that share markets have bottomed and the next few months are likely to remain volatile as worries about a deep recession in Europe linger and slower growth in China and the US linger.
• However, shares are likely to be higher by year end. Shares are very cheap relative to bonds, cash and term deposits and we are likely to see another round of monetary easing in the US and Europe and significant policy stimulus in China which will add liquidity to financial markets and boost confidence that global growth will continue. More rate cuts from the RBA are also likely to help boost the Australian share market into year end.
• Bond yields in major countries around record lows suggest very low medium term bond returns. The Australian ten year bond yield of 3% is the return an investor will get if they hold such a bond to maturity.
• The correction in the $A may still see it fall to around $US0.95 in the short term, reflecting worries about the global growth outlook. However, it’s likely to receive a boost during the second half of the year as global central banks, led by the Fed, undertake further monetary easing.

12 June 2012