Weekly economic and market update

Chinese December quarter GDP data confirmed the message from months of partial economic indicators: Chinese economic growth has bottomed, forget about a hard landing!

• GDP growth came in at 7.9% year on year, which was stronger than expected and well up from the low in the September quarter of 7.4%. December data provided the same message with growth in industrial production at 10.3% year on year up for the fourth month in a row, growth in retail sales at 15.2% year on year accelerating for the fifth month in a row and growth in fixed asset investment remaining strong at 20.6%. While we don’t expect a return to double digit growth, the pick up in China’s growth rate is good news for global growth and good news for Australia and resources stocks.
• The reawakening of Japan after a 20 year period of stop go recession and deflation is shaping up as a major issue for 2013. New Japanese PM Abe’s comments that he will seek a bold policy leader for the Bank of Japan and that the economy is not going to change “unless we display a firm commitment to escape deflation” underlines the fundamental change in policy making now taking place in Japan. If, as appears increasingly to be the case, Japan is serious and embarks on a path of monetary reflation intent on exiting deflation it has a number of (mostly positive) implications for the global economy: the Japanese Yen is likely to fall further; Japanese shares are likely to outperform; further monetary easing in Japan will add to very easy global monetary conditions; the Japanese economy will no longer be a drag on global growth; and weakness in the Yen will put more pressure on competitor countries such as Korea and Taiwan to also adopt easier monetary conditions. As Australia’s second largest export market an exit from deflation in Japan would also be a positive for Australia, albeit more monetary easing in Japan will add to carry trade pressure boosting the $A.
• While it occurred while I was on leave, the relaxation and now phased implementation of the Basle liquidity requirements for banks is good news. The original requirements would have posed a major threat to global bank lending at a time when the global economy is still a bit fragile. Fortunately global central bankers have seen sense and have removed, yet again, another threat to the global economy.
• In the US, the debt ceiling is looming as a major issue with the Government having to prioritise commitments beyond mid February/early March unless it is raised. Fitch Ratings has warned that America’s AAA sovereign rating is at risk unless it raises the ceiling in time or if it fails to come up with long term deficit reduction measures this year. However, news that House Republicans will likely pass a three month extension to the debt ceiling is very positive to the extent that such a delay will allow time to hopefully resolve the fight over longer term budget savings and the sequester spending cuts due to occur on March 1. Its also worth noting that as with the fiscal cliff, everyone is talking about the debt ceiling issue and the brinkmanship that prevails in US politics is well known so unless things really go off the rails such that there will be no deal then the impact on markets may be less than feared.

Major global economic events and implications

• While the US debt ceiling and budget issues are now looming, most US data suggests that the US economy is motoring along pretty well. To be sure, soft readings over the past week for regional manufacturing conditions indicators were a disappointment.  However, retail sales growth remained solid in December despite the fiscal cliff worries at the time, housing related indicators remain strong with housing starts up a whopping 12% in December and a survey of home builders and rising weekly mortgage applications pointing to more strength ahead, growth in industrial production was reasonable in December, jobless claims fell sharply over the past week and the Fed’s Beige Book pointed to an improvement in economic activity. On top of this inflation remains benign suggesting no threat to the continuation of the Fed’s expansionary monetary policy.
• US December quarter earnings reports have been reasonable with around 66% of the 67 S&P 500 companies to have reported so far coming in better than expected.

Australian economic events and implications

• In Australia there was one bright note with car sales rising to a record high in December. Against this most other data releases were soft with weak readings for employment and unemployment, a further slump in job advertisements pointing to more labour market weakness ahead, consumer sentiment remaining sub-par in January, a sharp fall in December imports pointing to weak domestic demand and soft readings for housing finance in November leaving in place only a weak rising trend. Overall the Australian economy remains sub par, particularly so given that the RBA started cutting interest rates over a year ago.
• Fortunately, the TD/Melbourne Institute’s Inflation Gauge for December indicates that inflation remains benign suggesting plenty of flexibility for the RBA to cut interest rates further.

Major market moves

• Thanks to solid economic data, US shares rose 0.9% making it to a new post GFC high and are now just 5% below an all time high. This helped drive gains in European (up 0.3%), Japanese (up 1%) and Australian shares (up 1.3%). Chinese shares also pushed 3.3% higher, helped by solid December data.
• Commodity prices mostly rose on global growth optimism.
• The $A fell slightly with soft Australian economic data offsetting improving global confidence. More broadly though, the $A still seems to be stuck in a holding pattern.
• Bond yields fell slightly over the past week but with the broad trend remaining up as safe haven demand seems to be weakening in the face of more confidence regarding global growth.

What to watch over the next week?

• In the US, housing and manufacturing will be the key points of interest over the week ahead. December data for existing home sales (Tuesday) and new home sales (Friday) are likely to show that the US housing recovery remains on track. The Markit manufacturing conditions PMI (Wednesday) will also be watched for further signs of improvement in manufacturing.
• In the Euro-zone, business conditions PMIs for January (Thursday) will be watched for further evidence of stabilisation and improvement that has become evident in recent months’ readings.
• In Japan, all eyes will be on the Bank of Japan which meets Tuesday and is likely to lift its inflation “target” to 2% and possibly announce even more monetary stimulus, following intense pressure from the new Government. CPI data due Friday is likely to confirm that prices continued to deflate in December.
• In China, the HSBC flash manufacturing PMI ((Thursday) will be watched for further signs of improvement.
• In Australia, December quarter inflation data due Wednesday will be the key focus with a benign reading critical as to whether the RBA will cut interest rates again in the short term. After the carbon tax inspired boost to inflation in the September quarter, we expect inflation to have settled down again with headline inflation of 0.6% in the quarter or 2.6% year on year and core inflation of 0.6% in the quarter and 2.4% year on year. Falls in prices for food, clothing and health are expected to offset rises in prices for alcohol and tobacco, transport and holiday travel. With inflation likely to be in the middle of the RBA’s target range, this should leave plenty of scope for further rate cuts from the RBA in the months ahead. However, unless the underlying measures of inflation come in well below 2.4% year on year the RBA may well choose to do nothing at its February meeting, preferring instead to wait for more information as to how the economy is responding to recent rate cuts, particularly given the rebound in iron ore prices over the last two months.

Outlook for markets

• After 10% or so gains since mid November shares are a bit vulnerable to a short term correction, particularly as we go into US budget & debt ceiling negotiations and the Italian election in February. However, notwithstanding the risk of a short term correction, shares are likely to head much higher this year. The global growth outlook is improving led by China and the US and a fading of the Euro-zone crisis which should result in better momentum for profits. Global monetary conditions are ultra easy and getting even easier. Shares are likely to benefit from investors switching out of low yielding bonds. And share market valuations remain reasonable. Australian shares will also benefit from RBA rate cuts starting to drive a pick up in the cyclical parts of the economy. So notwithstanding the usual bumps along the way this all adds up to a positive backdrop for share markets. By year end we see the ASX 200 rising to around 5000.
• Sovereign bonds have been a great diversifier and a great investment in recent years but are now very vulnerable as the year ahead is likely to see a rising trend in bond yields as global economic growth improves which will result in capital losses for investors in sovereign bonds.
• The outlook for the Australian dollar remains messy. Softish Australian data and RBA rate cuts are negatives. But growing quantitative easing in the US and now Japan, central bank buying and prospects for improved global growth are positives. The likely outcome is for a $US0.95 to $US1.10 range.