Assessing risk is one of the key factors in the investment process since every investment involves some level of risk. Most investors consider medium to high probability risks when making their investment choices. Low probability risks tend, perhaps understandably, to garner less attention. However, in our view, considering the impact of a variety of risks is crucial for effective risk management. It is important not only to consider high probability risks, but also low probability ones, especially where they would have a serious negative impact. This is a lesson that many investors learned when the GFC occurred and they were taken unawares.

Bonds have started to fall out of favour as investors are worrying about the end of the bond rally and rising interest rates in the medium term. However, were a low probability, high impact risk to occur, then it’s important to maintain an allocation to bonds in a diversified portfolio. If investors had had a higher allocation to traditional defensive Australian fixed income funds during the GFC, their portfolios may have been better protected. Fixed income provides superior volatility-adjusted returns (return per unit of risk) than equities, which has benefited fixed income investors during economic downturns.

In this paper, we discuss three low probability, high impact risks that Tyndall AM has been factoring into its thinking about the global macroeconomic landscape. We emphasise that we believe these events are unlikely to occur, but that the fallout if they did could be extremely severe. In such a situation, the portion of an investor’s portfolio allocated to bonds could help cushion the overall portfolio losses on the equity portion.

Is there a Canadian housing bubble and what would happen if it pops?

Interest rates across the world are at record lows and major central banks are indulging in huge quantitative easing (QE) policies. This has created a large amount of money that needs to be deployed. Following the GFC, banks globally have been reluctant to lend, particularly to small and medium-sized businesses. However, in some countries that came through the GFC relatively unscathed, banks have been willing to lend to individuals, in particular to invest in real estate.

In Canada, the household debt to GDP ratio has been steadily rising, such that it now stands at almost 100% of GDP (see chart 1). According to the World Bank, the increase in this ratio since 2006 has been faster in Canada than any other country.

This phenomenon seems to be driven heavily by mortgage borrowing, which would explain the hefty rise in house prices over the same period (see chart 2).

Countries that suffered severe housing market over-pricing in the lead up to the GFC, such as the US and Ireland, saw a strong correction and haven’t recovered much since then. As a result, those countries are now slightly undervalued. Countries that weathered the GFC more successfully are now the ones facing potential housing bubbles. As chart 3 shows, Canada was second only to Norway in that list as of the end of 2012 and Canada’s house prices are more than 60% higher than their long-term average. The Organisation for Economic Co-operation and Development (OECD) has ranked Canada as one of the countries most at risk of a price correction, especially if borrowing costs increase or income growth slows.

Due to its well-regulated financial system and fairly solid banks, Canada has been seen as a relative safe-haven following the GFC, attracting significant foreign capital inflows. Former Governor of the Bank of Canada (now Governor of the Bank of England), Mark Carney sounded the warning bell over using these foreign capital inflows to inflate the housing market rather than putting it towards business initiatives. He said that it was like a film that has “just played in a major cinema just south of here, over and over and over again, and it would be the height of folly to repeat those mistakes.” 1

Construction projects are booming in response to demand from investors and home buyers taking advantage of record low interest rates. But analysts are warning that Canada’s housing market is due for a correction due to this overbuilding, as well as overvaluation and excessive household debt. The Bank of Canada recently noted: “The elevated level of household debt and stretched valuations in some segments of the housing market remain an important downside risk to the Canadian economy.” 2

The immediate impact of a major housing market correction would be on the Canadian banking system. However,

Canada’s banks remain relatively strong and although a slump in the housing market could create difficulties for the smaller banks, it is unlikely to have the same deadly impact in Canada as the slump in Irish property had on banks in Ireland. In addition, although Canadian banks extend globally, especially into Latin America and Asia, they are still minor players compared with major US or European banks so the knock-on effects would be more muted.

For Australian banks, the direct impact would likely be limited given that their exposure to Canadian banks is relatively low. However, the similarities between Canada and Australia could cause a severe weakening of sentiment towards Australian banks if their Canadian counterparts were to stumble. In such a case, the Australian banks’ dependency on offshore funding for a substantial part of their balance sheet could become a pressure point and the cost of funding could become elevated. Although it’s unlikely that this alone would be sufficient to cause major disruption in the Australian banking system, it could affect the credit spreads on the banks’ bonds and lead them to underperform for some time.

What are the downside risks for China?

China’s economy is no longer seeing the stellar growth that it had become accustomed to. The consensus view is that the country is unlikely to suffer a hard landing. While this is the most likely scenario, there are several issues about China that concern us: its shadow banking system, the extent and size of which is staggering; property prices in the major urban centres, which are displaying bubble-like conditions; and local government debt levels.

