• Share markets were mixed over the past week with good economic data propelling the US share market to record highs and hopes of more ECB stimulus helping in Europe, but with soft data and profits weighing in Japan and Australia and increased Ukraine tensions weighing across the board. Bond yields generally fell back again on the prospect of more monetary stimulus in Europe. While the gold price rose slightly, oil and metal prices fell. Notable on the commodity front has been the renewed fall in the iron ore price partly on the back of worries about the Chinese housing market. Despite this, the seemingly Teflon coated Australian dollar rose over the week.
• The somewhat messy and desynchronised global growth environment remains clearly evident with good news out of the US, but Europe and Japanese data disappointing and geopolitical issues continuing to hover in the background. This all means occasional bouts of uncertainty for investors but as long as the broad trend in global growth is one of improvement, desynchronisation is not bad because it means central banks will stay supportive. Perhaps the bigger risk is that the longer rates stay low, the longer investors will expect this to remain the case which could set up bubble like conditions in various assets as investment yields (be they bond yields, dividend yields, rental yields, etc) get pushed ever lower as investors search for yield. However, for growth assets we look to be early in this process.
• In Australia, the June half profit reporting season is now wrapped up. While aggregate earnings growth in 2013-14 came in slightly lower than expected at the start of the results season thanks to misses by some large cap stocks (notably BHP), at around 12% it was still solid with two thirds of companies seeing gains in profits on a year ago. Rising dividends suggest amongst other things that the corporate sector is reasonably confidence in the outlook. See below for details

Major global economic events and implications

• US economic data was pretty favourable. While home prices were mixed in June and new home sales fell in July, pending home sales rose strongly, the Markit services conditions PMI remained strong, consumer confidence rose and durable goods orders surged. While a 23% rise in July durable goods orders owed to strong aircraft orders, the underlying trend is solid particularly for capital goods orders pointing to solid growth in business investment. Stronger investment also drove an upwards revision to June quarter GDP growth to 4.2% annualised from 4% initially reported.
• While momentum in money supply and bank lending improved a bit in July in the Eurozone, various confidence surveys softened in August confirming the loss of momentum seen recently in European growth adding pressure on the ECB to do more to stimulate growth. Quantitative easing focussed on the ECB using printed money to buy securitized bank loans looks likely to be launched soon.
• Japanese data for July disappointed with a smaller than expected gain in industrial production, continued softness in household spending, a rise in the unemployment rate and inflation falling slightly to 3.4% year on year, or 1.4% after the sales tax hike is allowed for. That said, the jobs to applicant ratio held at its highest since 1992 suggesting companies must be reasonably comfortable. Nevertheless, the soft July data will put more pressure on the Bank of Japan to consider further monetary easing.
• Korea was a bright spot though reporting a much stronger than expected gain in July industrial production.

Australian economic events and implications

• Australian economic data was a bit soft with falls in June quarter construction and equipment investment and a fall in new home sales in July. Private credit growth softened a bit after a stronger than expected rise in June with housing related credit looking like it has peaked on a monthly basis. Business investment plans for the current financial year also point to another decline on the back of falling mining investment. However, this has long been expected and there are some positive signs on the investment front. In particular, residential construction is continuing to rise and investment in what the ABS refers to as “other selected industries” looks like rising solidly in the year ahead. So dwelling construction and non-mining investment are helping to provide an offset to the slump in mining investment.
• The profit reporting season is now over and while the quality of results trailed off at the end as usual, overall it was pretty good. Particularly compared to the nervousness ahead of the results being released. 54% of companies have exceeded expectations (compared to a norm of 43%), which is the best result in nine years; 68% of companies have seen their profits rise from a year ago (compared to a norm of 66%); 65% of companies have increased their dividends from a year ago (up from around 60% in the last two years); and 59% of companies have seen their share price outperform the market on the day they released results, which is the best result in four years. Key themes have been strong profit growth for resources (notably Rio, although BHP disappointed a bit), banks doing well (with a good result from CBA) but no better than expected, ongoing cost control making up for still soft revenue growth and strong growth in dividends reflecting investor demand for income and corporate confidence in earnings prospects. Australian earnings growth for 2013-14 looks to have come in around 12%, which while down a bit from expectations a few weeks ago due to the BHP result causing a slight downgrade for resources, is still a solid outcome. Resources led with a 27% gain, followed by banks up 9% and the rest of the market up around 5%. Consensus expectations for the current financial year remain for 5% earnings growth, but this looks a bit low to me.

 What to watch over the next week?

• In the US, expect more solid readings from the ISM and Markit manufacturing conditions PMIs (Tuesday) and services conditions PMIs (Thursday), but the main focus is likely to be on jobs data (Friday) which is expected to show another strong gain in payrolls of 220,000 and the unemployment rate falling back to 6.1%. The Fed’s Beige Book of anecdotes on the economy (Wednesday) and trade data (Thursday) are also due for release.
• In Europe, the main focus will be on the ECB’s meeting on Thursday, where, following President Draghi’s recent comments regarding falling inflationary expectations, there is a 50/50 chance that it will unveil a quantitative easing program involving the purchase of private sector asset backed securities or if not allude that it’s on the way.
• The Bank of Japan also meets Thursday but it’s unlikely to make any changes to monetary policy.
• In China, the official manufacturing conditions PMI for August (Monday) is likely to have fallen back a bit in line with the HSBC flash PMI already released.
• In Australia, the RBA is expected to leave interest rates on hold yet again. Nothing much has changed since Governor Steven’s recent Parliamentary testimony where he expressed comfort with current interest rate settings. Rates have already been cut to record lows and the housing sector has led the response but with mining investment still slowing, non-mining capex still soft and the $A still strong its way too early to consider raising rates.
• It’s also going to be a bit of a data avalanche in Australia. The main focus is likely to be on the June quarter GDP data and here the news is unlikely to be good. Our expectation is for GDP growth of 0.5% quarter on quarter (or 3.1% year on year), but weak readings for net exports, consumer spending and investment suggest the risks are all skewed to the downside. In fact there is a high risk of a slight contraction in GDP. Inevitably this would invite talk of a recession, but as was the case with the previous three negative quarters seen in the last 23 years, a recession is unlikely. First, the soft June quarter result will be payback for the unexpectedly strong trade driven growth seen in the March quarter. So best to average the two quarters out. Second, a range of timely indicators relating to housing, retail sales, consumer confidence and the jobs market point to stronger conditions in the September quarter.
• In terms of other Australian data releases expect to see a further rise in house prices (Monday), a -0.7%  contribution to growth from June quarter net exports, weak public demand and a bounce back in building approvals (all Tuesday), another large trade deficit and modest growth in July retail sales (both Thursday). The AIG’s business conditions PMI’s will also be released.

Outlook for markets

• While shares have seen a strong recovery from the mini-slump seen in early August, the correction season consistent with the old adage “sell in May, go away and come back on St Leger’s Day” is still upon us with September historically being the weakest month of the year for US shares partly due to tax loss selling and the September-October period often being tough in Australia.

