Both the Fed and the ECB disappointed markets with a lack of immediate action. However, both promise of action to come if needed, so its not nearly as bad as the initial market reaction following their meetings suggests.
- ECB President Draghi basically confirmed a plan to buy bonds in countries such as Italy and Spain providing they apply to the European Financial Stability Facility for assistance and sign a Memorandum of Understanding committing them to reforms. Such action will effectively involve the EFSF buying bonds in the primary market and the ECB buying bonds in the secondary market until yields fall to more sustainable levels. Markets were disappointed that the ECB is not acting immediately. However, it would be wrong to underestimate the ECB’s commitment to preserving the euro. There are a number of points to note. First, Mario Draghi has a track record of delivering despite initial scepticism as was seen last year with the provision of cheap funding for banks. Second, the proposed approach has two benefits: by acting with the EFSF the ECB can allay its fear that it is providing “money for nothing” as it will be conditional on MoUs being signed; and the ECB can effectively boost the firepower of the EFSF. Third, Draghi has made three very positive comments in saying that investor concerns about the ECB ranking senior to private investors will be addressed, that the ECB will consider further non-standard easing measures and that any bond buying may not be sterilised opening the door to quantitative easing. Fourthly, while the Bundesbank is opposed to any ECB bond buying, this is unlikely to be a problem as its majority rules at the ECB. Finally, there’s an element of win-win here – either Spanish and Italian bond yields settle down or if they don’t they will apply for assistance and bond buying by the EFSF and ECB will force them down. So it may all take longer than would be ideal but its all heading in the right direction.
- The US Federal Reserve has clearly signalled it will provide more monetary easing if the pace of growth doesn’t improve. We expect QE3 will be introduced after its next meeting in mid September. In the meantime watch payroll releases, retail sales and Ben Bernanke’s address August 31 at the Jackson Hole central bankers’ conference. Again there’s an element of win-win here – either US jobs growth picks up or the Fed does QE3.
- Should the RBA intervene to limit the $A? While a case can be made for currency intervention if temporary “hot money” capital flows have pushed a currency far away from fair value, its far from clear that this is the case with the $A. We don’t know whether the capital inflows driving the $A are temporary or permanent, allowing for the still high level of the terms of trade the $A is unlikely to be far from fair value, in any case fair value levels are far from clear and its well known from the period before the December 1983 $A float that if we try to control the $A we lose control of domestic interest rates. In fact I would argue that intervention to limit the $A risks sliding us back into the economic mediocrity that prevailed prior to the currency being floated. Strong countries have strong currencies – we should learn to live with it and focus on boosting productivity.
Major global economic releases and implications
- US economic data remained mixed with the ISM business conditions index recovering only slightly in July, other business surveys mostly coming in on the soft side and weekly retail sales data remaining soft. Against this though, consumer confidence rose in July, house price data continues to point to a housing recovery and employment readings were a bit better than expected. The overall picture remains of an economy growing at a sub-par rate but not collapsing. US June quarter profit results are still coming in better than feared with 68% beating earnings expectations and 63% beating on revenue. Corporate guidance has been soft though.
- European data remained weak with final PMI business conditions indicators for July and various economic sentiment readings pointing to ongoing recession the severity of which was highlighted by news that the Euro-zones unemployment rate has increased to a record high of 11.2%. Unemployment in Spain is highest at 24.8% with 52.7% of youth unemployed. Perhaps the big surprise in Europe is the speed with which German indicators are weakening suggesting that it too is heading into recession. As in the US, European June quarter profit results have been coming in better than feared with 55% beatings on earnings and 62% beating on revenue.
- Japanese data was generally weaker than expected with softer than expected readings for industrial production, household spending and housing starts and a fall in the PMI business conditions indicator for July.
- In China, the official and HSBC business conditions PMIs suggest that growth has stabilised but that it is yet to improve. Chinese Premier Wen Jiabao again stressed that supporting growth was the priority but is yet to follow through with additional stimulus. Another monthly gain in house prices in July adds to confidence that the housing sector is not collapsing but also supports the view that the Government won’t relax its housing constraints. However, we continue to expect more rate cuts, reserve ratio reductions and fiscal stimulus in the months ahead with low inflation leaving plenty of room for extra stimulus.
