AMP: Weekly market & economic update

Headline developments of the past week

• The European debt crisis is continuing to rumble along with increasing talk of a “soft debt restructuring” for Greece which would involve extending the maturities on Greek debt but without changing the principle or interest rates. Greece announced that it would double the size of its austerity measures from €3billion in cuts to €6 billion, following a scolding from the EU finance minsters that further reforms were required. The risk is that more austerity will just make the economy worse which will make it even harder to get the budget deficit down.
• Meanwhile, the uncertainty regarding the leadership of the IMF is unlikely to affect its ability to fulfil its global economic and financial responsibilities but could hasten the shift to greater involvement in its running by emerging countries.
• Debate of the ceiling imposed by Congress on US Federal debt also hotted up with the ceiling being hit on May 16. The US Government has indicated that it can survive until early August (eg, by ceasing payments into pension funds) but its likely the debate will become increasingly acrimonious with another last minute deal being likely to involve more cuts to discretionary spending. This could be a periodic source of nervousness for investors over the next couple of months.
• In Australia, the big four banks saw their credit ratings cut one level to Aa2 by Moody’s on concern their reliance on wholesale debt markets makes them vulnerable to swings in investor confidence. While one can wonder about the timing – the reliance on wholesale funding has been an issue for the last three and a half years now and the banks have sought to reduce it – it’s unlikely to have much impact on the banks’ access to,or cost of, funding.

Major global economic releases and implications

• The soft patch in US economic data generally continued over the last week. Manufacturing conditions in the New York and Philadelphia regions both softened in May, industrial production was flat in April with auto production sliding on parts shortages from Japan, housing starts and permits fell in April as did existing home sales, home builders’ conditions remain weak, a leading indicator of economic activity fell and weekly mortgage applications and retail sales were soft. However, there was some good news with a sharp fall in unemployment claims over the last week following the distortions caused by the late timing of Easter.
• The minutes from the Fed’s last meeting provided a reminder that US interest rates are likely to remain on hold for some time yet. While there was a discussion on how the Fed might eventually exit from its easy monetary policies (which looks like it will start off with stopping the reinvestment of maturing assets, followed by removing the commitment to keep rates low, then raising rates and then asset sales) there was nothing new in this from what Chairman Bernanke said at his first post meeting press conference.
• Inflation in Europe remains an issue with euro-zone inflation rising to 2.8% in April or 1.6% on a core basis and inflation rising to 4.5% in the UK. While the pick up in euro-zone inflation is likely to be making the European Central Bank twitchy for more rate hikes the minutes from the Bank of England’s last meeting implied a fairly relaxed stance.
• As expected, Japan plunged back into recession with an earthquake induced slump in GDP in the March quarter coming on the back of the earlier reported slump in the December quarter. It’s worth bearing in mind that this is Japan’s sixth recession in 18 years, but over that period Australia has had no recessions, so its impact globally and on Australia has waned. Other Japanese data was mixed with sharp falls in tertiary activity,condominium sales and consumer confidence but gains in machine orders and a survey of manufacturers.
• In China, property prices continued to slow in April adding to evidence that the economy is cooling and providing support for the view that interest rate hikes are at or close to an end.
  

Australian economic releases and implications

• The minutes from the Reserve Bank’s last rate setting provided nothing more than a reminder that the RBA is inclined to raise interest rates further at some stage if economic conditions continue to unfold as expected. Meanwhile, Australian economic data was generally soft. Housing finance continued to fall in March with the number of housing finance commitments to owner occupiers falling to a 10 year low,consumer confidence fell to an 11 month low in May presumably on the back of more RBA rate hike talk, the“tough” budget and news that employment fell last month. Finally, wages growth was modest in the March quarter. The combination of housing sector weakness, soft consumer confidence, slowing employment growth and benign wages suggest that a June interest rate hike would be way too premature and that the RBA really needs to wait and see clearer evidence that the economy has picked up before undertaking another rate hike.

Major market moves

• After a poor start to the week, equities rallied on the back of good US earnings news, strong debuts for new public offerings such as LinkedIn and as investors took advantage of oversold conditions. This still left them mixed over the week as a whole: up in the US and Australia but flat to down in the Europe and Asia.
• Commodity prices had a modest bounce after recent weakness and this along with weakness in the US dollar saw the Australian dollar rise modestly.

What to watch in the week ahead?

• In the US, expect another week of mixed economic data. New home sales for April due Tuesday are expected to rise but pending home sales data due Friday are likely to fall slightly after a strong rise in March. April durable goods orders due Wednesday are likely to have fallen slightly but March quarter GDP growth is likely to be revised up to 2.2% annualised from the 1.8% pace initially reported. Data for house prices and personal income and spending will also be released.
• In Australia, March quarter data for construction work due Wednesday and private capital expenditure due Thursday are likely to have been constrained by the impact of the floods earlier this year. The key to watch in the capex data will be mining sector investment plans for the next financial year which we expect to remain strong. There is a risk though that investment plans outside of the mining sector may have weakened following the softening seen in non-mining sector business conditions and profitability. A speech by RBA Deputy Governor Battellino will be watched closely for any further clues regarding how soon interest rates will rise again.

Outlook for markets

• The long worry list at present, eg Greece, European monetary tightening, US housing, the US debt ceiling, the aftermath of the Japanese earthquake, Chinese inflation, high oil prices, the two speed economy in Australia, etc, suggest that share markets will remain volatile. Nevertheless, our broad assessment remains that shares will continue to climb the ‘wall of worry’ this year helped by still cheap valuations, the continuing global economic and profit recovery and easy global monetary conditions. However,Australian shares are likely to lag their global counterparts as a result of the dampening impact of higher local interest rates and the strong Australian dollar.
• Notwithstanding, the vulnerability to a further short term correction in the Australian dollar, providing the global recovery continues the $A is likely to remain strong, particularly with RBA keeping its finger firmly on the interest rate tightening trigger.
• Sovereign bonds offer poor returns given low bond yields. But they also provide a good diversifier with yields likely to fall further in the short term if global growth expectations continue to weaken on the back of a soft patch in economic data releases.