• However, despite the risk of another correction the cyclical bull market in shares likely has a lot further to go as we still don’t see the signs of shares being over valued, over loved and over bought normally seen at major market tops.Valuations remain okay particularly once low interest rates and bond yields are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In fact, in terms of the latter there still seems to be a lot of wariness regarding shares. Our year-end target for the S&P/ASX 200 remains 5800.
• Low bond yields, eg 10 year yields of just 0.5% in Japan and 3.5% in Australia, will likely mean soft returns from government bonds.
• The combination of soft commodity prices, the likelihood the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. Expect to see $US0.80 in the next few years, but getting the timing right is hard.

By Dr Shane Oliver, Head of Investment Strategy & Chief Economist, AMP Capital

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Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

• Most share markets managed to rise over the last week, but the lack of momentum seen all year remains a feature. In some ways it seems that after the strong gains in global and Australian shares last year, they are now undergoing a bit of a stealth correction with softer than expected global growth in the first quarter, the mess in Ukraine and uncertainty about China all playing a role globally and this being added to in Australia by uncertainty regarding the impact of the Budget. The past week also saw bond yields move a bit higher, particularly so in peripheral Eurozone countries where it looks like their sovereign bonds had become a bit overbought. Meanwhile commodity prices were mixed with oil and gold up but metals and the iron ore price down. The $A fell further, not helped by the lower iron ore price and the fall in consumer confidence, as did the Euro on increasing signs the ECB is set to ease next month.
• The minutes from the Fed’s last meeting confirmed that it’s more confident regarding growth picking up and inflation bottoming but not so much that it’s signalling an imminent rate hike, which still looks likely to be around mid-next year. That said, as part of its “prudent planning” process, the Fed has started to revisit how it will eventually exit from its extraordinary monetary stimulus measures with New York Fed President Dudley suggesting that it will not start unwinding its stock of bonds until after it first starts raising interest rates. But whatever the order, as the start of tightening approaches it will likely see bond yields move higher.
• Uncertainty remains high around China, but as yet there is still no evidence of a hard landing and we remain of the view that the authorities will do enough to ensure growth comes in around 7.5% this year (which means 7% at least). The combination of a further slowing in house prices in April with official measures to curb the interbank lending market added to fears of a hard landing. This arguably all contributed to a fall in the iron ore price below $US100/tonne. Against this though a stronger than expected bounce back in the HSBC flash manufacturing conditions index for May supports the view that growth may be stabilising after the first quarter slowdown. More announcements of incremental loosening measures add confidence to this. These included announcements of support for employment and allowing ten provinces and cities to issue their own bonds.
• Political developments in the emerging world were all over the place highlighting why investors need to be a lot more selective regarding emerging market assets this decade. At one end of the scale, the huge mandate delivered to the BJP to reform the Indian economy augurs very well for the Indian economy and asset markets. At the other end Thailand’s latest coup highlights the mess Thailand has fallen into with civilian politicians unable to work things out. While coups are normal in Thailand, this being the 12^th since 1932 and arguably are better than red shirts and yellow shirts fighting it out, the risks are greater that there will be a negative flow on to the economy and Thai assets than was the case with the 2006 coup as the two sides are more polarised now. And of course Ukraine remains a huge source of uncertainty.
• In Australia, a 6.8% slump in consumer confidence and evidence of a fall in retail sales in the last week confirms the Budget has had a negative impact on sentiment. This may prove to be an over-reaction, but quite clearly the Government needs to do a better job of selling the Budget. Ditching some of the Budget’s harsher measures, eg the plan to prevent those up to age 30 from getting unemployment benefits for six months, and funding them by dropping or delaying paid parental leave might be an option and might be necessary to get Senate passage anyway. Clearly if the blow to confidence remains it will be bad news for consumer spending and have the effect of pushing any RBA rate hikes into next year.

Major global economic events and implications

• US data was mostly good. A fall in mortgage applications and a rise in unemployment claims were the main disappointments but the level of claims remains low. More significantly, the Markit manufacturing PMI rose to a quite solid 56.2 in May, the leading index rose and existing home sales rose, albeit after several months of falls.
• European data was also reasonable with May data showing a rise in consumer confidence and in the Markit services sector conditions PMI. The manufacturing conditions PMI fell slightly but the combined services and manufacturing PMI was little changed at 53.9, which is consistent with Eurozone economic growth rebounding to around 0.4% in the current quarter from 0.2% in the March quarter.
• There were no surprises from the Bank of Japan which left monetary policy unchanged, as it’s too early for it to gauge whether the April tax hike has had anything other than a temporary impact on growth. In terms of the latter there are some positive signs with machine orders up in March and the May manufacturing PMI up slightly.

Australian economic events and implications

• In Australia, a slump in consumer confidence confirmed the Budget has had a negative impact on sentiment, with ALP voters and those earning between $60,000-$80,000 showing the biggest drop. It does look like a bit of an overreaction though and a similar fall after last year’s Budget saw a bounce back in the subsequent month. This may occur next month as some may be a bit confused about the impact on their personal finances and many of the Budget measures will take a long time to phase in, even if they do get through the Senate. Meanwhile wages growth held at a record low of 2.6% year on year in the March quarter which is another drag on household spending, but at least confirms that labour costs are no threat to inflation.
• The slump in consumer confidence and low wages growth are consistent with the RBA remaining on hold. We were looking for the first rate hike to be around September/October but given the negative reaction to the Budget this is increasingly looking like it will get pushed into 2015. If consumer confidence does not bounce back in the months ahead it’s likely that there will be increasing talk that the next move in interest rates will be down.

What to watch over the next week?

• In the US, the bad news is likely to be that March quarter GDP growth (Thursday) will be revised to -0.6% annualised from an initially reported 0.1% reinforcing that it was a poor quarter. However, a range of indicators suggest growth is bouncing back this quarter. Durable goods orders (Tuesday) are expected to fall slightly but this reflects a payback for the very strong gain seen in March with the underlying trend likely to remain strong. Consumer confidence (Tuesday) is expected to have increased slightly. House prices (Tuesday) are expected to show further gains but pending home sales (Thursday) are likely to be flat after a strong March.
• In Europe, the focus is likely to be on the results from the Ukrainian and EU parliamentary elections. Whether the Ukrainian elections resolve the uncertainty hovering over the country is doubtful. A successful orderly election with whole of country participation won’t be sufficient to end the crisis, but its nevertheless likely to be required if it is to end. The EU elections are likely to see Euroskeptic parties do well which may cause some investor concern, but it’s unlikely to change policy directions in Europe, in particular support for peripheral countries. May economic confidence indicators (Thursday) will be watched for an improvement after the slight setback seen last month.
• Japanese data for April will show the initial impact from the recent sales tax hike. This is likely to show up as a fall in household spending and industrial production (both of which were boosted prior to the hike) and a spike in inflation to around 3%. Labour market data is unlikely to be much affected.
• In Australia, March quarter construction data (Wednesday) is likely to remain weak as a rebound in residential investment only partly offsets the ongoing slump in mining investment and March quarter capital spending (Thursday) is expected to show a further decline. Of greater interest will be capital spending intentions data which will show further weakness in mining investment but will be watched for signs that the outlook for non-mining investment is starting to improve. Credit data (Friday) is likely to show a further modest lift in momentum.

