Weekly economic and market update

The past week has seen reasonable gains in share markets despite fiscal cliff worries as economic data has generally been supportive. December is normally a strong month for shares but most of the Santa Claus rally normally comes around Christmas/New Year.  There are four things of note for investors from the past week.

1. Firstly, while the risks are high there seems to be some progress towards resolving the fiscal cliff. Quite clearly both sides at present are focussing on resolving the need for a longer term reduction in the US budget deficit along with reducing the size of next year’s fiscal cutback. What has been proposed so far by the Democrats (with $2 trillion in savings over ten years split between $0.4trn in spending cuts and $1.6trn in extra revenue) and the Republicans (with $1.4trn in spending cuts and $0.8trn in extra revenue) are ambit claims. The two sides will need to get closer for a deal to occur. On this front Obama seems to be winning the publicity war in convincing Americans of the need for “balance”, so if access to entitlements is to be cut as Republicans demand then tax rates for the wealthy will have to rise too. President Obama has indicated he’s ready to make concessions on entitlements and some Republicans including House Leader Boehner have at various times implied they may accept some increase in the top marginal tax rate, between say the 35% current rate and the 39.6% rate scheduled for next year. Apparently President Obama and Boehner are having regular phone calls on the issue which is a positive sign. But obviously a lot will need to be done in the next week. I would put the probabilities at: 30% chance of no deal by Christmas, 30% chance of a short term fix and 40% probability of a comprehensive deal covering both the cliff and the debt ceiling.
2. Secondly, it’s interesting to see how European shares have started to outperform US shares. While the worries in Europe are still high, they are starting to diminish a bit following ECB action, political moves to more Europe/not less and a more relaxed stance to fiscal austerity including more help for Greece. In the meantime European shares are much cheaper than US shares with forward PEs at a 20% or discount. 
3. Thirdly, Chinese shares may have seen their lows. While there have been numerous false starts and the 4.1% bounce over the past week may just be another one, its worth noting that Chinese shares are amongst the cheapest in the world at a time when economic data out of China is showing signs of bottoming.
4. Finally, in Australia the pressure on investors to look beyond bank term deposits is becoming intense. The RBA cut rates again over the last week and with the mining investment boom rapidly deflating and non-mining activity looking very subdued at a time when the $A remains high and fiscal policy is tightening, further rate cuts will be necessary, ultimately pushing the cash rate down to 2.5% during the first half of 2013. This will likely push average bank term deposit rates below 4%, which is well down from the 6 to 8% of a couple of years ago. Corporate debt, commercial property and infrastructure (both listed and unlisted) and shares with decent yields are all offering much higher yields than bank term deposits now and are all likely to be beneficiaries of lower interest rates. In terms of shares generally it should be noted that the Australian share market’s relative underperformance started in late 2009 soon after the RBA commenced raising rates. The unwinding of past rate hikes is going a long way to help improve its relative fortunes.

Major global economic events and implications

• US economic data was mostly okay. While the manufacturing ISM fell in November, the alternative Markit manufacturing PMI actually rose slightly, the non-manufacturing ISM rose, construction spending rose in October with residential construction up 19% year on year, auto sales were very strong in November, weekly jobless claims have fallen back to pre Sandy levels and payroll employment was stronger than expected in November. Overall growth in the US looks to be continuing, but the does appear to have slowed a bit in the December quarter.
• Final November business conditions PMIs in Europe remained consistent with recession but in aggregate were up on October and preliminary readings. German factory orders also rose strongly The ECB meeting left rates on hold despite revising down its growth forecasts for next year but it does seem to have left the door open to providing more stimulus.
• Chinese house prices and non-manufacturing business conditions both rose in November adding to evidence that Chinese growth has bottomed.
• There was also good news across Asia with Korean exports up 4 months in a row and India’s manufacturing PMI rising in November.

Australian economic events and implications

• Australian economic data was mostly weak. September quarter GDP growth was 0.5%, with half of that due to inventory accumulation; profits and wages fell in the September quarter; the terms of trade fell a further 4% in the September quarter leaving it down 14% from last year’s high resulting in a sharp slowdown in nominal GDP growth; retail sales and building approvals both fell in October; house prices were flat in November; the trade deficit blew out to a four and a half year high in October; and while employment surprisingly rose and unemployment fell in November the slowdown in the economy and a further fall in ANZ’s job ads series points to rising unemployment ahead.
• While the RBA’s latest monetary easing has taken the cash rate back to GFC lows its worth bearing in mind that overall policy conditions are nowhere near as easy as they were at the time of the GFC. Bank lending rates are 0.7% or so higher, the $A is 45% higher and fiscal policy is taking 2-3% of GDP out of the economy compared to a 4% of GDP stimulus back then. The RBA now appears to be finally recognising that the “normal” level of bank lending rates may now be lower than simple historic averages would suggest which in turn suggests they are realising that monetary policy is not as easy as they had been thinking. Too right.
• Finally, it’s good to see that the Federal Government is looking at ditching its surplus commitment for this year as slower GDP growth and softer commodity prices decimate nominal growth in the economy. The Budget deficit will still be heading in the right direction, but further fiscal austerity could risk being self defeating.

Major market moves

• Global shares rose further over the last week helped by reasonable economic data. Chinese shares rose 4.1%. Australian shares were up another 1% helped along by the latest rate cut from the RBA.
• While commodity prices were mixed, the $A defied normal logic and rose.

What to watch over the week ahead?

• In the US, apart from negotiations around the fiscal cliff, the key focus will be on the Federal Reserve (Wednesday) which is expected to replace Operation Twist with $US45 million or so of monthly long term bond purchases financed by printed money, ie more quantitative easing. On the data front, expect a small bounce in November retail sales (Thursday) after October’s fall, benign readings for inflation (Friday), a slight rise in industrial production and a reading for the Markit business conditions PMI for December around 52. Trade data will also be released.
• In the Euro zone, an EU leaders’ summit will be watched for progress towards a banking union. Advance readings for business conditions PMIs (Friday) are expected to continue to show the recession remains mild.
• In China, trade data for November (Monday) is expected to show a slight slowing in export growth but remaining well up from recent lows.
• In Australia, expect the modest uptrend in housing finance (Monday) to continue, the NAB business survey (Tuesday) to show that business conditions and confidence remain subdued and consumer sentiment (Wednesday) to show a modest further improvement on the back of the latest cut in interest rates. A speech by RBA Governor Stevens (Wednesday) is expected to indicate that the RBA retains an easing bias.

Outlook for markets

• Although fiscal cliff uncertainties may intensify in the week ahead as the deadline for a solution approaches our assessment is that shares are likely to see their normal seasonal strength into 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 rates which should help boost profit growth in 2013. As a result we see further gains in share markets by year end and through 2013.
• Sovereign bonds in safe countries are a good diversifier most of the time, but bond yields are very low and point to low medium-term bond returns.
• 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.