Shadow banks issue liabilities and hold assets, much like normal banks. However, unlike banks they lack an official lender of last resort. The International Monetary Fund (IMF) has pointed out that “a fast-growing share of credit is flowing through the less-well-supervised parts of the financial system.” 3   In fact, JP Morgan Chase & Co. estimates that from 2010 to 2012, shadow lending doubled to an estimated 36 trillion yuan or about 69% of China’s GDP. 4 The vast proportion of shadow banks’ business involves wealth management products (WMPs), which raise money from investors in large increments and for short periods. The problem with WMPs is that they have a potentially risky duration mismatch with the long-term underlying illiquid assets (such as property) they are secured against. The other issue is that those assets are not usually disclosed to investors so that they have no idea what they’re investing in. Often the banks repay maturing WMPs using money raised from new WMPs, which creates huge risk if the underlying assets were to perform poorly or default.

Another concern with shadow banks is that they are deeply intertwined with the commercial banks, which means there could be a knock-on effect if any of them fail. Shadow banks have sprung up because of the official policy of financial repression, where interest rates have been held at artificially low levels for a very long period to enable banks to keep lending to enterprises and governments, especially those engaged in building infrastructure. This drives Chinese households into WMPs in search of yield above the sub-inflation rates they are offered on bank deposits. The problem is that if enough of the riskier WMPs fail, investors might stop buying new products. Given the short-term nature of the WMPs vs. the long-term nature of the underlying assets, it could lead to a credit crunch on otherwise solvent projects.

The housing bubble issue is related to that same search for yield. China has very few investment vehicles on offer and real estate is one of those few. Prices continue to rise as a result, particularly in the larger cities, such as Shanghai, Shenzhen and Beijing. However, the pace of building may be starting to outstrip sales, particularly outside the larger cities where there is a growing stock of completed but unsold homes. The government has tried to curb this appetite for real estate, but with economic growth weakening it can’t risk leaning on the housing market too hard while it remains an engine for growth. Another concern is how indebted the property developers are, which makes them vulnerable to any downturn.

In December 2013, China announced the results of a debt audit on local governments, which included contingent liabilities and debt guarantees. The audit revealed that liabilities of local governments totalled 17.9 trillion yuan as of the end of June, compared with 10.7 trillion yuan as of the end of 2010, a 67% increase.5 Local authorities have been using debt to fuel growth, channelling money into infrastructure projects, some which may not have been particularly viable. However, given that the debt is almost all denominated in the domestic currency (yuan) and owned domestically, the central bank can prevent a crisis by deploying its unlimited liquidity supply.

The Chinese government realises that growth via such an investment-based economy is unsustainable. As a result, it is attempting to shift growth away from fixed asset investment towards domestic consumption, but this rebalancing is a delicate task. 2013 has seen repeated bouts of stress in China’s money markets as the government has attempted to tighten monetary conditions and reduce the economy’s reliance on cheap capital. By raising short-term rates and making them more volatile, the government is encouraging banks to stop relying on short-term liabilities in the interbank market to finance risky longer-term assets. Although the government doesn’t want to see a severe cash crunch, a miscalculation is possible if it doesn’t correctly predict the supply of and demand for cash when conducting monetary tightening. China needs to reform its financial sector, rein in government debt and increase consumer spending all at the same time – not an easy task.

Given how much control authorities have over the economy, for a crisis in China to emerge, it would likely be an accident, the result of an underestimation by authorities of the magnitude of one of these three issues and letting it get out of control.  Any resulting slowdown would threaten stable growth in other economies. Australia in particular would be hit extremely hard by a crisis in China, so although such an occurrence might be extremely unlikely, it must be a factor in Australian investors’ thinking.

The post Assessing risk: low probability, high impact events appeared first on AdviserVoice.

Europe slides towards deflation

Greece, as is often the case, is a bellwether for all that is going wrong in Europe. Among the latest woes for an economy that has contracted for six years straight is deflation.

Greece has battled deepening deflation since reports showed prices fell 0.2% in the year to March.¹ By the 12 months ended November, deflation was running at an annual pace of 2.9%, thanks in no small part to a jobless rate of 27% triggering a 12% plunge in wages.

In recent months, the list of eurozone economies suffering from annual deflation peaked at four; Cyprus, Ireland and Latvia, which started using the euro on January 1, are the others featured. This deflation roll threatens to expand because in November prices dropped in Belgium, Estonia, Italy, Luxembourg, Malta, the Netherlands, Portugal and Slovenia, while prices were flat in France, Finland, Slovakia and Spain. (See table below.) For the eurozone, prices slid 0.1% in November and only rose 0.9% in the 12 months to November. (Eurostat said on January 7 released as estimate that showed prices in the eurozone only rose 0.8% for 2013.) Such is the concern about deflation on top of a jobless, banking and sovereign-debt crisis that the European Central Bank in November unexpectedly cut the cash rate to a fresh record low of 0.25%, in a bid to get prices to inflation at closer to its 2% target.

No one should be surprised by Europe’s slide towards deflation. It’s the logical and foreseeable consequence of the austerity and market-based reforms inflicted on bailed-out countries. The worry for investors is that deflation carries big risks for Europe if it spreads and that policymakers are split on how to stop deflation infecting more countries.

