Europe dominated investment markets over the past week following an initially botched bailout of Cyprus, along with uncertainty regarding Italy and poor business conditions indicators or PMIs for March. All of this has contributed to a bit of a further correction in shares after their huge gains in recent months.
- The immediate focus is likely to remain on Cyprus where a new bailout deal will have to be agreed upon by Monday otherwise the ECB will cut off support for Cypriot banks. Its a close call as to which way it will go, but the indications from Cyprus are that it will seek to raise the €5.8bn it needs to find in order to receive €10bn from the EU by winding down at least one bank, possibly setting up a “bad bank” and imposing a levy on deposits over €100,000, but protecting all deposits below €100,000 and sparing them from any levy. Shielding deposits below €100,000 is important because it would preserve the credibility of deposit insurance in the Eurozone.
- While Cyprus could cause more nervousness ahead, the deposit levy even if limited to large deposits or the worst case of a bust and potentially an exit from the Euro are most unlikely to be precedents for the rest of Europe. Rather Cyprus should be seen as a special case reflecting: its tiny size at just 0.25% of Eurozone GDP; the fact the amount Cyprus requires relative to its GDP is bigger than any bailout granted so far; and more importantly its bloated banking sector on the back of money laundering and tax minimisation and a big Russian deposit base. Why should the Eurozone foot all the bill to bail out a lot of non-Eurozone depositors? Such considerations simply do not apply in the case of Greece, Spain, etc.
- Meanwhile, it remains unclear whether a new Government can be formed in Italy. If Social Democrat leader Bersani can’t form a Government the most likely outcome will be the President proposing another technocratic PM and Government. This may not be a bad outcome.
- In the US the Fed remains clearly supportive of the economy and investment markets, with quantitative easing continuing at $US85bn a month and Fed officials signalling no rate hikes until 2015. While the Fed was a little more confident about the outlook, it remains concerned that unemployment is still too high, fiscal policy is becoming more restrictive and that the risks to the outlook remain on the downside. While the Fed had another discussion about the benefits versus the costs of QE quite clearly it still sees the benefits dominating. While a tapering in the pace of QE is expected at some point, it probably won’t occur till later this year, but only when the improvement in the labour market looks sustainable.
- The open ended nature of the current round of US QE is one reason to be confident that we won’t see another mid year bout of growth worries as occurred in mid 2010 and mid 2011 soon after QE1 and QE2 respectively came to an end. Another reason is the housing recovery now underway.
Major global economic events and implications
- News on the US economy remains good with housing starts, house prices and existing home sales continuing to rise and permits to build new homes and a home builder survey pointing to a continuing housing recovery ahead. The housing upswing both directly via its impact on construction activity and indirectly via its impact on wealth and confidence along with the US energy boom will be key drivers of the US economy this year. More broadly both the nationwide Markit manufacturing conditions PMI and the Philadelphia Fed’s regional manufacturing survey indicate improved conditions in March, jobless claims held on to recent sharp falls and a leading index rose further.
- China’s new Premier Li Keqiang said all the right things in terms of opening the economy more to market forces, reducing regulation and cutting bureaucracy in order to achieve the 7.5% pa growth necessary to double per capita income by 2020. Meanwhile while another month of solid property price gains in February supported stepped up property cooling measures, a rebound in HSBC’s flash manufacturing conditions PMI for March suggests growth is remaining solid supporting the view that the February softness was largely due to the New Year holiday. Falling output prices along with falling food prices also points to a fall back in inflation this month.
- While March PMIs rose nicely in the US and China they clearly disappointed in the Eurozone for the second month in a row. Recession continues, but at least the PMIs remain off last year’s low with a mild rising trend.
- While we are getting close to the end point, the global policy easing cycle continued over the last week with the Reserve Bank of India cutting interest rates. However, its comments suggest limited room for further cuts given still elevated inflation.
