So why is this important and why is the market selling off?

Over the past few years Hedge Funds and others have been able to make certain investments on expectation that the trends will continue. That is that QE will keep bonds yields low and that this will mean other yield orientated investments will also be attractive. These investors are now starting to unravel some of their positions which are causing an adjustment for the markets.

Implications

The implications for our market are as follows:

1. It places downward pressure on our currency as A$ bonds and high yield stocks were one of those investments that have benefited from QE. In the short term as offshore investors sell out of the Australian positions it creates some negative volatility.
2. Ultimately a pullback in the currency has positive implications for profits of the Australian market and will improve the competitive position of many companies. We estimate that at a 90 cent A$ there is a 9% positive impact to profits.
3. From a valuation perspective the Australian market has pulled back 10% so when combined with the impact of a lower currency the Australian market is nearly 20% cheaper than it was two months ago.

In addition to the QE easing the Australian market is adjusting to life after the resource boom. Some of those sectors of the economy which have done well in the past few years are likely to struggle and the RBA will be looking for other segments such as housing and non-residential construction to breathe life into the economy. A lower currency and lower interest rates will help in this regard as will an election to remove current uncertainty.

From a positioning perspective we continue to like those companies exposed to offshore earnings such as Brambles, QBE and Ansell and those companies which can benefit as money flows out of bond markets (such as QBE and Macquarie Bank). We will also be looking at opportunities that emerge from the current volatility.

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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.

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• The Reserve Bank Governor has delivered testimony to the House of Representatives Economics Committee.
• The Governor says that the economy is growing close to trend or average; Inflation is low and unemployment is relatively low; and the global economy is expected to growth at a trend pace. In short, nirvana has been achieved.
• In terms of the Aussie dollar, the Governor noted that “it was a bit on the high side but not dramatically so.” The Governor said the Reserve Bank hadn’t intervened to support a certain level of the currency.

What does it all mean?

• If the Reserve Bank Governor wanted to let us in on a secret, today would have been the day to do it. He didn’t. There were no fresh insights, and no new concerns. Even in terms of the Aussie dollar, the Governor indicated that it was high, but not dramatically so. In an economic sense, some would suggest that it was all a bit boring.
• But it is a good form of boring; a form of boring that can assure businesses and consumers. In fact the Governor believes our economy is as good now as it has ever been. That view is certainly not new as the Governor has been trying to get the community to see the glass as “half full” rather than “half empty”.
• That doesn’t mean that there are no risks ahead – there always are. But the Reserve Bank Governor believes we are in a happy place.
• The bottom line is that interest rates won’t be changing any time soon. That is, provided that there are no fresh shocks in Europe.

