Weekly market and economic update – 01 October 2010

Headline developments of the past week

• Concerns about problems in Europe returned to the fore over the last week with Moody’s downgrading Spain’s credit rating, ongoing issues regarding Irish banks, more pressure on bond yields in peripheral countries and protests about fiscal cutbacks. This all weighed on European share markets.
• US Federal Reserve officials painted a mixed picture as to whether another round of quantitative easing is on the way. This was to be expected given that the Fed’s last meeting was only last week. We remain of the view though that if growth looks like remaining insufficient to reduce unemployment then Fed Chairman Ben Bernanke will find the support necessary for QE2, particularly with the Senate approving noted doves Janet Yellen and Sarah Bloom Raskin to the Fed Board.
• Talk of a US/China trade war escalated with the US Congress voting in favour of legislation to place pressure on the Chinese over the value of the Renminbi. While the measure may add to the war of words between the US and China, its doubtful that it will pass the US Senate or be signed into law by President Obama. China is likely to respond by allowing further Renminbi appreciation, which should help defuse the issue over time.

Major global economic releases and implications

• US economic data was mixed. On the negative side, consumer confidence fell to its lowest level since February and a measure of house prices fell in July catching up to the earlier fall in housing activity measures. Manufacturing conditions surveys were mixed with several regions showing weakness but the Chicago manufacturing survey actually improved. On the positive side, unemployment claims fell, completely reversing a rise in the previous week and new mortgage applications rose after a couple of weeks of falls and continue to trace out a flat to slightly up pattern.
• European economic sentiment improved in September led by gains in manufacturers and measures of consumer confidence improved in both France and Germany. The standout though was a further fall in German unemployment to 7.5% in September, making it the 15th consecutive monthly decline and taking the unemployment rate to its lowest level since 1992. Germany must be doing something right!
• Japanese data was mixed consistent with continuing slow growth. The Bank of Japan’s quarterly Tankan survey showed an improvement in current conditions but a deterioration in the outlook, possibly on the back of the strong Yen. Data for industrial production was weaker than expected, but unemployment fell and the ratio of jobs to applicants rose. Deflation continued in August, although at a slightly slower pace.
• Chinese manufacturing conditions surveys or PMIs improved again in September confirming that the economic slowdown has been mild and that growth has stabilised at a still high level. Meanwhile the Chinese Government announced additional measures to curb property speculation, with plans to trial a property tax and tougher lending rules for buyers of second and third homes but reduced transaction taxes for first time home buyers. Clearly another case of one foot on the brake and one foot on the accelerator!
• Monetary tightening continued in Asia with the central bank in Taiwan raising its key interest rate by 0.125% to 1.5% reflecting a normalisation in interest rates in the face of a solid economic recovery.
  Australian economic releases and implications
• Australian economic data was generally soft. New home sales, building approvals and RP Data-Rismark house price data all softened in August and private sector credit growth remained weak with a fall in business credit. Quite clearly the housing sector has cooled down consistent with the earlier fall in housing finance. A softening in house prices was inevitable given the 20% plus surge since the March quarter last year and this now appears to be getting underway. What’s more a survey of manufacturers continued to weaken, presumably not helped by the strong $A. On the flipside though job vacancies rose nearly 10% over the three months to August underpinning the strength in the labour market, which is consistent with continuing strength in the rest of the economy.
• Australia’s population growth slowed somewhat to 1.8% over the year to the March quarter as a result of Government policies to slow immigration levels. However, Australia’s population growth is still ahead of most other countries including India’s and outside of the last few years remains the strongest since the 1970s.
• Meanwhile, the Reserve Bank’s semi annual Financial Stability Review pointed to a continuing improvement in the health in the Australian financial sector.

Major market moves

• After a month of strong gains, most share markets struggled over the last week on mixed economic data, continuing worries about European sovereign debt problems and general profit taking. Australian shares were also constrained by the prospect of another rate hike and the likelihood that the strong Australian dollar will lead to earnings downgrades for internationally exposed companies without a natural hedge.

• The $US remained under pressure and this saw commodity prices and the Australian dollar climb higher.

What to watch in the week ahead?

• In Australia, all eyes will be on the Reserve Bank which is expected to resume interest rate increases after a four month pause. Over the last month there have been several warnings from the RBA that further monetary tightening will likely be necessary to control inflation and while housing sector data has been week most other economic indicators have been strong, most notably those relating to the labour market and investment. As a result, while it’s not a dead certainty, we see the RBA raising the cash rate by another 0.25% taking it to 4.75% on Tuesday. While we expect the RBA to leave the door open to more interest rate hikes we expect that it will be a slow process going forward given the ongoing uncertainty regarding the global recovery and the strength in the Australian dollar which is akin to a defacto monetary tightening.
• It’s also possible bank lending rates may increase by more than what the RBA moves by, following recent bank claims that their funding costs are still rising. However, there is little support from the RBA for this which notes in its Financial Stability Review that banks have been able to fully recoup higher funding costs over the last two years and that current market rates would only have a marginal effect on interest margins over the year ahead.
• Australian data for job ads, the NAB’s business survey, retail sales and employment will also be released. The ongoing strength in job vacancies points to further gains in employment in September. We expect employment to rise by 20,000 and unemployment to fall to 5%.
• It’s a big week for central banks with the Bank of Japan, European Central Bank and Bank of England all meeting but all likely to leave interest rates on hold.
• In the US, the focus will be on non-farm payroll employment data for September. Total payrolls are likely to be flat reflecting continued layoffs of temporary census workers and government employees, but private payrolls are likely to rise by around 90,000. US data for pending home sales and the ISM non-manufacturing survey will also be released.

Outlook for markets

• While shares are at risk of a near term consolidation or correction, further decent gains are likely into year-end and through 2011. From a technical perspective, while the rally since late August has come on low volumes it has come with broad based participation from most stocks and share markets have been tracing out a rising trend since the lows in early July, which points to a resumption of the cyclical bull market which started in March last year. More fundamentally, shares are very cheap relative to government bonds, investors are still 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 a 10% 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. A return to the pre 1982 norm above parity for the $A against the $US is just a matter of time given the strength in the terms of trade, Australia’s trade surplus, relatively high Australian interest rates and the ongoing downtrend in the $US.
• 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.