• Share markets have been resuming their slide following a brief bounce, the $A continuing to fall and safe haven flows driving falls to record lows for bond yields in the US, UK, Germany and Australia. Australian Government ten year bond yields at around 2.77% have now fallen below their previous post Federation record low of 2.99% (Jan 1941) and their pre Federation low of 2.9% (Sept 1897).
• While the Irish backed the Euro-zone fiscal compact, the mess in Europe is evident on several fronts. Opinion polls regarding the June 17 Greek election are bouncing around all over the place. Spain urgently needs to recapitalise its banks, but to do so will need a bailout from the Euro-zone bailout fund. And of course, economic data in Europe is continuing to worsen. Reflecting investor nervousness, Spanish and Italian bond yields rose further into unsustainable territory and an Italian bond auction went off poorly.
• So what should Europe do? First, use the Euro-zone bailout fund to immediately recapitalise Spanish banks. Second, provide a Europe wide guarantee of bank deposits to stop bank runs. Third, act to reduce bond yields in troubled countries to sustainable levels, initially via aggressive bond buying from the ECB or bailout fund but ultimately using Euro-bonds or the German redemption fund concept. Finally, the ECB should aggressively ease monetary policy by cutting interest rates to near zero and engaging in aggressive quantitative easing.
• All these concepts appear to be gaining increasing support in Europe, but Germany is still dragging the chain and there appears to be an inclination to wait till the June 28-29 leaders’ summit before acting on many of them. But waiting till then may be too late. It’s also worth noting that Germany is gaining immensely from the current crisis via the lower euro and a collapse in its borrowing costs (to zero for two year bonds!). Ultimately Europe will move to stabilise things, but unfortunately we may have to get closer to the brink before this occurs.
• However, its not just Europe that’s a worry but also the mounting evidence of another soft patch in the US. While data for US house prices rose, pending home sales fell, weekly mortgage applications fells, consumer confidence fell, the ISM manufacturing index slowed, weekly retail sales fell, labour market indicators were softer than expected and March quarter GDP growth was revised down from 2.2% to 1.9%. A slowdown in US jobs growth for the third month in a row and a rise in unemployment is particularly concerning. QE3 here we come.

Major global economic releases and implications

• There was some good German retail sales and jobs data but the overall picture in the Europe is bleak. Business confidence fell, unemployment is 11%, lending is weakening and Spanish retail sales are down 10%.
• Japanese economic data was mostly soft with higher unemployment, soft retail sales, a fall in small business confidence and soft industrial production. But there were some positives with a manufacturing business conditions indicator unchanged in May and gains in construction orders and housing starts.
• Xinhua said the China will not roll out another massive GFC style stimulus plan. But why should it? The Chinese economy is not as weak as it was back then and the RMB4 trillion GFC stimulus plan was overkill. That said we are still likely to see significant stimulus ahead with maybe a RMB2 trillion fiscal stimulus and more monetary easing. A fall back in China’s manufacturing PMI for May has confirmed the slowing in China’s economy already evident in other indicators and house prices fell for the ninth month. Expectations for policy easing partly explain why Chinese A shares only fell 1% last month versus a 7.5% fall in global shares.
• Adding to global gloom, March quarter Indian GDP growth slowed to 5.3% and Brazilian GDP growth slowed to 0.7%. Brazil cut official short term interest rates by 0.5%, taking them to a record low of 8.5%.

Australian economic releases and implications

• Australian economic data was consistent with sub-par economic growth. Construction activity and business investment rose more than expected in the March quarter. However, the surge in construction and investment is being driven by mining related activity in WA with everything else pretty weak. Other indicators were all soft. New home sales bounced in April but this wasn’t enough to reverse the previous month’s slide.
• Meanwhile, retail sales and building approvals fell in April, private credit growth remains soft, AIG’s manufacturing PMI fell further in May and house prices fell 1.4% May according to RP Data/Rismark resuming their slide after a couple of months of stability. So the overall picture is one that is very lopsided in its dependence on the mining sector, but with the rest of the economy really struggling.

