The weekly economic and market report reviews the key developments of the past week for investment markets, as well as the outlook.
Headline developments of the past week
After much delay Europe finally delivered its latest response to its sovereign debt crisis. As pretty much expected the key elements are:
- a write down in Greek debt by 50% for private investors
- a recapitalisation of banks
- a boost to the firepower of its bailout fund to around €1 trillion
- better integration of fiscal policies.
While its still a work in progress with the details far from being finalised, it does provide confidence that Europe will avoid a near term financial blow resulting in a deep recession and a big threat to global growth.
However, we are still a long way from the end of Europe’s problems. It’s doubtful the bank recapitalisation plan or the enhanced firepower of the EFSF will be big enough, France is at high risk of a ratings downgrade and Europe is likely to remain in a vicious cycle where fiscal austerity continues to depress growth, causing budget blowouts, more ratings downgrades and market panic, more austerity, etc. What Europe needs is monetary easing and a much lower euro to offset the impact of fiscal austerity, and an unlimited buyer of bonds in troubled countries to put an end to speculative attacks on otherwise solvent countries such as Italy and Spain. The ECB holds the key to this, but notwithstanding a likely rate cut on Thursday, it is likely to keep dragging the chain.
And don’t forget that America’s sovereign debt woes are a long way from solved. The next month is likely to see the focus return to this as the US Congressional super committee charged with finding ways to reduce America’s long term budget deficit is due to report by 23 November, but current indications are that it is deadlocked on the issue of tax increases. If it can’t reach agreement then $US1.2 trillion in spending and defence
cuts will be triggered and if this is watered down a further ratings downgrade is possible.
In Australia, benign underlying inflation strengthened the case for an interest rate cut. This came after the normally hawkish RBA Deputy Governor Ric Battellino delivered a somewhat more dovish speech than normal.
Major global economic releases and implications
- US economic data continued to please with solid gains in underlying capital goods orders, new home sales, and weekly mortgage applications and a further drift down in unemployment claims. September quarter GDP came in at 2.5% annualised confirming a pick up from the weak growth of the first half of the year. However, there was some soft news: house prices were flat in August and pending home sales were weak. While consumer confidence fell sharply it has been a poor guide to retail sales which have stayed solid. Basically the US economy is continuing to grow, albeit not strongly enough to reduce unemployment, but still a long way from recession.
- US earnings continue to come in on the strong side with 71% of results coming in better than expected.
- And its not just due to cost cutting – revenue growth over the year to September is coming in just below 10%.
- There was also good news in China with a manufacturing conditions indicator rising in October and Chinese Premier Wen Jiabao signalling a further move towards easing.
- Europe looks much weaker, with Euro-zone business conditions and confidence readings continuing to deteriorate consistent with mild recession. The UK also looks weak.
- Japanese economic data was mixed with stronger than expected exports and household spending and a fall in unemployment but a steeper than expected fall in industrial production and continued underlying price deflation.
- The Reserve Bank of India raised interest rates again, but signalled a pause. If growth continues to slow, the next move is likely to be a cut. The Bank of Japan slightly increased the pace of quantitative easing.
Australian economic releases and implications
- Headline September quarter inflation came as expected at 0.6% or 3.5% year on year. However, the key is that the underlying inflation measures came in at just 0.3% in the quarter, which was half market expectations for a 0.6% gain. What’s more the average of the year ended underlying measures has now fallen to 2.45%, ie, // 2 below the mid point of the RBA’s target range. Quite clearly weakness in domestic demand combined with the dampening impact on import prices from the strong $A has combined to push underlying inflation pressures back down after a brief pick up during the first half of the year.
- Meanwhile Australian Property Monitors confirmed the ongoing softness in the housing market with national average capital city house prices falling 1.6% in the September quarter and 3.5% over the last year.
Major market moves
- Share markets surged again (with US shares having their best month since 1974) as Europe delivered its debt rescue plan contrary to the fears of many that they wouldn’t get it together, US and Chinese data surprised on the upside and US profit results remained positive. Australian shares were given an additional lift by heighted expectations for an interest rate cut.
- With fears of a European financial meltdown, a US recession and a Chinese hard landing fading, commodity prices have surged higher and this is flowing straight through to $A, which has now broken its downtrend since end July. The return to risk taking also saw a further sell off in bonds, except in troubled European countries.
What to watch in the week ahead?
- Globally the focus will be on the G20 leaders meeting in Cannes on Thursday and Friday for evidence that world leaders back Europe’s latest public debt rescue plans. Specifically, indications that individual countries via sovereign wealth funds and also the IMF are prepared to help fund the proposed Special Purpose Vehicle in buying debt in troubled countries will be looked for.
- In the US the ISM manufacturing conditions index for October (due Tuesday) is expected to have improved slightly to 52 from a reading of 51.6 in September and October employment due Friday is expected to show a 100,000 gain but with unemployment remaining at 9.1%. The Fed meets on Wednesday and is expected to leave monetary policy unchanged but indicate it stands ready to do more (read QE3) if inflation falls.
- In Europe, the ECB is expected to at last cut its cash rate by 0.5% taking it to 1% to reflect the reality of deteriorating growth in Europe.
- In China the official and HSBC manufacturing conditions indicators due Tuesday are likely to confirm the slight improvement indicated in the HSBC preliminary index for October.
- In Australia we expect the RBA to cut the official cash rate by 0.25% taking it to 4.5% when it meets on Tuesday. Of course, a cut is not assured as the RBA may take the view that the moves in Europe have reduced the risks to the global outlook, so as such we attach a 60% probability to a cut occurring.
- However, the case to cut is very strong. Despite the European debt rescue plan, the global growth outlook is still much weaker than when interest rates were raised a year ago to 4.75%. Likewise domestic demand has been weaker than expected with unemployment now drifting higher. And the much anticipated September quarter inflation figures have confirmed that the inflation outlook is far more benign than the RBA was assuming a few months ago. Current settings for interest rates – which assumed much stronger global and Australian growth and a worsening profile for underlying inflation – are too high. So if it’s not on Tuesday we would anticipate a cut in December. Out of interest the last five Melbourne Cup days have seen interest rate moves.
- The RBA will also release its latest Statement on Monetary Policy on Friday which we expect to show a downwards revision to underlying inflation forecasts from around 3% to around 2.5%. Expect private credit growth data (Monday) to remain soft, ABS September qtr house price data (Tuesday) to show a 1.5% fall, and soft outcomes for building approvals (Wednesday) and retail sales (Thursday) after strong gains in both in August.
Outlook for markets
- Shares may be due for a bit of a pull back having rallied by 12% or more since early October. However, there is a good chance we will see further gains into year end. Europe’s latest debt rescue plan has helped head off a much feared financial meltdown which could have dragged the world down with it, the US economy appears to be a long way from the double dip recession many were fearing, monetary conditions globally are getting easier (with the RBA likely to be next to ease and China edging towards easing), shares are still cheap
and October is often the spring board for market gains into year end. What’s more investors have been caught short by the recent surge in shares and may now likely want to get on board. However, the ride is likely to remain volatile particularly with Europe’s debt problems likely to continue next year and the US facing its own issues. - The $A is also vulnerable to a pullback after a 12% rise since early October. However, the medium-term trend is likely to remain up as the $US remains under long-term downward pressure, not helped by its debt woes and the prospect of more quantitative easing, Chinese commodity demand remains strong over the longterm and Australian interest rates will remain well above US rates even if the RBA cuts rates.
- Government bonds in major global countries are a good diversifier. However, yields are still extremely low so expect modest medium-term returns.