Key aspects of the testimony

• The messages were the same. European leaders have a lot of challenges in front of them. In the US, growth is OK, but not great. In China, more sustainable economic growth is occurring.
• The world economy is OK. “The kind of growth envisaged for the world as a whole is close to its long-run average.”
• Europe has a lot of work to do. “Realistically, it will be quite some time before the Europeans will be able to say these problems have been put behind them, even if things go well.”
• In Australia, the economy is in good shape. “Looking back, then, the economy appears to have been recording reasonable overall growth, relatively low unemployment, and low inflation.”
• Looking ahead, the economy is expected to remain in good shape, although the composition of growth may change. “Overall, growth is forecast still to be close to trend, albeit with a different composition from that seen in the past year or two, and inflation consistent with the target.”
• The Governor sees a peaking of the construction phase of the mining boom, with production taking the reins thereafter. And then there may be a shift from mining to domestic building as a growth driver. “Looking ahead, the peak of the resource investment boom as share of GDP – the highest such peak in at least a century – will occur within the next year or two. After that the rate of resource investment is likely to decline, while the export shipments of the resources themselves will pick up. By then we might expect that some other sectors that have been weak of late, like residential and non-residential construction, might be starting to pick up.”
• Interest rates? The Governor is waiting to see what happens as a result of recent rate cuts. “It is too early to tell how much difference the sequence of decisions to lower interest rates late last year and in the middle of this year has made to the economy, though we can observe that dwelling prices may have stopped their earlier gentle decline, and business credit has been growing at its fastest pace for three years.”
• Questions & answers. Glenn Stevens said we (collectively Australians) needed to “get real” about home prices, and we have. That is, we had to realise that home prices don’t always go up, and go up significantly. He said we came to that realisation a few years ago.
• Stevens again rejected suggestions that bank profits were too high or that there wasn’t enough competition. Competition for deposits was strong. And return on equity for the banking sector was similar to other listed companies.
• Stevens said that he had not changed his mind on the mining boom. He had always expected the construction phase to end around 2013-2014 and that appears on track. He said that we have come through the boom without a jump in inflation and he believes that we will come through it without a slump in the economy at the end.
• Stevens also said that the RBA had not seen anything that would cause it to materially change its view on the pipeline of resource projects.
• Stevens rejected suggestions that there was currently a greater variation in economic performance across regions than in the past. He said that the economy had always been a “patchwork” and was surprised that variability in economic performance wasn’t actually bigger.
• Stevens was asked about the Aussie dollar. He said that “it was a bit on the high side but not dramatically so.” He also noted that “it is probably at present trading a bit above what I thought it would be on the basis of past relationships…”
• Assistant Governor Lowe described the new co-operation between central banks and governments in Europe as a “dance” and noted that they were “gradually moving in the right direction.” Inflation wasn’t a problem in Europe as banks were content to leave money with central banks at present rather than lend it out.

What is the importance of the economic data?

• The Reserve Bank Governor testifies to the House of Representatives Economics Committee twice a year.

What are the implications for interest rates and investors?

• The Reserve Bank maintains an easing bias, but it is by no means explicit. While we are pencilling in a rate cut near the end of the year, it is more a risk, not a definite forecast.
• The Reserve Bank isn’t unduly worried about the Aussie dollar at present, but it is on the radar screen. If the Aussie was to rise markedly from here, we believe that this would increase the chance of a rate cut. 

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• Spain’s economy is now bearing down on various regional governments forcing them to seek support. The ECB, EU and IMF commenced a review of Greece amidst general expectations that it is way behind in terms of its bailout commitments. And even Germany is starting to look more and more vulnerable with deteriorating economic data and Moody’s putting its AAA sovereign rating on negative outlook. Against this backdrop, Spanish bond yields initially rose to new crisis highs, Italian bond yields also surged and the euro fell to its lowest since June 2010.
• However, the good news is that the bad news looks like it has been enough to galvanise the ECB into further action, with the backing of the German Government.  ECB President Draghi’s strongly worded comments that the ECB is ready to do whatever it takes to defend the euro and then tying this to high sovereign bond yields in some countries and the impact of this in hampering monetary policy are very positive. It has always been within the power of the ECB to bring an end to the financial panic sweeping through Europe, which is preventing monetary policy from working properly, threatening to turn otherwise solvent countries insolvent, and threatening to blow the euro apart. President Draghi’s comments not only recognise this but also recognise that it’s within the ECB’s mandate to do something about it and that it has the power to be effective. Of course Draghi has to follow his words up with action. But on this front the signs are positive with German Chancellor Merkel committing with French President Hollande to do everything necessary to protect the euro, suggesting Draghi has Merkel’s support. What’s more Draghi looks to have a concrete plan to bring down Spanish and Italian bond yields involving both the EFSF bailout fund to buy bonds in the primary market and the ECB buying bonds in the secondary market. In this regard the ECB’s meeting on August 2 is key and will be watched very closely. We expect the ECB to formerly announce bond purchases following this meeting.
• At the same time its looking like the Fed is on the verge of another round of quantitative easing, with numerous Fed officials arguing the case for more stimulus. It’s a close call but this is likely to be announced following the Fed’s meeting on Wednesday. So with the Fed on Wednesday and the ECB on Thursday and both on the verge of more policy stimulus the next week is shaping up as pretty important. Let’s hope they deliver.

