It was back to “risk on” over most of the past week as the positive impetus provided by Japan’s monetary reflation, good Chinese economic data and a reasonable start to the March quarter earnings reporting season in the US boosted investor confidence.
- The financial impact of Japan’s massive quantitative easing program is clearly starting to be felt. By pumping cash into its economy and displacing investors in Japanese bonds it helps put downwards pressure on bond yields globally and in particular in higher yielding countries like Australia, but also forces investors to take on more risk which helps boost equity markets globally.
- An outworking of this, is also more upwards pressure on the $A and not just against the Yen. This has been evident over the past week with further gains against the Yen but also against the $US, with the $A reaching a 28 year high on a trade weighted basis. While reflation in Japan is the right thing to do and we would be far worse of if they along with the US were not trying to boost their growth, the ongoing upwards pressure on the $A is creating a problem for the RBA when it is trying to boost non-mining activity. At the very least it means more downwards pressure on domestic interest rates but I wouldn’t be at all surprised to see pressure on the RBA to intervene in the foreign exchange market and maybe do their own QE in the months ahead.
- North Korea and bird flu remain risk factors to keep an eye on. The risks around North Korea should settle down in the weeks ahead as we have seen after bouts of such escalation in the past, as it arguably doesn’t really want to start a war and South Korea and the US want to avoid triggering an attack on Seoul. But with a new North Korean leader and the US possibly less willing to respond with aid than it has been in the past the risks are arguably a bit higher now.
- The bird flu situation in eastern China is also yet to stabilize with around 40 cases, 10 deaths and signs that the new strain, H7N9, may have some resistance to anti flu drugs. However, as we have seen with bird flu over the last few years, in the absence of human to human transmission its hard to see bird flu causing anything more than a minor economic impact and occasional bouts of financial market nervousness.
Major global economic events and implications
- In the US the minutes from the Fed’s last meeting suggested an inclination to start tapering its quantitative easing program later this year. However, while this is in line with our own view, the minutes are likely to have become dated by the subsequent soft March employment reports. One thing for sure is that unlike the last two QE programs which had arbitrary end dates in March 2010 and June 2011, QE3 will only start phasing down once it’s clear the US economy is much stronger. US data releases over the past week were mixed with a 0.4% fall in March retail sales, a fall in consumer sentiment, a slight fall in small business confidence and a fall in mortgage applications but with weekly unemployment claims falling sharply and with gains in job openings and weekly retail sales. March retail sales were disappointing but followed a very strong rise in February and may have been distorted by the timing of Easter and poor weather. Meanwhile the March quarter earnings reporting season has had a reasonable start with 70% of results coming in better than expected so far.
- President Obama released his proposed budget with both tax revenue increases from cuts to deductions and some long term spending cuts. Any agreement with Republicans is unlikely to be reached though until some time in the September quarter when debt ceiling and government funding issues will again arise resulting in another last minute compromise. Against this though the improving trend in the US budget deficit should not be ignored. Over the last 12 months it was 5.8% of GDP which is well down from the post GFC high of 10.6%. It still needs to fall further though to be sustainable, but at least its going in the right direction.
- In Europe, Cyprus remains a problem, potentially needing to raise an extra €6bn and with the EU unlikely to provide extra support. The ongoing Cypriot problem has had little impact on Spanish and Italian bond yields though which actually fell over the past week.
- In Japan, machinery orders rebounded in February after a fall in January but more importantly an Ecowatchers survey showed an improvement in sentiment amongst households and corporates.
- Chinese economic data for March provided some good news with stronger than expected imports, auto sales, lending and money supply growth and inflation falling back to 2.1% from 3.2% in February. After the uncertainty created by January/February data the March readings suggest that growth momentum remains solid and inflation remains benign. This leaves Chinese policy makers with plenty of flexibility to manage the economy. Fitch’s downgrading of China’s local currency debt rating to A+ provides a reminder of the risks around its rising domestic debt levels and shadow banking. However, at this stage it’s hard to see a major problem given China’s strong growth and measures to slow local government debt and shadow banking.
Australian economic events and implications
- Australian economic data releases over the past week were pretty disappointing. While the AIG’s construction conditions index improved in February, the NAB’s business survey showed a sharp fall in business conditions, consumer confidence gave back some of tis recent gains, ANZ job ads fell in March and employment retraced half the unbelievable surge reported in February with unemployment rising to 5.6%, the highest level since 2009.
- What’s more, were it not for a fall in the participation rate over the last few years the unemployment rate would be higher (at around 6.3% if participation had remained at its 2011 average). To be sure there does appear to be some loss of downwards momentum in job ads, business confidence is off its lows and consumer confidence remains above its long term average. However, the still fragile and uncertain nature of the response to lower interest rates, the ever strengthening $A and benign inflation is keeping open the likelihood that the RBA will have to cut the cash rate again in the months ahead. Probably around mid year.
Major market moves
- Share markets rose helped by a combination of Japan’s reflation efforts, favourable Chinese economic data, good US economic news and optimism regarding the US profit reporting season. US shares gained 2.3%, European shares 1.9%, Japanese shares 5.1% and Australian shares 2.5%.
- Commodity prices fell though, with gold plunging 6.3% partly on Cyprus’ plans to sell gold from its reserves.
- Reflecting the risk on tone and Japan’s stepped up monetary reflation, the Australian dollar rose.
What to watch over the next week?
- The main focus in the week ahead will be Monday’s economic activity indicators from China, which are expected to confirm that solid steady growth is continuing in China despite New Year holiday distortions seen in February. No boom, but no bust either. Expect March quarter GDP growth to come in around 8% year on year, up from a low of 7.4% in the June quarter last year, along with March data showing 9.9% growth in industrial production, a pick up in retail sales growth to 13% and 21.5% growth in fixed asset investment.
- In the US, expect a slight rise in the home builders’ conditions index (Monday), solid gains in housing starts (Tuesday), business conditions readings for the New York and Philadelphia regions remaining consistent with reasonable growth (due Monday and Thursday respectively) and continuing benign inflation (Tuesday). US March quarter earnings results will start to flow in earnest with profits likely to come in up 5% on year ago levels.
- In Australia the minutes from the Reserve Bank’s last meeting are expected to confirm that it remains in wait and see mode for now, while at the same time retaining a bias to cut interest rates again.
- The G20 finance ministers meeting on Thursday and Friday is likely to discuss currency wars again following the depreciation of the Yen but is unlikely to move beyond the usual motherhood statements.
Outlook for markets
- Shares remain at risk of a more significant correction as we come into the seasonally weaker period around mid year and given that after strong gains they are not as cheap as they were a year ago. Europe, a possible sequester inspired soft patch in US economic growth, North Korea and bird flu are all risk factors.
- However, any set backs in shares are likely to remain mild and the broad trend is likely to remain up. Shares are still far from expensive, the strengthening growth outlook led by the US 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.
- Sovereign bonds will be helped by Japanese monetary reflation and any correction in shares. However, they remain fundamentally 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.
- Further gains in the Australian dollar against the Yen are likely as Japan steps up money printing. This has also shifted the risks for the $A against the $US to the upside in the short term. A break above $US1.06 (ie, out of the $US1.02 to $US1.06 range its been in since July) could see it push up to $US1.10.