Weekly market & economic update – 26 November 2010

Headline developments of the past week

• While there was good news at the start of the week in terms of Ireland agreeing to accept a bailout from the European Union and the IMF, the worry list for investors actually expanded. It now includes worries about whether Ireland will deliver on its austerity package, concerns that Portugal will need a bailout too, an insider trading case in the US, ongoing issues with US mortgages, renewed tensions on the Korean peninsula, worries that China will tighten too much and concerns that rising inflation in emerging countries will become a problem. With this list of worries its little wonder investors are skittish.
• However, there are some positives worth noting. Firstly, the flow of economic data in Europe tells us that Germany and other core European countries are providing an offset to the weakness in peripheral countries. And at least Europe is now moving quickly to provide assistance to troubled countries. Secondly, US economic data is looking healthier. Thirdly, while North Korea is an ongoing worry, over the years it has a habit of doing provocative acts only to settle down again. Fourthly, while we are seeing almost a daily flow of news regarding tightening measures to combat inflation in China there is nothing in any of this to suggest that the Chinese authorities are going to crunch their economy, particularly with the pick up inflation essentially due to weather related food prices increases. Similarly, higher food prices accounts for most of the rise in inflation rates in other emerging countries and so is not a reason for aggressive monetary tightening. And finally, investors would be wise to remember the old saying that “shares climb a wall of worry”, in that its often when the worry list seems the longest that shares do their best, because invariably some of the worries start to fade which then prompts investors to close shorts and/or buy shares.
• In Australia, RBA Governor Glenn Stevens indicated that once allowance is made for the additional increase in bank lending rates and the strong Australian dollar, the current level of the cash rate is appropriate for the “period ahead”. This is pretty much in line with market expectations that rates are on hold for now. However, the Governor’s assessment that the medium term risks to inflation are that it will be too high on the back of only modest amounts of spare capacity and the need to accommodate a huge expansion in mining investment indicate the Reserve retains an inclination to continue raising interest rates next year. This was reinforced by the Governor’s observation that growth in labour costs is now rising. Our view is that the cash rate is likely on hold until March, but that it will rise to a cyclical peak of 5.5% in a year’s time.

Major global economic releases and implications

• US economic data came in on the positive side on balance. Data for home sales were weak and house prices also fell in September, but against this, weekly mortgage applications for new homes rose strongly suggesting that there is some light at the end of the housing tunnel.  While durable goods orders fell in October this may reflect a seasonal distortion. On the clearly positive front though, September quarter GDP growth was revised up, manufacturing surveys in the Richmond and Kansas areas both rose solidly, consumer sentiment rose and there was another sharp fall in weekly unemployment claims taking them to the lowest level since July 2008. The basic message from the flow of US economic data is that the recovery is continuing.
• European economic data was also mostly positive with rises in consumer confidence and business conditions. Germany remains a standout with business conditions rising to their highest level on record according to the IFO survey. Business confidence also rose in Belgium, France and Italy.
• In China, we saw more signs of tightening, including indications that banks will have to wind down lending in the last two months of the year in order to stay within the Government’s 7.5 trillion Renminbi target for new loans this year, given that so far 6.9 trillion has been lent out, indications that this target will be wound back down to 6.5-7 trillion RMB for next year and indications from the central bank that it will “normalise” monetary policy after running stimulatory monetary policy for several years. However, even if the new lending target is wound back to 6.5 trillion RMB this will still see credit growth of around 14%% & because monetary conditions are coming from very easy currently we remain of the view that such moves won’t crunch the economy.
• Across Asia, growth rates have slowed from the double digit pace seen earlier this year as activity bounced back from the GFC, but are still around 5 to 10%. Moderation is necessary to avoid overheating.

Australian economic releases and implications

• Australian economic data was somewhat mixed. Construction activity unexpectedly fell in the September quarter due to a fall in housing activity. While business investment rose in the September quarter, intentions for 2010-11 were scaled back. However, it’s worth noting that based on long term realisation ratios investment is still expected to surge by around 20% this financial year, which compares to the Governments forecast for an 8% rise. The scaling back from a previously implied rise of 25% may simply reflect capacity constraints rather than any loss of confidence. Mining investment looks like rising around 45%.
• An agreed large increase in pay for aviation workers secured by the Transport Workers Union averaging around 4.5% pa over three years has added to concerns about upwards pressure on wages. This will no doubt serve to maintain the Reserve Bank’s inclination to raise interest rates further next year.

Major market moves

• Share markets had another volatile week, initially being affected by the North Korean attack on South Korea and ongoing debt concerns in Europe, but settled later in the week after positive economic news out of the US and Europe lifted spirits.
• Commodity prices rose on the back of stronger global economic data, but the Australian dollar slipped back on softer than expected economic data in Australia and RBA comments that rates are appropriate for the period ahead. The euro also weakened further against the $US.

What to watch in the week ahead?

• In the US, key to watch will be the ISM manufacturing conditions index (due Wednesday) which we expect to remain solid and employment data (Friday) which is expected to show another 150,000 gain in payrolls but unemployment remaining high at 9.6%. Consumer confidence data (Tuesday) is likely to show a small improvement as are pending home sales (Thursday) and the ISM non-manufacturing index (Friday) is likely to remain solid. Against this house price data (Tuesday) is likely to show further weakness lagging the earlier fall in housing activity indicators. The Fed’s Beige Book of anecdotal evidence on the economy will also be released.
• In China, the official and HSBC PMIs, or business conditions indicators, (due Wednesday) are likely to remain solid but show a small fall back after recent strong gains.
• The European Central Bank meets on Thursday but is likely to leave interest rates on hold at 1%, and may signal a slower exit from its liquidity boosting measures given public debt problems in Europe.
• The week ahead in Australia will see an avalanche of data releases. The main focus will be on September quarter GDP growth (due Wednesday) which is likely to show growth of around 0.5%, or 3.4% year on year after an unexpectedly strong rise of 1.2% in the June quarter. Consumer spending is likely to be a key driver, with flat business investment and a fall in dwelling investment. Other data to be released includes: profits, inventories and new home sales (all due Monday), building approvals (Tuesday) which are likely to show a bounce after a sharp fall in September, private credit (Tuesday) which is likely to remain soft and retail sales (Wednesday) which are expected to show growth of around 0.2%. A couple of speeches by RBA officials, including Governor Stevens, will also be closely watched.

Outlook for markets

• It’s too early to say whether the share market correction we have seen since early November is over or not. However, we continue to expect solid gains in shares into year end and through next year. Shares are cheap, particularly relative to government bonds, the run of better than expected economic data globally is continuing suggesting that the global recovery remains on track, the global liquidity backdrop is highly favourable underpinned by QE2 in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. The period from US Thanksgiving to May is normally strong for shares, particularly December and January.
• Notwithstanding normal bumps along the way, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia continue to trend up, and commodity prices resume their rising trend. It’s likely that the $A will 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.