Headline developments of the past week

• After 28 years in the dogbox on the back of falling commodity prices and poor economic management the Australian dollar spiked above parity against the $US, briefly reaching $US1.004 before falling back to just above $US0.99. The return to parity has taken a bit longer than I first thought back in 2007 but we have finally got there. But is it sustainable? Currencies are always volatile and normal volatility suggests a pull back at some point particularly after such a strong run up since late August. However, with the $US likely to remain under pressure, the RBA remaining on track to raise interest rates further and Australia’s terms of trade at a near sixty year high it is likely that the $A will settle above parity over the year ahead – probably around the $US1.10 level. Of course, if global growth collapses anew then all bets are off and a plunge back below $US0.80 would be possible – but this is unlikely.
• Talk of a global currency war continues with some emerging countries intervening and imposing capital controls to try and stop their currencies from rising against the $US. The IMF meeting last weekend provided nothing more than the usual hot air on the topic – but nothing more was likely anyway. The bottom line is that major advanced economies need lower currencies to rebalance their economies towards greater exports and to ease their debt burdens. For this to occur emerging countries need to consume more and export less and a rise in their exchange rates would help facilitate this. Intervening and resisting will only mean that easy US monetary policy will spread globally – into emerging countries for which it is completely inappropriate and will just cause asset bubbles. Hong Kong – with its fixed currency peg to the US – is an extreme example of this.
• The past week has seen a range of better news globally: the odds of QE2 in the US have continued to increase; we have seen solid profit results for US companies; Chinese economic data has remained solid; Chinese shares have gained 12% over six trading days; and growth sensitive markets such as copper, the $A and oil have remained strong.

Major global economic releases and implications

• US economic data remained consistent with an ongoing sub-par recovery. On the positive side there was a stronger than expected gain in retail sales, a solid rise in manufacturing in the New York region, a slight rise in small business optimism, a rebound in weekly chain store sales and strong gains in mortgage refinancing. Against this, consumer sentiment slipped further in early October, new mortgage applications fell, weekly jobless claims unexpectedly rose and the trade deficit widened. On top of this core inflation fell to just 0.8% in September, well below the level that the Fed regards as consistent with price stability. All of which is consistent with a move towards more quantitative easing by the Fed, with the minutes from the Fed’s last meeting and comments by Fed Chairman Bernanke clearly pointing in this direction unless economic data strengthens soon.
• A moratorium on US mortgage foreclosures in response to various irregularities may weigh on US banks, but it could help provide a bit of temporary relief for US home owners and so buy more time for the market to absorb the excess supply of housing.
• The US September quarter profit reporting season is off to a solid start with so far 73% of results coming in better than expected including for JP Morgan, Google and Intel.
• In Europe, industrial production beat market expectations in August while UK inflation was unchanged in September. Also in the UK, consumer confidence fell sharply in September, jobless claims rose and housing data remained weak all pointing to more quantitative easing from the Bank of England.
• In Japan, consumer confidence fell in September but machine orders jumped more than 10% in August and bank lending was only slightly lower in September.
• September data in China indicated ongoing strong growth with slightly faster than expected loan growth, increased business confidence and strong gains in car sales. Export and import growth was a bit softer than expected but this may be due to holiday effects. Meanwhile, the People’s Bank of China raised reserve requirements for major banks for a two month period in a sign that it still wants to see loan growth remain under control. Its hard to see a major impact though as banks still retain reserves in excess of requirements.

Australian economic releases and implications

• Australian data was generally solid with gains in consumer confidence and business conditions, with the highlight being a big rebound in new orders, and still solid business confidence. Housing finance remained mixed though with falls in investor finance but an increase in owner occupied finance.

Major market moves

• US, European and Asian share markets continued to move higher over the last week helped in particular by strengthening expectations for more quantitative easing in the US and also better than expected earnings results.
• Australian shares saw a volatile week with a few profit warnings weighing on investors along with worries about the impact of the strong $A.
• Commodity prices remained strong on the back of ongoing $US weakness with the gold price making a new record high.

What to watch in the week ahead?

• The global focus in the week ahead is likely to be on China where September quarter GDP data and September activity data will be released. Reflecting the drop out of double digit quarterly growth a year ago we expect year on year GDP growth to have slowed to around 9.5% which is where we expect growth to settle over the year ahead. Growth in retail sales, industrial production and investment is likely to have remained strong. Food price increases are likely to have pushed inflation up to 3.6% year on year (from 3.5%) but non-food inflation is likely to have remained very soft. Overall, upcoming Chinese data is likely to confirm that growth remains solid and a hard landing in China is not on the cards.
• In the US, data for industrial production, housing starts, a survey of home builders and a survey of manufacturers will be released. Housing data is likely to confirm the picture of stabilisation, albeit at a low level. The Fed’s Beige Book of anecdotal evidence on the economy will likely confirm that the pace of US economic growth has slowed. The US profit reporting season will move into top gear with 118 S&P 500 companies due to report. Consensus expectations are for earnings to have grown 24% over the year to the September quarter, but if reports continue to surprise as they have done so far then this is likely to be revised up.
• In Australia, the minutes from the RBA’s last Board meeting are likely to confirm that the Bank retains a strong bias to raise interest rates again. Data for car sales, skilled vacancies and trade prices will also be released. The AGM season will also continue with the main focus likely to be on earnings risk for internationally exposed companies.
  

  Outlook for markets

• While shares are at risk of a near-term correction, further decent gains are likely into year-end and through 2011. 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 wary 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.
• Like shares, the Australian dollar is also vulnerable to a short term correction – particularly with speculative positions and investor sentiment towards it now running very high. However, a further rise above parity against the $US is likely as commodity prices remain strong, the $US remains under pressure 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. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

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