Headline developments of the past week

• Another round of strong Chinese economic activity indicators, excessive loan growth and a further rise in inflation to 5.1% in November on the back of a sharp rise in food prices have kept Chinese authorities in tightening mode with the People’s Bank of China raising bank required reserve ratios to a new record high. A further hike in interest rates is also looking imminent. Both export and import growth accelerated in November and economic activity indicators remained strong suggesting that the economy is healthy enough to be able to bear further tightening. However, the growth in economic activity indicators remains down from the blistering pace seen earlier this year, recent weekly data is showing a fall in food prices suggesting that price controls and supply boosting measures are starting to work in which case inflation is likely at or near its peak and measures to slow the property market appear to have worked with house price inflation slowing further over the year to November. As such we remain of the view that policy tightening won’t get aggressive enough to crunch the Chinese economy.
• It still has to pass through Congress, but more stimulus is likely on the way for the US economy with President Obama agreeing to a two year extension of the Bush era tax cuts including the 15% tax rate on capital gains and dividends. However, the real surprise came in the form of an agreement to temporarily extend long term unemployment benefits and cut employee payroll taxes. Coming hot on the heals of news that Fed Chairman Ben Bernanke was prepared to extend the Fed’s quantitative easing program if need be and an improvement in US economic data the latest round of fiscal stimulus adds to confidence that the US recovery may pick up pace next year. The added stimulus is not so good for the US budget deficit though and this partly explains why bond yields rose sharply over the last week.
• As had been widely foreshadowed, the Reserve Bank of Australia left interest rates unchanged at 4.75%. The accompanying statement was relatively dovish, pointing to the boost to national income from the high terms of trade on the one hand and the degree of caution in spending and borrowing on the part of households on the other. The clear implication is that the RBA sees no urgency to raise interest rates further at this stage. However, with the RBA still expecting inflation to rise over the medium term it appears to retain a bias to raise interest rates next year. Continuing evidence of a tightening labour market and the risk this poses to wages growth supports our assessment that while interest rates are likely to be on hold for the next few months, they will start to rise again in the June quarter next year.

Major global economic releases and implications

• US economic data retained its recent better tone, with a rise in consumer sentiment in early December to a six month high, a rise in job openings, a fall in initial jobless claims and another rise in new mortgage applications. A sharp decline in the trade deficit in October on the back of stronger exports points to a strong contribution to December quarter GDP growth if sustained.
• There was also more good news from German economic data with a rise in factory orders and industrial production. There were no surprises from the Bank of England which left interest rates on hold as expected.
• Japanese economic data was mixed with falls in bank lending and core machinery orders but a rise in economic confidence for the first time in four months, stronger machine tool orders and lower bankruptcies.
• A pick up in exports in many emerging countries in November – including China, Korea, Taiwan, Brazil, Chile and Vietnam – provides further evidence that the global economy is accelerating again after a mid-year soft patch.

Australian economic releases and implications

• After a run of soft economic data in recent weeks, Australian economic data was on the strong side over the past week with the TD Securities/Melbourne Institute’s inflation gauge pointing to a rise in inflation, housing finance rising again in October adding to evidence that it has stabilised after a sharp fall into earlier this year and job ads and employment continuing to rise in November. The November employment report was particularly strong with another 54,600 new jobs being created taking total employment growth over the last year to over 400,000 jobs (or +3.7%). Either the labour market data is lagging or the soft patch evident in other data isn’t for real or maybe employers don’t believe it will last. Whatever the reason, the strength in the labour market is underpinning continuing very strong growth in household income which sooner or latter could translate into stronger retail sales and secondly it adds to the risk of an acceleration in wages growth putting pressure on inflation. So while the November labour market report is unlikely to change the rates on hold message for the next few months, it remains consistent with further rate hikes from the June quarter next year.

Major market moves

• Share markets rose over the last week helped along by reasonable economic data, talk of more stimulus in the US and the absence of any new negative developments in relation to European debt problems.
• Commodity prices were mixed with a fall in gold and oil prices but gains in metal prices. The Australian dollar fell slightly after the RBA indicated no urgency to further raise interest rates and as expectations for US economic growth improved and pushed up the $US.
• Government bonds continued to sell off reflecting increased optimism regarding the US growth outlook, the boost to the US budget deficit from the latest stimulus package and reduced safe haven demand. Bond funds have seen record inflows over the last two years and this might be starting to reverse as investors re-assess the prospects for bond returns in the face of still low yields, improving growth and still high budget deficits.

What to watch in the week ahead?

• In the US, the Fed meets on Tuesday and while it is likely to acknowledge an improvement in recent economic data it won’t be enough to alter the Fed’s assessment that interest rates will likely need to stay near zero for an extended period and that it will need to complete its recently announced quantitative easing program. US November data for retail sales (due Tuesday) is likely to show a decent rise based on various private surveys, inflation data (Wednesday) is likely to remain benign and housing starts and permits (Thursday) are likely to show modest gains adding to evidence that the US housing sector has stabilised. Data for industrial production and surveys of homebuilders and manufacturers in the Philadelphia and New York regions are also due for release.
• In Japan, the Tankan business survey for the December quarter (due Wednesday) is likely to show a further deterioration in Japanese business conditions. By contrast the German IFO business survey (Friday) is expected to show that German business conditions remain strong.
• In Australia, the NAB business survey (Tuesday) and Westpac’s consumer confidence survey (Wednesday) will be watched closely as a guide to how long the current soft patch in the economy will last. Given interest rates were left on hold this month and the good news on the labour market it’s possible that consumer confidence will recover some of the fall posted in November. Housing starts data (Tuesday) is likely to show weakness reflecting earlier falls in building approvals and data for car sales, skilled vacancies and imports will also be released.

Outlook for markets

• Share markets often have a soft patch into mid December before seasonal strength, known as the “Santa Claus” rally, kicks in pushing them higher into year end and into January and this is pretty much how we see share markets playing out over the next few weeks. More broadly, while the ride will likely remain volatile as GFC aftershocks continue to impact, shares are likely to post solid gains over the year ahead. Shares are cheap, the run of better than expected global economic data is continuing suggesting that the global economic recovery remains on track which should in turn drive another year of solid profit growth, 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.
• Notwithstanding inevitable volatility, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia remain relatively high and commodity prices keep the terms of trade near early 1950s highs. By end 2011 the $A is likely to have reached $US1.10.
• While low inflation, central bank government bond purchases and the absence of any near term monetary tightening should help keep bond yields in key advanced countries reasonably low in the short term, the risk of a sharp back up in bond yields at some point is very high. Bond yields in key advanced countries are well below longer term sustainable levels and sooner or later the record inflows into bond funds seen in recent years are at risk of becoming record outflows as investors realise that bond returns are likely to be poor going forward. The back-up in bond yields over the last few weeks is possibly a warning of things to come.

The post Weekly market & economic update – 10 December 2010 appeared first on AdviserVoice.