Major global economic releases and implications

• US economic data remains soft. As was widely expected GDP growth slowed to 1.5% annualised in the June quarter from 2% in the March quarter.  Various manufacturing conditions indices fell further in July, home sales fell and core durable goods orders were weak. Jobless claims fell but this is distorted by seasonal problems. Meanwhile the evidence of a housing recovery continues to build with another gain in house prices in May.
• US earnings results saw a few misses and outlook downgrades, but on balance the results are still coming in better than feared, with 68% beating profit expectations and 63% beating on revenue so far.
• Euro-zone flash PMI business conditions readings were unchanged in July at levels consistent with a mild recession, but at least they haven’t got any worse. Perhaps the main concern though is that German indicators suggest it is sliding into recession as well – but this could be a blessing in disguise if it forces Euro-zone policy makers into more aggressive action. Across the channel the UK slid deeper into recession in the June quarter. 
• There was some good news out of China with HSBC’s flash PMI manufacturing conditions index surprisingly rising in July and profit momentum improving in June. Reports of a massive stimulus package in Hunan province suggests stimulus spending may be ramping up.

Australian economic releases and implications

• Inflationary pressures remained benign in the June quarter with producer and consumer prices up just 0.5% and the annual increase in the CPI coming in well below target at 1.2%. More importantly the underlying measures of inflation are running around 2% or lower adding to the message that inflation is benign.
• Meanwhile, RBA Governor Stevens continued his efforts talking up confidence in the Australian economy with a speech titled The Lucky Country. Governor Steven’s relatively upbeat assessment highlighted a relaxed assessment of China, the lessening risk of a house price crash, the reduced funding vulnerability of Australian banks and significant scope to move on the policy front if need be. I can’t disagree with any of that and we are lucky. But it’s worth noting the RBA sounded pretty relaxed and comfortable earlier this year with many concluding that rate cuts were done only to see it cut again in May and June, so I would be cautious in reading too much into the Governor’s comments with respect to the outlook for interest rates.
• Our assessment remains that with sub-par confidence, Australian economic growth likely to disappoint and inflation remaining benign the cash rate will be cut further this year taking it to 3% or just below by year end. We have a 0.25% cut pencilled in for August, but admit that it’s a close call.

Major market moves

• Share markets sagged earlier in the week before getting a huge boost by ECB President Draghi’s commitment to do whatever it takes to preserve the euro and hopes for more easing from the Fed. This left US shares up 1.7% for the week, European shares up 0.6% and Australian shares up 0.3%. A year ago shares were crashing, now they are being supported by attractive valuations and stimulative global policy action.
• It was a similar ride for commodity prices and the $A. The prospect of more quantitative easing in the US is particularly positive for the $A which rose to $US1.0483 and is also receiving support as Australia is now one of only 7 countries globally with a safe AAA rating.   
• Bond yields fell sharply in Spain and Italy on the back of President Draghi’s comments.

What to watch over the week ahead?