Outlook for markets

• Shares remain vulnerable to a mid-year correction, consistent with weak seasonal influences that kick in around May and continue into the September quarter. However, with shares having been in a bit of a stealth correction all year, any pull back may well be mild and in any case the broad trend in shares is expected to remain up. Share market fundamentals remain favourable with reasonable valuations, global earnings are improving on the back of rising economic growth and monetary conditions are set to remain easy for some time. So any dip should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.
• Bond yields are likely to resume their gradual rising trend as it becomes clear that US inflation has bottomed and this combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.
• With $A short positions now largely unwound, it’s likely that the broad downtrend in the $A is resuming. Commodity prices remain relatively soft, interest rate hikes are getting pushed out and the $A is likely to revert to levels that offset Australia’s relatively high cost base.

By Dr Shane Oliver, Head of Investment Strategy & Chief Economist

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Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

Investors looking at their medium-term and long-term investments are currently asking themselves: what is in store for bonds when rates normalise? As central banks’ bold experiment in monetary policy comes to an end and they begin to normalise cash rates, many investors fear possible negative returns on bonds, such as we had in 1994, which is notorious as the year of the great bond rout. Either we will see an orderly bond selloff (with a slow, steady rise in yields) as the central banks successfully manage to exit quantitative easing (QE) without causing market panic, or we may experience a disorderly one if central banks lose control of the process. Another possibility is that there is a selloff caused by inflationary fears. Whichever scenario one subscribes to, the outlook for bonds does look risky.

Obviously with any asset class, investors must ask the question: does the cost of holding bonds outweigh the benefits of holding bonds? In our view, the answer is no. Bonds remain an important component of a portfolio: even in a rising cash rate environment, diversifying a portfolio so that it includes fixed income alongside other assets can help balance returns, diversify risk and reduce overall volatility. The approach should not be to avoid or sell out of bonds, but to look at the types of bonds in a portfolio and to adopt a flexible, active approach that helps cushion the bond portfolio against rising rates.

Bonds are the only truly defensive asset

Over the past few decades, Australian investors have largely ignored fixed income investments, preferring cash or term deposits as the defensive assets in their portfolios. Although they believed they were investing in asset classes which were getting higher returns, actual returns were higher for true fixed income funds since cash and term deposit holdings missed out on the capital returns enjoyed by bonds.

In addition, these investors missed out on the major benefit of holding high quality bonds – the negative correlation they provide to equities. Although bonds don’t generally deliver the high returns that equities do, holding them in addition

to equities should decrease the risk in a portfolio. In market environments when equities are performing poorly, the bond holding can help to offset losses on the equity portion. So it’s possible to construct an efficient portfolio that maximises potential returns while helping to minimise risk. This cannot be done with other defensive asset classes, such as cash or term deposits, because their correlation to equities is zero and can even verge on positive in the long term since falls in equity markets can lead to cash rate cuts by central banks.

Bonds tend to perform relatively better in market downturns and when, due to very low inflation or deflation, prices are falling. Although bonds may perform well during times of low inflation or deflation, such an environment is bad for most other asset classes, particularly equities. Central banks around the world have strived for low inflation, but the risk from any cyclical fall in inflation can lead to a deflationary scare in financial markets, such as we saw in 2001 and 2009.

The reason why we have seen such a bold QE experiment by central banks is that they have learnt how to deal with inflation and have the tools to do so. However, most have not had to deal with deflation and don’t necessarily have the tools to handle such a scenario. Japan in the 1990s and the US in the 1930s are examples of the risk of deflation and the difficulty it takes to get out of such a situation once in it. With low world inflation and the weakening of conventional monetary and fiscal policies, deflation is still a potential risk for investors to consider, just as inflation was in the 1970s and 1980s. Maintaining an allocation to bonds would help to offset this risk given their superior performance in such an environment. Cash and term deposits would not offset the risk of deflation because the RBA would cut the cash rate to very low levels in order to try to jump-start the economy in that scenario.

Assessing risk for bond portfolios

The short-term risk of higher rates is compounded by the current relatively low yields and the fact that duration has increased for bonds and the typical benchmarks. The lower a bond’s duration, the lower its price volatility and the less sensitive it will be to interest rate changes. The duration of the UBS Composite Bond Index 0+YR (the benchmark for most Australian bond funds) is currently around four years compared with three years prior to the GFC1. The major reason for this is that government issuance since the GFC has tended to be longer in nature. For example, Australia issued a 20-year government bond in November, the longest maturity bond to be issued since the 1960s.

Apart from duration, it’s important to consider what will happen to bond yields when assessing what a rise in rates will do to bonds. The most important consideration is when and how orderly, or disorderly, the bond selloff is. If rates were to rise and bond yields rose in an orderly and steady manner, they wouldn’t suffer large losses. However, in a disorderly selloff or market panic, it’s possible that we could see negative returns, as in 1994. The big risk to bonds isn’t so much rising rates, it’s rapidly rising rates. A fact that might surprise some investors is that in the past 20 years, Australian bonds have only experienced negative returns twice, in 1994 and 1999. Although 1994 saw a very disorderly selloff in the bond market, it only delivered a negative return of  4.66%, with -1.22% for 1999 . The most common returns over the whole 20-year period have been between +5% and +15%.

In addition, unlike capital losses experienced on equities, capital losses on bonds are recovered over subsequent periods until maturity. This is called the ‘pull-to-par’ effect: As a bond approaches maturity, its market value gets closer and closer to its face value based on an assumption by the market that the bond will be repaid in full and on time. Even if rates do rise and prices fall, as long as the issuer remains solvent, investors will receive repayment of their full capital investment at the bond’s maturity. So, if you hold a bond until it matures, you won’t lose your principal. The potential for capital loss thus only comes when selling a bond before it matures or if the issuer defaults.

New natural rate of interest is around 4%

Quantitative easing from global central banks has depressed real rates and term premiums. The chart below shows how we believe the new natural interest rate (NRI) has changed from being around 5-5.5% from the start of the century until the GFC, to around 4-4.5% since then. In our view, the reasons for the drop are pressure on the government to rein in spending and that since the Reserve Bank of Australia (RBA) started cutting the official cash rate, Australia’s banks have retained around 100 bps of those cuts and not passed them on.

Source: Bloomberg

If rates were to normalise, we should expect the cash rate to head toward this new NRI, so potentially the extent of the rise over time would be around 150-200 basis points (bps). Obviously, the NRI can change temporarily, but this means the extent of the selloff shouldn’t equate to 1994.

