Uncertainty continues regarding Spain and Greece.
- Spain is resisting applying for assistance for several reasons, including national pride, upcoming regional elections and the fact that 2 year borrowing costs remain affordable below 4%. Our view remains though that ultimately Spain will have no choice but to apply for help, but that uncertainty may continue for a few weeks till it does. Similarly uncertainty remains regarding Greece with ongoing differences regarding required austerity cuts and the IMF making it clear that for it to give Greece any more funds the EU may need to take a hit on its existing loans to Greece. Again, ultimately agreement is likely to be reached on both sides given the lack of interest in letting a Greek exit derail progress in Europe more generally, but in the short term there is a risk of another bout of market worries about Greece.
- In Australia, there were no surprises with the RBA taking the cash rate to 3.25% from 3.5% citing a softening global outlook, uncertainty regarding China, the need to boost non-mining demand, low inflation and the strength in the $A. The need to boost the non-mining sectors of the economy as the mining boom fades at a time when the $A remains strong and fiscal cutbacks are intensifying means the RBA will have to cut rates further.
- Post GFC caution has likely resulted in a reduction in the neutral level for bank lending rates, such that they are only just now starting to become stimulatory. Our assessment remains that standard variable mortgage rates will need to fall to around 6% (from an average of around 6.62% after the RBA’s latest rate cut), which implies that the official cash rate will need to fall to 2.5% (assuming banks continue to pass on about 80% of RBA cuts).
- We expect this to occur over the next six months, with the RBA cutting again next month by another 0.25%.
- But will rate cuts work? So far the rate cuts since last November haven’t had much impact because they haven’t come down enough to offset negatives such as job insecurity, they are only now starting to fall below neutral levels and the lags with monetary policy are long and variable. But there is no reason not to expect a positive impact over the next year. The reduction in mortgage rates that has already occurred over the last year has already reduced the interest bill on a $300,000 mortgage by roughly $2500 pa. If mortgage rates fall to 6% as expected then this saving will rise to $4500 pa. Some of this will likely be spent. The improvement in housing affordability that flows from lower mortgage rates will likely also encourage a pick up in housing construction after a long period of under building. And to the extent that lower rates take pressure off the $A it will help manufacturing, tourism, miners, farmers and retailers.
Major global economic releases and implications
- US economic data was positive with both the ISM business conditions indexes rising, payroll employment growth remaining moderate but a strong gain in a household survey of employment seeing unemployment fall to 7.8%, auto sales rising, consumer credit rising more than expected, new weekly mortgage applications rising solidly and mortgage refinancing applications soaring. In fact, the impact of QE3 can already be seen in a collapse in 30 year mortgage rates to a record low of just 3.38% which in turn is driving the surge in mortgage refinancing. This is likely to provide a big tailwind to consumer spending. Another tailwind is coming in the form of a 15 year high in US oil production which is helping keep oil prices down in the face of Middle East tensions.
- Final Euro-zone business conditions PMIs for September came in slightly better than initially reported and continue to point to a mild as opposed to a deep recession. The ECB meeting and President Draghi’s subsequent press conference offered nothing new with interest rates remaining unchanged (not that a cut will have much impact anyway as they are already effectively zero) and Draghi reiterating that having set up its bond buying program its now in the hands of governments (ie Spain to apply for help and commit to a reform program).
- The Bank of England also announced nothing new, with the focus now shifting to its November meeting where its existing, but due to expire, quantitative easing program is likely to be extended in the face of soft economic data.
- China’s non-manufacturing PMI index fell, but it remains reasonably high. November 8 has been set for the National Congress to resolve the leadership transition, so at least the leadership uncertainty will soon be over.
- Japanese data was soft with another fall in the Tankan survey for September. The Bank of Japan announced no further changes to monetary policy. More easing is likely though as Japan’s economy has weakened significantly.
- Korean exports surprised on the upside in September rising two months in a row. Maybe too early to get too excited but a positive sign nonetheless.
Australian economic releases and implications
- Australian economic data was generally soft, pointing to more interest rate cuts ahead. While house prices rose strongly in September according to RP Data/Rismark other housing related indicators remain weak with new home sales falling to a 15 year low in August. Building approvals rose solidly in August but this was all due to approvals for volatile multi-dwelling buildings with private house approvals falling. Retail sales rose by less than expected in August with annual growth remaining in the same mediocre range it has been in for the last three years. Business conditions indicators for manufacturing, services and construction all weakened and the trade deficit deteriorated further in August highlighting the slump in export earnings. Meanwhile the TD Securities Inflation Gauge rose slightly in September and continues to suggest only a modest flow through of the carbon tax.
Major market moves
- Share markets mostly rose as US economic data was better than expected. Uncertainly regarding Spain and Greece limited gains though. Chinese shares were closed for Golden Week national holidays.
- Australian shares rose 2.4% over the past week reaching their highest since August last year, helped along by the RBA’s latest rate cut with consumer and financial stocks leading the gains, and defensives such as health and telcos lagging.
- Commodity prices were mixed with the oil price down on increased US oil production, but gold and metal prices seeing gains. The $A fell in response to the RBA’s rate cut and the fall in the US unemployment rate.
What to watch over the week ahead? - In the US the trade deficit for August (due Thursday) is expected to have deteriorated slightly, producer price inflation (Friday) is expected to remain benign on an underlying basis and consumer confidence (also Friday) is expected to fall slightly. The Fed’s Beige Book of anecdotal evidence will also be released Wednesday.
- The third quarter profit reporting season will kick off with Alcoa reporting on Tuesday. The analyst consensus expects a 0.6% rise in earnings over the year to the September quarter, but with profit downgrades to upgrades running at 4 to 1 actual results are likely to surprise on the upside.
- In Europe finance ministers meet on Monday and Tuesday, but are unlikely to come to any major decisions regarding Greece, banking supervision, etc which will likely await the leaders’ summit on October 18 and 19.
- Chinese economic data for September is expected to show at least a stabilisation in growth. New bank loans are expected to have remained strong and trade data (Saturday) is expected to show a slight improvement in both export and imports.
- On Thursday the Bank of Korea is expected to cut interest rates again reflecting recent soft data.
- In Australia expect business conditions and confidence in the NAB survey (Tuesday) to remain subdued, but consumer sentiment (Wednesday) to show a small bounce on the RBA’s latest rate cut. Employment is expected to have declined by 5000 in September (Thursday) resulting in a rise in unemployment to 5.3%. A speech by RBA Deputy Governor Lowe on Tuesday will be watched closely for any clues regarding interest rates.
Outlook for markets
- Global shares have been undergoing a consolidation after strong gains in the September quarter. Given uncertainties regarding Spain, Greece and China this may have a bit further to run. However, the broad rising trend is likely to remain intact. A pick up in global growth by year end and going into next year on the back of easing by the Fed, the ECB’s bond buying program and more decisive stimulus action in China once its leadership transition is resolved next month should support profit growth in 2013. Australian shares are now being given an added impetus by the resumption of RBA interest rate cuts. With shares remaining cheap, particularly against government and corporate bonds, we see further gains into year end. If there are any set backs in the weeks ahead they should be seen as a good buying opportunity.
- While sovereign bonds in safe countries are a good diversifier, bond yields in major countries remain very low and point to 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 short term outlook for the $A is messy. US QE3, foreign central bank buying and prospects for improved global growth and higher commodity prices into next year are positive. But against this, uncertainties regarding China, soft bulk commodity prices and ongoing RBA rate cuts are negatives. The likely outcome is for a volatile range of between $US0.95 to $US1.10, with the risk on the downside. We have probably seen the best for the $A.