Oliver’s Insights: Weekly economic and market update

The game of “yes we will, no we won’t” political ping pong is continuing in Europe.

On the negative side there were problems with a European bank requiring government support, more sovereign and bank downgrades by ratings agencies with warnings of more to come, Greece indicating that its budget deficit is coming in above its agreed targets, Euro-zone finance ministers yet again delaying agreement on the release of the next 8bn euro tranche to Greece and indicating that private sector investors may have to bear more of the pain in the Greece bailout than envisaged back in back in July.

Against this, Europe seems to be moving towards some form of recapitalisation of European banks and ideas on how to expand the firepower of Europe’s bailout fund (the EFSF) appear to be proceeding, albeit all of this is occurring very slowly and in a way which is sure to continue to test investors’ patience every so often. A big problem is that bank recapitalisation is likely to require between 150 to 200 bn euros which won’t leave much left over for sovereign bond purchases in the 440 bn euro European Financial Stability Facility if it has to be drawn upon.

While Europe looks to be either in, or on its way into, recession, the US economy looks like it is continuing to avoid recession. Stronger than expected payroll growth in the US for September backs up the message from the ISM business conditions surveys released earlier in the week that the US economy is continuing to grow, albeit slowly.

The global monetary easing cycle is continuing to gather pace with the Bank of England announcing another round of quantitative easing, the European Central Bank announcing an extension of its bank liquidity facilities and even the Reserve Bank of Australia finally opening the door to a rate cut. This of course already follows rate cuts in Brazil and Russia. While the ECB should be cutting rates immediately at least it appears to be heading in this direction in sounding a lot less confident about the economic outlook. We expect it to start cutting rates before year end. The Bank of England’s second round of quantitative easing, which amounts to buying 75bn pounds of gilts and thereby injecting money into its flagging economy, is likely to be the equivalent of a 0.75% interest rate cut. 

While the RBA left its cash rate on hold at 4.75% as expected, it has opened the door to an easing by signalling that it is becoming less concerned about inflation and even raising the prospect of a rate cut to support demand. With global growth weakening, commodity prices down sharply, domestic demand subdued, unemployment on the rise and inflation fears fading we continue to expect a 0.25% rate cut next month, with probably more to come early next year. 

The bounce in share markets over the last week could just be another short covering rally, of which there have been lots over the last two months,  and with Europe yet to get on top of its sovereign debt crisis, it’s still too early to say that shares have bottomed. However, there are some signs that shares might have seen the bottom or are not far from it.

Europe appears to get the message that it needs to do more, central banks are starting to ease, the US economy appears to be avoiding recession, the failure of share markets to follow through to the downside following their breakdown earlier in the past week is a positive technical sign and while October is often a very volatile month it also often sees markets bottom before heading higher into year end. And for long term investors there is good value to be had in share markets with eg Australian shares offering grossed up dividend yields of around 7%. 

The 15% fall in the $A from its July high to its recent low is pretty consistent with the experience of the last few years which has seen the $A suffer every time there are serious worries about global growth and hence the outlook for commodity prices. In the short term as with share markets, it’s too early to say the $A has bottomed. However, just as we saw after the GFC, the medium-term trend is likely to remain up as the $US remains under long-term downwards pressure, not helped by its debt woes and more quantitative easing, Chinese commodity demand will likely remain strong over the long term and Australian interest rates will remain well above US rates even if the RBA cuts rates. 

The focus in the week ahead will likely remain on Europe to see whether it makes any more progress in supporting its banks and dealing with the debt problems in peripheral countries. A G20 Finance Ministers meeting on Friday and Saturday will be watched for signs of progress towards the “action plan of coordinated policies” to deal with global problems that were promised at last month’s meeting to be in place for the Cannes G20 leaders summit in early November. 

The week ahead sees the release of key data on the Chinese economy for September. While inflation data due Friday is likely to show an edging up to 6.3% over the year to September thanks to still elevated Chinese food price inflation we remain of the view that July’s 6.5% inflation rate marked the peak in inflation for this cycle. 

In the US the minutes from the Fed’s last meeting to be released on Tuesday are likely to confirm that it stands ready to ease policy further if need be. The US September quarter earnings reporting season starts on Tuesday with Alcoa reporting. Consensus estimates are for profit growth of 14.2% over the year to the September quarter but with negative earnings guidance running very high recently the odds favour results surprising on the upside, albeit outlook comments are likely to remain subdued. 

In Australia, expect data for job ads (Monday), business conditions (Tuesday) and consumer confidence (Wednesday) to remain soft. Employment data for September due Thursday is expected to show a 5000 rise after the 10,000 fall in August but unemployment is likely to remain unchanged at 5.3% and the slowing trend in jobs will remain evident. 

Despite the better than expected news on employment, Friday night saw US shares  fall slightly with the S&P 500 down 0.8%, partly on the back of news of ratings downgrades for Italy and Spain. After an 8.4% rebound over 3 days a pullback was inevitable. Friday night futures trading points to  26 point or 0.6% fall in the Australian share market when it opens on Monday morning.