Headline developments of the past week

• China continued to tighten the monetary screws with another interest rates hike. This should not really have been a surprise to anyone and further tightening is likely as Chinese authorities move to vacuum up liquidity being pumped into the economy by their efforts to slow the appreciation of the Renminbi and as part of an ongoing effort to control inflation. However, we remain of the view that China’s growth will slow back to a more sustainable pace but it will not be crunched. Most of the inflation problem in China is food related and likely to reverse later this year. Moreover China’s economy is not particularly interest rate sensitive with the bulk of fixed investment financed by corporate earnings and household debt is very low.
• RBA Governor Glenn Steven’s Parliamentary testimony reinforced the message that, beyond the short term disruption caused by the floods, the RBA has an upbeat medium term economic outlook but that for the time being its comfortable with current settings for interest rates. Our view remains that interest rates will remain on hold until mid year before rates start to head slowly higher again.

Major global economic releases and implications

• US economic data was generally solid. Weekly mortgage applications fell but against this consumer credit, small business confidence and weekly retail sales data rose by more than expected and weekly jobless claims fell to their lowest level since July 2008. With the US economy looking stronger and stronger it wouldn’t surprise to see increasing market talk of the first rate hike from later this year.
• US earnings results continued to surprise on the upside, with so far 70% of results coming in better than expected. December quarter 2010 profits are on track to come in 32% above year ago levels. The driver of stronger profits has shifted from cost savings to revenue growth, with revenue growth running around 6.8%.
• European data was a bit on the soft side with a sharp fall in German factor orders and industrial production, but the former followed a very strong rise the previous month. Japanese economic data was generally positive with gains in the December leading index rose, consumer confidence, housing finance and machine orders.

Australian economic releases and implications

• In Australia, the December half earnings reporting season has kicked off on a relatively solid note with good results from companies such as Boral, Commonwealth Bank, Stockland and Rio. So far 47% of companies have come in above expectations compared to a norm over the last seven years of 46% and 73% of companies have reported a rise in profits on a year ago. However, it’s early days yet with only 35 major companies having reported. Two themes are readily apparent. First, the outstanding strength of the resources sector compared to non-resources stocks. Second, several companies announced plans to return capital to shareholders via increased dividends and share buybacks. With corporate cash holdings at record levels and gearing low there is plenty of scope for further increases in dividends and buybacks going forward.

Source: AMP Capital Investors

Source: AMP Capital Investors

• Australian economic data was mixed. Retail sales rose but only marginally in December and business conditions softened in January mainly due to the floods. Against this February consumer confidence recorded a small rise and despite the floods both employment and job advertisements rose again in January indicating that the labour market remains reasonably solid, although forward looking indicators continue to point to some softening in employment growth going forward, albeit from exceptionally strong levels over the last year. There is now a high risk of negative December quarter GDP growth and thanks to a 1% or so flood related detraction from growth in the March quarter its probable March quarter growth will be negative. So two quarters in a row of negative growth in Australia is distinctly possible. However, given the key driver will be the floods it would be dangerous to read much into this as growth is likely to come roaring back from the June quarter as production returns to normal levels, flood and cyclone rebuilding kicks in and mining investment really starts ramp up.

Major market moves

• Share markets continued to move higher over the last week on increasing takeover activity, more confidence in the global growth outlook and on reduced concerns about Egypt. In Australia, the All Ords rose through the 5000 level for the first time since April reflecting good profit results and several companies announcing increased dividends and share buybacks. We expect the S&P/ASX 200 Index to hit 5,500 by year-end, which would translate to 5600 for the All Ords. Bonds continued their sell off as investors continued to bail out and confidence in the global growth outlook continued to improve.
• Industrial commodity prices generally softened on Chinese/Asian monetary tightening. Oil prices were also weighed down by increased oil stockpile levels in the US and an easing of political tensions in Egypt. Soft commodity prices continued to rise though on ongoing global supply disruptions. Softer commodity prices also weighed a bit on the Australian dollar.

What to watch in the week ahead?

• In the US, the focus will be on retail sales for January (due Tuesday) which are expected to record a modest rise but are subject to greater than normal uncertainty due to the impact of snow storms. Housing starts and permits data due will be watched closely for signs the housing sector has bottomed. While headline inflation in the US is likely to have been boosted by higher food and energy prices in January, core inflation is likely to remain benign supporting the Fed’s assessment that monetary policy should remain easy.
• In China the focus will be on inflation data for January (due Tuesday) which are expected to show a rebound to around 5.4% (from 4.6% in December) as a result of another weather related boost to food prices. Property price data for January is likely to show another slowdown in residential property price growth to around 5.5%, from 6.4% in December.
• In Australia, the minutes from the Reserve Bank’s February policy meeting and a speech by Assistant RBA Governor Lowe are likely to confirm the rates on hold for now but with a tightening bias message. Meanwhile, housing finance for December (due Monday) is likely to leave intact the impression that housing finance has stabilised after an earlier fall. January car sales data (Wednesday) may attract greater than normal attention as it may be depressed as a result of the floods.
• In Australia, the December half earnings reporting season will continue with about 60 major companies due to report including AXA, Brambles, BHP Billiton, CSL, Westfield, Qantas and Fortescue. The results are likely to continue 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

• After months of strong gains globally, and with measures of investor sentiment running at high levels and February normally being a soft month, the risk of a short term correction or consolidation in share markets is high. However, any pullback in shares should be seen as a buying opportunity as the fundamental backdrop for shares is very positive. Valuations are reasonable, the global economic recovery is looking stronger, the global liquidity backdrop is very favourable with very low interest rates in key countries, the corporate sector is cashed up, and investors are only just starting to switch from bond funds into share funds.
• The broad trend in the $A is likely to remain up as the US dollar 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 this year is very high. Bond yields in key advanced countries are still below longer-term sustainable levels and bond funds are now starting to see outflows.

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