Major market moves

• After a bounce into the early part of the week, share markets resumed their slide as worries about Europe intensified and economic data in the US, China, India and elsewhere deteriorated. The slide accelerated after US payroll growth for May came in at less than half expectations and unemployment rose.
• Worries about global growth also weighed on commodity prices and this combined with soft Australian data saw the $A fall further. Gold gained though on increasing expectations for US quantitative easing.
• Safe haven demand saw sovereign bond yields in perceived safe countries continue their slide pushing Australian ten year bond yields down to record lows. The collapse in Australian bond yields has been driven by expectations for RBA rate cuts and global investors taking advantage of relatively high yields in Australia.

What to watch over the week ahead?

• In the US, expect a slight fall in the non-manufacturing ISM business conditions index for May (due Tuesday). The Fed’s Beige Book of anecdotal evidence along with productivity data will also be released.
• On Wednesday the European Central Bank should and hopefully will cut its official short term interest rate to 0.75% from 1% as it is increasingly clear that recession in the Euro-zone will be far deeper than ECB forecasts allow for. The Bank of England may announce more quantitative easing when it meets on Thursday.
• Chinese data for industrial production, investment, retail sales and trade due Friday will be watched nervously to see whether the slowdown evident in April has intensified. Fortunately, Chinese inflation is expected to fall further to 3.2% from 3.4%, providing scope for a likely imminent and significant policy easing.
• In Australia, our view is that the RBA should and will cut rates by another 0.5% on Tuesday as conditions have worsened substantially since the last Board meeting and the RBA needs to be bold to get ahead of the worsening outlook in order to bolster the economy. Europe is threatening to implode, China is slowing more than expected – a fact acknowledged by Governor Stevens – and this is taking the edge off the mining boom and the non-mining economy is struggling very badly. And of course the inflation outlook remains benign. But whether it’s this month or next, the cash rate will go lower, ultimately falling to around 2.75% by year end. Bank mortgage rates at around 7% are only just below their long term average of 7.25%, but probably need to fall closer to 6%.
• March quarter GDP is expected to confirm Australian growth remains below trend. While the annual growth rate is expected to bounce up to 3.2% as last year’s flood impact drops out, quarterly growth is expected to be just 0.5% as a detraction from net exports offsets strong retail sales volumes and business investment.
• Expect Australian labour force data due Thursday to show a 20,000 contraction in employment after two surprisingly hard to explain strong months and a rise in unemployment to 5.2%. Housing finance (Friday) is likely to have remained soft in April and the April trade balance (also Friday) is likely to show another deficit.

Outlook for markets

• I have been looking for a 5-10% correction in shares which we have now seen, but shares look like they will still fall further over the next few months as worries about a break up in the euro and Spanish banks continue with Euro-zone policy makers continuing to fiddle, made worse by slowdowns in China and the US.
• However, shares are likely to be higher by year end. Shares are very cheap relative to bonds, cash and term deposits and we are likely to see another round of monetary easing in the US and Europe and significant policy stimulus in China which will add liquidity to financial markets and boost confidence that global growth will continue. More rate cuts from the RBA are also likely to help boost the Australian share market into year end.
• Bond yields in major countries are now at record lows suggesting very poor medium term bond returns. The Australian ten year bond yield of just 2.77% is the return an investor will get if they buy and hold such a bond to maturity. That might be fine if Australia slips into Japanese style deflation, but it’s hard to see the RBA allowing this. If the RBA is successful and achieves its inflation target of 2-3% pa over the next decade, then a 2.77% ten year bond yield implies little or no real return.
• The correction in the $A may see it fall to around $US0.95 in the short term, reflecting worries about the global growth outlook. However, it’s likely to receive a boost during the second half of the year as global central banks, led by the Fed, undertake further monetary easing.

4 June 2012

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