The past week has seen investors switch back to “risk on” in a big way thanks to talk of a fast tracked fiscal union in the Euro zone which will hopefully clear the way for more aggressive ECB intervention along with talk of greater IMF involvement, coordinated action by central banks to provide struggling banks with US dollar funding and generally solid economic data releases in the US.
Other headline news included:
- China has joined other central banks in easing monetary conditions by cutting its required reserve ratio for banks. Further easing is likely as the slowdown in economic growth and money supply growth leads to a further slowing in inflation. The onset of an easing cycle in China will add to confidence that it will avoid a hard landing and after a two year bear market in which Chinese A shares fell 33% largely due to policy tightening is likely to see Chinese shares start to outperform on a relative basis and removes a big drag from Australian shares.
- The US Federal Reserve, along with the ECB and four other central banks announced a 0.5% cut in the cost of borrowing $US funds and an extension in the provision of cheap US dollar funding from August next year to February 2013. This should help alleviate some bank funding pressures for European banks, ie if banks were starting to have trouble getting US dollar funding from the private sector not helped by recent bank rating downgrades they can now get it very cheaply from the Fed without having to sell US dollar assets which could have helped spread the crisis into the US. However, while it underlines the point that the Fed will do whatever it takes to keep the US recovery going it does nothing to help alleviate the underlying problem in Europe.
- However, there are signs that Europe is getting closer to a point of resolution. Much uncertainty surrounds the Merkel-Sarkozy plan for a fast tracked fiscal union – how long will it take to set up? which countries will be involved? Etc. However, the ECB appears to be seeing a fiscal union, and the firm commitment it would entail to reducing budget deficits, as helping to clear the way for stronger action from it in terms of supporting troubled bond markets. At the same time the deteriorating economic outlook across Europe is getting to the point where it will be easy for ECB to justify buying bonds more aggressively, simply on the grounds of implementing monetary policy to avoid price deflation. If all goes well the ECB will cut rates again at its meeting on Thursday and the EU leaders summit on Friday will see key core countries along with Italy and Spain commit to a fiscal union with all that entails in terms of shrinking budget deficits which should all hopefully put the ECB on a path to more aggressive bond buying and quantitative easing.
- In Australia, the Federal Government’s mid year budget review saw downwards revisions to the growth outlook, a blow out in the underlying budget balance for this financial year and a return to a wafer thin surplus in 2012-13. While maintaining the surplus commitment will help maintain Australia’s fiscal credentials when many countries have lost theirs, it comes with the risk that fiscal drag will hit the economy hard in 2012-13.
- While Moody’s warned the European debt crisis threatened downgrades to sovereign debt credit ratings across Europe, S&P downgraded several global banks and Australian banks and Fitch put America’s sovereign rating on a negative outlook, Australia became one of only a few countries to have a AAA rating from all three major credit rating agencies, after Fitch upgraded its rating from AA+. So while one can quibble whether the Australian Government has or hasn’t cut spending enough and whether or not a return to surplus by the next financial year is necessary there is no denying Australia’s public finances are in good shape.
Major global economic releases and implications
- US economic data retained the positive tone we have seen over the last couple of months. On the soft side the Fed’s Beige Book of anecdotal evidence reiterated that the US economy is growing at a slow to moderate pace and house price surveys were mixed. But against this business conditions indicators including the ISM index improved, employment indicators were solid, pending and new home sales rose and various surveys suggest strong post Thanksgiving sales as Americans battled their way into good old retail therapy armed with mace spray and guns. No sign of any double dip recession here.
- Euro-zone data was mostly soft with weak economic sentiment readings, unemployment rising to 10.3% in October and super soft money and credit supply growth data. Lots of double dip signs here!
- Japanese economic data was mixed with a solid rise in industrial production and vehicle sales but a fall in a business conditions or PMI index, a rise in unemployment and soft household spending.
- China’s official manufacturing conditions index fell in November, but is still consistent with a soft landing. A slowdown was also evident elsewhere in Asia with Indian GDP growth slowing to 6.9% over the year to the September quarter (from 7.7%) and an unexpected fall in Korean industrial production. Apart from the monetary easing in China, central banks in Thailand, Brazil and Israel also cut interest rates.
Australian economic releases and implications
- Australian economic data over the last week ranged from the very strong to the very weak. Business investment surged in the September quarter with investment plans pointing to a 36% rise this financial year. Retail sales also rose again in October, but outside of food are a bit soft. Private credit growth is soft with annual growth in housing credit at a 30 year low. While new home sales rose solidly in October they remain below GFC lows and what’s more house prices are continuing to slide. At the very weak end of the spectrum building approvals fell another 10.7% in October and have now fallen to their lowest level since the GFC.
Major market moves
- Share markets surged on central bank action, hopes that a fiscal union in Europe will clear the way for more aggressive ECB intervention and better US economic data.
- Commodity prices and the $A followed shares higher. Bond yields were mixed – up in the US and Australia on reduced safe haven buying, but down in Europe on hopes it may be edging to a new solution to its problems.
What to watch in the week ahead?
- Europe will likely remain the focus for investors in the week ahead with the European Central Bank meeting on Thursday and the EU leaders’ summit on Friday. In view of the increasing deterioration in the European economic outlook and rising evidence of a credit crunch we expect the ECB to announce another cut in its key short term interest rate taking it from 1.25% to 1% and new measures to ease bank access to funding. The EU leaders’ summit is expected to announce concrete measures to move towards greater fiscal integration, which will hopefully clear the way for the ECB to get more confident in playing a lender of last resort role.
- In the US, expect a slight improvement in the ISM non-manufacturing conditions index (Monday) and an improvement in consumer sentiment (Friday).
- Chinese economic data for November due Friday are likely to show a further moderation in the pace of economic growth and a slowing in inflation to 4.5% reflecting softening food and non-food price inflation. Cooling economic growth and slowing inflation will underpin further policy easing in the months ahead.
- In Australia, the RBA is expected to cut interest rates again by another 0.25% taking the cash rate down to 4.25%. While recent better than expected data in Australia, notably for business investment, make it a close call, the threat from Europe and rising bank funding costs at a time when the inflation outlook is benign, strongly argue in favour of another rate cut. Waiting two months till the next Board meeting in February is too big a risk to take given the deteriorating situation in Europe. So the RBA’s policy of “least regret” would argue strongly in favour of a precautionary rate cut in the week ahead.
- Expect a solid 1% or more gain in the September quarter GDP (Wednesday) on the back of surging business investment and solid consumer spending. Expect a +10,000 gain in employment (Thursday).
Outlook for markets
- The European debt debacle means the short term outlook for shares still remains highly uncertain. However, long term value is good, the US and China are looking okay, global monetary easing is positive, we are in a seasonally stronger period of the year and there are signs that Europe may be getting closer to a solution.
- 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 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.