In our view, the concept of duration should be rethought, particularly as it applies to individual bonds. As a measurement of risk in a portfolio, duration is still highly relevant since it measures the portfolio’s sensitivity to interest rates. However, that does not mean that long duration bonds are necessarily more risky – as the chart above shows, 10-year bonds are currently within the 4-4.5% band of this new NRI. If long-term rates don’t move or don’t move by too much, then longer duration bonds shouldn’t be particularly affected. If we saw the cash rate rise to 4.0%, then it would be the yield on the shorter maturity bonds which would react the most and despite their shorter durations, they would suffer worse losses than higher duration bonds. Longer duration bonds are more vulnerable to central banks decreasing their purchases or decreased foreign investment in Australian bonds as the supply increases. However, a normalisation of cash rates would not hurt all maturities of bonds equally.

Because a bond portfolio comprises a variety of bonds with different interest rate levels and maturities, it should have a steady stream of maturities which can be invested at the higher yields if cash rates/yields are rising. By owning bonds of different maturities, fund managers ensure that they are not tying up money for too long. If and when interest rates go up, maturing assets offer the opportunity to reinvest that capital into more recently issued, higher yielding bonds. As such, the effect of any return erosion is constantly being reduced and so any capital losses on bonds should be recovered over time. It’s important to remember that not all bonds are the same: a diverse portfolio containing different bond types and maturities helps to minimise any potential losses.

Conclusion: Bonds remain a good long-term investment

Bonds remain a viable asset class despite the risk of higher rates in the short term. Apart from bonds’ defensive qualities and negative correlation to equities, the longer term threat of deflation and the impotence of central banks to deal with it also warrants an allocation to bonds. The question is which bonds to invest in and at what level. Good value can still be found in various areas of the bond market, such as semi-government, bank and some corporate bonds, as well as by using duration and yield curve strategies. Opportunities remain to add value through bonds via active management using a variety of different strategies in combination to produce a diversified, well performing portfolio.

By Roger Bridges

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual. The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

This week, Aussie 10-year government bond yields hit 3.648 per cent – the lowest yield since June 1951 when yields averaged 3.51 per cent, according to Reserve Bank data. Australian 3 year bonds also ease. Yields on 3-year bonds hit 3.015 per cent – lowest since December 19 last year.
 
What does it all mean?
The plunge in the Australian ‘long bond’ rate to 61-year lows caps a red letter day. Not only has deflation returned to Australia (0.2 per cent fall in seasonally adjusted consumer price index) but government bond yields are now close to the levels trading in the early 1950s.

The two are clearly inter-related. Bond yields have fallen in response to the drying up of price pressures. But it is also a case that Australian government bonds are in demand from investors across the globe, worried about economies in the Northern Hemisphere. If Netherlands does lose its AAA status as some analysts speculate then demand for Australian government debt is likely to be boosted.

The low level of government bond yields represents good news for the Government, serving to keep downward pressure on borrowing costs.

If government bond yields continue to ease, this means further downward pressure on fixed lending rates, representing good news for business and home loan borrowers alike.

With all the focus on debts and deficits, many investors rightly want to know what that has to do with us in Australia. And then there is the attention devoted to bond yields – hardly mainstream for most investors.

There are no easy answers to the issues facing European countries. Simply they need to get their financial houses in order. And governments must convince investors, rating agencies and institutions like the International Monetary Fund and European Central Bank that they are taking the necessary measures to stabilise, and ultimately address the problems they face.

To read about the key issues of the European debt crisis and its impact on bond yields, click here.

Greg Michel, head of fixed income at INGIM said the global appetite for Australian bonds is likely to continue with investors drawn to current yields of 5% to 6%, outstripping available yields available from global alternatives.

“The Australian economy has proven to be resilient to the effects of the GFC and continues to expand at a robust pace. The bond market has been in a bear market phase since early 2009 and bond yields are now close to long term average levels,” he said.

Global bonds are a different story, and INGIM expects flat to negative returns in 2011.

While the major European economies are expanding strongly, aided largely by a weak currency and accommodative monetary policy, the peripheral Euro markets continue to be held down by the large levels of sovereign debt and associated funding challenges.

“On balance we believe the combination of improving economic growth and high sovereign debt levels will result in Euro bond yields continuing to head higher in 2011,” said Mr Michel.

Credit best performing sub-sector

Turning to fixed income sub-sectors, INGIM said credit is expected to be the best performing assuming the default cycle pans out as expected.  While underlying interest rates will rise, continued credit spread contraction should see credit perform in a relative sense.

“The rally we have seen in credit markets over the past two years has been strong, supported by improving fundamentals and monetary and fiscal stimulus in the economy.  That being said, there is a sense the rally has overshot the fair value mark and there are few catalysts to drive spreads tighter,” INGIM’s head of credit research, Scott Rundell said.

For issuers, Mr Rundell said offshore markets continue to be more competitive than the Australian bond market with some suggesting several large players are demanding unpalatable spread levels.

“It’s relatively easy for investment grade credit to issue long dated loans or bonds into the US market.  New issuance is likely to be low and we expect few first time local issuers in Australia,” he said.

Global government bond yields on rise

Looking to Australian government bonds, INGIM is expecting limited further tightening in monetary policy in 2011 and now expects government bond yields will remain at or near current levels for the rest of the calendar year. Demand for local government bonds will continue to be dominated by offshore investors.

Despite recent geo-political tensions in the Middle East and North Africa, global government bond yields are expected to continue to rise over the medium term.  US government bonds yields are also expected to continue their upward rise as the market prices in the recovery.

“We’re now seeing ongoing evidence of a broad based economic recovery in the US and government bond yields are set to continue to rise through 2011 as the global economic recovery gathers pace,” said Mr Michel.

World issues cause headwinds

Meanwhile European sovereign debt challenges will continue to cause headwinds for fixed income. In particular, forced losses (or ‘haircuts’) on Irish senior bank debt could create contagion risk to other EU banks, causing the cost of bank funding to spike.

“We also advise monitoring changing bank regulatory regimes and structures as they will impact capital flows and the cost of credit in general,” Mr Rundell said.

Other world factors to watch include Chinese growth and demand for raw materials and the impact of recent events in the Middle-East and North Africa on oil prices.

“The management of many global companies may look to appease shareholders who have experienced negligible growth with capital initiatives aimed at increasing their returns. This could also be a negative credit event,” Mr Rundell said.