A brief spurt with deflation in peripheral countries won’t damage the eurozone, to be sure. It’s probably more likely that eurozone prices will rise at some sluggish rate in coming years, rather than tumble. Surveys show that people still expect prices to rise at an annual rate of 2% or over the next 12 months (perhaps a side benefit of all the spurious warnings about inflation). There is such a thing as “good” deflation too. Greater productivity due to technological innovations or supply shocks such as the entry of China’s cheap workforce into the world economy from 1978 can lead to benign declines in prices that raise living standards.

The deflation taking hold in bailed-out peripheral countries might not be classed as “good” as it is accompanied by crippling unemployment but the relative price adjustments has benefits. It is helping these countries regain their international competitiveness – Ireland, Portugal and Spain are now posting current-account surpluses and Greece is close to one. For within a fixed exchange-rate system, the only way current-account deficit countries can re-grasp their export edge is to engineer lower inflation rates than those prevailing in surplus countries. Since inflation in creditor countries is low, that means deflation for debtor nations. But even if there is this competitive benefit, the deflation in peripheral countries threatens to mutate into the “worst kind of deflation”, as Reserve Bank of Australia’s Glenn Stevens described this danger in 2003.² This is when a slump in domestic demand leads to a “persistent and widespread expectations of falling prices” that becomes a self-perpetuating downward spiral. Such an outcome cripples, among other victims, people and countries with excessive debts – and government debt in the eurozone has now reached 93.4% of GDP.³

Euro straightjacket

A glance at the 1930s shows how devastating deflation can be and why it is taking hold in Europe. Many economists now trace the scourge of the Great Depression to the flawed nature of the gold standard to which countries including Australia adhered. Pre-World War I, this fixed-exchange-rate regime soothed current-account imbalances by inflicting a dose of deflation on deficit countries and inflation on surplus countries – thus restoring balance among the gold-pegging countries. (A trade deficit led to gold outflows, thus a contraction in the money supply, which lowered prices, and vice versa. The rebalancing, called the “price-specie flow mechanism”, was underpinned by lending from surplus to deficit countries.)

But in the 1920s, financial distortions from the cost of the war and the fact that countries fixed their currencies to gold at inappropriate levels sabotaged this mechanism. For various reasons, surplus countries such as the US stopped recycling the lending that trade-deficit (and gold-losing) countries such as Germany needed to soothe balance-of-payments crises. Deficit countries were forced into deflationary spirals that triggered depressions to maintain their fixed exchange rates and restore competitiveness. Countries only escaped deflation by quitting the gold standard. Australia took this recovery option in 1932.

The euro is a more rigid system than the gold standard. Unlike the gold peggers, members of the eurozone lack their own currency, so can’t readily quit the exchange-rate system. Euro users lack their own monetary policy. They share a half-baked central bank, one that lacks lender-of-last-resort powers. The sole macro tool of policymakers is fiscal policy, though; through fiscal policy and other powers, they can implement reforms to regain competitiveness. That’s why policymakers felt they had little choice but to inflict a dose of austerity-induced deflation (an “internal devaluation”) to make their countries export fit again.

Bad deflation is a curse anywhere. It weakens economies as it boosts real interest rates (even if nominal rates are 0%). It prompts consumers to postpone purchases in the hope that goods will be cheaper tomorrow. The resultant slump in sales forces businesses to cut prices, which reduces their profits. Bad deflation drives up real debt burdens. Under the euro straightjacket, this combination could prove lethal for the eurozone. A deflating economy battering government revenue and forcing more spending on social security is bolstering debt-to-GDP ratios to the point of default, especially for Greece. At the end of the second quarter, this ratio stood at 169% in Greece, 130% in Italy, 131% in Portugal and 92% in Spain.⁴ The other reason why deflation is dangerous for southern Europe is that it makes it difficult to attack the jobless crisis that is sapping political stability in troubled countries.

Policy loggerheads

The deflation in peripheral countries reveals how eurozone policymaking is at cross-purposes. By cutting rates, the ECB is acting against the austerity (deflationary) policies that are making the struggling countries more competitive but which boost their likelihood of default. The central bank’s as-yet-unused pledge to buy the government bonds of troubled countries and its lending to commercial banks against junk assets are other ECB policies that hinder the competitive recalibration in southern Europe. There is no guarantee that rate cuts or unorthodox monetary policies, which could one day include quantitative easing, will help peripheral economies grow enough anyway to allow governments to get their debts under control. Their banks have too many dud loans to resume normal lending. The risk is that ECB’s steps to combat deflation will only over-inflate housing and other asset markets in creditor nations, especially in Germany.

