Weekly market & economic update – 21 January 2011

Headline developments

• An acceleration in Chinese economic growth in the December quarter to an estimated annualised pace of around 12% along with ongoing inflation worries have reinforced the case for further Chinese tightening in the months ahead. While inflation fell back to 4.6% in December from 5.1% in November this looks like a temporary reprieve with higher food prices this month and the Lunar New Year holidays likely to push inflation back up again in the months ahead. We expect another three interest rate hikes and bank required reserve ratio increases over the next six months. However, there is still nothing indicating that the Chinese are going to crunch their economy. First, while non-food inflation rose to 2.1% in December it is still low. Second, fixed asset investment is already moderating and a further slowing is likely this year as real estate construction slows and stimulus projects complete. Finally, much of the tightening measures we are now seeing are necessary just to mop up the liquidity the Chinese authorities are pumping into their economy to stop a more rapid appreciation in the Renminbi. Monetary conditions are still a long way from being tight. As such, investor fears that China will crunch its economy evident in a 5% or so fall in Chinese shares so far this year coming on the back of a 23% fall last year are overdone. While the Chinese share market may remain vulnerable until tightening stops, Chinese domestic shares are trading on a price to earnings ratio of 18 times which is well below their historic average of 34 times suggesting that a lot of bad news is already factored in.
• In Australia, flooding continues to wreak havoc with now nearly a third of Victoria flood affected. As a result expectations of the damage bill and the hit to economic growth in the March quarter continue to escalate. We now expect the damage bill to property, equipment, infrastructure, etc, to be around $15bn with the floods likely to detract 1% from economic growth concentrated in the current quarter. Fortunately, growth should rebound starting next quarter as the rebuilding effort kicks in and production returns to normal. While the floods will add 0.5% to 0.75% to March quarter inflation, we expect the RBA to look through this and hold off raising interest rates again until it becomes clear that growth is recovering from the impact of the floods. This suggests that interest rates will be on hold out until around May at least.

Major global economic releases and implications

• US data released over the last week remained consistent with an acceleration in the US economy. Surveys of manufacturers remained strong, jobless claims fell sharply and the US leading indicator rose strongly. Housing indicators were mixed with housing conditions flat according to a survey of home builders and housing starts fell due to bad weather but existing home sales rose very strongly. Our overall view remains that the US housing sector has found a base, but its also worth noting that housing activity is now only around 2.5% of US GDP compared to 6% in 2005 so its impact on the US economy is far less than it used to be.
• The US December quarter earnings reporting season got underway in earnest over the last week with 50 major companies reporting. So far 69% of results have come in better than expected including for JP Morgan, Apple and IBM. While upside surprise is down compared to recent quarters this appears to be because analyst expectations have finally caught up to the recovery in earnings with earnings growth estimates for the year to the December quarter already very strong at +32%.
• Japanese economic data was generally upbeat with gains in machine tool orders, a tertiary activity index and Tokyo condominium sales. Against this, consumer confidence fell slightly in December.
• While interest rates are well and truly on hold in key advanced countries, monetary tightening is continuing in emerging countries as part of an effort to deal with inflationary pressures. This is clearly evident in China, Indonesia, Korea and Thailand which all tightened last week but in the past week Brazil also tightened, raising its key policy rate by 0.5%. Inflationary pressures in the emerging world point to further tightening in these countries ahead. So far the increase in inflation is mainly food related so tightening is unlikely to be aggressive but it is worth keeping an eye on.
  Australian economic releases and implications
• Australian economic data was mixed.  New vehicle sales for December rose solidly in December and the TD Securities/Melbourne Institutes’ Inflation Gauge showed significant inflationary pressure in December. But against this, consumer sentiment and skilled vacancies both fell sharply in January, presumably in response to the impact of the severe flooding. Both are likely to rebound once the flood waters subside. While a sharper fall in export prices than import prices implies a fall in the terms of trade in the December quarter, it should be noted that it is likely to rebound this quarter as the flood boosts coal prices.

Major market moves

• Global share markets fell over the past week reflecting a combination of profit taking after strong gains in recent months and worries about the impact of Chinese tightening. While the Australian share market briefly broke out to its highest level since last April, it was knocked back down again in response to a fall back in US shares and worries about the impact of Chinese tightening on commodity demand.
• Worries about the impact of further Chinese tightening also weighed on commodity prices and the $A.
• Bond yields rose as global economic data continued to surprise on the upside.

What to watch in the week ahead?

• In the US, the main focus is likely to be on December quarter GDP data (due Friday) which we expect to show an acceleration in growth to a 3.5% annualised pace after 2.6% annualised growth in the September quarter. US data for consumer confidence (Tuesday) is likely to improve slightly after a soft reading in December, data for new home sales (Wednesday) and pending home sales (Thursday) are likely to rise modestly and durable goods orders (Thursday) are likely to remain solid. Meanwhile, following its meeting on Tuesday and Wednesday the Fed is likely to signal greater optimism about the outlook for the US economy but not enough to warrant any imminent tightening in monetary policy. The December quarter profit reporting season in the US will also continue with 150 or so S&P500 companies due to report.
• Japanese data for inflation, the labour market and retail sales will be released on Thursday.
• In Australia, the importance of December quarter inflation data (due for release on Tuesday) for monetary policy has been somewhat reduced by flooding in Queensland and other states. Increases in prices for food, housing costs and petrol prices are expected to push up the consumer price index by 0.7% in the December quarter pushing the annual rate of inflation up to 3%. Underlying inflation is likely to also rise by around 0.7% in the quarter or 2.5% year on year.

Outlook for markets

• Share markets are vulnerable to a short term correction. After very strong gains since August last year many technical indicators show that shares generally are overbought, measures of investor sentiment are at high levels suggesting that a lot of good news is factored in and the seasonal tendency is for share market strength in December and January to be followed by weakness in February. Further Chinese tightening could be the trigger for a further short term correction in shares.
• However, shares are likely to put in good gains through 2011 as a whole so any short term pullback should be seen as a buying opportunity.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that 2011 is on track for strong economic growth which should in turn drive another year of solid profit growth, the global liquidity backdrop is highly favourable underpinned by very low interest rates in key countries & quantitative easing 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. By end 2011 we see the Australian ASX 200 index rising to 5500, once it shrugs off the current malaise which appears to reflect a combination of worries about the floods and Chinese tightening.
• The Australian dollar is at risk of a further correction in response to ongoing uncertainty about the impact of Chinese tightening on commodity prices and as a result of the negative impact on local growth from the floods. However, the broad trend is likely to remain up as the $US and the euro remain under downwards pressure, interest rates in Australia remain relatively high and high commodity prices keep the terms of trade near early 1950s highs. By year end the $A is likely to have reached $US1.10.
• The risk of a sharp back up in global bond yields at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels, at some point market expectations are likely to swing back towards monetary tightening in the US and Australia and the record inflows into bond funds seen in recent years are at risk of becoming record outflows. Fortunately, bond yields in Australia are more in line with long term sustainable levels so the risk of a sharp back up in Australian bond yields is less than is the case for global bonds.