• Next week is a big one for central banks with the Fed, ECB and BoE all meeting. The outcome of the Fed’s meeting (Wednesday) will be watched very closely. We expect the Fed to announce further easing. Fed Chairman Ben Bernanke has repeatedly indicated that the Fed stands ready to do more if the US economy slows and there is little doubt that it has done just that with various other Fed officials indicating their support for more easing. This may well take the form of extending the commitment to keep interest rates down into 2015 and cutting the interest rate the Fed pays on bank deposits with it, but we also think that the Fed is now concerned enough about the economic outlook to take the plunge with another round of quantitative easing, ie QE3. If we are right and QE3 is announced it would mean a boost for shares, downwards pressure on the $US and more upwards pressure on the $A.
• On the data front in the US, the key ISM manufacturing conditions index (Wednesday) is expected to rise from 49.7 in June to 50.5 to be more consistent with the Markit PMI but payroll growth (Friday) is expected to have remained subdued with a 95,000 gain in jobs in July with unemployment remaining at 8.2%. Expect house price data (Tuesday) to show another modest rise and consumer confidence (also Tuesday) to be unchanged. The US June quarter profit reporting season will also continue with 119 S&P 500 companies reporting – the first few weeks are normally the most upbeat so expect more mixed results over the week ahead.
• In the Euro-zone, economic sentiment surveys and final PMI business conditions indicators for July are expected to remain consistent with a 1% contraction in economic activity this year.  Given the deeper recession than expected by the ECB and ECB President Draghi’s recent comments, the ECB is likely to announce more policy action when it meets on Thursday to reduce bond yields in trouble countries.
• Following a slight rise in HSBC’s flash Chinese PMI for July the official PMI is expected to show a slight rise (Wednesday), adding to evidence that growth may be stabilising.
• In Australia, expect new home sales (Tuesday) to remain soft, a modest 0.3% rise in private credit (Tuesday), a sharp fall in building approvals (also Tuesday) after an aberrant 27.3% gain in May, a 0.5% fall in June quarter house prices (Wednesday), soft retail sales in June and a 0.5% rise in retail sales volumes in the June quarter (Wednesday) and another small trade deficit for June (also Wednesday).

Outlook for markets

• Shares are still somewhat vulnerable in the short term given the deteriorating economic outlook in Europe, the US slowdown and lingering worries about China. However, if the ECB and Fed follow up with more policy action, which we expect they will and hopefully in the next week, shares will surge higher as valuations are attractive and investors are very sceptical and bearish which is a good sign from a contrarian perspective. We remain of the view that shares will be higher by year end.
• While sovereign bonds in safe countries are a good diversifier, bond yields in major countries around record lows suggest very low medium term bond returns. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
• The Australian dollar is likely to move higher by year end as global central banks undertake further monetary easing, commodity prices hold up and as central bank reserve diversification continues.

30 July 2012

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Reporting season wrap up
The good news was most companies saw profit growth over the last year with 68% of companies having reported a rise.

Against this, only 31% of results beat expectations, down from 37% for the June half 2011 results and well below the norm of 45%.

This is the worst result since February 2009, in the midst of the GFC. Reflecting this, results were greeted cautiously with 52% of companies seeing their share price underperform the market on the day results were released. While outlook statements have improved slightly from the last reporting season the net balance of positive statements remains relatively low.

Reflecting the generally lacklustre reporting season, analyst revisions to earnings expectations have generally been negative in Australia. The next chart shows that the number of Australian companies seeing their earnings forecasts being revised down by analysts has continued to outweigh the number of companies seeing upgrades. What’s more the pace of downgrades in Australia has been far more intense that has been the case globally for the last couple of years – which partly explains the relative underperformance of Australian shares. However, the good news is that the pace of downwards revisions is slowing, as is the case globally. In fact, based on weekly trends global earnings revisions are likely to turn into net upgrades soon.

2011-12 consensus earnings expectations have been revised down to 3%, from 7% in late January and from 14% a year ago. The downgrades have been concentrated in resources, insurers, other financials and media.

Key themes
Several key themes are apparent. First, earnings growth was non-existent through 2011 – with aggregate earnings effectively flat to down slightly from the December half 2010.

Second, the weakness in earnings was broad based across all major sectors with resources profits down slightly, non-bank industrials flat and banks up slightly. A similar message is apparent in ABS measures of profits up just 2.7% on a year ago and most sectors seeing falls in the December quarter including mining. This stands in contrast to a year ago when aggregate profits were up 20% and a three speed economy was evident with surging resources sector profit growth, solid bank profit growth and flat to slightly negative growth for industrials. Now they are all soft.

Third, the weakness in profits reflects a combination of factors with the main ones being weak domestic demand, the strong $A and commodity price softness during the second half of last year.

• Non-bank industrials have been hit by a combination of weak domestic demand, sticky cost bases partly reflecting the 2010 surge in workforces and the strong $A bearing down on trade exposed sectors. Industrials profits have been doing it tough since before the GFC.