There are solutions to preventing deflation taking hold across the bloc. But they involve the creditor nations – that is to say, Germany – agreeing to higher inflation. If Germany allowed its inflation to rise to, say, 5% then Greece could regain competitiveness with inflation of 2%. But as Germany’s inflation is 1.2%, deflation it must be for Greece. Alas for Greece and others, there is little chance of Berlin agreeing to a higher inflation target for Germans are still tormented by memories of the hyperinflation of 1921-23 – perversely forgetting how deflation and unemployment helped Adolf Hitler ascend to power. In fact, Germany is putting downward pressure on its inflation by reducing its fiscal deficit at a time when its neighbours would benefit from more domestic demand in Europe’s largest economy that expanded just 0.3% in the third quarter. Even as fiscal policy is squeezed in Germany, inflation fears triumph. Chancellor Angela Merkel told an election rally last year that the ECB “for Germany … would have actually have to raise rates” to dampen inflationary pressures.⁵

Such thinking helps explain why the two German members of the ECB’s 23-strong policy-setting board led a six-vote attempt to prevent the ECB’s rate cut in November. Influential German economists and mainstream financial media slammed the rate reduction, in what is another example of how perceived national interests being placed ahead of the eurozone’s welfare dog the continent’s future.

Frustration is growing at Berlin’s attitude against regional solutions such as a proper banking union (which would help resume lending and snip the suicide-pact between governments and banks), shared debt (eurobonds), fiscal transfers and higher inflation. The best hope for the eurozone may well be that German self-interest demands that it consider the welfare of the region, not least of all because EU members take nearly 60% of its exports. Troubled neighbours absorb rescue money and any default by a eurozone country or departure from the euro could wreak huge losses on Germany. Another hope is that Germany’s new ruling coalition between Merkel’s centre-right Christian Democrats and the leftist Social Democrats was moulded on promises to boost pensions and wages and boost fiscal spending.

The pressure on Berlin and other creditor countries to boost their economies will only grow now the deflation in southern Europe threatens to blight the eurozone. But it’s questionable whether enough pressure can be mustered against the danger of deflation to prompt an imminent solution that prioritises the welfare of the region above all.

Inflation figures come from Bloomberg and Eurostat while other financial information comes from Bloomberg unless stated otherwise.

Inflation in the 18 countries in the eurozone

Eurostat release 196/2013. “Euro area inflation up to 0.9%”. 17 December 2013. Countries ordered as done by Eurostat.
http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-17122013-AP/EN/2-17122013-AP-EN.PDF

1 Hellenic Statistical Authority or ELSTAT. Consumer price index. Timeseries 03. Comparisons of the overall consumer price index (2009+100.0). The main El.Stat page in English is: http://www.statistics.gr/portal/page/portal/ESYE
2 Glenn Stevens, the Deputy Governor of the Reserve Bank of Australia. Speech to the South Australian Centre for Economic Studies April 2003 Economic Briefing. 10 April 2003. Copy published in the Reserve Bank of Australia Bulletin, April 2003. http://www.rba.gov.au/publications/bulletin/2003/apr/pdf/bu-0403-3.pdf
3 Eurostat. “Euro area and EU28 government debt up to 93.4% and 86.8% of GDP.” 23 October 2013. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-23102013-AP/EN/2-23102013-AP-EN.PDF
4 Eurostat. Op. cit.
5 Reuters. “Update 1 – Merkel: ECB would have to raise rates if looking at Germany only.” 25 April 2013. http://www.reuters.com/article/2013/04/25/germany-ecb-merkel-idUSL6N0DC26720130425

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by Michael Collins, Investment Commentator at Fidelity

The post Europe’s crisis response stirs danger of deflation appeared first on AdviserVoice.

In fact, in the Interactive Asset Allocation Model recently made available on our online research portal iRate, the likelihood attributed to each of four different inflation scenarios (Functional or disinflation, Inflation, Deflation, and Stagflation) is a key input to strategic asset allocation decisions.

The one question we (and all economists, central bankers, and other pundits around the world) have struggled with for the past few years is whether deflationary or inflationary forces will eventually prevail.  The Great Recession has spread from the US to Europe and more recently to emerging markets.

Outlooks for growth are diminishing everywhere and it stands to reason that if this trend isn’t reversed, deflation may soon take hold. On the other hand, central banks have used every play in (and off) the book to avoid deflation.

The US and the EU have lowered interest rates to zero or near-zero levels. In the past few weeks the Federal Reserve and the European Central Bank announced new rounds of quantitative easing, which combined with their previous actions (QE1, QE2, LTROs etc) and various forms of government stimulus – not just in the US and Europe but in China as well – amount to an unprecedented flooding of liquidity into the financial system. Or in other words, the perfect storm for future high inflation.

While the price of gold is often used as a barometer of inflation fears, a little known fact is that silver is often more sensitive to changes in inflation or deflation. The use of silver is roughly equally split between industrial and monetary uses. As a monetary metal, silver will (very much like gold) appreciate when global sentiment shifts toward expectations of higher inflation, as investors look for ways to shield their capital.

At the same time, since above-ground inventories of silver are relatively low and demand for silver in the industry is significant, it is also considered a particularly volatile metal. Therefore, the process of silver price appreciation (or depreciation) is accelerated, when compared to gold’s. Chart 1 tracks inflation (as measured by the US CPI) and the ratio of the silver price to the gold price over time.

