The past week was one of “risk off” for global markets as concerns about Europe remain (particularly with French and Greek elections likely to further question Europe’s ability to solve its problems) and an ongoing softer patch in US economic data highlighted by a soft employment report.
- Bright spots though have been China where economic growth looks like it may have bottomed and this has helped boost Chinese shares, and Australian shares which benefitted from the RBA at last swinging into action on rates. Expect the next few months to remain a bit rough for markets though given the normal seasonal weakness seen from around this time of year, Europe’s problems and an ongoing soft patch in the US economy.
- In Australia, the Reserve Bank cut interest rates by an as required 0.5% in an effort to make up for lost time in getting rates down to combat economic weakness. The RBA got it wrong by leaving rates too high for too long. It is now trying to correct the error of its ways and get back on track. The RBA’s quarterly Statement on Monetary Policy offered little guidance regarding future rate moves, although our assessment is that the downwards revision to the RBA’s growth and inflation forecasts imply an easing bias. With underlying inflation excluding the impact of the carbon tax now expected by the RBA to be at the bottom of the 2-3% target range this year there is plenty of scope to cut rates further.
- So far banks are only passing on between 0.32% to 0.4% of the cut and this is leaving standard variable mortgage rates around 7%, which is well above “neutral” levels, which we estimate to be around 6.75%.
- Still too high mortgage rates, along with the likelihood that economic uncertainty will probably persist for several months and the Budget set to act as a big drag on economic growth over the year ahead, indicate that more interest rates cuts will be required before we start to see the economy perking up. I expect another two or three 25 basis points cuts over the next four months. This will take the cash rate down to either 3% or 3.25% by year end and average standard variable mortgage rates down to around 6.5%.
- As the next chart highlights, the gap between the standard variable mortgage rate and the cash rate is continuing to blow out. But the events of the last week highlight that the RBA still drives the broad direction of mortgage rates. It’s just that it has to move a bit more than used to be the case to get the level it wants.
Major global economic releases and implications
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US data releases remain mixed. April payroll employment, the ISM non-manufacturing index and construction spending all came in weaker than expected. But the April ISM manufacturing conditions survey improved, personal spending showed reasonable gains, housing vacancy rates fell further, weekly mortgage applications rose again, jobless claims fell and a Fed survey showed a slight easing in bank lending standards and more demand for credit. So yes it’s another soft patch in US data, but the economy still seems to be growing.
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US March quarter earnings have softened over the last two weeks to just 67% beating expectations, but earnings growth still looks like coming in around 10%. European earnings results have had a slight positive bias.
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European data remained poor with business conditions indicators coming in slightly weaker than the already soft flash reports and unemployment rising to 10.9% which is a 15 year high. German unemployment remained low at 5.6% but German retail sales still remain soft. The overall picture remains one of a mild recession with GDP likely to contract by around 1% this year. As expected no change from the ECB, and although President Draghi noted downside risks, the ECBs lack of discussion about further easing suggests it has its head back in the sand. Don’t expect anything pre-emptive from them.
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In China, manufacturing PMIs rose adding to confidence that economic growth may have bottomed.
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The combination of soft industrial production, exports and inflation in Korea all point to further monetary easing ahead. Inflation also fell in Thailand where production and exports were weaker than expected in March, but there was good news out of Taiwan which saw GDP growth recover in the March quarter. Similarly India’s manufacturing PMI rose slightly in April and is consistent with a bottoming in growth.
Australian economic releases and implications
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In Australia, economic data remained weak with a 9.4% fall in April new home sales, soft readings for household credit growth, a fall in house prices for the fifth quarter in a row and sharp falls in the AIG’s manufacturing and services sector conditions’ PMIs in April. Quite clearly the non-mining economy remains weak, supporting the case for further monetary easing ahead.
Major market moves
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Global shares fell on ongoing worries about Europe and some softer US data. Chinese shares were an exception, as signs of a bottoming in Chinese growth and ongoing expectations for policy easing have boosted shares and this is also helping Asian shares generally. Australian shares rose helped by the RBA’s rate cut.
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Commodity prices fell on global growth concerns and this plus lower rates in Australia all saw the $A fall sharply.
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Sovereign bond yields fell, particularly in Australia on reduced interest rate expectations. Spanish, Italian and French bond yields also fell.
What to watch over the week ahead?
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In China, April economic data due on Thursday and Friday is likely to add to confidence that growth is bottoming and inflation is benign. Expect 11.8% growth in industrial production, 15.5% growth in retail sales, 20.5% growth in fixed asset investment and 3.5% inflation down from 3.6% in March thanks to lower food price inflation. Bank lending growth is likely to be down a bit from the surge seen in March but still remaining strong.
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In the US it’s a relatively quite week with data for the March trade balance (Thursday), producer price inflation (Friday) which is likely to remain benign and consumer sentiment (Friday).
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In Europe, all eyes will be on the results of the French and Greek elections. The Bank of England is unlikely to make any changes to monetary policy when it meets on Thursday.
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In Australia, the focus will be on the 2012-13 Budget where we expect the Treasurer to announce a $1bn surplus. The admission of revenue running below target means the most recent MYEFO projection from November last year of a $37bn deficit for 2011-12 has likely blown out to $42bn, suggesting that the starting point surplus for 2012-13 of $1.5bn has likely turned into a circa $3bn deficit. In other words another $3-$4bn in savings may be required, increasing the size of the fiscal drag to around $43bn or nearly 3% of GDP. This will be a record amount of fiscal drag and will act as a real constraint on the economy over the year ahead, albeit it likely exaggerates the actual negative economic impact on the economy which is more likely to be around 1% of GDP. Budget savings are likely to focus on better targeting welfare, raising the superannuation contributions tax for high income earners, reduced industry allowances and cutbacks for defence, foreign aid and the public service. The danger is that budget cutbacks discourage longer term savings and investment. In terms of economic assumptions the Government is likely to forecast 3.25% growth for 2012-13 and a rise in unemployment to 5.5%, but given the degree of fiscal drag sharp reductions in interest rates are likely to be required if such growth is going to be achieved.
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As to whether the Government should stick to its commitment to return the budget to surplus for 2012-13, we think on balance it should. The economic backdrop is not so bad that we need further fiscal stimulus, if we can’t get back to surplus when unemployment is around 5.2% and commodity prices are high when will we?, a return to surplus will add to the scope for the RBA to cut interest rates further, a surplus will add to confidence in the minds of foreign investors regarding Australia’s underlying economic strength at a time when most other countries are still struggling to bring deficits under control and it will start to put the public finances back into the position where they can provide another bout of stimulus should the global economy take another turn for the worst.
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On the data front in Australia, expect continued subdued growth in retail sales for March (Monday), continued softness in March building approvals (also Monday), a return to a trade surplus after two months of deficits (Tuesday) and a 15,000 contraction in employment in April (Thursday) following a 44,000 gain in March to drive the unemployment rate up to 5.4% from 5.2%.
Outlook for markets
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Global share markets remain in a rough patch which could continue for several months reflecting renewed worries about Europe, a soft patch in US economic data and normal seasonal weakness.
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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.
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The Australian share market has been somewhat stronger recently and if the RBA cuts rates further as we expect and confidence regarding a Chinese soft landing builds then the local market could be in for a period of further relative outperformance. The main local drag though is ongoing earnings downgrades.
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Low bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies.
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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.