The past week has been dominated by the European Union leaders’
summit, with Germany insisting that centralised controls of budgets and banking be in place before agreeing to any form of common funding or a Euro-zone wide banking guarantee, but Italy, Spain and, their new ally, France insisting it should be the other way around. In the event, while Euro-zone leaders made no progress on a fiscal union, they have agreed to a move to centralised Euro-zone supervision of banks, with proposals to be considered by year end, and more importantly agreed to open up the use of its bailout funds and agreed on a growth pact worth €120bn. While the agreed growth pact may actually have little impact, the announcements in relation to the use of the Euro-zone bailout funds are very positive.

• The key changes are that bailout funds provided to Spain for its banks will not have preferred credit status (which should help boost investor interest in Spanish bonds), that banks may be recapitalised directly from the ESM bailout fund once a single supervisory arrangement for banks is in place (which means that any funds provided to a country’s banks won’t boost that country’s public debt) and that the bailout funds can be used to buy bonds in countries, such as Spain and Italy, as long as such countries are respecting their deficit reduction timelines. The opening up of the use of the bailout funds is very positive and should help reduce Spanish and Italian bond yields. In fact Spanish ten year bond yields fell 60 basis points in response to the news.
• An obvious concern is that the €500bn left in the combined EFSF and ESM bailout funds (or €400bn after allowing for money earmarked for Spanish banks) will not be enough to “bailout” both Spain and Italy (whether its via a direct bailout or bond purchases) and that Europe is still no closer to a fiscal union and common debt issuance. In this sense the summit is just another example of muddling through. But the outcome is arguably far more positive than investors had expected – with some even talking about some sort of bust up – and the moves
  regarding the use of the bailout funds, if implemented quickly, should keep Europe from going over the abyss into a deep recession and full blown financial crisis rivalling the GFC that many feared it was sinking into.
• The past financial year has been very disappointing with Australian shares down around 11% and global shares down around 6% as worries about Europe and global growth generally weighed in the September quarter last year only to return in the June quarter this year and Australian shares were additionally hit by the impact of relatively high interest rates which have kept investors in cash and depressed spending and profits, the strong $A which has weighed on companies that compete internationally and worries about a hard landing in China which has weighed on commodity prices and resources stocks. Resources shares have been the worst performers along with IT and consumer discretionary stocks whereas defensive sectors like telcos, utilities and health performed strongly. While earnings downgrades are set to continue in Australia for the next few months, the shift to lower interest rates in Australia and easing in China should help improve the relative performance of Australian shares over the next 12 months.

Major global economic releases and implications

• US economic data was reasonable. Good gains in home sales and another rise in house prices add to the evidence that the US housing sector has bottomed and is starting to recover. Durable goods orders also rose in May, but consumer confidence slipped. Regional business surveys were mixed – up in the Texas, Chicago and Milwaukee regions but down in the Richmond and Kansas regions. It’s worth noting falls in mortgage rates and gasoline prices have helped spur in the past and we have now seen sharp falls in both recently.
• European data was soft with falls in economic sentiment, albeit not by as much as feared, and falls in German, Italian and Spanish retail sales. German and French consumer sentiment readings were little changed.
• Japanese economic data was mixed, consistent with underlying growth running around 1%. Industrial production fell sharply in May and small business confidence fell, but household spending was solid and the jobless rate fell slightly. Meanwhile, price deflation continues highlighting that the Bank of Japan has little chance of meeting its 1% inflation objective unless it pumps in a lot more monetary stimulus.
• In China, a leading economic indicator rose again in May, contradicting soft readings from other indicators.

Australian economic releases and implications

• Australian economic data remained soft with new home sales staying depressed, job vacancies falling and credit growth remaining subdued. While private credit growth improved a notch this was all due to business credit which may reflect a switch from internal to bank funding, with annual growth in housing credit falling to its lowest since records began in 1977. That we have yet to see any impact on timely indicators like consumer sentiment and auction clearance rates from interest rate cuts so far demonstrates how subdued and cautious Australian households are and supports our view that further interest rate cuts will be required.

Major market moves

• Share markets were little changed in the run-up to the EU leaders’ summit, but then bounced sharply on news that the summit had agreed to a more flexible and aggressive use of bailout funds in terms of recapitalising banks and stabilising bond markets in troubled countries. As a result share markets saw strong gains on Friday, resulting in solid gains over the last week.
• Commodity prices were also boosted by the outcome of the EU summit, with strong gains in oil and metal prices. The Australian dollar also rose strongly on the news out of Europe, as did the euro.
• Bond yields were mixed in the US and Australia but Spanish bond yields fell sharply on the EU summit news.

What to watch over the week ahead?

• The week ahead will no doubt see further reaction to the outcome of the EU leaders’ summit, but with the focus now likely to shift to the ECB meeting on Thursday. The deterioration in the European economic outlook is likely to see the ECB cut its official interest rate by 0.25% taking it to 0.75% and some reduction in the deposit rate it pays to banks (currently 0.25%) to encourage them to lend.
• In the US, regional surveys point to a fall in the key ISM manufacturing conditions index (Monday) to 51 from 53.5 in May and payroll employment (Friday) is expected to rise by a subdued 90,000 leaving unemployment at 8.2%. Construction activity is also likely to be soft and the ISM non-manufacturing index (Thursday) is also likely to fall slightly. The bottom line is that the US soft patch is likely to continue for a bit longer.
• In the UK the Bank of England is expected to announce more quantitative easing on Thursday.
• In Australia, it’s a big week with the carbon and mining taxes commencing and the RBA meeting on Tuesday. The mining tax should be well and truly factored into investor expectations and for most households the commencement of the carbon tax will initially feel like a bit of a non-event as most consumer prices will be little affected. Average price levels are expected to rise by just 0.7%, but most of this will occur via higher electricity prices so the real shock won’t come until the next power bill which will rise sharply in most states led by NSW where electricity prices are set to rise by 18%, 8% of which is due to the carbon tax. Meanwhile household spending power should see a decent boost thanks to carbon tax compensation, July 1 tax cuts, the school kid bonus and the ending of the flood levy. That said the boost will be less than seen through the GFC.
• On the interest rate front we expect the RBA to leave rates on hold on the grounds that after the last rate cut GDP and employment data surprised on the upside and after cutting two months in a row it would prefer to wait and see what the impact has been. However, we remain of the view that further rate cuts lie ahead thanks to combination of global weakness, soft commodity prices, weakness outside the mining sector, benign inflation and still high borrowing rates at a time when households and businesses are feeling cautious about spending. Rate cuts are likely to resume in August and by year end we see the cash rate at 2.75%.
• On the data front in Australia, expect a bit of a bounce back in building approvals (Tuesday) following a sharp fall in April and continued soft retail sales (Wednesday).

Outlook for markets

• Shares are likely to remain volatile in the short term on the back of worries about the growth outlook, but with a lot of bad news already factored in as indicated by attractive valuations and Europe starting to move in the right direction they stand to benefit if policy makers undertake more policy stimulus and/or the economic news becomes a little less bad. As such, while the short term outlook is uncertain we remain of the view that share markets will be higher by year end.
• While sovereign bonds in safe countries are a good diversifier, bond yields in major countries around record lows suggest very low medium term bond returns.
• The Australian dollar remains vulnerable in the short term, reflecting worries about the global growth outlook. However, it is likely to receive a boost during the second half of the year as global central banks undertake further monetary easing.

2 July 2012

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