A technical analysis of the chart shows that on three distinct occasions over the past 20 years, the breaking of long-term trendlines in the silver/gold ratio was followed by major shifts in inflation.

Chart 2 focuses on the latest data for the silver/gold ratio, and shows a clear breakout of the trend line to the upside.

As a stand-alone indicator, we wouldn’t give disproportionate attention to the technical analysis of the silver/gold ratio, but it happens to be supported by some mainstream economic data. The S&P GSCI Index of commodities has risen close to 20% from its lows in mid-June, a fact often overlooked in Australia where we have focused on the recent slide in iron ore prices.

It is evidently too early to assert that inflation has won its tug of war with deflation, but it seems that the printing of money in the US and Europe has initiated of phase of reflation. It remains to be seen whether this trend will last, and more importantly, whether it will result in inflation or stagflation.

For more articles from van Eyk Research, download the van Eyk View iPad app
http://itunes.apple.com/au/app/the-van-eyk-view/id476210180

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Is the US economy about to take off?

Will China continue to dominate?

Will the Aussie dollar be stronger for longer?

How high will interest rates go?

Is there a housing bubble?

What we will be the impact of climate change policies?

Will inflation or deflation rule?

How long before shares return to record highs?

How tight is the job market?

Click here to download this document (pdf)

The post Big issues for 2011 appeared first on AdviserVoice.

Headline developments of the past week

• While there was good news at the start of the week in terms of Ireland agreeing to accept a bailout from the European Union and the IMF, the worry list for investors actually expanded. It now includes worries about whether Ireland will deliver on its austerity package, concerns that Portugal will need a bailout too, an insider trading case in the US, ongoing issues with US mortgages, renewed tensions on the Korean peninsula, worries that China will tighten too much and concerns that rising inflation in emerging countries will become a problem. With this list of worries its little wonder investors are skittish.
• However, there are some positives worth noting. Firstly, the flow of economic data in Europe tells us that Germany and other core European countries are providing an offset to the weakness in peripheral countries. And at least Europe is now moving quickly to provide assistance to troubled countries. Secondly, US economic data is looking healthier. Thirdly, while North Korea is an ongoing worry, over the years it has a habit of doing provocative acts only to settle down again. Fourthly, while we are seeing almost a daily flow of news regarding tightening measures to combat inflation in China there is nothing in any of this to suggest that the Chinese authorities are going to crunch their economy, particularly with the pick up inflation essentially due to weather related food prices increases. Similarly, higher food prices accounts for most of the rise in inflation rates in other emerging countries and so is not a reason for aggressive monetary tightening. And finally, investors would be wise to remember the old saying that “shares climb a wall of worry”, in that its often when the worry list seems the longest that shares do their best, because invariably some of the worries start to fade which then prompts investors to close shorts and/or buy shares.
• In Australia, RBA Governor Glenn Stevens indicated that once allowance is made for the additional increase in bank lending rates and the strong Australian dollar, the current level of the cash rate is appropriate for the “period ahead”. This is pretty much in line with market expectations that rates are on hold for now. However, the Governor’s assessment that the medium term risks to inflation are that it will be too high on the back of only modest amounts of spare capacity and the need to accommodate a huge expansion in mining investment indicate the Reserve retains an inclination to continue raising interest rates next year. This was reinforced by the Governor’s observation that growth in labour costs is now rising. Our view is that the cash rate is likely on hold until March, but that it will rise to a cyclical peak of 5.5% in a year’s time.

Major global economic releases and implications

• US economic data came in on the positive side on balance. Data for home sales were weak and house prices also fell in September, but against this, weekly mortgage applications for new homes rose strongly suggesting that there is some light at the end of the housing tunnel.  While durable goods orders fell in October this may reflect a seasonal distortion. On the clearly positive front though, September quarter GDP growth was revised up, manufacturing surveys in the Richmond and Kansas areas both rose solidly, consumer sentiment rose and there was another sharp fall in weekly unemployment claims taking them to the lowest level since July 2008. The basic message from the flow of US economic data is that the recovery is continuing.
• European economic data was also mostly positive with rises in consumer confidence and business conditions. Germany remains a standout with business conditions rising to their highest level on record according to the IFO survey. Business confidence also rose in Belgium, France and Italy.
• In China, we saw more signs of tightening, including indications that banks will have to wind down lending in the last two months of the year in order to stay within the Government’s 7.5 trillion Renminbi target for new loans this year, given that so far 6.9 trillion has been lent out, indications that this target will be wound back down to 6.5-7 trillion RMB for next year and indications from the central bank that it will “normalise” monetary policy after running stimulatory monetary policy for several years. However, even if the new lending target is wound back to 6.5 trillion RMB this will still see credit growth of around 14%% & because monetary conditions are coming from very easy currently we remain of the view that such moves won’t crunch the economy.
• Across Asia, growth rates have slowed from the double digit pace seen earlier this year as activity bounced back from the GFC, but are still around 5 to 10%. Moderation is necessary to avoid overheating.

