The bad news earlier in the past week threatened to see a return to panic in Europe.
- Spain’s economy is now bearing down on various regional governments forcing them to seek support. The ECB, EU and IMF commenced a review of Greece amidst general expectations that it is way behind in terms of its bailout commitments. And even Germany is starting to look more and more vulnerable with deteriorating economic data and Moody’s putting its AAA sovereign rating on negative outlook. Against this backdrop, Spanish bond yields initially rose to new crisis highs, Italian bond yields also surged and the euro fell to its lowest since June 2010.
- However, the good news is that the bad news looks like it has been enough to galvanise the ECB into further action, with the backing of the German Government. ECB President Draghi’s strongly worded comments that the ECB is ready to do whatever it takes to defend the euro and then tying this to high sovereign bond yields in some countries and the impact of this in hampering monetary policy are very positive. It has always been within the power of the ECB to bring an end to the financial panic sweeping through Europe, which is preventing monetary policy from working properly, threatening to turn otherwise solvent countries insolvent, and threatening to blow the euro apart. President Draghi’s comments not only recognise this but also recognise that it’s within the ECB’s mandate to do something about it and that it has the power to be effective. Of course Draghi has to follow his words up with action. But on this front the signs are positive with German Chancellor Merkel committing with French President Hollande to do everything necessary to protect the euro, suggesting Draghi has Merkel’s support. What’s more Draghi looks to have a concrete plan to bring down Spanish and Italian bond yields involving both the EFSF bailout fund to buy bonds in the primary market and the ECB buying bonds in the secondary market. In this regard the ECB’s meeting on August 2 is key and will be watched very closely. We expect the ECB to formerly announce bond purchases following this meeting.
- At the same time its looking like the Fed is on the verge of another round of quantitative easing, with numerous Fed officials arguing the case for more stimulus. It’s a close call but this is likely to be announced following the Fed’s meeting on Wednesday. So with the Fed on Wednesday and the ECB on Thursday and both on the verge of more policy stimulus the next week is shaping up as pretty important. Let’s hope they deliver.
Major global economic releases and implications
- US economic data remains soft. As was widely expected GDP growth slowed to 1.5% annualised in the June quarter from 2% in the March quarter. Various manufacturing conditions indices fell further in July, home sales fell and core durable goods orders were weak. Jobless claims fell but this is distorted by seasonal problems. Meanwhile the evidence of a housing recovery continues to build with another gain in house prices in May.
- US earnings results saw a few misses and outlook downgrades, but on balance the results are still coming in better than feared, with 68% beating profit expectations and 63% beating on revenue so far.
- Euro-zone flash PMI business conditions readings were unchanged in July at levels consistent with a mild recession, but at least they haven’t got any worse. Perhaps the main concern though is that German indicators suggest it is sliding into recession as well – but this could be a blessing in disguise if it forces Euro-zone policy makers into more aggressive action. Across the channel the UK slid deeper into recession in the June quarter.
- There was some good news out of China with HSBC’s flash PMI manufacturing conditions index surprisingly rising in July and profit momentum improving in June. Reports of a massive stimulus package in Hunan province suggests stimulus spending may be ramping up.
Australian economic releases and implications
- Inflationary pressures remained benign in the June quarter with producer and consumer prices up just 0.5% and the annual increase in the CPI coming in well below target at 1.2%. More importantly the underlying measures of inflation are running around 2% or lower adding to the message that inflation is benign.
- Meanwhile, RBA Governor Stevens continued his efforts talking up confidence in the Australian economy with a speech titled The Lucky Country. Governor Steven’s relatively upbeat assessment highlighted a relaxed assessment of China, the lessening risk of a house price crash, the reduced funding vulnerability of Australian banks and significant scope to move on the policy front if need be. I can’t disagree with any of that and we are lucky. But it’s worth noting the RBA sounded pretty relaxed and comfortable earlier this year with many concluding that rate cuts were done only to see it cut again in May and June, so I would be cautious in reading too much into the Governor’s comments with respect to the outlook for interest rates.
- Our assessment remains that with sub-par confidence, Australian economic growth likely to disappoint and inflation remaining benign the cash rate will be cut further this year taking it to 3% or just below by year end. We have a 0.25% cut pencilled in for August, but admit that it’s a close call.
Major market moves
- Share markets sagged earlier in the week before getting a huge boost by ECB President Draghi’s commitment to do whatever it takes to preserve the euro and hopes for more easing from the Fed. This left US shares up 1.7% for the week, European shares up 0.6% and Australian shares up 0.3%. A year ago shares were crashing, now they are being supported by attractive valuations and stimulative global policy action.
- It was a similar ride for commodity prices and the $A. The prospect of more quantitative easing in the US is particularly positive for the $A which rose to $US1.0483 and is also receiving support as Australia is now one of only 7 countries globally with a safe AAA rating.
- Bond yields fell sharply in Spain and Italy on the back of President Draghi’s comments.
What to watch over the week ahead?
- Next week is a big one for central banks with the Fed, ECB and BoE all meeting. The outcome of the Fed’s meeting (Wednesday) will be watched very closely. We expect the Fed to announce further easing. Fed Chairman Ben Bernanke has repeatedly indicated that the Fed stands ready to do more if the US economy slows and there is little doubt that it has done just that with various other Fed officials indicating their support for more easing. This may well take the form of extending the commitment to keep interest rates down into 2015 and cutting the interest rate the Fed pays on bank deposits with it, but we also think that the Fed is now concerned enough about the economic outlook to take the plunge with another round of quantitative easing, ie QE3. If we are right and QE3 is announced it would mean a boost for shares, downwards pressure on the $US and more upwards pressure on the $A.
- On the data front in the US, the key ISM manufacturing conditions index (Wednesday) is expected to rise from 49.7 in June to 50.5 to be more consistent with the Markit PMI but payroll growth (Friday) is expected to have remained subdued with a 95,000 gain in jobs in July with unemployment remaining at 8.2%. Expect house price data (Tuesday) to show another modest rise and consumer confidence (also Tuesday) to be unchanged. The US June quarter profit reporting season will also continue with 119 S&P 500 companies reporting – the first few weeks are normally the most upbeat so expect more mixed results over the week ahead.
- In the Euro-zone, economic sentiment surveys and final PMI business conditions indicators for July are expected to remain consistent with a 1% contraction in economic activity this year. Given the deeper recession than expected by the ECB and ECB President Draghi’s recent comments, the ECB is likely to announce more policy action when it meets on Thursday to reduce bond yields in trouble countries.
- Following a slight rise in HSBC’s flash Chinese PMI for July the official PMI is expected to show a slight rise (Wednesday), adding to evidence that growth may be stabilising.
- In Australia, expect new home sales (Tuesday) to remain soft, a modest 0.3% rise in private credit (Tuesday), a sharp fall in building approvals (also Tuesday) after an aberrant 27.3% gain in May, a 0.5% fall in June quarter house prices (Wednesday), soft retail sales in June and a 0.5% rise in retail sales volumes in the June quarter (Wednesday) and another small trade deficit for June (also Wednesday).
Outlook for markets
- Shares are still somewhat vulnerable in the short term given the deteriorating economic outlook in Europe, the US slowdown and lingering worries about China. However, if the ECB and Fed follow up with more policy action, which we expect they will and hopefully in the next week, shares will surge higher as valuations are attractive and investors are very sceptical and bearish which is a good sign from a contrarian perspective. We remain of the view that shares 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. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
- The Australian dollar is likely to move higher by year end as global central banks undertake further monetary easing, commodity prices hold up and as central bank reserve diversification continues.
30 July 2012