Weekly economic and market update – week beginning 23 April 2012

Europe remains a source of consternation, but there have been some positive developments.

• News that Italy is delaying its return to budget surplus by one year, Spanish banks’ bad loans had increased to 8% of assets and the prospect of a socialist president in France all weighed on investor sentiment. But against this there was some good news with successful Spanish & French bond auctions, German economic data surprising on the upside and the IMF receiving pledges to expand its bailout funding by more than $US430bn, which would take its total capacity to over $US810bn (or €610bn). Combined with the €500bn in new capacity in Europe’s bailout fund it should be enough to more than cover both Spain and Italy’s funding out to end 2014 if needed.
• In Australia, there is much debate about the merits of returning the budget to surplus by 2012-13. Weaker than expected revenues on the back of a softer economy are necessitating even more budget cutbacks, possibly to the tune of another $5bn on top of the circa $40bn turnaround already projected. With the non-mining economy very fragile this is a dangerous time to be undertaking fiscal cutbacks, so the Government needs to be careful, hopefully using more smoke and mirrors and better targeting of spending rather than cutting to the bone.
• From a broad economic perspective, it’s probably neither here nor there whether the surplus is reached in 2012-13 or the year after. However, on balance I think the Government should stick to returning to surplus for 2012-13. There are two good reasons. First, a delay may be greeted dimly by foreign investors who now hold 75% of Australia’s public debt. This would mean higher borrowing costs over the long term for ordinary Australians. Second, we need to start putting money aside for a rainy day. While times are tough they are not disastrous. If we can’t run budget surpluses when commodity prices are high and unemployment is around 5% when will we? The global economy is still fragile and we need to start reducing our public debt so that, if the world turns sour again, the Government has the firepower to undertake another round of fiscal stimulus. The problems in Europe and the US highlight what happens when deficit reduction is endlessly put off.
• With the non-mining part of the economy struggling it is clear the Australian economy needs a bit of fine tuning. But it’s the RBA not the Federal Government that is best placed to do this. Interest rates are too high and need to come down. This is regardless of whether we have a small deficit or a small surplus in 2012-13, but there is no doubt that a $40bn, or 2.5% of GDP, or more bout of fiscal austerity which is what we are about to see over the next financial year will substantially add to the case for lower interest rates.

Major global economic releases and implications

• US data releases were disappointing adding to fears of another re-run of the last two years where the US economy ran into double dip worries through the June quarter. Headline readings for manufacturing conditions, industrial production, a survey of home builders, weekly mortgage applications, housing starts, home sales and jobless claims were all weaker than expected. There were some positives though with permits to build new homes rising strongly, solid gains in retail sales, a better than expected rise in the leading index and the detail in the manufacturing surveys were solid. There is also evidence claims pick up around Easter before falling back.
• What’s clearly positive in the US though are March quarter earnings. So far with 25% of companies having reported, around 81% have exceeded expectations, including Microsoft, GE, Travelers Co and Verizon.
• Euro-zone data was mixed with a reduced trade surplus, a fall in construction and a fall in consumer confidence. Against this the ZEW survey of financial analysts & the German IFO survey were surprisingly strong.
• Central banks in Brazil and India cut interest rates. In the past rate cuts have been positive for Indian shares.

Australian economic releases and implications

• In Australia, the Westpac leading index is still growing below trend and the terms of trade fell again in the March quarter with a sharp 7% fall in export prices. Continued weakness in land sales according to the HIA and data confirms that the outlook for housing construction remains poor.
• Meanwhile the minutes from the RBA’s last Board meeting contained plenty of references to housing weakness, the subdued labour market and below trend growth confirming that it’s on track for further easing. I am still wondering why they just didn’t get it over and done with rather than pin it on the next set of noisy inflation data.

Major market moves

• Global shares had another volatile week not helped by ongoing European worries and softer than expected US data. But US, European and some Asian markets managed to rise helped by stronger than expected US retail sales, solid US earnings, an upgrade to the IMF’s global growth forecasts, increased IMF funding and better than expected German data. Chinese shares rose on expectations for further monetary easing.
• Australian shares are proving very resilient in the face of recent global share market weakness, with the ASX200 pushing further beyond the previous ceiling of 4300 over the last week as investors are starting to recognise value in the local market after two years of relative underperformance, helped by the $A being off its highs, RBA rate cuts looking imminent and China starting to look a bit less worrying.
• While bond yields were flat to down in the US, Japan, Germany and Australia they rose in France and Italy.
• Commodity prices rose slightly as did the $A.

What to watch over the week ahead?

• In the US, the Federal Reserve’s meeting on Wednesday is unlikely to see any changes to monetary policy but the post meeting statement will be watched closely for indications as to how confident the Fed is regarding the economic outlook and the prospect for any further stimulus. On the data front, expect flattish house prices (Tuesday), a small rebound in new home sales (Tuesday) and pending home sales (Thursday), unchanged consumer confidence (Tuesday) and a slight fall back in durable goods orders (Wednesday). US earnings results will continue to flow with more than 100 major companies due to report.
• In China, the HSBC flash manufacturing PMI will be released on Monday and will be watched to see whether it rises to be more in line with the somewhat stronger reading for the official PMI.
• In Europe, PMIs for both manufacturing and services (Monday) will be watched closely. So far they are consistent with a mild recession for the Euro-zone. The results from the first round of the French Presidential election will also be watched very closely. President Sarkozy seems to be a voice of reason against some crazy ideas from the alternative candidates, but he is still trailing in the polls for the May run-off election.
• Japanese data on Friday is likely to be consistent with modest economic growth but continuing deflation. A Bank of Japan meeting also on Friday will be watched closely for evidence BoJ Governor Shirakawa is as committed to further monetary easing and his 1% inflation goal as he say he is. So far the evidence is not so good.
• In Australia the big focus will be on March quarter inflation data to be released Tuesday as the RBA appears to have publicly tied an interest rate cut in May to seeing a benign outcome from these figures. We think that inflation will remain benign with headline inflation expected to rise 0.7% in the quarter or 2.2% year on year and underlying inflation to come in at 0.5% in the quarter and 2.25% year on year, both of which are at the low end of the RBA’s 2 to 3% target range. While seasonal rises in prices for health, utilities and education and a rise in petrol prices will boost headline inflation, underlying inflation pressures are likely to have remained subdued thanks to soft demand and the strong $A.

Outlook for markets

• After a strong March quarter, its now clear that we have entered a rougher patch in global share markets triggered by renewed worries about Europe and a softer patch of data in the US with investors naturally fearful of a re-run of the last few years where a strong start to the year saw shares peak around April only to fall 15 to 20% over the next few months. Our assessment is that this rough patch could continue for a few more months.
• However, any correction should be mild – say 5 to 10% rather than 15 to 20% – and we still see share markets higher by year end. Shares are cheaper than was the case a year ago – particularly against bonds, the risk of a Euro-zone banking meltdown has faded, momentum in global economic indicators is more positive, global monetary conditions are getting easier and there is lots of cash on the sidelines. Chinese and emerging country share markets should pick up as China starts to more aggressively ease economic policy.
• The Australian share market has been holding up better lately and if the RBA cuts rates and confidence regarding a Chinese soft landing builds then the local market could be in for a period of relative outperformance.
• Low bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies.
• The correction in the $A may have further to go reflecting soft data in Australia and volatility in global share markets. However, the $A is likely to remain strong overall as the continuing global recovery supports commodity prices and as Australian interest rates remain above US rates.