Headline developments

• An acceleration in Chinese economic growth in the December quarter to an estimated annualised pace of around 12% along with ongoing inflation worries have reinforced the case for further Chinese tightening in the months ahead. While inflation fell back to 4.6% in December from 5.1% in November this looks like a temporary reprieve with higher food prices this month and the Lunar New Year holidays likely to push inflation back up again in the months ahead. We expect another three interest rate hikes and bank required reserve ratio increases over the next six months. However, there is still nothing indicating that the Chinese are going to crunch their economy. First, while non-food inflation rose to 2.1% in December it is still low. Second, fixed asset investment is already moderating and a further slowing is likely this year as real estate construction slows and stimulus projects complete. Finally, much of the tightening measures we are now seeing are necessary just to mop up the liquidity the Chinese authorities are pumping into their economy to stop a more rapid appreciation in the Renminbi. Monetary conditions are still a long way from being tight. As such, investor fears that China will crunch its economy evident in a 5% or so fall in Chinese shares so far this year coming on the back of a 23% fall last year are overdone. While the Chinese share market may remain vulnerable until tightening stops, Chinese domestic shares are trading on a price to earnings ratio of 18 times which is well below their historic average of 34 times suggesting that a lot of bad news is already factored in.
• In Australia, flooding continues to wreak havoc with now nearly a third of Victoria flood affected. As a result expectations of the damage bill and the hit to economic growth in the March quarter continue to escalate. We now expect the damage bill to property, equipment, infrastructure, etc, to be around $15bn with the floods likely to detract 1% from economic growth concentrated in the current quarter. Fortunately, growth should rebound starting next quarter as the rebuilding effort kicks in and production returns to normal. While the floods will add 0.5% to 0.75% to March quarter inflation, we expect the RBA to look through this and hold off raising interest rates again until it becomes clear that growth is recovering from the impact of the floods. This suggests that interest rates will be on hold out until around May at least.

Major global economic releases and implications

• US data released over the last week remained consistent with an acceleration in the US economy. Surveys of manufacturers remained strong, jobless claims fell sharply and the US leading indicator rose strongly. Housing indicators were mixed with housing conditions flat according to a survey of home builders and housing starts fell due to bad weather but existing home sales rose very strongly. Our overall view remains that the US housing sector has found a base, but its also worth noting that housing activity is now only around 2.5% of US GDP compared to 6% in 2005 so its impact on the US economy is far less than it used to be.
• The US December quarter earnings reporting season got underway in earnest over the last week with 50 major companies reporting. So far 69% of results have come in better than expected including for JP Morgan, Apple and IBM. While upside surprise is down compared to recent quarters this appears to be because analyst expectations have finally caught up to the recovery in earnings with earnings growth estimates for the year to the December quarter already very strong at +32%.
• Japanese economic data was generally upbeat with gains in machine tool orders, a tertiary activity index and Tokyo condominium sales. Against this, consumer confidence fell slightly in December.
• While interest rates are well and truly on hold in key advanced countries, monetary tightening is continuing in emerging countries as part of an effort to deal with inflationary pressures. This is clearly evident in China, Indonesia, Korea and Thailand which all tightened last week but in the past week Brazil also tightened, raising its key policy rate by 0.5%. Inflationary pressures in the emerging world point to further tightening in these countries ahead. So far the increase in inflation is mainly food related so tightening is unlikely to be aggressive but it is worth keeping an eye on.
  Australian economic releases and implications
• Australian economic data was mixed.  New vehicle sales for December rose solidly in December and the TD Securities/Melbourne Institutes’ Inflation Gauge showed significant inflationary pressure in December. But against this, consumer sentiment and skilled vacancies both fell sharply in January, presumably in response to the impact of the severe flooding. Both are likely to rebound once the flood waters subside. While a sharper fall in export prices than import prices implies a fall in the terms of trade in the December quarter, it should be noted that it is likely to rebound this quarter as the flood boosts coal prices.

Major market moves

• Global share markets fell over the past week reflecting a combination of profit taking after strong gains in recent months and worries about the impact of Chinese tightening. While the Australian share market briefly broke out to its highest level since last April, it was knocked back down again in response to a fall back in US shares and worries about the impact of Chinese tightening on commodity demand.
• Worries about the impact of further Chinese tightening also weighed on commodity prices and the $A.
• Bond yields rose as global economic data continued to surprise on the upside.

What to watch in the week ahead?

• In the US, the main focus is likely to be on December quarter GDP data (due Friday) which we expect to show an acceleration in growth to a 3.5% annualised pace after 2.6% annualised growth in the September quarter. US data for consumer confidence (Tuesday) is likely to improve slightly after a soft reading in December, data for new home sales (Wednesday) and pending home sales (Thursday) are likely to rise modestly and durable goods orders (Thursday) are likely to remain solid. Meanwhile, following its meeting on Tuesday and Wednesday the Fed is likely to signal greater optimism about the outlook for the US economy but not enough to warrant any imminent tightening in monetary policy. The December quarter profit reporting season in the US will also continue with 150 or so S&P500 companies due to report.
• Japanese data for inflation, the labour market and retail sales will be released on Thursday.
• In Australia, the importance of December quarter inflation data (due for release on Tuesday) for monetary policy has been somewhat reduced by flooding in Queensland and other states. Increases in prices for food, housing costs and petrol prices are expected to push up the consumer price index by 0.7% in the December quarter pushing the annual rate of inflation up to 3%. Underlying inflation is likely to also rise by around 0.7% in the quarter or 2.5% year on year.

Outlook for markets

• Share markets are vulnerable to a short term correction. After very strong gains since August last year many technical indicators show that shares generally are overbought, measures of investor sentiment are at high levels suggesting that a lot of good news is factored in and the seasonal tendency is for share market strength in December and January to be followed by weakness in February. Further Chinese tightening could be the trigger for a further short term correction in shares.
• However, shares are likely to put in good gains through 2011 as a whole so any short term pullback should be seen as a buying opportunity.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that 2011 is on track for strong economic growth which should in turn drive another year of solid profit growth, the global liquidity backdrop is highly favourable underpinned by very low interest rates in key countries & quantitative easing in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. By end 2011 we see the Australian ASX 200 index rising to 5500, once it shrugs off the current malaise which appears to reflect a combination of worries about the floods and Chinese tightening.
• The Australian dollar is at risk of a further correction in response to ongoing uncertainty about the impact of Chinese tightening on commodity prices and as a result of the negative impact on local growth from the floods. However, the broad trend is likely to remain up as the $US and the euro remain under downwards pressure, interest rates in Australia remain relatively high and high commodity prices keep the terms of trade near early 1950s highs. By year end the $A is likely to have reached $US1.10.
• The risk of a sharp back up in global bond yields at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels, at some point market expectations are likely to swing back towards monetary tightening in the US and Australia and the record inflows into bond funds seen in recent years are at risk of becoming record outflows. Fortunately, bond yields in Australia are more in line with long term sustainable levels so the risk of a sharp back up in Australian bond yields is less than is the case for global bonds.

After a disappointing start to 2010, diversified fund investors enjoyed solid returns during the second half of the year, largely reflecting the strength in world share markets. While the Australian share market tended to lag overseas markets during the year, the stronger Australian Dollar (which exceeded parity with the US Dollar for the first time since 1982) did detract significantly from unhedged global equity returns. Over the year to December diversified funds posted lacklustre, but nevertheless positive returns.

Global investment grade bond yields fell over the year to December resulting in capital gains and solid returns. However, global Government bond yields rose sharply towards the end of the year, and investment grade debt securities posted a negative return for the December quarter. This rise in yields, which was likely due to more positive growth expectations, occurred despite an announcement by the US Federal Reserve that they would carry out another round of Quantitative easing – outright purchases of US Treasury securities on the open market. Official interest rates have been maintained at historic lows in most major economies (and close to zero in the US and Japan).

Major asset class returns for the periods leading up to the end of December 2010 are shown in the table below.

