Weekly market & economic update 28 January 2011

Headline developments

• The Australian Government announced that it needs around $5.6bn to help rebuild flood affected areas and that it will source $1.8bn of this from a temporary levy on taxpayers with the remainder coming from spending cuts. It makes sense for the Government to still be aiming to return the budget to surplus by 2012-13 as the economy is likely to be a lot stronger by then. However, given that consumer spending is already pretty soft it would have been preferable to see more of the burden placed on spending cutbacks as opposed to households. While the impact of the levy on average income earners is modest (eg only $250 for someone on $100,000) and it is temporary, news of another impost won’t help consumer spending with households already facing sharp increases for food prices, utility bills, insurance premiums, rents and health costs.
• China announced another round of measures to cool its property sector including increases in required down payments for second homes and a ban on the purchase of second homes in all major cities. Quite clearly the tightening process is continuing in China as it struggles to stop capital inflows associated with its management of the Renminbi from spilling over into consumer and asset price inflation. However, so far the tightening is measured and targeted and so we remain of the view that China will not crunch its economy.
• Japan is the latest major advanced country to see its sovereign debt rating downgraded because of its bleak public debt outlook. However, it’s unlikely to have much impact as Japan is actually a net lender to the rest of the world and 95% of Japanese public debt is held by domestic investors. The longer term concern for Japan though is what happens when more of those domestic investors start to retire, as the Japanese population is aging rapidly, and so start running down their holdings of Japanese bonds.

Major global economic releases and implications

• US economic data was generally solid. While house prices remain weak reflecting the lagged response to the ending of the first home buyer tax credit, pending home sales and new home sales rose adding to confidence that the housing sector has found a base. On top of this, consumer confidence rose strongly in January, underlying durable goods orders are continuing to rise and the ISM business conditions index for December was revised up suggesting that manufacturing conditions are even stronger than thought. While unemployment claims spiked in the last week this was mainly due to bad weather. Meanwhile, despite the improvement in the economy it’s still not enough to satisfy the Fed, particularly with underlying inflation measures trending down and unemployment still high and so as a result it is continuing with its quantitative easing program (QE2). President Obama’s State of the Union address also went down well with investors as it continued the shift to a more pro-business stance that has been evident since the Democrats drubbing in the mid term elections late last year. Good economic data, a dovish Fed and an increasingly pro-business President are all good news for investors and US shares in particular for the year ahead.
• US earnings results continued to surprise on the upside, with so far 72% of results coming in better than expected. December quarter 2010 profits are on track to come in 32% above year ago levels.
• Euro-zone data was positive with solid readings for business conditions and confidence in January and a strong rise in industrial new orders. UK GDP fell in the December quarter (partly due to bad weather) adding to confusion over the outlook for the UK economy with inflation surprising on the upside. This confusion was evident at the last Bank of England meeting which seemed to come close to raising interest rates. With the UK yet to feel the impact of recent fiscal tightening, a monetary tightening at this stage would be very dangerous.
• Japanese economic data was mixed with less price deflation than expected and an unexpected fall in the unemployment rate but weak retail sales. Tightening to control inflation continued in Asia with the Reserve Bank of India raising its key interest rates by another 0.25%, with further tightening likely.

Australian economic releases and implications

• Australian inflation data for the December quarter was surprising benign and leaves inflation comfortably within the RBA’s 2 to 3% target range. While food prices are rising solidly, discounting is keeping a lid on inflationary pressures generally leaving plenty of scope for the RBA to leave interest rates on hold in the face of uncertainty caused by the floods. We expect rates to remain on hold out to May at least.

Major market moves

• Share markets generally rose over the last week helped by positive economic and earnings news. The lower than expected rise in Australian inflation also helped the Australian share market by further taking pressure off interest rates.
• Commodity prices were mixed, but with the gold price continuing to fall as the improving global growth outlook is reducing investor demand for assets like gold that benefit from monetary reflation and provide a hedge against a falling US dollar. The Australian dollar and euro rose against the $US.

What to watch in the week ahead

• In the US, the key ISM business conditions survey (due Tuesday) is likely to show a further strengthening in the manufacturing sector and payroll employment data (Friday) is likely to show a gain of 150,000 jobs. Data for personal income and spending (Monday) will also be watched closely but is likely to confirm the pick up in consumer spending evident in other data. December quarter earnings results will continue to flow.
• The European Central Bank meets Thursday, but is likely to leave rates on hold. The EU leaders’ summit on Friday may be more important given the issues around extending the European sovereign debt rescue fund.
• The Reserve Bank of Australia is likely to leave interest rates firmly on hold. Recent economic data has had a soft tone and the benign December quarter inflation data has provided plenty of leeway for the RBA to sit back for several months and assess the impact of the floods on the economy. We expect rates to remain on hold out to May at least but for rate hikes to resume from mid year as flood rebuilding activity combines with mining related investment to push economic growth back up again. The RBA’s Statement on Monetary policy will likely be watched for more clues as to how the Bank sees the floods impacting the economic outlook. Australian data for private sector credit (due Monday) will be watched for further signs of improvement, December quarter house price data (Tuesday) is likely to show flat house prices in the final quarter of the year and building approvals data (Thursday) will be watched for any signs of a rebound after the fall in November. The NAB business confidence survey for December will also be released on Tuesday.
• In Australia, the December half earnings reporting season will start with Crane, NewsCorp and Tabcorp due to report. The results are likely to reflect the two speed Australian economy with resources and related stocks doing very well on the back of the surge in commodity prices but non-bank industrials likely to be much more constrained and at risk of further earnings downgrades reflecting the slowing housing and retail sectors and the strong $A.

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.
• 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 easy monetary conditions in key countries, the corporate sector is cashed up and US mutual fund investors are starting to shift out of bond funds into share funds.
• 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 this year 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 now reversing.