• Banks have seen profit growth slow to a crawl on the back of soft credit growth, pressure on bank margins from higher funding costs and disappointing trading income.
• Resources have seen profits stall partly reflecting the high base of 2010 but also a fall back in commodity prices during the second half of 2011 and increased costs associated with booming mining investment.

Of course there have been some pockets of strength with mining services companies benefitting from the surge in mining related investment, and health care stocks with high quality franchises (such as CSL, Cochlear and Resmed). But the overall softness in profits is a confirmation of the broader weakness in much of the Australian economy.

Outlook
Consensus earnings expectations are for 12.6% earnings growth in 2012-13.

Profit growth is likely to pick up over the next financial year. The resources sector is likely to benefit from a continuing global recovery, modestly higher commodity prices and a rise in production.  And industrials are likely to benefit from corporate restructuring, further falls in interest rates and an eventual pick-up in domestic demand, which should result in some margin expansion.

Consensus expectations for margins are also more realistic than was the case six to 12 months ago. However, profit growth is still unlikely to meet current consensus expectations for 2012-13 with an outcome around 7% growth more likely – as domestic demand is likely to remain constrained and the $A is likely to remain strong.

Where does this leave Australian shares?
A likely further downgrade in expected earnings growth for the year ahead should be largely factored in. The Australian share market is trading on a forward price to earnings multiple of 11.5 times. This is well down from 12.9 times a year ago. And even if year ahead earnings expectations are downgraded by another 5%, this would still leave room for capital growth of around 8% if the market were to rise to say a 13 times forward PE. (A level which is below the market’s 15 year average of 14.5 times, but which may be appropriate for the more volatile environment we are now in.)

Another positive is that with corporate cash holdings at record levels and gearing low, there is plenty of scope for further increases in dividends, buybacks and M&A activity going forward, which are positive for the share market.

Notwithstanding the risk of a short term correction, further gains in global shares on the back of attractive valuations, continuing global recovery, easy monetary conditions and receding risks of a European melt down are likely to help drag up the local share market over the year ahead.

However, for the time being the Australian share market is likely to remain a relative underperformer. Since late 2009, Australian shares have underperformed global shares thanks to a combination of: the tougher domestic monetary environment which has both constrained domestic demand and limited the flow of funds into shares as Australian’s have preferred “cash in the bank”; the strong Australian dollar; and worries about a hard landing in China.

The fear of a Chinese hard landing is likely to recede further. However, there is unlikely to be much relief in terms of the Australian dollar (unless the world falls apart again, in which case it would actually be bad news) and monetary conditions in Australia are unlikely to ease much relative to the situation in the US and Europe. This suggests that Australian shares could rise further this year, but continue to lag global shares for a while yet.

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However, the news flow in Australia has not been as positive. While the mining boom is as strong as ever, household related demand and the labour market have been weak and the decision by the RBA to leave rates on hold has added to the short term uncertainty.

What does this mean for the economy and Australian assets?
While the RBA chose to wait and see following its latest meeting, it still appears to retain a bias to ease further in describing monetary policy as appropriate for the “moment” and indicating that the inflation outlook provides scope for easier monetary policy. However, its urgency to ease seems to be low and the hurdle to ease higher, with the RBA suggesting it will require a “material” weakening in domestic conditions. 

Two thoughts on this though. First, reading too much into RBA statements is dangerous – witness the big U turn on interest rates during the second half of last year – and prone to generate a lot of hot air from economists and other RBA watchers. Second, while we agree with the Reserve that the global backdrop has become less threatening we ultimately think it will have to ease a bit further – largely for domestic reasons.

There are several reasons why.

• Retail sales remain very weak. Retail sales were flat over the last three months of 2011 and up just 2.6% over the last year, a range they have hovered around for the last two years, in contrast to past experience where such low growth during cyclical downturns has been limited to a few months. Unfortunately, anecdotal evidence doesn’t suggest any improvement for the start of 2012.
• Retailers are struggling under the weight of consumer caution, a newfound desire to reduce debt levels and save more following the GFC, rising costs for utilities & rents eating into spending power, a rise in online shopping and more Australians shopping overseas on holiday. These trends are unlikely to change any time soon.

