Weekly market & economic update: 5 November 2010


Headline developments of the past week

  • The contrast in global central banks was stark over the past week with those in weak countries such as the US, Japan and Europe leaving monetary conditions very easy and in the US actually easing further via more quantitative easing, whereas those in strong countries such as India and Australia actually raising interest rates. The move to QE2 in the US will result in a further huge boost to global liquidity which is positive for shares, particularly in emerging countries, and commodity prices and will reinforce the ongoing fall in the $US against commodity currencies such as the Australian dollar and emerging country currencies.
  • The big event of the last week was of course the US Federal Reserve’s announcement of another round of quantitative easing (QE2), choosing to purchase an additional $US600bn of US Treasury bonds by the end of June next year with further moves subject to economic conditions. Will it work or will it just boost inflation? The claim by some that inflation will take off is nonsense. This will only be an issue once broad measures of money supply and credit pick up and capacity utilisation returns to normal but we have a long way to go to reach that point. The more substantive argument against QE2 is that the basic problem in the US is a lack of demand for credit. However, doing nothing is not an option. QE1 in 2008-09 does appear to have boosted the US economy. Moreover, QE2 could help the continuing US recovery by keeping borrowing costs low, boosting asset prices and hence having a positive wealth effect, keeping inflationary expectations positive and maintaining downwards pressure on the $US. The first three are likely to help support spending and a lower $US should help US exporters. With bond yields and the $US substantially lower and US shares up 17% or so since QE2 was first mooted in late August, it appears to have already had a positive effect.
  • The US mid-term Congressional elections saw the Republicans regain control of the House of Representatives but fall short of control of the Senate. Republican control of the House of Representatives should help blunt some of the less business friendly policies that were emanating from the President Obama. More importantly, it may be good for the US if it leads to a more pragmatic and centrist approach from President Obama, much as occurred with President Clinton after the 1994 mid-term elections.
  • In Australia, the Reserve Bank decided to act on its often stated tightening bias and raised the official cash rate by another 0.25% taking it to 4.75%. The Reserve Bank’s expectation that inflation will rise over the next few years points to further tightening ahead. However, the additional tightening that has flowed from the $A pushing through parity and bank moves to raise lending rates by more than the RBA rate increase suggest the next move probably won’t come until February and that the peak will be lower than otherwise would have been the case. Within a year’s time the cash rate is likely to have increased to around 5.5%.
  • The RBA’s Quarterly Statement on Monetary Policy only served to reinforce its ongoing tightening bias. While inflation forecasts for this year were revised down, growth forecasts were revised up and the RBA still sees underlying inflation heading up to the top of its target range through the second half of next year as the boost to national income from high commodity prices pushes the economy up against capacity constraints.
  • After a two week consolidation since first hitting parity, the $A broke decisively through the parity level against the $US on the back of the RBA’s rate hike and the Fed’s announcement of QE2. While gyrations in the $A will remain significant, the continuing strength in Australia’s terms of trade, further tightening in Australian monetary policy and an ongoing downtrend in the $US are likely to see the $A push up to around $US1.10 in the year ahead. Above parity for the $A will become part of the landscape, so get used to it!

Major global economic releases and implications

  • US economic data was positive suggesting that the soft patch in growth may have ended and that, combined with QE2, the risk of a double dip back into recession has faded significantly. Both the ISM manufacturing and non-manufacturing conditions indicators rose in October, factory orders rose more than expected in September, weekly new mortgage applications rose further and most importantly payroll employment rose solidly in October led by 159,000 new private sector jobs.
  • US profit reports remained very strong, consistent with continuing strength in productivity in the September quarter, and providing solid support for capex, employment and M&A activity going forward.
  • European manufacturing conditions indicators rose in October with Germany remaining pretty solid.
  • A further rise in Chinese manufacturing conditions indicators (or PMIs) and continuing strength in services sectors PMIs in October highlights the ongoing strength in the Chinese economy and points to a further tapping of the policy brakes in the months ahead. I have just spent the last week in China and have to say that there are no signs of the Chinese hard landing that was much feared earlier this year, let alone the bust that the China sceptics are always raving on about.

Australian economic releases and implications

  • Australian economic data was mixed with a rise in indicators of manufacturing and services sector conditions, continued moderate growth in retail sales but flat house prices and another slide in building approvals. Quite clearly the 20% surge in house prices from the March quarter 2009 has now run its course and with affordability around record lows and set to worsen as mortgage rates rise further, house prices are likely to be flat to maybe even down slightly over the year ahead. However, the continuing undersupply highlighted by the latest fall in building approvals should provide a solid floor under house prices.

Major market moves

  • Global shares are surging higher on a positive cocktail of better than expected global economic data and earnings news, the US announcement of QE2 and optimism that the Republican victories in US elections will lead to more business friendly policies. The surge in optimism has pushed US shares to new recovery highs and Australian shares decisively above the range they have been stuck in for a month with both markets up 3% over the last week. Asian shares which are likely to be key beneficiaries of the global liquidity boost flowing from QE2 were up even more with Hong Kong shares up 7.7% and Chinese shares up 5.1%.
  • News of the increased supply of US dollars pushed the $US lower and this along with greater economic optimism pushed other growth trades such as commodity prices and the $A decisively higher.

What to watch in the week ahead?

  • In the week ahead, the focus is likely to be on Chinese economic data for October. Activity indicators are expected to show ongoing solid, but not overheating growth. Housing indicators are likely to be soft. Higher food prices are likely to boost inflation to around 4%. However, this may well be the peak and benign non-food inflation and increasingly well balanced growth is likely to ensure that further policy tightening remains gradual and targeted.
  • In Australia, employment data for October, due Thursday, is likely to show another decent gain in jobs and a fall in unemployment to 5%. Data for job ads are likely to remain solid, but Westpac’s consumer confidence index is likely to have fallen as a result on the latest rate hike and housing finance data for September is likely to have remained soft. The Government’s mid year economic and fiscal review is likely to see upside revisions to near term growth forecasts and a downwards revision to near term inflation forecasts.
  • The G20 leaders’ summit is likely to provide nothing more than the usual hot air about commitments to market determined exchange rates and international cooperation. It may see more pressure on China to speed up the pace of Renminbi revaluation, but is unlikely to result in anything significant.

Outlook for markets

  • Having undergone a consolidation in recent weeks, shares have now decisively broken out on the upside with further solid gains likely into year end and through next year. The global liquidity backdrop is getting even more favourable for shares underpinned by QE2 in the US, the soft patch in global growth appears to be over resulting in a return to investor confidence, 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. Emerging market and Asian shares are likely to continue to outperform, but the key direction setting US share market is also likely to post solid gains. The average gain in US shares post mid-term elections has been 27% over the subsequent 12 months and we are now coming into the third year of the US presidential election cycle which is normally the strongest with an average post war gain of 18% pa. Against this backdrop, the Australian ASX200 share index is on track to push above the 5000 level by year end.
  • After a period of consolidation since first hitting parity a few weeks ago the Australian dollar has broken decisively above it, and notwithstanding normal bumps along the way, looks to be heading even higher thanks to a falling US dollar, rising interest rates in Australia and high commodity prices. 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.

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