Economic and market developments

The disappointing performance of world equity markets during the first half of 2010 reflected a combination of factors. The sovereign risk crisis enveloping the peripheral European economies – Greece most notably, but also Portugal, Ireland, Spain, and to some extent Italy – dominated the financial news for much of the year to date, and added to existing concerns about the durability of the global economic recovery. Those global recovery concerns arose largely on the back of a range of economic data – from the US and elsewhere – that tended to fall short of market expectations, but nevertheless remained broadly consistent with continued economic growth.

However, in recent months some of the leading indicators that were previously pointing to quite a pronounced slowdown in growth – or even perhaps a renewed recession in the US and elsewhere – now seem to have turned up again. While economic conditions and prospects for peripheral European countries such as Greece and Ireland remain dire, elsewhere economic conditions have been reasonably favourable.

The US economy continues to grow and generate jobs, but not yet at a fast enough rate to bring unemployment down in any meaningful way. In a surprising development prospects for US growth were given a boost over the month by the Obama Administration and Congress agreeing on a useful package of budget measures, including cuts to payroll tax and the extension of the Bush-era tax cuts.

Germany continues to lead the way in Europe, posting growth of close to 4% for the year to September, with solid growth in both consumer spending and business investment.

After experiencing one of the earliest and deepest recessions during the aftermath of the Global Financial Crisis, Japan has enjoyed one of the most impressive rebounds and is likely to have grown the fastest of the major economies for 2010 as a whole. However, the recovery has heavily dependant on a rebound in exports and by a relatively large fiscal stimulus. Over the year ahead the fiscal stimulus is likely to fade, and it is unclear how much more export-led growth Japan can enjoy, especially given the effect of a very strong yen.

The major emerging economies have enjoyed a robust, decidedly V-shaped recovery. The charts below show the performance of industrial output and export volumes in the major emerging regions. Many of these economies have benefited not simply from the recovery in their key export markets, but also from the fact that they have been in considerably better financial health than the developed world. After some moderation in activity during the year, the key emerging markets seem to have ended 2010 with renewed momentum.

In particular, growth in China and India remains spectacular despite some slowdown in Chinese growth during 2010. The decision by the Chinese authorities to increase lending rates by 25 basis points on Christmas Day may signal a new determination by the Chinese to address their rising inflation, which could cloud growth expectations going forward.

Rapid growth rates in China and India have had and continue to have profound implications for the performance of the Australian economy. The economic data in Australia currently describe a two-speed
economy where the resource rich states enjoy the benefits of a massive boost to Australia’s terms of trade and an enormous surge in business investment (although the shorterterm impact of the disastrous flooding currently being experienced across much of Queensland is likely to be severe). Elsewhere though, the picture is mixed. Outside of resources, business investment growth has been lacklustre. Some of the leading indicators of housing activity that had weakened around mid-year have recovered somewhat but do not suggest a massive upswing in housing activity. Employment growth remains very strong. Over the year to November total employment grew by 3.7% – the fastest annual rate of jobs growth since August 2005. At the same time consumers remain somewhat cautious, preferring to save a much greater proportion of what has been very strong income growth despite also reporting a quite high level of confidence.

Prospects

We have argued consistently over the past year or more that the world economy and financial markets are facing an environment that is considerably more uncertain than anyone has seen for some time. We expect overall economic growth in the developed world to be reasonable, but decidedly unspectacular. While we do not foresee a renewed recession or double-dip in the US, or in the world economy more generally, the outlook is still highly uncertain. The improvement seen in the recent economic data have made us, and indeed many other observers, more confident in this view. For those countries on the European periphery, the outlook remains much worse. If we look at Greece and Ireland in particular, what those countries are facing is utterly dire.

When it comes to prospective returns for the major asset classes, we are still of the view that over the medium-term, equities seem to offer the best return prospects for investors, particularly because traditional safe haven assets, such as Government bonds appear to offer poor future returns, especially in overseas markets. Broadly speaking, equity markets look to be fairly valued. While share prices have risen of late, so too have corporate earnings, and the outlook for the global economy remains generally supportive for share markets.

A key headwind facing the world economy is the prospect that financial institutions and consumers in the US, UK, and elsewhere will need to make further progress in repairing particular, private sector employment growth has been weak, but nevertheless positive some months now, and core labour incomes (i.e. private sector wage and salary income) are rising, albeit modestly. While rising incomes ultimately allow at least modest spending growth, it is still the case that both the demand for and supply of credit is likely to be subdued for some time, even though survey data increasingly show that banks in the US in particular, are now much less unwilling to provide credit. Moreover, there are signs that while households may be reluctant borrowers at this point, the demand for credit on the part of businesses – again most notably in the US – may be rising.

A continued recovery in the fortunes of the world economy is our core view, but there are a range of paths that such a recovery could take. Moreover, as suggested earlier, there is a real risk of policy error threatening the world recovery. Policymakers will be required to exercise some extremely difficult judgements over the coming years to sustain growth and prevent a slide into a Japan-style deflation, while also guarding against an excessive, undesirable rise in either asset price or generalised inflation further down the track. They will also need to rein in excessive budget deficits over the medium to longer-term. Even without further action to rein in these deficits in the near-term, past fiscal stimulus measures are running their course, and the positive impact of those measures has been fading, and will continue to fade.

Headline developments of the past week

• Sovereign debt issues in Europe raised their ugly head again over the last week. While the Irish austerity package was passed by its Parliament, investors were kept on edge by Moody’s putting Spain and Greece on credit watch, Standard and Poors doing the same for Belgium and bickering amongst euro-zone politicians about whether to increase the size of its bailout fund and about a longer term crisis resolution mechanism. This issue is likely to keep flaring up periodically for years, until public debt levels are clearly heading back towards more sustainable levels. In the meantime, the European Central Bank will continue to have to play a big role in keeping investor panic at bay by buying the bonds of troubled countries and ensuring that liquidity conditions remain easy. In this regard it is helpful that the ECB will receive an extra 5 billion euro of capital.
• Global bond yields continued to push higher as investors revised up their global growth expectations, with an unwinding of the record inflows of recent years into bond funds likely exaggerating the size and the speed of the sell off in bonds. Australian bond yields were little changed though and as they are well above global yields and are already around long term sustainable levels and so therefore are at much less at risk of a sharp sell-off.

