“Risk off” remained the big theme for the third week in a row as global shares, commodity prices, the euro and the $A fell on the back of worries about Greece exiting the Euro-zone, Spanish banks, Chinese economic growth and weak US economic data.
- From their highs this year global shares have now fallen by 10.2%, Asian (ex Japan) shares by 10.5% and Australian shares by 8.8%. In the short term shares are way oversold and due for a bounce, but the ride is likely to remain rough in the months ahead.
- The possibility of Greece exiting the euro is now being openly talked about by European officials. Worryingly Greeks themselves are starting to take it seriously and withdraw their euro denominated deposits from Greek banks. And the ECB hasn’t helped matters by stopping lending to some Greek banks, to limit its risk should Greece leave. Quite clearly the boost in support for anti-bailout parties in Greece has increased the chance it will default and exit. The EU and IMF will not agree to changes to the bailout terms beyond any minor tinkering and have made it clear that if it is not followed then Greece will not get any more funds, which would set it on a path to default probably in early July and probable exit from the euro as it will need to be able to print its own money to survive. As a result the June 17 election will effectively be a referendum on whether it stays in the euro or not. 78% of Greeks want to stay in the euro and a recent poll has shown an increase in support for pro-bailout party New Democracy, putting it ahead of the main anti-bailout party Syriza, raising the hope that it will be able to form Government with the other pro-bailout party Pasok and implement the bailout terms.
- So an imminent “Grexit” is not a foregone conclusion. The trouble is that June 17 is a month away and even if Greece doesn’t have a disorderly default and exit, Spanish banks are becoming an increasing concern.
- What would Greece’s exit from the euro mean? The exposure of European banks to Greece has fallen substantially following debt write downs. The real concern would be the fear of contagion to Portugal, Spain and Italy and this is why bond yields in these countries have been under so much pressure. On this front, Europe’s firewall fund has been enhanced and so too has the bailout firepower of the IMF and the ECB could also aggressively buy bonds in vulnerable countries. However, the issue will be how quickly Europe moves to protect these other countries in the event of a Greek exit. If it moves too slowly then a Greek exit could be similar to a Lehman event. In this scenario credit markets would dry up as would bank funding and Euro-zone GDP could contract 5%. Alternatively, if the European authorities move quickly the impact could be limited to a still mild recession in Europe this year. Obviously there are still a lot of balls in the air and so the next few months could remain quiet volatile in investment markets.
- While things look bleak there are some positives compared to last year when share markets fell roughly 20% between April/May highs and lows in September/October: US housing and manufacturing are looking stronger, Japan is growing, global car makers haven’t been hit by supply chain disruptions, we haven’t seen the same surge in oil prices that occurred early last year, shares are cheaper, sovereign bonds are a lot more expensive, monetary policy is easing in China and emerging markets whereas a year ago it was tightening and in Australia the RBA is cutting rates whereas a year ago it was threatening to raise them.
Major global economic releases and implications
- US data was mixed. Housing data was strong with an index of homebuilders conditions rising to its highest level in four years and mortgage delinquency rates falling to their lowest since the September quarter 2008, retail sales were solid, weekly jobless claims held at relatively low levels and industrial production rose strongly in April. Against this, regional manufacturing conditions surveys were mixed – better in the NY region but much worse in the Philadelphia region and a leading index for the US fell. Hopefully, the fall in the Philadelphia index is just an outlier, but if it isn’t it may be a sign of a softening in the US economy, possibly on the back of the confidence zapping news out of Europe.
- Economic data out Europe was actually a bit better than expected, with March quarter GDP failing to confirm that the Euro-zone had entered a technical recession, thanks to German strength. However, it would be dangerous to get too excited. Spain and Italy are certainly in recession and forward looking indicators point to falling GDP going forward. We still see a mild recession in Europe resulting in a 1% contraction in GDP. However, if Greece has a disorderly default and euro exit a 5% slump in GDP would be a high risk.