• Housing activity is soft with building approvals remaining in a downtrend.

• Capital city average house prices are down 5.5% from their 2010 high and still appear to be drifting down.
• The pace of job layoffs appears to have picked up again with almost a daily drip feed of anecdotes of job losses in manufacturing or the finance sector, which in the absence of an offset will only weigh on consumer confidence.
• The reluctance of the RBA to ease at a time when the US Federal Reserve is becoming more dovish and the European Central Bank is set to provide another huge cash injection into its economy later this month via its Long Term Refinancing Operation has further reinforced an already strong rebound in the $A. This will put further immense pressure on the already struggling manufacturing, tourism, higher education and retailing industries. Retailing used to be a beneficiary of a strong $A as it meant lower wholesale costs for imported retail goods. It still does, but any benefit is being swamped as the strong $A is reinforcing the trend of more Australians going overseas, realising how cheap things are and shopping online.
• The increase in bank funding costs in the absence of an offsetting fall in the RBA’s cash rate risks prompting a rise in mortgage rates.
• Finally, while mortgage rates may now be characterised as being around their long term average suggesting monetary policy is neutral, this is doubtful. First, while the average standard variable mortgage rate at 7.3% is in line with its average over the last decade, small businesses face borrowing rates well above their decade average. See the next chart.

• In the current environment of consumer caution and reluctance to take on debt it’s likely the so called “neutral” level for borrowing rates has fallen below the average of the last decade, perhaps by 0.5%. This would imply a further 0.5% reduction in the cash rate (or more if small business borrowers are allowed for). Third, it ignores the influence of the rising Australian dollar, which amounts to a de facto monetary tightening. All of this suggests monetary conditions are still a long way from neutral.
• While the mining boom is continuing, the key message of the last year is that it is not delivering anything like the trickle down boost to the economy seen through the first mining boom last decade or as was generally expected a year ago. There is no huge revenue windfall for the Federal Government to allow annual tax cuts, wages growth outside mining is soft and the impact on the labour market has been minor.
• None of this is to say the Australian economy is in dire straights. In fact broadly it is in good shape with our export markets holding up reasonably well, an absence of public debt problems, low corporate gearing and a high household savings rate. Rather the key point is that for trend growth of around 3.0 to 3.25% to be achieved over the year ahead, interest rates will need to be lowered further.

Implications for Australian investment markets

• The relatively tougher stance of the Reserve Bank of Australia has a number of implications for Australian investment markets.
• Australian dollar – while the $A is due for a short term pullback having risen 9% since its last decent correction in mid December, further gains look likely as the RBA’s relatively tough stance at a time when the US Fed and ECB are easing has put another rocket under it, adding to the boost from improving global economic confidence. Abstracting from the risk of a short term correction, a retest of the July high of $US1.1081 looks likely in the next few months, if not sooner.
• Australian share market – the relatively tougher stance of the RBA, along with the impact of the strong $A and worries about a Chinese hard landing have been the three main factors leading to the relative underperformance of Australian shares over the last two years. The first two are likely to fade, but it may take a while in the case of the RBA. As a result, the risk is that the Australian share market will continue to underperform in the short term. So while improved confidence in the global growth outlook, coming at a time when shares are cheap and global monetary conditions are easing, has helped underpin a recovery in shares in recent months that is likely to continue, global and emerging markets are likely to continue outperforming  Australian shares in the short term. 
• The residential property market – while the rate of decline in national average house prices appeared to slow down late last year, further price declines are likely in the short term. A decent recovery will probably require further falls in mortgage rates. In the short term this has probably been set back a bit, to further into the second half of the year.
• Commercial property – after a slump in 2009, commercial property (ie office, retail and industrial) has been a relatively solid and steady performer reflecting yields of around 7%. This is unlikely to change much although tough conditions for retailers and soft office employment will act as a drag.

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