The past week has seen investment markets remain in “risk off” mode as the “wall of worry” remained in sharp focus.
- The main concerns have been the US fiscal cliff, delays in finalising the latest bailout payment for Greece, poor data in Europe generally and geo-political risk in the Middle East following Israeli strikes on Gaza.
- Our assessment remains that there will ultimately be a compromise enabling the US fiscal cliff to be averted – the Republicans won’t want to be blamed for causing a recession and Obama is likely to compromise such that his last term is not remembered for recession but rather putting the budget on a more sustainable path. While fiscal cliff talks between President Obama, Republican House Speaker John Boehner and others appear to have been constructive, helping drive a small bounce back in US shares on Friday, negotiations could go on for weeks and there will be a lot of tension along the way as both Republicans and Democrats stake out negotiating positions. Note that the pressure on US shares is not coming just from worries about the impact of the fiscal cliff on growth and earnings but also from “tax harvesting” as investors sell shares with capital gains ahead of a possible rise in the tax rate on capital gains from 15% to 20%.
- Concerns about Greece and Spain caused some consternation over the past week, as Euro-zone finance ministers and the IMF are yet to agree on how to finance an extension to Greece’s deficit reduction program and the European Commission noted Spain may miss its deficit targets. But this seems to be more of a case of trying to find negatives amid positive news. On both counts the EU seems to be relaxing its austerity push granting Greece an extra two years to reduce its budget deficit to 2% of GDP and the European Commission saying Spain doesn’t need to add to its austerity and would be eligible for a credit line, effectively implying that if Spain applies for help it won’t have to face additional austerity.
- China’s new leadership team to take over in March next year, headed by Xi Linping as President and Li Keqiang as Premier, contained no great surprises. Both have played key roles under the existing leadership so abrupt policy changes are unlikely. Rather they are likely to continue the gradual reform process towards a greater reliance on market forces, improving the provision of social welfare and health and tackling corruption seen over the last decade.
Major global economic releases and implications
- US economic data was messy. Retail sales, industrial production and business conditions in the Philadelphia region fell and jobless claims rose sharply with Hurricane Sandy likely playing a big role. For example, the Fed estimates that Sandy cut production by 1% in October. This is quite clearly confusing interpretations of the US economy. If the post Katrina experience is any guide, jobless claims will stay high for another week then fall sharply. On the positive side, weekly chain store sales rose suggesting little lasting impact from Hurricane Sandy, small business optimism rose slightly in October, weekly mortgage applications rose very strongly and mortgage foreclosures continued to fall in the September quarter. The overall impression is that the US economy continues to grow, but while September quarter GDP growth looks like being revised to a 3% pace, December quarter growth looks to have slowed back to around 2% or less. Meanwhile, inflation data pointed to receding inflation pressures suggesting that there is plenty of scope to replace Operation Twist when it ends in December with more quantitative easing focussed on buying government bonds (probably around $US45bn a month) as an expansion to the existing open ended quantitative easing (QE3) program, bring it to a total of $US85bn a month.
- European economic data remained poor with a modest 0.1% fall in September quarter GDP as growth in Germany and France partly offset falls in Italy and Spain. A sharp fall in industrial production in September, particularly in Portugal and Ireland, suggests a worse decline in December quarter GDP. Quite clearly the recession in Europe continues with further monetary easing by the ECB urgently required.
> The news out of Japan was no better with GDP contracting in the September quarter, likely signalling yet another recession, after having a brief recovery from last year’s earthquake. An election has also been called for December 16 which will likely see the Liberal Democratic Party returned to power. While the LDP is likely to put more pressure on the Bank of Japan to ease, its track record prior to 2009 wasn’t particularly impressive.
Australian economic releases and implications
- Australian economic data was confusing with a solid gain in consumer confidence in November and a rise in housing finance suggesting that interest rate cuts over the past year are starting to get traction, but a slump in business conditions to a three year low according to the NAB business survey suggesting they aren’t. The big picture remains that retail sales and housing indicators are running well below where they would normally be this far into an easing cycle suggesting that household caution remains. As such we remain of the view that the RBA will need to cut interest rates further, but admit to being a little concerned that the bounce in consumer confidence may be taken by the RBA as bolstering the case to remain on hold. Benign wages growth in the September quarter supports the view that inflationary pressures are no barrier to further rate cuts.
Major market moves
- Global shares continued to slide over the past week on the back of fiscal cliff worries, soft economic data, worries about Europe and concerns about Middle East tensions involving Israel. After proving relatively resilient initially Australian shares also fell sharply perhaps playing catch up not helped by ongoing profit warnings in Australia and concerns about the Australian economy. Japanese shares bucked the trend though and managed to rise at the prospect of a change of Government next month putting pressure on the BoJ to ease more aggressively. Since their high points in the last two months shares are down 7.5% in the US, 6% in Europe and 3% in Asia. Australian shares are down 5%.
- Oil prices rose on tensions involving Israel and base metals also rose slightly. The $A slid as it resumed its normal positive correlation with shares and October data appeared to indicate more passive intervention by the RBA to keep the $A down. Bucking its normal role as a safe haven the Yen weakened sharply as the market starts to factor in a new LDP Government which is calling for unlimited BoJ monetary easing.
What to watch over the week ahead?
- In the US, expect the NAHB home builders conditions index (Monday) to take a pause after several months of gains, flat existing home sales (Monday) and a fall back in housing starts and permits (Tuesday) after strong gains. The Markit manufacturing conditions index and consumer sentiment data will also be released Wednesday. Hurricane Sandy may play a role in depressing all US data released over the week ahead.
- On Tuesday Euro-zone finance ministers will meet again to discuss how they will finance the two year extension they have provided to Greece, which is estimated to cost €32bn. Odds are they will eventually work it out – otherwise they wouldn’t have already told Greece it has another two years. Euro-zone business conditions PMIs (Thursday) are likely to have remained soft in November and may even have deteriorated slightly.
- HSBC’s flash China business conditions PMIs (Thursday) will be watched closely for a further improvement having increased over the last few months.
- The Bank of Japan meets Tuesday and should be ramping up its quantitative easing program dramatically, but this seems unlikely, at least until there is a change of Government next month.
- In Australia, it will be a quiet week on the data front, but the minutes from the RBA’s last interest rate setting meeting (Tuesday) will likely confirm that the Bank still retains a mild easing bias. A speech by Governor Stevens (also Tuesday) will be watched closely for any clues regarding the outlook for interest rates.
Outlook for markets
- The correction in share markets may still have further to run. The fiscal cliff probably won’t be resolved until December, current issues around Greece and Spain will likely linger and the latest geopolitical tensions around Israel could last a few weeks.
- However, we remain of the view that the broad rising trend in shares is likely to resume by year end. Shares remain cheap, monetary conditions are ultra easy and a slight pick-up in global growth on the back of easing by the Fed, a likely solution to the US fiscal cliff, the ECB’s bond-buying program and improving momentum in China should support profit growth in 2013. Australian shares are being given an added impetus by lower RBA interest rate which should help boost profit growth in 2013. As a result we see gains in share markets by year end and through 2013.
- While sovereign bonds in safe countries are yet again proving their worth as a good diversifier, bond yields are very low and point to low medium-term bond returns. Corporate debt is a better proposition for those after income.
- The outlook for the Australian dollar remains messy. Uncertainties regarding global growth and ongoing RBA rate cuts are negatives. But quantitative easing in the US (QE3), central bank buying and prospects for improved global growth are positives. The likely outcome is for a US$0.95 to US$1.10 range, with the risk on the downside.