Major global economic releases and implications

• Signs continue to build that the US economic recovery is gathering momentum with retail sales up strongly in November resulting in a gain of 7.7% over the last 12 months – so much for the US consumer being wiped out! On top of this industrial production rose solidly in November, business conditions in the New York and Philadelphia regions were solid, small business optimism rose to its highest level since December 2007 and unemployment claims continued to fall. Housing indicators remained softish though with a modest rise in housing starts but a further fall in permits to build new homes, demand conditions remaining poor according to home builders and new mortgage applications falling over the last week. At least housing seems to have found a floor though. Inflation remains down and out with the core CPI up 0.1% in November resulting in an annual gain of just 0.8%. While the Fed sounded a little more optimistic on the economy, it signalled that it remains in no rush to raise interest rates and will continue with quantitative easing as growth remains insufficient to bring down unemployment and inflation remains below levels that it is comfortable with.
• European data was generally favourable with another improvement in manufacturing conditions in November, led by Germany. While conditions in the services sector fell in November they remain levels consistent with reasonable growth. Euro-zone inflation remained benign at 1.9% year on year, or just 1.1% on a core basis.
• Japanese data was mixed with a softening in the Tankan business survey but a rise in a tertiary activity index.
• China reportedly raised its 2011 inflation target to 4%, from 3% for 2010, suggesting that it will allow time for inflation to fall back. This along with the likely maintenance of a reasonably high target for new loan growth in 2011 adds to confidence that China is not willing to crunch its economy in the face of higher food prices. While China maintained its growth target at 8%, this should be seen as more of a floor to growth rather than an actual objective.

Australian economic releases and implications

• Australian economic data was mixed over the last week. While dwelling starts fell sharply in the September quarter reflecting the earlier fall in building approvals and skilled vacancies fell in December, consumer sentiment edged up slightly and remains well above long term average levels, and new vehicle sales rose slightly in November. While the NAB business survey showed that business confidence fell in November reflecting last month’s rate hike, business conditions actually improved slightly and both remain at levels consistent with reasonable economic growth.

Major market moves

• Share markets continued to rally on the back of good global economic and corporate news.
• Commodity prices were mixed with gold down possibly on investor concerns that with the global outlook improving again the liquidity backdrop might become tighter and demand for a safe haven might recede, whereas base metal prices continued to benefit from improving confidence in the economic growth outlook.
• The Australian dollar rose modestly helped by the news that China left interest rates on hold despite fears last week that it would raise them.
  What to watch in the week ahead?
• In the US, data for existing home sales for November (due Wednesday) are likely to show a strong rise reflecting a 10% gain in pending home sales in October. New home sales (Thursday) are also likely to rise solidly. September quarter GDP growth (Tuesday) is likely to be revised up to 2.8% annualised and durable goods orders for November (Thursday) are likely to rise after a sharp fall in October.
• In Australia, the minutes from the Reserve Bank’s last rate setting meeting (due Tuesday) are expected to simply reinforce the message that interest rates are likely to remain on hold for several months.  We remain of the view that the RBA won’t start to tighten monetary policy until April next year at the earliest.

Outlook for markets

• Share markets are likely to benefit from seasonal strength over the next few weeks. The period from mid December into early January is normally positive for shares reflecting new year optimism, the absence of new capital raising and the investment of year end bonuses. Over the last 15 years, over this period the US share market has risen 11 times and the Australian share market 14 times.
• While GFC aftershocks will continue to cause volatility and shares may become vulnerable to a correction in January/February after several months of very strong gains, shares are likely to put in good gains through 2011 as a whole.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that the global economic recovery remains on track which should in turn drive another year of solid profit growth, the global liquidity backdrop is highly favourable underpinned by very low interest rates in key countries and quantitative easing in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends.
• Notwithstanding inevitable volatility, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia remain relatively high and high commodity prices keep the terms of trade near early 1950s highs. By end 2011 the $A is likely to have reached $US1.10.
• While low inflation, central bank government bond purchases and the absence of any near term monetary tightening should help keep bond yields in key advanced countries reasonably low in the short term, the risk of a sharp back up in bond yields at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels and sooner or later the record inflows into bond funds seen in recent years are at risk of becoming record outflows. The back up in bond yields over the last few weeks may be a warning sign of things to come.

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Headline developments of the past week

• Sovereign debt issues in Europe raised their ugly head again over the last week. While the Irish austerity package was passed by its Parliament, investors were kept on edge by Moody’s putting Spain and Greece on credit watch, Standard and Poors doing the same for Belgium and bickering amongst euro-zone politicians about whether to increase the size of its bailout fund and about a longer term crisis resolution mechanism. This issue is likely to keep flaring up periodically for years, until public debt levels are clearly heading back towards more sustainable levels. In the meantime, the European Central Bank will continue to have to play a big role in keeping investor panic at bay by buying the bonds of troubled countries and ensuring that liquidity conditions remain easy. In this regard it is helpful that the ECB will receive an extra 5 billion euro of capital.
• Global bond yields continued to push higher as investors revised up their global growth expectations, with an unwinding of the record inflows of recent years into bond funds likely exaggerating the size and the speed of the sell off in bonds. Australian bond yields were little changed though and as they are well above global yields and are already around long term sustainable levels and so therefore are at much less at risk of a sharp sell-off.

Major global economic releases and implications

• Signs continue to build that the US economic recovery is gathering momentum with retail sales up strongly in November resulting in a gain of 7.7% over the last 12 months – so much for the US consumer being wiped out! On top of this industrial production rose solidly in November, business conditions in the New York and Philadelphia regions were solid, small business optimism rose to its highest level since December 2007 and unemployment claims continued to fall. Housing indicators remained softish though with a modest rise in housing starts but a further fall in permits to build new homes, demand conditions remaining poor according to home builders and new mortgage applications falling over the last week. At least housing seems to have found a floor though. Inflation remains down and out with the core CPI up 0.1% in November resulting in an annual gain of just 0.8%. While the Fed sounded a little more optimistic on the economy, it signalled that it remains in no rush to raise interest rates and will continue with quantitative easing as growth remains insufficient to bring down unemployment and inflation remains below levels that it is comfortable with.
• European data was generally favourable with another improvement in manufacturing conditions in November, led by Germany. While conditions in the services sector fell in November they remain levels consistent with reasonable growth. Euro-zone inflation remained benign at 1.9% year on year, or just 1.1% on a core basis.
• Japanese data was mixed with a softening in the Tankan business survey but a rise in a tertiary activity index.
• China reportedly raised its 2011 inflation target to 4%, from 3% for 2010, suggesting that it will allow time for inflation to fall back. This along with the likely maintenance of a reasonably high target for new loan growth in 2011 adds to confidence that China is not willing to crunch its economy in the face of higher food prices. While China maintained its growth target at 8%, this should be seen as more of a floor to growth rather than an actual objective.

Australian economic releases and implications

• Australian economic data was mixed over the last week. While dwelling starts fell sharply in the September quarter reflecting the earlier fall in building approvals and skilled vacancies fell in December, consumer sentiment edged up slightly and remains well above long term average levels, and new vehicle sales rose slightly in November. While the NAB business survey showed that business confidence fell in November reflecting last month’s rate hike, business conditions actually improved slightly and both remain at levels consistent with reasonable economic growth.

