• Good news included: flash manufacturing conditions PMIs rising in the world’s big 3 regions, ie China, Europe and the US; Japan adopting a 2% inflation target and open ended quantitative easing; an extension to America’s debt ceiling; & European banks set to pay back cheap ECB loans faster than expected providing more evidence the Euro-zone crisis is fading rapidly. This all further enhances the positive fundamental backdrop for investment markets so it’s no surprise shares had another good week.
• The Bank of Japan will likely have to do more when its new governor takes over in April, but with its 2% inflation target and open ended quantitative easing coming on top of its increased QE program for 2013 announced in December, its clearly on an aggressive reflationary path with the Government appearing to be looking for a fall in the Yen to at least ¥100 against the $US, from around ¥90 at present. Our assessment is that it will fall to around ¥105 by year end, with the boost to exporters and the Japanese economy generally likely to push the Japanese share market up 30% or so this year.
• Near term budget risk in the US has been substantially diminished by the 3 month extension of the debt ceiling leaving more time to resolve budget differences. In fact the bill authorising the extension withholds pay for Congress members unless a budget is passed by April 15. This is all very positive and reduces the risk of the US Government having to prioritise payments and the risk of more sovereign ratings downgrades.
• While the IMF downgraded its 2013 growth forecast to 3.5%, not much should be made of this. The move is trivial as the previous forecast was 3.6%, as always the IMF is lagging market expectations and in any case the IMF is still looking for growth to pick up in 2013 from 3.2% in 2012.
• The benign December quarter inflation reading in Australia leaves plenty of room for the RBA to cut interest rates further to stimulate growth in the face of the loss of momentum in mining investment. While a February rate cut is far from assured as the RBA may decide to take a raincheck in the face of the improvement in global conditions and the rebound in the iron ore price our assessment remains that sub-par response in the economy after more than a year of rate cuts indicates that bank lending rates are still too high in the face of consumer and business caution and the strong $A. They will still need to fall further over the next six months to boost growth in areas of the economy like housing and retailing as growth in mining investment subsides. As such a cut in the cash rate to 2.5% still seems likely over the next six months.

Major global economic events and implications

• US data releases were mostly good. While home sales slipped in December, this looks to be due to a combination of monthly volatility and a weak supply of homes. Meanwhile house prices continue to rise as do weekly mortgage applications, weekly unemployment claims fell to their lowest since January 2008 and Markit’s flash manufacturing conditions PMI for the US rose sharply in January.
• US December quarter earnings reports have remained reasonable with around 66% of the 147 S&P 500 companies to have reported so far coming in better than expected on earnings and 72% beating on revenue.
• Euro-zone manufacturing and services conditions PMIs rose again in January and are tracing out a rising trend consistent with a continuing but fading recession in Europe. The German Ifo index rose to its highest since June. This is consistent with our expectation for the Euro-zone to return to growth in the second half of the year.
• Continued deflation and another large trade deficit in Japan on the back of export weakness vindicate the need for the new Japanese Government’s efforts to weaken the Yen.
• Korean GDP growth picked up in the December quarter. Further improvement is likely on the back of fiscal stimulus and stronger global export demand. Yen weakness versus the Won could be a constraint though.
• A further gain in the HSBC manufacturing conditions PMI for China in January, its fifth monthly rise in a row, indicates that the Chinese growth acceleration has continued into the New Year.

Australian economic events and implications

• December quarter inflation was less than expected with headline inflation of just 2.2% and core inflation of just 2.3%. After adjusting for the introduction of the carbon tax, which proved to have far less of an impact than expected, inflation looks to be running at around 2% or just below. In fact abstracting from gains in volatile items like food and fuel and non-market influenced prices for things like health and education, inflation is just 1.2%. In other words there is very little pricing power in the Australian economy thanks to the strong $A and weak demand. There is clearly no barrier on the inflation front to further RBA rate cuts.

Major market moves

• The rally in shares continued over the past week with most markets up on the back of favourable news. US shares rose 1.1% with the S&P 500 above 1500 for the first time since 2007, European shares rose 1.3% and Australian shares rose 1.3%. However, a bit of profit taking saw corrections in several Asian markets.
• Commodity prices were little changed but the $A slipped torn between good news coming out of China but lower than expected inflation reinvigorating expectations for more rate cuts in Australia. The money market is currently pricing in another 50 basis points in rate cuts, and about a one third probability of a cut in February.
• While the Japanese Yen initially rose on concerns that the BoJ is not being aggressive enough, it has since fallen to a new low. Similarly, the correction in Japanese shares over the past week looks to have been short lived. 

What to watch over the next week?

• In the US, it will be a big week on the economic front with the main focus being the Fed on Wednesday and payroll employment and the ISM survey on Friday. The Fed is unlikely to make any change to its open ended quantitative easing program as not enough has changed since its last meeting. January employment data (Friday) is expected to show that payrolls grew by a reasonable 160,000 and unemployment remained at 7.8%. The January manufacturing conditions ISM index (Friday) is expected to be little changed with the Markit PMI pointing up but various regional PMIs pointing down. In other data, durable goods orders and pending home sales (both due Monday) are likely to show gains, consumer confidence (Tuesday) is likely to have been unchanged and December quarter GDP growth (Wednesday) is likely to have slowed to 1.2% annualised.
• US Q4 earnings reports will continue to flow with around 150 S&P 500 companies due to report.
• In the Euro-zone, confidence surveys (Wednesday) and the final manufacturing conditions PMI (Friday) are expected to show a continued gradual improvement.
• In Japan, data for retail trade is likely to remain soft, but industrial production is expected to show a bounce.
• In China, manufacturing conditions PMIs (Friday) are expected to confirm a continuing improvement.
• In Australia, expect the NAB’s business survey for December (Tuesday) to show business conditions remain sub-par, private credit growth (Thursday) to remain soft and producer price inflation (Friday) to remain benign. Data for new home sales and house prices will also be released. December half earnings reports will also start to trickle through, kicking off an earnings reporting season which will likely show that earnings remain very weak but with conditions starting to stabilise. After sharp downgrades to earnings expectations for 2012-13, to show zero growth, the risk of another round of significant earnings disappointment is low.

Outlook for markets

• Having risen by 11% or more since mid November shares are overbought technically and at risk of a short term pause or correction. February often sees a softer patch in shares after December/January strength and several hurdles may constrain markets in the month ahead including negotiations around US spending cuts due to kick in March 1, Italian elections and uncertainty around the earnings reporting season in Australia.
• However, any set back should be seen as a buying opportunity as shares are likely to head much higher this year. The positive momentum now being seen in share markets is indicative of a bull market, during which corrections are usually short lived and mild. The global growth outlook is steadily improving 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 key cyclical parts of the economy that have been lagging over the past few years. 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, with the risks being on the upside.
• 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.

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