Weekly market & economic update

Headline developments of the past week

• While the risk of a double dip back into recession may be waning, the prospect of sub-par growth in key developed countries suggests that another round of global reflation looks to be on the way, via more quantitative easing (or QE2), with both the US Federal Reserve and the Bank of England indicating that they are considering it if needed to support their recoveries. In the US it seems that deflation is becoming a bigger concern for the Fed and with the Fed’s 2011 growth forecasts likely to be revised down to below levels necessary to cut unemployment we think the odds favour QE2 getting underway in November. This will mean more US dollars sloshing around putting more downwards pressure on the greenback. But with Japan, the UK and ultimately Europe likely to be pumping up the supply of their currencies as well this weakness is more likely to show up in continued strength in Asian currencies, gold and commodity currencies like the $A.
• The past week has seen more messages from the Reserve Bank to the effect that higher interest rates are likely to be necessary to keep inflation under control – this time from the Governor and the Minutes from the last Board meeting. The clear message from Governor Stevens was also that the regional differences across the country – and by implication the two speed economy – are not an impediment to further interest rate hikes. As a result, market expectations have now moved into line with our expectation for an October rate hike.
• All the talk of QE2 in the US and more rate hikes in Australia is helping propel the $A back closer to parity against the $US. Its worth noting that the norm for the $A over the last century up until early 1982, was for the $A to trade above parity versus the $US. This includes the early 1950s when the terms of trade was about as strong as it is now. Back then one Australian dollar bought $US1.12.
• There was good news in the US from the National Bureau of Economic Research which determined that the recession that began in December 2007 officially ended in June last year, making it the longest recession since the Great Depression. Of course the share market anticipated – as it usually does – the end of the recession back in March last year. But while the contraction may have ended, this is not to say that the economy has returned to normal and certainly most Americans would still see the country as being in recession.

Major global economic releases and implications

• US economic data was mixed. Housing activity related data was generally flat to slightly better with housing starts and permits rising, existing home sales up 7.6% in August and new home sales and the National Association of Home Builder’s conditions index tracking sideways. Weekly mortgage applications to purchase a home fell but have been essentially stable for the last three months now. The basic picture is that housing activity related indicators have stabilised after their post first home buyer tax credit slump, but they are yet to stage a decent recovery. A survey of home prices fell for the second consecutive month in lagged response to earlier weakness. Jobless claims rose after four weeks of falls. On the positive side though, durable goods orders were much stronger than expected and a leading index of growth rose in August consistent with a continuing recovery in the US.
• In Europe, industrial orders fell by more than expected, manufacturing and services conditions indicators fell in September and consumer confidence was steady in September. While Germany continues to do a bit better than the rest of Europe with a rise in business conditions, a fall in unemployment and better consumer confidence, worries about peripheral countries continued with Ireland’s GDP contracting 1.2% in the June quarter. In the UK, housing data was weaker, with a dip in mortgage approvals in August and a third consecutive decline in the Rightmove house price index.
• Various public holidays saw a quite week across Asia. Japan saw softness in super market sales but stronger than expected readings for coincident and leading economic indicators and the all industry activity index and strong machine tool orders.

Australian economic releases and implications

• In Australia, the Australian Bureau of Agricultural and Resource Economics raised its forecast for commodity exports, both volumes and prices, this fiscal year and the Westpac/Melbourne Institute’s Leading Index rose in July.

Major market moves

• US and European shares received a strong boost on Friday from stronger than expected durable goods orders in the US, an unexpected rise in German business conditions and good news on corporate earnings, resulting in solid gains over the past week as a whole. Asian shares were generally higher, but Japanese and Australian shares were softer partly in response to an earlier negative lead from Wall Street.
• Public sector bond yields fell on expectations that the Fed will buy more treasuries.
• Commodity prices continued to rise with the gold price rising to a new record high on the prospect of the Fed flooding the world with more US dollars and base metal prices rising further on the back of falling inventories and the weak $US.
• Higher commodity prices, more talk of easing in the US and more talk of rate hikes in Australia all worked to push the Australian dollar higher.

What to watch in the week ahead?

• In the US, various regional surveys suggest that the key ISM manufacturing conditions index is likely to slip slightly to a reading around 54.5 (from 56.3 in August). This would still be consistent with continuing recovery though. Consumer confidence is likely to have fallen slightly and the Case-Shiller house price index is likely to be weak. Data for construction spending, personal spending and the third estimate of second quarter GDP will also be released.
• China’s manufacturing conditions survey, or PMI, is likely to show that conditions remain stable consistent with overall economic growth around 9%.
• In Japan, the Tankan business survey for the September quarter is likely to show a softening in conditions and the outlook.
• In Australia, August building approvals data is likely to show a modest rise of around 1% and private sector credit growth is likely to remain soft. As foreshadowed in the Minutes from the last Board meeting the RBA’s latest Financial Stability Review is expected to show that the Australian financial system remains strong.

Outlook for markets

• After very strong gains in shares since their August lows, shares are at risk of a correction in the short term. However, while near-term uncertainties remain, shares are likely to see further strong gains into year-end and through 2011. Shares are very cheap relative to government bonds, investors are still very bearish which is positive from a contrarian perspective, and once it becomes clear that the US/global recovery is continuing (albeit slowly) there is likely to be a big reversal of investment flows – out of government bonds and back into shares.
• After an 8% gain since late August which has taken it to a 26 month high, the Australian dollar is vulnerable to a correction. However, further gains in the value of the $A are likely on a six to 12 month horizon as it becomes clear that the global recovery is continuing and commodity prices are remaining strong, the US Federal Reserve embarks on more quantitative easing and Australian interest rates continue to rise well above global rates.
• Double dip and deflation worries along with the prospect of more central bank government bond purchases in the US and elsewhere are likely to keep bond yields low in the short term, but medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.