Australian economic releases and implications

• Australian economic data was somewhat mixed. Construction activity unexpectedly fell in the September quarter due to a fall in housing activity. While business investment rose in the September quarter, intentions for 2010-11 were scaled back. However, it’s worth noting that based on long term realisation ratios investment is still expected to surge by around 20% this financial year, which compares to the Governments forecast for an 8% rise. The scaling back from a previously implied rise of 25% may simply reflect capacity constraints rather than any loss of confidence. Mining investment looks like rising around 45%.
• An agreed large increase in pay for aviation workers secured by the Transport Workers Union averaging around 4.5% pa over three years has added to concerns about upwards pressure on wages. This will no doubt serve to maintain the Reserve Bank’s inclination to raise interest rates further next year.

Major market moves

• Share markets had another volatile week, initially being affected by the North Korean attack on South Korea and ongoing debt concerns in Europe, but settled later in the week after positive economic news out of the US and Europe lifted spirits.
• Commodity prices rose on the back of stronger global economic data, but the Australian dollar slipped back on softer than expected economic data in Australia and RBA comments that rates are appropriate for the period ahead. The euro also weakened further against the $US.

What to watch in the week ahead?

• In the US, key to watch will be the ISM manufacturing conditions index (due Wednesday) which we expect to remain solid and employment data (Friday) which is expected to show another 150,000 gain in payrolls but unemployment remaining high at 9.6%. Consumer confidence data (Tuesday) is likely to show a small improvement as are pending home sales (Thursday) and the ISM non-manufacturing index (Friday) is likely to remain solid. Against this house price data (Tuesday) is likely to show further weakness lagging the earlier fall in housing activity indicators. The Fed’s Beige Book of anecdotal evidence on the economy will also be released.
• In China, the official and HSBC PMIs, or business conditions indicators, (due Wednesday) are likely to remain solid but show a small fall back after recent strong gains.
• The European Central Bank meets on Thursday but is likely to leave interest rates on hold at 1%, and may signal a slower exit from its liquidity boosting measures given public debt problems in Europe.
• The week ahead in Australia will see an avalanche of data releases. The main focus will be on September quarter GDP growth (due Wednesday) which is likely to show growth of around 0.5%, or 3.4% year on year after an unexpectedly strong rise of 1.2% in the June quarter. Consumer spending is likely to be a key driver, with flat business investment and a fall in dwelling investment. Other data to be released includes: profits, inventories and new home sales (all due Monday), building approvals (Tuesday) which are likely to show a bounce after a sharp fall in September, private credit (Tuesday) which is likely to remain soft and retail sales (Wednesday) which are expected to show growth of around 0.2%. A couple of speeches by RBA officials, including Governor Stevens, will also be closely watched.

Outlook for markets

• It’s too early to say whether the share market correction we have seen since early November is over or not. However, we continue to expect solid gains in shares into year end and through next year. Shares are cheap, particularly relative to government bonds, the run of better than expected economic data globally is continuing suggesting that the global recovery remains on track, the global liquidity backdrop is highly favourable underpinned by QE2 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. The period from US Thanksgiving to May is normally strong for shares, particularly December and January.
• Notwithstanding normal bumps along the way, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia continue to trend up, and commodity prices resume their rising trend. It’s likely that the $A will settle around $US1.10 in the year ahead.
• Deflation worries, along with central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

The post Weekly market & economic update – 26 November 2010 appeared first on AdviserVoice.

Headline developments of the past week

• Worries about Europe’s debt problems and tightening in China were again key issues for investors over the last week, and had the effect of initially pushing share markets down ahead of a reversal later on as some of the fears receded. Europe seems to be moving pretty quickly this time to try and limit the contagion from Ireland to other European countries – in fact, a bailout package for Ireland from the IMF and European Union looks imminent.
• Concerns about an aggressive tightening in China receded a bit after Chinese authorities announced a range of administrative measures to curb inflation. These involved measures to boost the supply of key foodstuffs, subsidies for low income households, temporary price controls on necessities and a crackdown on speculation. While the merits of price controls can be debated, to the extent that China is relying on targeted administrative measures to control inflation it may help take pressure of blunter less targeted measures such as interest rate hikes. However, Friday’s hike in the banks’ required reserve ratio – the fifth this year – highlighted that macro tightening is still on the agenda. The increase in the reserve ratio is necessary to mop up the increase in the money supply being generated by the current account surplus and the managed exchange rate. We still anticipate a few interest rate hikes and a further increase in the banks’ required reserve ratio going forward, but remain of the view that they will not be aggressive enough to crunch the Chinese economy.

