The “risk off” tone in global financial markets continued over the last week following swings to the left in French, Greek and even German (regional) elections and worries that Spain’s nationalisation of a bank foreshadows more bank bailouts using public funds and hence upwards pressure on its public debt not helped by rumours of imminent ratings downgrades of Spanish banks.
Of these:
- France is probably ultimately the least worrying: New President Hollande is actually more a centrist and is not proposing a radical change in economic policy, just a softer approach to austerity. And Chancellor Merkel might be inclined to go along with him a bit given her coalition’s election losses and more broadly Euro-zone authorities generally seem to be moving towards some relaxation of budget target enforcement anyway.
- Greece is an unstable mess, but its default and exit from the euro may not be as imminent as many fear. A failure to implement the agreement with the EU and IMF will mean even more austerity for Greece as it wouldn’t get any more funding for its budget deficit and an almost certain exit from the euro which would see financial chaos. However, it looks to be heading back to another election and, with the electorate having had their protest vote but 70-80% of them wanting to stay in the euro, the likely outcome will be stronger support for Pasok and New Democracy such that they can form Government and implement the agreement with the EU and IMF.
- Spain is more of a worry, with deep recession and falling property prices making the situation of its banks more and more difficult risking the need for a public sector bailout which could add maybe 10 percentage points to Spain’s public debt to GDP ratio which would take it to around 80% of GDP. This would still be below the Euro-zone average of 87% and in normal times wouldn’t be a major problem but these are not normal times. So Spain could remain a problem until the threat to the banks recedes, or it gets a bailout from the European Stability Mechanism and or the ECB jumps in with more purchases of Spanish bonds and/or monetary easing.
- It’s worth noting that the Bundesbank appears to be becoming a bit more tolerant of German inflation running above the Euro-zone average, which might imply a bit more tolerance to easier ECB monetary policy. But as always it may take more bad news before the ECB finally swings into action with more easing.
- Chinese data for April was particularly concerning with growth in industrial production, retail sales, fixed asset investment, exports & imports all slowing sharply and new bank lending and money supply growth coming in weaker than expected. While this is contrary to readings from business conditions indicators or PMIs which have been pointing to an improvement in growth it will add to fears of a hard landing. Fortunately, inflation fell to 3.4% in April so there is plenty of scope for monetary easing, which we now expect to become more aggressive in the months ahead and to involve both interest rate cuts and a reduction in banks’ required reserve ratios.
- In Australia, there were no great surprises from the Budget which projected a $1.5bn surplus for 2012-13 with savings sourced from cuts to defence, foreign aid, the public service, an increase in the superannuation contributions tax for high income earners and not proceeding with a company tax rate cut partially offset by more support for low to middle income earners. The projected return to surplus is to be welcomed as its helps provide flexibility for fiscal policy to respond to future economic shocks and more scope for the RBA to cut rates further. It was also pleasing to see that additional fiscal tightening was done in a way that shouldn’t cause too much damage to short term economic growth. The downside in the Budget is that by taking money from high income earners and the corporate sector generally it may hamper long term incentive and investment and the continuous tinkering to superannuation risks damaging confidence in it.
Major global economic releases and implications
- US data reasonably good, with a solid rise in consumer credit, gains in consumer sentiment and small business optimism, a rise in job openings to their highest since July 2008, a further slight fall in weekly jobless claims and a solid gain in weekly mortgage applications. A widening in the trade deficit was disappointing.
- German economic data was better than expected with solid gains in factory orders, industrial production and exports. Industrial production elsewhere across Europe was mixed: up in Italy, but down in France and the UK.
- Japanese economic data was mixed with a fall in current business conditions but an improvement in expectations and a fall in bankruptcies. A key point though is that the Japanese economy is growing in contrast to a year ago when it was knocked into recession by the earthquake and tsunami.
- As in China, Indian industrial production came in far weaker than expected, actually falling 3.5% year on year in March and Taiwan also saw weaker than expected exports in April.
Australian economic releases and implications
- Australian data painted a rather confusing picture with surprisingly strong gains in retail sales in nominal and in volume terms, a strong bounce in March building approvals and a surprise rise in employment and fall in unemployment to just 4.9% in April. So maybe the economy is not so soft after all. Against this though, business conditions fell in March according to the NAB business survey, ANZ job ads fell, the AIG’s construction PMI fell further in April and another big trade deficit in March points to net exports knocking between 0.7 to 1 percentage points off March quarter GDP growth.
- Our assessment is that while the surprise sudden strength in retail sales and jobs tells us the economy is not quite as weak as some may have been fearing its inconsistency with anecdotal evidence, the mixed nature of data releases generally and the natural tendency for economic data to go through hot and cold patches tells us that its too early to get excited. While the fall back in unemployment probably means a June rate cut is now unlikely (barring a blow up in Europe), more rate cuts are still likely going forward, starting again around July/August and taking the cash rate down to around 3-3.25% by year end.
Major market moves
- Global shares fell again over the last week on fears the European crisis was worsening & a trading loss at JP Morgan, not helped by weak Chinese data. Australian shares also succumbed to global risk aversion.
- Risk aversion also saw commodity prices and the Australian dollar fall, with the latter only just above parity.
- Safe haven buying saw sovereign bond yields in “safe” countries fall slightly and a further sharp fall in Australian bond yields to new 61 year lows (of just 3.39% for 10 year bonds) as the Budget confirmed a return to surplus.
What to watch over the week ahead?
- In the US in the week ahead expect benign inflation readings (Tuesday), a 0.2% gain in April retail sales (Tuesday) after strong growth in March, a bounce in the NAHB homebuilders survey (Tuesday) and housing starts (Wednesday) after soft readings in the previous months, a 0.5% rise in April industrial production (Wednesday) and slightly stronger readings for manufacturing conditions in both the New York and Philadelphia regions (due Tuesday and Thursday respectively). The minutes from the Fed’s last meeting (Wednesday) are likely to reaffirm the message from Fed Chairman Ben Bernanke that QE3 remains on the table.
- Euro-zone March quarter GDP data is likely to show a second quarter of contraction confirming the Euro-zone is back in recession. This is likely to have been led by peripheral countries with Germany stronger.
- By contrast Japanese March quarter GDP growth (Thursday) is likely to show solid growth of 0.9% quarter on quarter, more than reversing a 0.2% contraction in the December quarter.
- In Australia expect a 0.5% fall in housing finance (Monday), a bounce in consumer confidence (Wednesday) on the back of the cut in mortgage rates and the Budget handouts to low and middle income households and benign March quarter wages growth (Wednesday). A speech by RBA Deputy Governor Lowe (Monday) and the minutes from the RBA’s last meeting (Tuesday) will be watched for clues on the outlook for interest rates.
Outlook for markets
- Global share markets remain in a rough patch which could continue for several months reflecting renewed worries about Europe and now China, a soft patch in US economic data & normal seasonal weakness.
- However, I remain of the view that the correction will be mild – say 5 to 10% rather than the 15 to 20% plunges we saw from April highs in 2010 and 2011. And shares are still likely to be 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, China is likely to start easing more aggressively and the ECB may be gearing up to ease further too.
- 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.
- Low bond yields in major countries suggest very low bond returns unless Europe’s debt crisis intensifies.
- The correction in the $A may see it dip below parity reflecting worries about the global growth outlook. 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, particularly if the Fed undertakes QE3.