The past week has seen the usual post summit let down in Europe with general scepticism regarding whether the latest EU summit will achieve much in terms of stabilising Europe’s debt problems, let alone be implemented. Our view remains that only the ECB can stabilise the Euro zone bond markets by stepping up its bond purchases directly and providing aggressive monetary easing as an offset to debilitating fiscal austerity.
Headline developments of the past week have included
- The past week has seen the usual post summit let down in Europe with general scepticism regarding whether the latest EU summit will achieve much in terms of stabilising Europe’s debt problems, let alone be implemented. Helping to fuel this are diminishing hopes for more aggressive intervention by the ECB following comments by the Presidents of the Bundesbank and ECB, concerns additional support for Europe from the IMF will not be forthcoming, comments from Chancellor Merkel opposing any increase in the lending limit for Europe’s new bailout fund (the ESM), comments from the French presidential favourite that he would renegotiate the latest European accord suggesting that France’s support for it is shaky as it heads into presidential elections next May, more warnings regarding sovereign credit ratings across Europe and ratings downgrades of banks and news that Greece’s budget deficit is continuing to blow out as the economy deteriorates.
- Some policy makers in Europe have hailed an ECB “bazooka” unveiled last week in the form of bank access to 3 year loans at just 1% interest and the hope that the banks’ will use this to at least hold and maybe even buy sovereign debt in countries like Italy and Spain to profit from a yield pick up of 5% or so in the process. But while this may help at the margin its hard to see European banks doing what the ECB is unwilling to do – European banks are already under stress with poor capitalisation, already high exposures to such bond markets, big refinancing needs and are fearful of more losses on such bond investments. Our view remains that only the ECB can stabilise the Euro zone bond markets by stepping up its bond purchases directly and providing aggressive monetary easing as an offset to debilitating fiscal austerity.
- Investor sentiment wasn’t helped by the latest US Federal Reserve meeting which saw the Fed refer again to significant downside risks to the economic outlook but fail to offer any new stimulus, not that it was ever expected to at this meeting. Another round of quantitative easing is probably still on the table in the US – and I think likely next year – but the next move is likely to be a communication from the Fed following its January meeting that it sees the Fed Funds rate staying around 0 to 0.25% out to 2014 which will have the effect of further pulling down long term interest rates in the US.
- The good news though is that global economic data releases were if anything a bit better than expected, notably in the US and the US Congress appears to be stumbling towards an extension of payroll tax cuts (that expire at year end) and a spending bill necessary to avert a government shutdown.
Major global economic releases and implications>
- Economic data in the US was mostly positive with gains in small business optimism and manufacturing conditions in the New York and Philadelphia regions, a sharp fall in weekly jobless claims and solid retail sales. Inflation readings were benign. While industrial production fell in November, it appears to reflect disruption flowing from the Thai floods. The US economy looks to be on track for annualised growth of 3.5% in the current quarter.
- The benefit of economic growth was highlighted in the US, which saw a further fall in its budget deficit in November and its rolling 12 month budget deficit falling to a still high 8.3% of GDP, but its lowest level since May 2009. Very different to Greece where economic contraction is seeing it budget deficit continuing to blow out.
- Euro zone industrial production continued to fall in October consistent with a slide into recession, but December business conditions indicators or PMIs rose slightly, albeit remaining at recessionary levels.
- Japanese economic data was mixed with a rise in tertiary activity in October, but a fall in the Tankan business conditions survey and lower consumer confidence in November.
- Chinese economic data was mixed. While new loan growth in November was solid, annual money supply growth fell to its lowest level since 1997, a leading economic index fell in October and a flash manufacturing conditions index surprisingly improved slightly. There is still no sign of a hard landing though but while the Chinese Government’s annual economic conference signalled a shift from focussing on inflation to growth the lack of a clear policy easing just yet has left investors free to worry that a hard landing is on the way. This saw Chinese shares fall to their lowest level since March 2009. While policy uncertainty in the short term leaves the Chinese share market vulnerable to further falls our assessment remains that policy easing will accelerate in the months ahead and that this will provide a strong boost to the share market given that valuations have become very attractive. For example, the price to earnings multiple on Chinese shares is now 12.6 times and is at the lows seen at market bottoms in 2005 and 2008 and compares to a long term average of 32 times.
- The softening in the emerging world was further highlighted by a 5.1% fall in Indian industrial production over the year to October. The good news though is that India’s inflation rate slowed to its lowest level in a year.
Australian economic releases and implications
- Australian data was disappointing. While business conditions and confidence were mostly stable in November, consumer confidence fell sharply in December, housing starts fell sharply in the September quarter, housing finance remained weak in October and the trade surplus in October fell to its lowest level since July. Following the announced tightening in Federal fiscal policy a few weeks ago, the Victorian Government also announced a fiscal tightening involving a 10% cut in public sector jobs. With the threat hanging over the economy from Europe Australia’s budget surplus fetish risks threatening growth unnecessarily.
- In a speech, RBA Deputy Governor Ric Battelino warned of pain from Europe and observed that if the ECB does not act more proactively it risks an even greater threat to overall financial instability. Weak economic data, fiscal tightening and the threat from Europe are all consistent with more interest rate cuts next year from the RBA.
Major market moves
- Share markets generally fell on global growth concerns, mainly on doubts about whether the latest EU summit will achieve much. Despite all the noise though it’s worth noting that global and Australian shares have just been churning up and down in the same range since early August.
- Commodity prices tumbled on the back of global growth concerns and a rise in the $US on safe haven buying. This in turn saw the Australian dollar fall below parity – for the fourth time since August.
- A big surprise for many has been the correction in gold prices, which are down 8% over the last week alone. Some safe haven! Bear in mind though that gold is not a safe haven against everything. For example it fell 30% between March and November 2008, partly as fund managers had to sell it in order to raise money for redemptions. Gold will be a hedge against a fall in the US dollar, which will be vulnerable in the event of more quantitative easing (as it will boost the supply of US dollars). But so far additional QE has not been forthcoming.
- Australian 10 year bond yields have fallen to their lowest level since 1951 as global investors push their yields further towards those prevailing for US and German bonds, which are starting to be perceived as more risky.
What to watch in the week ahead?
- In the US, expect a survey of home builders (Monday), housing starts (Tuesday), existing home sales (Wednesday) and new home sales (Friday) to show further evidence of a bottoming in the US housing sector and expect a bounce in durable goods orders (Friday).
- In Australia, the RBA’s Board meeting minutes will be watched closely for any clues about future rate moves.
Outlook for markets
- Thanks to dodgy policy making and political intransigence in Europe, share markets are likely to remain volatile over the next few months. Against this long term value is good, there is a lot of money sitting on the sidelines, the US looks ok and global monetary easing will ultimately be positive for shares all of which suggests the potential for solid gains on a one year view once the ECB is forced to intervene more aggressively in European bond markets which we expect some time in the next six months.
- In the very short term there is some chance we will see a bounce in share markets. The period from mid December into early January is normally strong for shares as the Santa Claus rally clicks in on the back of optimism about the new year, against a backdrop of low trading volumes and little capital raising. Australian shares may also benefit in the run up to year end by dividend payments and payments from recent takeovers.
- The $A, like all risky assets, remains vulnerable in the short term to the European debt debacle. However, the medium-term trend is likely to remain up as the US and Europe are eventually forced into more quantitative easing, Chinese long term commodity demand remains strong and Australian interest rates will remain well above US rates even as the RBA cuts rates by more.
- Government bonds in countries like Australia with secure AAA ratings are a good diversifier and with short term interest rates likely to remain low 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.