Major global economic releases and implications

• US economic data over the last week was all over the place. Housing starts, weekly mortgage applications and a survey of home builders were all soft – but at least still seem consistent with housing activity having found some sort of bottom. Industrial production was flat and manufacturing surveys were mixed – weaker in the New York region but much stronger in the Philadelphia region. Clearly positive though were weekly jobless claims essentially sustaining the sharp fall seen in the previous week, a fall in mortgage delinquencies in the September quarter and a better than expected rise in a leading index for October. Producer and consumer price inflation both came in on the soft side. In fact, core consumer prices have now been flat for three months in a row and the annual rate was the lowest level every recorded (with data back to 1957). Quite clearly all of this provides support for the Fed’s commencement of QE2 – mixed economic indicators suggest that growth is still too low for comfort and inflation is verging on deflation. It is now more than 18 months since the Fed started QE1 and yet there is no sign of the hyperinflation that many were predicting when it was first announced.
• Meanwhile, a forceful defence of the Fed’s latest round of quantitative easing (QE2) by Ben Bernanke provided confidence that the Fed will not be abandoning it, as investors might have been starting to fear given the heavy criticism it has attracted in both the US and globally since first announced.
• In Japan, the big surprise was a rise in annualised GDP in the September quarter of 3.9% driven mostly by strong consumer spending. However, it is hard to see this pace being sustained as consumer spending falls back and the strong Yen constrains exports.
• The pressure from rising food prices on inflation was also evident in Korea which raised its short term interest rate for the second time since the GFC to 2.5%. Further rate hikes are likely next year.  Meanwhile, GDP growth remained strong in Taiwan and Singapore in the September quarter with both growing around 10% year on year, underlining the continued strength in Asia.

Australian economic releases and implications

• In Australia two things stand out from the minutes from the last Reserve Bank Board meeting and a speech by Deputy Governor Ric Battellino. The first is that the RBA does not see any urgency to raise interest rates again: the November move itself was finely balanced; the over and above rate hikes from the banks were probably more than the RBA expected; housing has slowed and consumers remain cautious; and we have seen a renewed intensification of worries about sovereign debt in Europe. However, the second point is that the RBA still retains an inclination to raise interest rates further. This is clearly evident in Ric Battellino’s comments that the challenge going forward will be to manage the economy in a way that contains inflation in the face of the large amount of money likely to flow into the economy in the next few years as a result of the mining boom and that over the medium term inflation is more likely to rise than fall. So putting it all together while we don’t see the next rate hike coming until February at the earliest, in a year’s time the cash rate is likely to have increased to around 5.5%.
• Over the last week though, Australian economic data provided a messy picture. On the one hand car sales and skilled job vacancies came in on the soft side but on the other wages growth on the RBA’s preferred measure showed further signs of acceleration.

Major market moves

• Global share markets had a roller coaster week, initially falling sharply before recovering some lost ground as a bailout for Ireland seemed to be nearing, worries about an aggressive tightening in China receded a bit, economic data and profit news came in better than expected, the successful General Motors IPO helped boost confidence and Fed Chairman Bernanke provided a strong commitment to quantitative easing. While Asian and Australian shares fell over the week, US shares were flat and Japanese and European shares actually rose. Japanese shares now seem to be benefitting from the weaker Yen.
• It was a similarly rough ride for commodity prices and the Australian dollar with initial sharp falls giving way to some recovery as global growth concerns receded a notch.
• It’s interesting to note that despite the gyrations in growth trades such as share markets over the past week bond yields have moved higher. While this may reflect traders unwinding excessively long positions built up through the mid year growth scare and in anticipation of QE2 it is also consistent with a greater degree of confidence in the global growth outlook.

What to watch in the week ahead?

• In the US, October home sales data are likely to slip back a notch after strong gains in September, September quarter GDP growth is likely to be revised up slightly from the 2% annualised pace initially reported and durable goods orders are likely to have remained solid in October. The minutes from the last Fed meeting may also shed some more light on the thinking behind the Fed’s adoption of another round of quantitative easing.
• Various European business conditions surveys for November will be watched to see how well Europe is holding up.
• In Australia, data on construction spending and business investment will help firm up estimates for September quarter GDP growth to be released on 1st December. Capex spending is likely to show a decent rebound after a fall in the June quarter and capex plans are likely to remain strong. Meanwhile, RBA Governor Glenn Stevens’ testimony before a Parliamentary committee on Friday will be watched closely for more clues regarding the interest rate outlook.

Outlook for markets

• After strong gains since late August, shares were vulnerable to a correction, which we have certainly seen over the last two weeks. While it’s too early to say whether we have seen the bottom or not, we continue to expect solid gains in shares into year end and through next year. Shares are cheap, particularly relative to government bonds, the risk of a double dip back into recession appears to have receded, the global liquidity backdrop is highly favourable underpinned by QE2 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. In the past week we have seen BHP announce a resumption of share buybacks and Nike increase its dividend payout.
• Notwithstanding normal bumps along the way, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia continue to trend up, and commodity prices resume their rising trend. It’s likely that the $A will settle around $US1.10 in the year ahead.
• Deflation worries, along with central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

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• For the first time in six months the Reserve Bank has elected to increase official interest rates, lifting the cash rate by 25 basis points to 4.75 per cent. While inflation is in the middle of the 2-3 per cent target band and economic indicators are decidedly mixed, the Reserve Bank believes that “inflation is likely to rise over the next few years.” This is clearly a pre-emptive strike against inflation.
• The Reserve Bank Board “concluded that the balance of risks had shifted to the point where an early, modest tightening of monetary policy was prudent.”

