While new coalition governments in Italy and Greece look set to approve new austerity measures the risks in Europe remain high. Forward indicators point to a slide into recession ahead, fiscal austerity will only worsen the economic and public debt situation, elections early next year in both Italy and Greece will only prolong the uncertainty and increasing talk of countries leaving the euro is adding to fears of defaults.

The slide into the abyss by Italy since July is particularly concerning. While Italy’s level of public debt (120% of GDP) and budget deficit (4% of GDP) are far better than Greece’s, investors are starting to fear that it is heading down the same path ultimately requiring a debt write down. And these fears are in danger of becoming self fulfilling. Italian bond yields at 6.42% – having fallen from a mid week peak of over 7% – are well above sustainable levels (which is probably around 4% or less) and risk turning a liquidity crisis into a solvency crisis.

Italian bond yield spreads to Germany remain around levels that ultimately forced Ireland and Portugal to seek a bailout. The trouble is that Italy accounts for 17% of Euro-zone GDP and 23% of its public debt, and European banks have a near $US800bn exposure to it (nearly six times their exposure to Greece). The enhanced European bailout fund is unlikely to be big enough to deal with Italy as well as other countries and in any case it’s not yet up and running.

While European Central Bank purchases of Italian bonds helped push Italian bond yields back down late last week, on its current approach this is likely to be temporary and insufficient to make a lasting impact. The ECB should be committing to unlimited purchases of Italian bonds in order to ward off speculators and push yields back down to sustainable levels of around 4%. Unfortunately it remains reluctant to do this. In short the news out of Europe is likely to remain poor, albeit interspersed by brief bouts of relief and optimism.

However, it’s not all bleak globally. The US is continuing to grow despite numerous headwinds, China looks to be on track for a soft landing and various countries are continuing to ease monetary conditions, with the latest being Indonesia.

Major global economic releases and implications
US economic data was mostly positive over the last week with a rise in consumer sentiment, slight rise in small business confidence, a further fall in weekly jobless claims, a rise in weekly mortgage applications and a narrower than expected trade deficit. What’s more the September quarter profit reporting season is now largely complete with profit growth coming in at a much stronger than expected 18% year on year. The only negative was that a Fed survey pointed to fewer banks easing lending standards and signs that credit demand is weakening. Overall the picture remains of continuing growth in the US, albeit around a sub par 2-2.5% pace.

European economic data was soft with a fall in euro-zone retail sales, sharp falls in German, French and Italian industrial production and flat industrial production in the UK. Business conditions indicators point to further shape falls in European industrial production ahead.

Chinese economic data for October confirmed the picture of moderating growth and cooling inflation. While industrial production, export growth, money supply growth and the property market continue to slow, retail sales, fixed asset investment and imports remain strong. Overall, there remains no sign of a hard landing in China.  What’s more inflation is continuing to cool, falling to 5.5% in October from a cyclical peak of 6.5% in July. While food inflation is coming off the boil, non-food inflation is also slowing and falling producer price inflation and slowing growth all point to a further fall in inflation ahead. The moderation in growth and inflation is likely clearing the way for monetary easing in the next few months.

While the general picture across Asia remains one of moderating growth and slowing exports, there was some strong news out of Indonesia with GDP growth holding up at 6.5% over the year to the September quarter. However, with global uncertainty on the rise and inflation cooling, Indonesia cut interest rates again by another 0.5% taking them to 6%. Further interest rate cuts are likely across Asia in the months ahead.
Australian economic releases and implications

Australian economic data continued the somewhat more positive tone seen over the last month with gains in consumer and business confidence, housing finance and employment and another solid trade surplus for September. That said, it’s worth noting that this doesn’t mean the economy is suddenly booming. Both business and consumer confidence have just bounced back to average levels and housing finance remains low. While employment growth remains positive it is worth noting that trend monthly employment growth is now running around 6000 jobs a month compared to 30000 jobs a month a year ago. What’s more job ads and various business surveys and anecdotes point to labour market softness ahead.  This combined with the intensifying risks coming out of Europe means that the outlook for interest rates is still skewed to the downside.

Major market moves
Share markets had another volatile week with markets falling sharply mid week on the blowout in Italian bond yields and fears that Italy will knock Europe into an even deeper recession before staging a rebound later in the week as the political situation in Greece and Italy improved. Share markets were up in the US, Europe and Australia, but closed down in Asia.

Commodity prices also had a volatile week and ended mixed with oil and gold up, but metal prices down. Mixed commodity prices and the uncertainty over Europe also weighed on the Australian dollar.

Bond yields were generally mixed. A concern remains that despite an improvement later in the week, French and Italian bond yield spreads to German yields remain wide. 

What to watch in the week ahead?
In the US, October retail sales (due Tuesday) are likely to show modest growth, manufacturing conditions surveys (Tuesday and Thursday) are expected to show an improvement, inflation (Wednesday) is expected to be benign and housing starts & permits are expected to continue the basing action seen over the last year. Data for industrial production and consumer sentiment will also be released.

In Europe, September quarter GDP growth (Tuesday) is expected to come in around 0.2%, the same as in the June quarter.

In Japan, GDP data (Monday) is expected to have recorded a solid 1.5% rebound in the September quarter following three quarters of contraction partly due to the earthquake.

In Australia, the minutes from the RBA’s last Board meeting and a speech by RBA Governor Stevens will be watched closely for clues as to whether there will be another interest rate cut next month. Of particular interest will be any guidance as to how seriously the RBA views the European crisis. Wages data due for release on Wednesday is expected to remain benign with a gain of 0.8% in the September quarter and 3.7% year on year.

Outlook for markets
The mess in Europe continues to cloud the short term outlook for shares. Long term value is good for shares, the US and China are looking okay, global monetary easing is positive, we are entering a seasonally stronger period of the year and investors generally are short shares, but the event risk around Italy and Greece and the slide into recession in Europe generally are likely to keep the ride volatile in the short term.

The $A, like all risky assets, is likely to remain vulnerable in the short term to the ongoing European debt debacle. 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 long-term and Australian interest rates will remain well above US rates even if the RBA cuts rates by more.

Government bonds in major global countries are a good diversifier and with short term interest rates likely to remain low indefinitely it’s hard to see much sustained upwards pressure on bond yields for the foreseeable future. However, yields are extremely low so expect modest medium-term returns.

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