- The slowdown across Asia is continuing with weak readings for exports and industrial production in Korea, a contraction in GDP in Taiwan and a fall in manufacturing conditions in India. While high inflation is constraining the Reserve Bank of India from cutting rates, more rate cuts are likely in Korea and Taiwan.
Australian economic releases and implications
- Australian data releases were mostly positive. The AIG’s manufacturing conditions PMI fell sharply in July and credit growth remained soft, but against this new home sales rose marginally, building approvals only reversed a fraction of their huge surge in May, house prices rose, retail sales rose strongly for the second month in a row and the trade balance returned to a small surplus in June. While the surge in retail sales in May and June is likely partly temporary reflecting the $2bn in Government handouts, the generally positive tone to recent data provides scope for the RBA to sit back and leave interest rates on hold for now.
Major market moves
- Shares had a messy week, falling on annoyance at the lack of immediate action by the ECB and Fed.
- It was a similar story for commodity prices, although strong Australian data releases along with ongoing talk of foreign central banks diversifying their forex reserves saw the $A hold up pretty well.
- Bonds yields fell in the US, Germany, UK and Australia but backed up again in Italy and Spain.
What to watch over the week ahead?
- In China, July activity data (due Thursday) is expected to show a stabilisation in growth around recent levels with industrial production up 10.4% year on year and retail sales up 13.5%. Inflation is likely to have fallen further to 1.8% leaving plenty of room for more monetary easing.
- In Europe all eyes will be on whether Spain and Italy apply for EFSF, and hence ECB, assistance.
- In the US the June quarter profit reports will start to wind down and data for trade will be released Thursday.
- In Australia, the Reserve Bank is expected to leave interest rates on hold. Even though inflation is at the bottom of the RBA’s target range, recent commentary from the RBA has indicated a relatively relaxed stance on the economic outlook and various economic data releases over the last month including for retail sales and house prices have indicated a somewhat stronger tone. Ultimately, we see the RBA resuming rate cuts again around October as growth indicators return to a softer tone and inflation remains benign, but for now we expect the RBA to remain in wait and see mode. The RBA’s Statement on Monetary Policy (Friday) will be looked at closely for clues as to how long the wait and see mode might last. On the data front, expect a 0.5% gain in housing finance (Wednesday) & a 10,000 loss in July employment (Thursday) pushing unemployment to 5.3%.
- A handful of Australian companies will start to report June half profit results including Leighton, Computershare, Cochlear, Rio, Tabcorp and Telstra. Results are expected to be weak on the back of falling commodity prices, the strong $A, cost pressures and poor domestic demand. The risks are likely on the downside to consensus expectations for a 1% fall in earnings for 2011-12. Resources stocks are likely to fare the worst with a 15% fall in profits under the weight of falling commodity prices at a time of cost pressures associated with massive investment programs. Financials and industrials will likely be constrained but have modest positive profit growth of around 3 to 4%. Key things to watch are dividends given the focus on yield at present and outlook statements with consensus expectations for 9% profit growth in 2012-13 likely to remain at risk. Hopefully falling interest rates may have provided a bit of scope for hope for domestic cyclical stocks.
Outlook for markets
- The short term inaction by the ECB and the Fed has left shares vulnerable to the deteriorating economic outlook in Europe, the US slowdown, lingering worries about China and the upcoming profit reporting season in the case of Australian shares. However, if the ECB and Fed follow up with policy action, as they have foreshadowed, shares will benefit as valuations are attractive and investors are very bearish which is a good sign from a contrarian perspective. We remain of the view that shares will be higher by year end.
- While sovereign bonds in safe countries are a good diversifier, bond yields in major countries around record lows suggest very low medium term bond returns. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
- The Australian dollar is likely to remain strong by year end as global central banks undertake further monetary easing, commodity prices hold up and as central bank reserve diversification continues.
6 August 2012