Headline developments

• Nature continued to wreak havoc in Australia, with Cyclone Yasi smashing into North Queensland as a category 5 storm (the highest they get) leaving a trail of devastation. Fortunately due to great preparation and the fact that it missed major population centres there appears to have been only one or two fatalities and the damage was less than feared. Nevertheless it will still have a major impact on the economy. 75% of Australia’s banana crop has been wiped out, up to 20% of Australia’s sugar cane crop has been affected, it will add to the disruption of mining production caused by the floods and will likely have an adverse affect on tourism. Coming on the back of the floods the combined affect is likely to detract 1% off March quarter GDP, likely pushing growth into negative territory, before a return to normal production and flood related rebuilding kicks in pushing growth up strongly from the June quarter. It will make the economy look like it’s on a roller coaster ride. The devastation to the banana crop is also going to have a big impact on inflation. If the experience of Cyclone Larry six years ago is any guide banana prices are likely to rise 250% of more adding at least 0.5% to inflation. This suggests that the combined impact of the floods and cyclone will add 1% to inflation spread across the March and June current quarters.
• While the Reserve Bank of Australia left interest rates on hold after its Board meeting and indicated no urgency to adjust interest rates for the time being, its clear from its Statement on Monetary Policy that it retains a tightening bias. Beyond the short term impact of the floods and Cyclone – which it has indicated it will look through – it sees a slight positive boost to growth coming from rebuilding over the next few years and this combined with a stronger outlook for the global economy, more confidence in the outlook for strong resources investment and expectations that inflation will rise to the top of the target range by the end of 2012 suggests that interest rate hikes are still well and truly on the agenda. That said, we see little reason to change our view that the RBA will sit tight until around mid year – as it waits to get more clarity regarding the conflicting impacts of the floods and Cyclone before then raising rates by a total of 0.5% to 0.75% by year end.
• Turmoil in Egypt remains a concern with worries that it could disrupt trade and oil flows through the Suez Canal or spread to oil producing countries in the Middle East. The latter seems unlikely though given that Saudi Arabia and other oil rich countries tend to use their huge oil revenues to keep cost pressures down for their citizens which in turn helps to subdue dissent. However, this won’t stop markets from worrying about it though as long as the turmoil continues.

Major global economic releases and implications

• US economic data was favourable, suggesting that growth has remained solid into the New Year. Strong gains were recorded in the ISM business conditions indexes, vehicle sales, labour market indicators and weekly mortgage applications. US December quarter earnings continued to surprise on the upside with 71% coming in better than expected. It’s also worth noting that the December quarter GDP data saw the level of GDP rise above its pre recession high – in other words the recovery in the US is actually over and it has now entered an expansion. The improvement in the US economy is clearly being recognised by Fed Chairman Ben Bernanke but he reiterated that the Fed wants to see a sustained period of stronger job growth and that core inflation remains too low. So the US is in a classic sweet spot of improving growth and profits, low underlying inflation and easy money – an environment which is usually very positive for shares.
• It’s a similar story in Europe, which saw more solid business conditions surveys both in the euro-zone and the UK, but the European Central Bank sounding reasonably relaxed about the inflation outlook despite the boost from higher commodity prices. Euro-zone unemployment remained steady at 10%, but unemployment fell to its lowest level since November 1992 in Germany.
• Chinese manufacturing conditions slipped in January, suggesting that tightening measures are starting to impact and possibly adding to confidence that additional tightening won’t become aggressive.
• Elsewhere in Asia export data continued to surprise on the upside in India and Korea, Korean and Japanese industrial production was strong in December and GDP growth remained robust in Taiwan in the December quarter. Clearly strong growth is continuing in Asia, although the pace has slowed from a year ago.

Australian economic releases and implications

• Australian economic data over the past week provided a mixed picture. Credit data remained soft but looks to be stabilising. Business confidence fell sharply but this appears to be mainly due to the floods with business conditions actually improving a bit. New home sales were soft in December as were underlying building approvals. House prices rose modestly in the December quarter but have been largely flat for nine months now. Finally the trade surplus held steady in December despite the floods and points to a modest positive contribution to December quarter GDP growth.

Major market moves

• Share markets had strong gains as solid economic and earnings data offset worries about the turmoil in Egypt. While insurers had a volatile ride, Australian shares rose to their highest level since April last year led by resources stocks on the back of higher commodity prices. The increase in confidence also saw bond yields rise, with investor flows now shifting aggressively away from bonds and into shares on a global basis.
• Commodity prices had solid gains on the back of increasing confidence in the global recovery. Sugar prices hit a 30-year high after crop damage in Australia and India. Strong commodity prices also saw the $A push back above parity against the $US.

What to watch in the week ahead?

• It’s a pretty quite week ahead on the data front in the US with only the trade balance and data for consumer sentiment due on Friday. Consumer sentiment will be watched for further signs of further improvement, although recent freezing weather in the US may have a dampening impact.
• Chinese economic data for January will be watched for signs of a cooling in growth. Trade data is due for release on Thursday and credit and money supply data will be released on Friday. Anecdotal evidence suggests that credit growth was strong in January, as is usually the case at the start of each year.
• In Australia, RBA Governor Steven’s testimony before a Parliamentary committee on Friday is likely to simply reiterate what we have heard over the last week which is essentially that current interest rate settings are appropriate, but that it retains a positive view on the medium term growth outlook and still sees inflation heading up to the top of its target range, all of which is consistent with more rate hikes this year.
• On the data front in Australia, we expect a modest rise in December retail sales (due Monday) to leave real retail sales for the quarter down slightly, consumer confidence (Wednesday) is likely to have been little changed in February after a big flood induced slump in January and employment data (Thursday) is likely to show an increase of 15,000 in January leaving the unemployment rate at 5%.
• The Australian December half earnings reporting season will start in earnest with Cochlear, Rio and Telstra due to report amongst others. 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 reflecting the slowing housing & 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, shares are at risk of a short term correction. However, any pullback should be seen as a buying opportunity as the fundamental back drop for shares is very positive. Valuations are reasonable, the global economic recovery is looking increasingly sustainable, 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 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.

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