Weekly market & economic update: 29 October 2010

Headline developments of the past week

• US GDP grew an annualised 2% in the September quarter, which was right in line with market expectations. Clearly the US economy has not plunged into the double dip that was much feared a few months ago, but by the same token it is not growing fast enough to stop unemployment from rising or inflation from falling. As a result, the US September quarter GDP report leaves the Fed on track to announce the commencement of another round of quantitative easing, or QE2, in the week ahead.
• Benign September quarter inflation data in Australia saw the odds of an interest rate hike in the week ahead substantially reduced. While headline inflation was boosted by strong gains in tobacco prices, utility charges and property rates it still fell to 2.8% on a year ended basis and more importantly the average of the Reserve Bank of Australia’s underlying inflation measures rose 2.4% over the year to the September quarter, which is in the bottom half of the target range. With inflation not providing a smoking gun on which to justify a rate hike our view is that the RBA can afford to wait another month before acting on its clearly announced tightening bias.

Major global economic releases and implications

• US economic data was mostly positive, with strong gains in homes sales in September albeit from a low base, a modest gain in consumer confidence in October, an improvement in manufacturing activity in various regional surveys, a decent fall in unemployment claims and gains in weekly mortgage applications. On the downside though underlying durable goods orders fell and appear to be losing some momentum and house prices fell in August. The picture remains of modest growth that is not strong enough to reduce unemployment.
• The US September profit reporting season continued to impress with 80% of companies to have reported so far beating earnings expectations, 63% beating revenue expectations and estimated profit growth for the year to the September quarter moving up to 28% from 24% a few weeks ago. While the US housing sector is in the dumps and the US consumer is fragile, the strength in the corporate sector should help underpin business investment and employment going forward.
• European data was positive with a solid increase in new orders, increases in consumer confidence in Germany, France and Italy, a decent rise in industrial confidence and much better than expected UK September quarter growth. A dampener was another rise in the Euro-zone unemployment rate to 10.1%.
• The European earnings reporting season is also off to a strong start with 73% of results so far beating earnings expectations and 66% beating revenue expectations.
• In Japan, industrial production fell more than expected in September and manufacturing conditions slipped further in October. Against this, the trade surplus in September surprised on the upside reflecting stronger than expected exports, the jobless rate fell to 5%, the jobs to applicants ratio rose and there was some indication of slower deflation in the Tokyo CPI figures for October. Meanwhile, the Bank of Japan didn’t add to its quantitative easing following its latest meeting but did bring forward its next meeting to November 4-5, which is the day after the Fed will likely announce another round of quantitative easing, suggesting that the BoJ stands ready to do more if there is more upwards pressure on the Yen.

Australian economic releases and implications

• Australian economic data was soft with private surveys reporting basically flat house prices in the September quarter, new home sales remaining depressed and private credit growth remaining very weak in September. However, it’s worth noting that the weakness in private credit is largely being driven by falls in business credit and this likely reflects strong internal cash flow and increased reliance on direct debt issuance by large corporates.

Major market moves

• Global shares were flat to down over the last week with positive earnings news providing support but profit taking in the run-up to the QE2 announcement in the US weighing on share markets. Australian shares were helped by more takeover activity and good bank quarterly results, but nevertheless had a volatile week. While a big question mark hangs over whether the Singapore Stock Exchange bid for the ASX will get approval, it nevertheless provides another reminder that stocks are cheap and that there are lots of cashed up companies out there likely to engage in M&A activity.
• Bond yields rose partly on concerns that the Fed’s QE2 may not be as big as is currently priced in.
• Benign Australian inflation data weighed on the $A, which has now been in a consolidation for two weeks.

What to watch in the week ahead?

• The week ahead will be a big one for financial markets with the likely announcement of another round of quantitative easing (QE2) in the US, mid-term US Congressional elections, the Reserve Bank of Australia’s decision on interest rates and central bank meetings in the UK, Europe and Japan.
• With QE2 almost a given, the big issue will be whether the Fed opts for a “shock and awe” approach with say $US1trillion in government bond purchases or something more incremental such as $US100-150bn in purchases per meeting subject to ongoing reassessment at each meeting or a commitment to do say $US500bn over six months. Comments from various Fed officials suggest that an incremental meeting to meeting approach to QE2 is more likely rather than “shock and awe” which may be seen as too risky by some Fed officials. This should largely be in line with market expectations, but it could well turn out to be a case of “buy on the rumour and sell on the fact” as shares have had very good gains over the last two months, are due for a correction and investors might wonder what next?
• The US mid term elections will likely see the Republicans take control of the House of Representatives  and possibly the Senate. Historically shares have performed well after the US mid-term elections and a Republican Congress may be good if it leads to a more business friendly approach from President Obama, much as occurred with President Clinton after the 1994 mid-terms. It’s also a big week on the data front in the US with regional manufacturing surveys pointing to a slight rise in the ISM index to be released on Monday. Non farm payrolls are likely to have increased by around 60,000 jobs with private payrolls up 80,000.
• Chinese business conditions surveys (or PMIs) will also be watched closely to see if recent upwards momentum has continued.
• The RBA’s decision on interest rates is likely to be finely balanced, just as it was at the last Board meeting. On the one hand the RBA could point to the outlook for rising inflation a year ahead as spare capacity is used up, indications of continued strong growth in China and another surge in the terms of trade in the September quarter as justifying a rate hike. However, with September quarter inflation coming in weaker than expected and underlying inflation actually now in the lower half of the target range there is no urgency for the RBA to move, particularly with uncertainty remaining regarding the global outlook and credit growth remaining soft. Our assessment is that the RBA can afford to wait another month, but a move to tighten on Tuesday would hardly be a surprise. One thing is clear – the Reserve Bank has clearly warned that, unless there is a change in the outlook, interest rates will need to rise at some point and it can’t wait indefinitely. So whether it’s in the week ahead or in December, rates are likely still headed higher. The RBA’s Quarterly Statement on Monetary Policy to be released on Friday will likely include a slight upgrade to growth forecasts and a slight downgrade to inflation forecasts for this year and will be watched closely for more clues on the interest rate front. In data releases, house prices are likely to have come in flat in the September quarter and October data for building approvals and retail sales are likely to show modest increases.

Outlook for markets

• Shares are vulnerable to more corrective activity in the short term as the gains from late August are digested, and with US quantitative easing already factored in it could prove to be a case of “buy on the rumour and sell on the fact” after QE2 is actually announced. However, 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 the surge in global liquidity on the back of the latest round of quantitative easing getting underway in the US and elsewhere, should provide a positive boost for shares.
• The Australian dollar is vulnerable to a further consolidation or correction in the short-term – particularly with speculative positions and investor sentiment towards it still high. However, a further rise above parity against the $US is likely over the year ahead as commodity prices remain strong, the $US remains under pressure and Australian interest rates continue to rise well above global rates.
• 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.