Another week dominated by Europe. The good news is that new governments led by technocrats in Italy and Greece are settling in.
However, passing austerity measures and economic reforms in either country doesn’t look like it will be smooth sailing at all. More broadly, bond investors are continuing to riot in Europe with bond yields, and yield spreads to German bonds, pushing higher in Italy, Spain, France and Belgium. Unfortunately, technocratic governments in Greece and Italy won’t do anything about the basic reality that fiscal austerity in the absence of significant monetary easing is causing a worsening economic downturn, which in turn is making deficit reduction harder and harder and driving investor panic which is pushing up bond yields and making debt burdens less sustainable. However, the surge in bond yields also reflects the unintended consequences of recent EU policy actions.
In particular, banks appear to be selling bonds in order to meet the heightened capital ratio requirements mandated by the EU, the haircut on Greek debt has led to a reassessment of the risks of holding public bonds, talk of providing first loss insurance on new bonds have reduced the value of existing bonds and investors have realised that credit default swap insurance on bonds may be of little value if it doesn’t pay out in response to “voluntary” debt restructuring. Europe badly needs a circuit breaker but unfortunately the ECB looks like it will need an even deeper crisis before it is willing to play this role.
While Europe continues to dominate, the economic news elsewhere was ok with a continuing run of better than expected economic data out of the US and a rebound in the Japanese economy in the third quarter.
Australia looks to be heading towards big spending cuts in order to keep the budget on track for a surplus by 2012-13 despite softer revenue growth and new spending commitments. The task is likely to be big as the budget deficit this year looks like being around $10bn worse than expected and that for 2012-13 about $6bn worse. While sticking to the timetable for returning the budget to surplus will help reinforce Australia’s fiscal credibility and might help pave the way for more interest rate cuts and possibly take some pressure off the $A, such a strategy is risky. Of course there is no guarantee the RBA will play ball and cut in response to fiscal tightening and, even if they do, rate cuts operate with longer lags than spending cuts, so the initial effect may be to dampen the economy before the impact of rate cuts are felt. Similarly spending cuts will have a more certain impact on the economy and may impact a broader cross section of the community than interest rate cuts.
News of a Trans-Pacific Partnership of free trade between nine Pacific nations including Australia is to be welcomed and will hopefully spread to the rest of APEC. It should be a positive for Australia, notably for farmers, but as with all free trade deals there is a danger in exaggerating the longer term boost to economic activity, particularly with many of our key trading partners such as China, Japan and Korea not included.
Major global economic releases and implications
US economic data continued the better than expected run we have seen for the last six weeks now. Manufacturing conditions indicators for the both the New York and Philadelphia regions showed a strong improvement in the outlook and there were solid gains in retail sales, industrial production and housing permits, an improvement in home builders’ conditions and a further fall in weekly jobless claims. What’s more underlying inflation appears to be fading after the largely commodity related pick-up seen earlier this year.
Japan was also a bright spot over the last week with GDP rebounding 1.5% in the September quarter as the economy shook off the effects of the earthquake from earlier this year and three quarters of contraction. Unfortunately softer growth in exports and capex will likely see a loss of momentum going forward. Exports continue to deteriorate across Asia, with a sharp fall in Singaporean exports in October.
Euro-zone data remains poor with September quarter GDP growth of just 0.2% driven mainly by Germany and France. Unfortunately leading indicators point to recession ahead. Sharp downwards revisions to the Bank of England’s growth & inflation forecasts point to more quantitative easing once the current round ends in February.
Australian economic releases and implications
The Minutes from the Reserve Bank’s rate last setting meeting left the impression the RBA would not be in a hurry to cut interest rates further. However, with the situation in Europe continuing to deteriorate, the Federal Government likely to announce significant spending cuts soon and a slowdown in wages growth to 0.7% in the September quarter or 3.6% year on year, there is now a good chance of a further rate cut from the RBA next month. Car sales rose in October, but the Westpac leading index and skilled job vacancies fell.
Major market moves
Share markets fell over the last week as the European debt crisis continued to intensify adding to fears that a deep recession and financial crisis in Europe will drag down the rest of the world.
Commodity prices and other risk trades like the Australian dollar followed share markets lower.
What to watch in the week ahead?
In the US in the week ahead the focus is likely to be on the Congressional super committee that was set up to find at least $US1.2 trillion worth of savings from the US budget over the next decade. It is due to report on Wednesday. While these things usually go right down to the wire in the US, current indications are that the committee is struggling to reach agreement with Democrats resisting cuts to entitlements and Republicans resisting any tax increases. If $US1.2 trillion in savings are not found then automatic cuts to defence and entitlements worth $US1.2 trillion (referred to as a “sequester”) are due to kick in. Failure to reach agreement could see more pressure on America’s credit rating, particularly if there appears to be any threat that Congress might prevent the “sequester” from operating. Failure to reach agreement on long term budget cutbacks may also make it harder to pass key aspects of President Obama’s short term stimulus plan – which would leave the US vulnerable to fiscal tightening worth around 1.5% of GDP next year. Meanwhile, expect data for existing home sales (due Monday) to fall slightly, final US September quarter GDP growth (Tuesday) to remain unchanged at 2.5%, durable goods orders to fall slightly and personal spending to rise solidly (both due Wednesday).
In Europe, expect more weakness in November PMIs or business conditions indicators and in industrial new orders, all due Wednesday. Expect Japanese CPI data (Friday) to show continued underlying deflation. HSBC’s flash PMI, or manufacturing conditions indicator, for China will also be released on Wednesday.
In Australia, September quarter construction data will be released Wednesday and speeches by RBA Assistant Governor Debelle and Governor Stevens will be watched closely for clues on the outlook for more rate cuts.
Outlook for markets
European debt woes continue 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 in a seasonally stronger period of the year and investors generally are short shares, but the risk of a financial crisis and slide into a deep recession in Europe is likely to keep the ride volatile in the short term. A retest of early October lows is high risk.
The Australian dollar, like all risky assets, is likely to remain vulnerable in the short term to the ongoing European debt debacle. A fall back below the early October low of $US0.94 is looking likely. 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 as the RBA cuts rates by more.
Government bonds 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.