Weekly market & economic update – 12 November 2010

Headline developments of the past week

• Shares, commodities and commodity currencies like the Australian dollar have had a tough week partly on renewed European debt concerns and worries that further Chinese monetary tightening in response to rising inflation will threaten China’s economy and hence the global recovery.
• European sovereign debt problems have reared their ugly head once again partly triggered by proposals several weeks ago that bond holders should share some of the cost of any debt restructuring and on concern that Ireland will require a bailout. As a result bond yields in Portugal and Ireland reached new crisis highs in the last week, which in turn prompted European leaders to assure existing bond investors that any crisis resolution mechanism that would force bond holders to share the cost of a bailout won’t apply to existing debt and would only apply after 2013. Hopefully, there shouldn’t be as big a flow-on to global financial markets from the latest concerns as there was six months ago because economic indicators are not falling like they were earlier this year and Europe has in place a European Financial Stability Facility which can be tapped by countries in difficulty. Nevertheless, the risk of the latest European crisis sparking a deeper correction in shares and other growth assets is worth watching. At the very least the issue highlights that it’s premature for the European Central Bank to be thinking of exiting its easy liquidity policies. It’s also clear that Europe cannot stand a stronger euro.
• The G20 leaders’ summit failed to come up with anything that will quickly deal with global imbalances and currency tensions. The commitment to move toward market determined exchange rates and to refrain from competitive devaluations is vague enough to allow countries to just continue doing what they have been doing. In particular, the US will feel no compulsion to stop quantitative easing even though it has the effect of pushing down the US dollar and China will feel no compulsion to speed up the appreciation of the Renminbi.  While the G20 gave a green light to capital controls in emerging countries with overvalued flexible exchange rates that are facing strong capital inflows, it is hard to see emerging countries with undervalued managed exchange rates not continuing to apply them as well.
• Of longer term interest the G20 did provide a commitment to develop early warning indicators of economic imbalances. However, while this may be helpful in shifting the focus away from the US-China dispute about the level of the Renminbi it is worth noting that there has been plenty of information around about current account imbalances for years and yet key countries have rarely moved to address them, except when a crisis has erupted. So it’s hard to believe that a new set of indicators will make any difference. So overall, it’s hard to see the outcome from G20 leaders’ summit having any major impact on financial markets. But at least there is one thing to be thankful for and that is that the tensions between countries evident in the run-up to the summit did not spill over into open conflict.

Major global economic releases and implications

• US economic data was generally positive with a rise in consumer sentiment, a further easing in bank lending standards, a slight improvement in small business optimism, another rise in weekly mortgage applications, a fall in weekly jobless claims which took its four week average below the low reached in March and an improvement in the trade deficit in September.
• European data was a bit disappointing with euro-zone GDP growth slowing to 0.4% in the September quarter after a 1% rise in the June quarter. After the unexpectedly strong growth in the June quarter a slowdown was inevitable. While Germany grew by 0.7% Greece contracted by 1.1%. the sluggish recovery in Europe highlights that it too should be thinking of joining the US in quantitative easing.
• UK data was mixed with a rise in industrial production and a positive reading for October retail sales but weak indications for house prices and a Bank of England report which lowered growth forecasts but raised inflation forecasts.
• Chinese activity indicators remained strong, albeit down on growth rates seen late last year or earlier this year, bank lending came in stronger than expected and inflation rose to 4.4% as the authorities announced a further increase in bank reserve requirements and new measures to control hot money inflows. Further interest rate hikes and bank reserve requirement increases are to be expected in order to ensure that inflation expectations remain under control. However, with activity indicators down from the blistering pace seen late last year and non-food inflation running at just 1.6%, additional tightening is likely to remain focussed on fine tuning and mopping up any boost to liquidity from foreign capital inflows as opposed to crunching the economy.

Australian economic releases and implications

• Australian economic data was mixed. Both business and consumer sentiment fell, although both remain above long term averages and consumer confidence virtually always falls after a rate hike often to then bounce back the next month. Against this, housing finance rose slightly and employment saw another month of decent gains. Interestingly the unemployment rate rose, although this reflected new entrants to the workforce which took the participation rate to a new record high. Maybe more Australian’s are returning to the workforce on the back of reports that demand for labour has strengthened.
• Meanwhile the Government released its mid year economic and fiscal review which saw only modest changes to growth and inflation forecasts and little change to budget projections with a return to surplus still expected by 2012-13.

Major market moves

• The last week has seen most share markets fall on worries about Chinese tightening, renewed European public debt worries and lowered earnings guidance from Cisco Systems. After big gains the previous week and double digit gains since late August share markets had become overbought and due for a bit of profit taking.
• European sovereign debt woes also weighed on the euro which fell sharply against the $US. Chinese tightening fears also weighed on commodity prices and the Australian dollar which has fallen back below parity against the $US.

What to watch in the week ahead?

• In the US, data for retail sales, inflation and housing starts will be released along with surveys of manufacturers in the New York and Philadelphia regions and a survey of home builders’ conditions. Housing starts will be watched closely to see if the recent stabilisation is maintained and inflation data is likely to remain benign.
• In Australia, the focus is likely to be on trying to glean any indications about the strength of the RBA’s tightening bias from the release of the minutes from its last meeting and a speech by Deputy Governor Ric Battllino. Meanwhile, it will be a slow week for economic data releases, with the highlight being wage data, which is expected to show a slight uptick in wages growth, and skilled vacancies data due mid week.

Outlook for markets

• After strong gains since late August shares are vulnerable to a further correction, with European debt concerns and further Chinese tightening posing obvious risks. However, beyond any near term volatility, we continue to see further solid gains as being likely into year end and through next year. The global liquidity backdrop is highly favourable for shares underpinned by QE2 in the US, the soft patch in global growth appears to be over, the corporate sector is cashed up and this is likely to result in a further pickup in M&A activity, and shares remain very cheap relative to government bonds.
• Notwithstanding normal bumps along the way, the Australian dollar is likely to head higher as the $US and now the euro remain under downwards pressure, interest rates in Australia continue to trend up and commodity prices remain strong. It is likely to settle around $US1.10 in the year ahead.
• Deflation worries, along with 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.