- Japan grew by more than expected in the March quarter, expanding by 1% (or 4.1% annualised). This highlights a big difference compared to last year when the Japanese economy was plunged into recession by the earthquake and supply chain disruptions also led to disruptions to industrial production in the US and elsewhere, which only added to global double dip fears at the time.
- China has followed up the latest cut to banks’ required reserve ratios with subsidies to buy energy saving consumer goods. Quite clearly policy makers are starting to swing into action in terms of providing stimulus. But so far the moves are only modest, so expect more easing going forward.
- India remains a concern with a rise in headline inflation in April making Reserve Bank of India rate cuts harder. Further rate cuts are still likely during the second half though.
Australian economic releases and implications
- In Australia, the minutes from the RBA’s last meeting offered nothing new, but a speech by RBA Deputy Governor left the impression that it will be reluctant in cutting rates further given its concerns about productivity and the need for structural adjustment in the economy. Nevertheless, our view remains that it will be forced into further rate cuts reflecting soft non-mining demand, a topping out in the mining boom, increasing global uncertainties and benign inflation. We see the cash rate falling to 3-3.25% over the next 6 months.
- Housing finance remained subdued, consumer sentiment improved fractionally (despite rate cuts and budget handouts) and wages growth remained benign. One piece of good news though is that auction clearance rates have edged up a bit since the RBA cut rates, indicating home buyers still respond to lower mortgage rates. Our assessment though is that given the headwinds of global uncertainty, higher electricity and gas prices and job insecurity more rate cuts will be needed to ensure a sustainable recovery.
Major market moves
- Global shares fell sharply on the back worries about Greek euro exit and Spain triggering financial chaos and a deep European recession along with poor US economic data later in the week. Australian shares fell by around 5.6% on the back of worries about Europe with continuing concerns about China seeing resources shares hit the hardest. Defensive sectors such as utilities, telcos and consumer staples outperformed.
- Worries about global growth and a rising $US resulted in sharp falls in commodity prices and the $A.
- Sovereign bond yields in the US, Germany and Australia slid on safe haven demand. Australian ten year bond yields fell to their lowest ever of 3.08% – the previous low of 3.09% was at the height of WW2 in 1941.
What to watch over the week ahead?
- Europe will likely remain a key focus with a Euro-zone leaders meeting on Thursday likely to focus on demands for an easing in the pace of fiscal austerity and the possibility of Greece exiting the Euro-zone and May business conditions indicators or PMIs due for release on Thursday along with the German IFO survey. The May PMIs may slip a bit further reflecting the impact of heightened uncertainty in Europe, but remain consistent with a mild recession as opposed to a deep recession. A weekend G8 leaders meeting will also be watched to see whether there is any coordinated action to stabilise markets, late last year.
- In the US in the week ahead expect a 2.5% gain in existing home sales (due Tuesday), another modest gain in house prices and a 2% gain in new home sales (both due Wednesday), a 1% rise in durable goods orders (Thursday) and a flattish reading on consumer sentiment (Friday).
- Japanese CPI data (Friday) is likely to show that deflation is continuing, highlighting the need for more aggressive monetary easing by the Bank of Japan.
- In Australia, there are only second order economic releases due in the week ahead including the Westpac leading index, skilled vacancies and housing affordability.
Outlook for markets
- Share markets could fall further over the next few months as worries about a break up in the euro continue, made worse by uncertainty about China and to a lesser degree the US.
- However, I remain of the view that shares will be higher by year end: shares are cheaper than was the case a year ago and we are likely to see another aggressive round of monetary easing in the US, Europe and China.
- Low bond yields in major countries are now at or around record lows suggest very low bond returns going forward unless Europe’s debt crisis continues to worsen.
- The correction in the $A may see it fall to around $US0.95 reflecting worries about the global growth outlook. However, it’s likely to be given a boost during the second half as global central banks led by the Fed undertake more monetary easing.