The past week saw share markets and other risk related trades supported by a combination of favourable economic data in the US and Europe, good profit results in the US and very dovish comments from the Fed, which have boosted expectations for another round of quantitative easing.
- The key message from the Fed was that it has shifted the likely timing of its first interest rate tightening from mid-2013 to at least late 2014. This combined with slight downwards revisions to growth forecasts, expectations that unemployment will decline only gradually and that inflation will remain below target along with an explicit reference to a preparedness to adjust security holdings to boost growth all suggests that the odds of another round of quantitative easing (QE3) are increasing. All of this is seen as positive for risk trades such as shares, commodities and the $A while at the same time keeping bond yields down.
- While the IMF downgraded its 2012 world growth forecast from 4% to 3.25% and repeated its warning of a 1930s style crisis if Europe is not brought under control, there was nothing new in this. Its growth downgrade, like that from the World Bank a week earlier (which downgraded to 3.4% if weighted on a purchasing power parity basis), is just catching up to private sector forecasts (our expectation is for 2012 world growth of 3%). Our assessment remains that the risks in Europe remain high but thanks to the provision of cheap funding to European banks they have receded from the situation in September/October when both the World Bank and IMF were warning of the global economy entering a “dangerous phase”.
- Negotiations aimed at restructuring Greek debt continued, with the EU insisting private investors accept a lower interest rate before it will consider another bailout for Greece which is necessary if Greece is to avoid defaulting on a bond payment due on 20th March. Indications are that private investors are willing to concede and accept a sub 4% rate of interest on top of a 68% write down in the net present value of their bond investments.
- Uncertainties remain as to whether all private investors will be forced into this, what this will mean for credit default swap payouts and whether the ECB will take a haircut too. Portuguese bond yields have pushed on to record highs (with investors fearing Portugal will go the same way as Greece), but Spanish and Italian bond yields fell sharply over the last week. Helping sentiment regarding Europe was news that Germany is now open to the idea of boosting the size of Europe’s new bailout fund (the ESM) by combining its €500bn with the €250bn which is remaining in its existing bailout fund (the EFSF). While Fitch downgraded sovereign ratings for Italy, Spain, Belgium, Cyprus and Slovenia this was just a catch up to Standard and Poor’s downgrades.
- An obvious risk to watch is the oil price. Geopolitical tensions in the Middle East are on the rise again with the European Union banning the purchase of Iranian oil from July and Iran threatening to close the Straits of Hormuz.
Major global economic releases and implications
- US data was mostly positive. Pending and new home sales fell in December after several months of strong gains and weekly unemployment claims rose but the trend remains down. Against this, house prices rose in November, durable goods orders rose strongly in December, leading indicators rose and regional manufacturing conditions indicators continued to improve as did consumer sentiment. December quarter GDP came in slightly below expectations, but at 2.8% was still a pick up on the 1.8% pace seen in the September quarter.
- US earnings results were generally positive with strong results from Apple, Caterpillar, Raytheon and Time Warner. While 70% of recent results have been better than expected the soft start to the reporting season means that in total only 60% are ahead (which is below that seen over the last 10 quarters). 74% of results have exceeded revenue expectations. The consensus estimate for operating earnings growth over the year to the December quarter last year has increased from 9.4% to 11% over the last two weeks.
- European economic data over the last week was also positive with gains in both manufacturing and services sector conditions indices for the second month in a row. Germany in particular is faring much better than feared.
- In Japan, deflation continued in December, but retail trade was a little bit stronger than expected.
- Monetary easing continued in Asia over the last week with the Bank of Thailand cutting rates again and the Reserve Bank of India joining the easing cycle for the first time by cutting bank cash reserve requirements. With growth and inflation cooling the RBI will likely start cutting interest rates next month.
Australian economic releases and implications
- In Australia, December quarter inflation data showed a further moderation in headline price measures and benign underlying inflation that supports further monetary easing by the RBA. While headline inflation was zero thanks in part to a reversal of the flood and cyclone related banana driven surge in inflation from a year ago, underlying inflation is at the mid point of the RBA’s 2 to 3% inflation target on a year ended basis and over the last six months has been running at an annualised rate of just 2%. While prices for domestic travel, rents, fuel and insurance rose solidly there are plenty of examples of underlying price weakness with falls in prices for clothing, household appliances, cars and electronic goods.
- With underlying inflationary pressures under control, retailers struggling, consumer and business confidence lacklustre, job layoffs accelerating and banks experiencing rising funding costs, a further reduction in interest rates is justified. We expect the RBA to cut the official cash by another 0.25% when it meets next month.
Major market moves
- Share markets generally continued to trend higher on solid economic and profit news, dovish comments from the Fed, but worries about the Greek debt impasse acting as a bit of a constraint. US shares were essentially flat, but shares rose in Europe, Asia and Australia.
- Commodity prices were also boosted by better economic news and increased prospects for another round of US quantitative easing. Oil prices were also boosted by news of the EU’s embargo on Iranian oil from July. The euro and the Australian dollar both rose as the $US weakened.
- Bonds rallied as investors focused on near zero US interest rates for longer and increasing prospects for QE3 on the back of the Fed’s latest statement.
What to watch over the week ahead?
- In the US, the focus will be on the January ISM manufacturing conditions index (due Wednesday) which is expected to show a further improvement and payroll employment data (Friday) which expected to gain 150,000 jobs with unemployment remaining unchanged at 8.5%. Data for personal spending (Monday), house prices and consumer confidence (Tuesday) and the ISM non-manufacturing conditions index (Friday) will also be released.
- In the Euro-zone, data for business and consumer confidence, unemployment, inflation and retail sales are due for release. The EU leaders’ summit on Monday will be watched for progress towards the fiscal compact announced in December and pro-growth measures, but don’t expect much of substance in terms of the latter.
- Chinese manufacturing conditions indicators (PMIs) will be released on Wednesday and are likely to remain around the 50 level. Japanese industrial data (Tuesday) is expected to show a modest rise.
- In Australia, we expect NAB business confidence (due Tuesday) to remain subdued, private credit (Tuesday) to rise 0.3%, ABS December quarter house prices (Wednesday) to fall 1% and building approvals (Thursday) to fall back slightly after a strong gain in November.
Outlook for markets
- After strong gains so far this year shares are a bit overbought and vulnerable to a correction, particularly as we enter the seasonally soft month of February. However, the broader picture for shares is looking more favourable: valuations are attractive particularly against very low bond yields, the risk of a meltdown in Europe has receded, the global recovery looks like it will continue (albeit at a slower pace than seen in 2010 and 2011), monetary conditions are easing and there is lots of cash on the sidelines. We expect a good year for shares overall and continue to see the ASX 200 pushing up to 4800 by year end.
- Global bond yields are very low in core countries suggesting low returns unless Europe’s debt crisis intensifies. Australian government bonds are relatively more appealing with higher yields. Australian corporate debt is an even better investment proposition if one needs income or is worried about shares.
- The $A is likely to see its usual large price swings this year, but generally remain solid helped by more quantitative easing in the US and Europe, solid commodity prices and safe haven flows reflecting Australia’s safe AAA rating status. After a short term pull-back, another run-up to $US1.10 in the next few months looks likely.