Australian economic events and implications
- In Australia, the minutes from the RBA’s last meeting reinforced its easing bias with the insertion of the line “while further reductions may be required”, the more timely speech by Deputy Governor Phil Lowe indicated the RBA remains firmly in wait and see mode for now with his observation that rate cuts appear to be helping the economy broadly as expected. While the short term bias in rates remains down its hard to see any cut next month and the broader picture remains one of the interest rate cycle being at or close to the bottom. A rise in some fixed mortgage rates are consistent with this.
- Australian economic data was light on with above trend growth in the Wespac leading index, flat vehicle sales in February but a further fall in skilled vacancies. Another rise in housing affordability in the December quarter will help contribute to a housing recovery.
- While there was much interest in Canberra politics over the past week, it’s hard to see this having a major impact on the economy or financial markets. Certainly the $A wasn’t affected as it actually rose over the last week.
Major market moves
- US, European, Japanese and Australian share markets fell on the back of fears that the debacle over Cyprus threatens to reignite the whole Eurozone crisis not helped by poor Eurozone economic data. Unlikely, but that’s what investors are worried about! European shares fell 1.5%, US shares fell 0.2%, Japanese shares fell 0.3% and Australian shares were down 3%. Against this though Chinese shares bounced back 2.2%.
- Bonds rallied on the back of safe haven buying, but interestingly Italian and Spanish bond yields also fell despite renewed fears of contagion in Europe, with Spanish bonds helped by a successful bond auction.
- While the euro fell it only ended the week down 0.7%. More importantly the $A didn’t respond in the usual “risk off” fashion and actually rose helped by better than expected Chinese economic data.
What to watch over the next week?
- In the US, expect a further gain in core durabable goods orders for February (due Tuesday) providing further evidence that the recovery in capital spending remains on track. Modest gains are also expected in house prices (Tuesday) and in pending home sales (Wednesday), but expect a slight fall in new home sales after a surge the previous month and in consumer confidence (both due Tuesday). December quarter GDP data (Thursday) is likely to show a further upwards revision to 0.5% growth.
- In the Eurozone, Cyprus will likely remain the centre of attention to see whether a deal can be agreed. Similarly, progress in Italy towards the formation of a new Government will be watched closely. More fundamentally economic confidence indexes (Wednesday) will be looked at to see whether they weaken in line with March PMI readings.
- Japanese data on Friday for employment, household spending, housing starts and industrial production will be looked at for signs of recovery but consumer prices are likely to have remained in deflation.
- In Australia, it will be a relatively quiet week on the data front but expect job vacancies to remain softish and growth in private sector credit (both due Thursday) to remain modest. On Tuesday a speech by RBA Governor Stevens will no doubt be watched closely for any clues on the outlook for interest rates and on Thursday the RBA’s semi annual Financial Stability Review is likely to indicate a somewhat less risky global financial system and that financial conditions in Australia are in pretty good shape.
Outlook for markets
- Shares are vulnerable to a further correction in the short term as overbought conditions are worked off and nervousness regarding Europe remains. However, the set back in shares is likely to remain mild and the broad trend is likely to remain up. Equity valuations remain reasonable, the strengthening growth outlook points to stronger profits ahead and investors are likely to increasingly switch from low yielding cash and bonds into shares as confidence continues to build ensuring solid “buy on the dips” demand.
- A pick up in M&A activity from cashed up lowly geared companies is also likely to be a big positive for shares this year. So notwithstanding the usual bumps along the way this all adds up to a positive backdrop for share markets.
- Notwithstanding some short term support as equities correct, sovereign bonds are vulnerable as the improving global, and Australian, growth outlook will likely see bond yields move higher over the year ahead resulting in capital losses for investors in them.
- The outlook for the Australian dollar remains messy. Mixed Australian economic data is a negative but quantitative easing in the US and Japan is a positive. The likely outcome is for a $US0.95 to $US1.10 range.