Weekly economic & market update

Europe is continuing to cause shockwaves in financial markets with increasing resistance to fiscal austerity (with the temporary collapse of the Dutch coalition Government and the Socialist candidate’s victory in the first round French Presidential elections), more soft economic data including 24.4% Spanish unemployment and Standard & Poor’s downgrading of Spain.

• However, Europe will probably agree to relax the pace of fiscal austerity in return for more measures to boost potential growth, the Dutch have agreed to an austerity budget and if François Hollande gains the French presidency he will probably back away from some of his radical proposals. Moreover, the news out of Europe hasn’t been all bad with bond yields in Spain, Italy and France falling and less European banks tightening lending standards. The basic picture in Europe still remains one of mild recession and occasional flare ups causing turbulence in global markets, but no GFC style banking crisis.
• US Fed Chairman Bernanke said another round of quantitative easing remains on the table and will be deployed if needed. This is very different to the ECB where the hurdle to provide more support appears much higher even though the Euro-zone is back in recession. Little wonder US shares are doing so much better.
• Australians are expected to start seeing interest rate relief from Tuesday following very low March quarter inflation. Low income households will also benefit from $300 cheques in the mail over May and June as part of the carbon tax compensation package, although much of this will likely be saved given impending price hikes for electricity and gas. The total $1.5bn in compensation payments over the next two months is also trivial compared to the two GFC stimulus payments of $8.7bn and $12.7bn made in late 2008 and early 2009.
  Major global economic releases and implications
• US economic data releases remained mixed. March quarter GDP growth at 2.2% annualised was less than expectations for 2.5% growth, jobless claims remained higher than expected and durable goods orders and new home sales fell more than expected in March. Note though that business surveys still point to a fall in jobless claims going forward and prior estimates for both durable goods orders and new home sales were revised up leaving reasonable trends in place. On the positive side though consumer confidence rose slightly and perceptions of the jobs market improved. Also measures of house prices rose in February and pending home sales rose strongly in March adding to confidence the US housing sector has turned the corner. Overall, the US economy still looks to be growing probably at around a 2% pace.
• US March quarter earnings results have softened a bit but are still strong. Out of the 300 S&P500 companies to have reported so far, around 75% have exceeded expectations. Earnings growth over the year to the March quarter looks like coming in around 10% versus consensus estimates for 5% growth a month ago.
• European data was poor with falls in business conditions and confidence indicators and a slight fall in UK GDP in the March quarter resulting in a return to recession. Note though that these indicators are still consistent with a mild recession in Europe, as opposed to a deep GFC style slump. Meanwhile, an ECB survey pointing to a substantial reduction in the number of banks tightening lending standards in the March quarter suggests the provision of cheap loans to banks by the ECB may have helped head off a banking crisis and credit crunch.
• Japanese March economic data showed improvement but it was less than expected and underlying price deflation is continuing. Reflecting this, the Bank of Japan announced an expansion in its quantitative easing program to help boost growth and inflation. But its still doubtful that its doing enough.
• In China, April data for the HSBC Flash manufacturing conditions PMI improved slightly and momentum in industrial profits turned up of which suggests monetary easing is working and growth may be bottoming.
• The news across Asia was mixed. Korean GDP grew 0.9% in the March quarter, the fastest in a year. Singapore saw an increase in inflation in March, but largely on the back of Government transport charges.
• Standard & Poor’s provided a reminder that not all emerging countries are free of public debt problems by placing India’s credit rating on negative outlook. India has been a standout on this front for several years with a general government budget deficit of around 7 to 8% of GDP and public debt equal to around 65% of GDP and a hefty reliance on foreign investors and in recent years the pace of economic reform has slowed to a crawl. That said its debt situation is a long way from being unsustainable. Its debt to GDP ratio is well below US and European levels and its fast growing population and economy make it relatively easy to service.

Australian economic releases and implications

• In Australia, benign inflation has cleared the way for an RBA rate cut. While the fall in headline inflation was exaggerated by a 60% plunge in banana prices, underlying inflation was also weaker than expected running around 2.2% year on year. Price discounting is huge in consumer sensitive parts of the economy.

Major market moves

• Global shares had another volatile week but US and European shares rose on the back of good US earnings news and indications from the Fed that QE3 is still on the table. Australian shares are grinding higher, despite earnings downgrades, on the back of expectations that interest rates will soon be cut.
• Commodity prices rose helped by a weaker US dollar pushed the $A higher as talk of QE3 in the US offset
  the negative impact of much weaker than expected inflation in Australia.
• Sovereign bond yields fell over the past week particularly in Australia as interest rate expectations moved lower. French, Spanish and Italian bond yields also fell implying a slight reduction in European debt fears.

What to watch over the week ahead?

• In the US, regional manufacturing surveys point to a slight fall in the ISM manufacturing survey (due Tuesday) and employment data (Friday) is expected to show a 175,000 gain in payrolls. Data for personal spending (Monday), the ISM services index (Thursday) and productivity (Thursday) will also be released.
• In Europe, the ECB should be cutting interest rates (currently 1%) when it meets Thursday given the ongoing recession in Euro-zone countries, but is likely to do nothing.
• PMI business conditions data in China (Tuesday) are expected to confirm Chinese growth has bottomed.
• In Australia the RBA is expected to cut interest rates on Tuesday. The case to cut rates is overwhelming: economic growth is running below trend; key sectors of the economy such as retailing, housing and manufacturing are really struggling; the jobs market is weak; and underlying inflation is at the low end of the 2 to 3% target range. The big issue though is by how much rates should be cut and it’s likely the RBA Board will spend much time debating this. While the absence of a major crisis probably means the RBA will stick to a 0.25% cut it should be cutting by 0.5%. A 0.25% cash rate cut will probably just see the banks cut by between 0.1 to 0.15% which will only take mortgage rates back to around where they were earlier this year, which wouldn’t be enough to have much economic impact. By contrast a 0.5% cash rate cut would see mortgage rates fall by around 0.35% which may go some way towards starting to restore confidence and decent growth in the economy. But whether its 0.25% or 0.5% on Tuesday, our assessment is that mortgage rates need to fall by around 0.75%, implying several cuts in the cash rate over the next few months. On Friday the RBA’s Statement on Monetary Policy will likely see downgrades to the RBA’s growth and inflation forecasts.
• On the data front in Australia, expect March new home sales (Monday) to have remained weak, private sector credit growth (Monday) to remain subdued and March quarter house prices (Tuesday) to come in around flat.

Outlook for markets

• Global share markets remain in a rough patch which could continue for several months reflecting renewed worries about Europe and a soft patch in US economic data.
• However, any correction should be mild – say 5 to 10% rather than the 15 to 20% plunges we saw from April highs in 2010 and 2011. And we still see share markets higher by year end. Shares are cheaper than was the case a year ago, the risk of a Euro-zone banking meltdown has faded, momentum in global economic indicators is more positive, global monetary conditions are easier, the Fed stands ready to provide more stimulus if required and investors are likely to anticipate this. Chinese and emerging country share markets should pick up as China starts to more aggressively ease economic policy.
• The Australian share market has been somewhat stronger in April 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.