Major market moves

• Share markets continued to rally on the back of good global economic and corporate news.
• Commodity prices were mixed with gold down possibly on investor concerns that with the global outlook improving again the liquidity backdrop might become tighter and demand for a safe haven might recede, whereas base metal prices continued to benefit from improving confidence in the economic growth outlook.
• The Australian dollar rose modestly helped by the news that China left interest rates on hold despite fears last week that it would raise them.
  What to watch in the week ahead?
• In the US, data for existing home sales for November (due Wednesday) are likely to show a strong rise reflecting a 10% gain in pending home sales in October. New home sales (Thursday) are also likely to rise solidly. September quarter GDP growth (Tuesday) is likely to be revised up to 2.8% annualised and durable goods orders for November (Thursday) are likely to rise after a sharp fall in October.
• In Australia, the minutes from the Reserve Bank’s last rate setting meeting (due Tuesday) are expected to simply reinforce the message that interest rates are likely to remain on hold for several months.  We remain of the view that the RBA won’t start to tighten monetary policy until April next year at the earliest.

Outlook for markets

• Share markets are likely to benefit from seasonal strength over the next few weeks. The period from mid December into early January is normally positive for shares reflecting new year optimism, the absence of new capital raising and the investment of year end bonuses. Over the last 15 years, over this period the US share market has risen 11 times and the Australian share market 14 times.
• While GFC aftershocks will continue to cause volatility and shares may become vulnerable to a correction in January/February after several months of very strong gains, shares are likely to put in good gains through 2011 as a whole.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that the global economic recovery remains on track which should in turn drive another year of solid profit growth, the global liquidity backdrop is highly favourable underpinned by very low interest rates in key countries and quantitative easing in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends.
• Notwithstanding inevitable volatility, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia remain relatively high and high commodity prices keep the terms of trade near early 1950s highs. By end 2011 the $A is likely to have reached $US1.10.
• While low inflation, central bank government bond purchases and the absence of any near term monetary tightening should help keep bond yields in key advanced countries reasonably low in the short term, the risk of a sharp back up in bond yields at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels and sooner or later the record inflows into bond funds seen in recent years are at risk of becoming record outflows. The back up in bond yields over the last few weeks may be a warning sign of things to come.

The post Weekly market & economic update 17 December 2010 appeared first on AdviserVoice.

Against this backdrop, the Australian equity market remains attractively valued. The overall market is trading on a price earnings ratio of around 12.7 times. This compares to an historical average ratio of closer to 14 times. As the chart below illustrates, the performance of the Australian equity market is highly correlated with earnings growth. In 2010 this relationship diverged, with the market lagging the improvement in earnings. This suggests some catch up is due in 2011, particularly given our expectation of continued solid earnings growth in Australia.

In terms of stocks, we continue to see value in cyclical sectors given the potential for an improvement in global growth next year, particularly if the US economy improves. Many cyclical companies are trading on modest multiples and earnings levels are lower than they should be on a long term view. Examples of the cyclical stocks that we favour include BlueScope Steel, Brambles, Billabong and News Corporation. These companies are particularly leveraged to an improvement in the US economy.

Whilst we have taken profit on some resource positions, selected stocks in this sector remain attractive given their leverage to stronger commodity prices and Chinese industrialisation. We particularly like BHP as it has significantly lagged its peers in the recent rally. BHP is trading around nine times next year’s earnings whilst many of the smaller, one commodity stocks are trading on 12 to 15 times.

The other sector of the market that could do well in 2011 is the banks. Much of the negative news that plagued this sector in 2010 is fully price in to current share prices and recent developments suggest regulatory risks may be abating.

The above information is of a general nature and has been prepared without taking account of your individual investment objectives, financial situation or particular investment needs. It is not intended as financial advice to retail clients. Before making an investment decision, you should consider the appropriateness of the information, having regard to your objectives, financial situation and needs. We recommend you consult with your financial adviser, who can help you determine how best to achieve your financial goals and whether investing in a fund is appropriate for you.

Global markets

Equities advanced for a second consecutive week as Barack Obama agreed to extend Bush-era tax cuts, which are widely expected to boost US growth, and the S&P 500 closed up 1.2% at 1,240 – a level last seen in September 2008. However, the cost of this fiscal stimulus, which is likely to run to trillions of dollars in years to come, caused a sustained sell off of US and other ‘core’ government bonds: with the yield on US ten-year bonds, or treasuries, spiking as high as 3.33% midweek.

Macroeconomic data also supported equities. UK industrial output rose 5.8% in the year to October, Japanese growth statistics were revised upwards, and the Nikkei 225 surged to a seven-month high. China’s November exports increased 35% over a year ago – but this and stubbornly rising prices are stocking expectations that the government will tighten the money supply by raising interest rates before the end of the year.

Higher US bond yields generally support the greenback, and the US dollar rose 1.5% against the yen and the euro. Silver, increasingly seen as an inflation-hedge by investors, hit an all time high of over $30 an ounce – while gold, copper and oil also remained in demand, before falling back slightly from cyclical peaks seen midweek.

Global equities

The FTSE 100 rose 1.2%, driven in part by the prospect of acquisition activity. Smith & Nephew spiked over nine per cent on conjecture that private equity outfits are eyeing the artificial-joint maker. Anglo-Danish security firm G4S rose on similar speculation, while shares in Cobham – which have fallen 20% this year – rebounded on rumours that US defence conglomerate Northrop Grumman is considering a bid. Burberry rose 6.5% on talk of a Far Eastern bid for the luxury goods retailer. Meanwhile, FTSE 250 stalwart De La Rue surged 25% as it emerged French rival Oberthur Technologies had twice
offered to buy the 200-year old bank-note printer in the last two months.

The US Treasury, which has spent $45bn shoring up Citibank, sold its remaining shares in the country’s third largest lender at an estimated $12bn profit – it is now looking to accelerate the disposal of its holding in insurance giant AIG. Diageo, formerly known as Guinness, emerged as a possible bidder for US consumer products specialist Fortune Brands’ drinks portfolio, including Jim Beam and Courvoisier brandy.
European carmakers BMW and Volkswagen rose strongly on the back of well-received Chinese economic data – both are major exporters to the country – while privately held Swiss-based commodity trading giant Glencore is apparently mulling a $31bn London listing.

Global bonds

US government bonds prices plummeted midweek on concern that renewing the previous Administration’s tax breaks will result in higher levels of borrowing. Although prices rebounded on a well-received auction of 30-year securities, the closing yield of 3.30% on ten-year debt was 30 basis points up on the week, and nearly one per cent higher than mid-October. Despite positively interpreted economic data, UK ten-year government bonds yields were higher at 3.52 as against 3.40% a week ago – nonetheless, the differential between UK and US borrowing costs has narrowed to a low of around 20 basis points – a spread
of 50 basis points has been typical of recent months. German government bond yields rose by 12 basis points to 2.97%, having at one stage breached three per cent. Less in the news, Japanese ten-year yields are also sharply up – and at 1.20% are around 25% higher than a month ago.

It was a mixed week for peripherals. A meeting of EU finance ministers could not agree measures – such as a European-wide sovereign bond, or ‘E-bond’ – to contain the crisis in weaker members’ finances – a failure widely blamed on German government intransigence – and Spanish and Portuguese yields moved up around 20 basis points in thin trading. The Irish parliament narrowly approved the government’s austerity budget – and Irish bond yields dipped slightly on Friday, shrugging off a two-notch downgrade from ratings agency Fitch.