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• There are more goods falling in price currently than at any time over the past decade. In the June quarter 33 items were cheaper than a year ago while 29 items were cheaper in the September quarter.
• In the September quarter alone, 25 goods were cheaper than in the three previous months.
• Deflation is putting significant pressure on retailers but it is clearly great news for consumers. And the news is likely to get even better for consumers given that the recent strength of the dollar has not yet been reflected in prices of imported goods.
• A greater incidence of unemployment in the community may be adding to consumer caution. In June, 7.0 per cent of Australian families had had least one family member unemployed – well above the long-term average. And the proportion of single parent families is at 6-year highs.

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• There is no doubt that there is only one game in town – one ‘hot button’ issue, if you like – and that’s quantitative easing. In essence the term refers to the printing of more money; but as you would expect economists ‘poohpooh’ that kind of simplification saying that it is more complicated than that. But with interest rates in the US effectively at zero and concerns that the economic recovery is at risk of stalling, many of the US Federal Reserve members believe that another round of quantitative easing – or QE2 – may be necessary.
• In the first round of QE, the Federal Reserve bought US$1.7 trillion of mortgage-backed securities and Treasuries. Now Federal Reserve policymakers say that another round of QE may be necessary “before long” – they are just working out how much will be needed and how they should explain what’s going on. Of course the Fed didn’t actually say it like that; it said they “wanted to consider further the most effective framework for calibrating and communicating any additional steps to provide such stimulus.”
• As mentioned, economists don’t like to use the term “printing money” to describe quantitative easing. They prefer to say that the Federal Reserve is making use of its balance sheet to apply more stimulus to the economy. But when you buy securities from financial institutions in exchange for cash, that cash has to come from somewhere.
• How did the Fed get to this situation? Well it’s largely because it has fired all their traditional bullets. That is, interest rates are near zero – the range for the federal funds rate is between zero and 0.25 per cent. If the Fed believes the economy requires more assistance to get going, there is not much else it can do.
• Note that Federal Reserve chief, Ben Bernanke, has done a lot of research on the Great Depression and is determined that the economy avoids going down that path. Bernanke famously goes by the title “Helicopter Ben”, after a speech he gave in 2002 where he said that deflation (falling prices) should be avoided at all costs even if it required the government to drop money from a helicopter to get people spending.
• Will it work? The problem is that you can put dollars in people’s pockets but that doesn’t mean they have to spend. Corporate America is already sitting on US$2 trillion of cash (in a US$14 trillion economy) but they aren’t confident to employ or invest. Companies want certainty – that is, if they do start to do business again, that the rug won’t be pulled from under them. In other words, that policy won’t go from ‘loose’ to ‘tight’ too quickly.
• What are the risks? One risk is that it doesn’t work, undermining confidence. But there is another risk – it works too well – that all that extra money in the system creates inflation. With inflation near 1 per cent currently, that is not a risk. Of course all those extra US dollars in the system reduce the value of the currency and that means other currencies like the Australian dollar go up. Our currency strategists believe that is just a matter of time before the Aussie dollar hits parity with the greenback, and a key reason is QE.

The week ahead

• The Reserve Bank seems to hog the spotlight most weeks and the situation is no different in the week ahead. The Reserve Bank releases minutes of the last Board meeting on Tuesday, and given the brevity of the statement released immediately after the meeting, analysts will be scouring the latest document more closely than normal.
• The interest rate announcement gave few insights into the Reserve Bank’s thinking on the Australian economy, especially key issues like the tight job market, consumer spending and the housing market. If the Reserve Bank believes that the economy is patchy, with inflation likely to remain in the 2-3 per cent target band, then it won’t be in a rush to change policy settings.
• In terms of economic data, there are no ‘top shelf’ items on the calendar. Car sales figures are released on Monday with skilled vacancies, private sector wealth and imports on Wednesday. Reserve Bank Head of Financial Stability Department, Luci Ellis, is a panel discussant at the Finsia Annual Financial Services Conference on Wednesday. And data on export and import prices is released on Friday.
• Car sales have proved quite healthy with more than a million vehicles sold in the past year. But a key influence has been last year’s tax break with deliveries of vehicles still trickling in. Car dealers were telling clients late last year that deliveries could take up to a year for custom vehicles. But low car prices are also an attraction for budding buyers, with lower tariffs and the firmer dollar the key influences.
• The data on private wealth will probably show some stabilisation with lower share prices offsetting higher home prices. Wealth is at record highs, highlighting the good position of household balance sheets.
• In the US, a consistent flow of indicators awaits investors over the coming week. On Monday industrial production figures are released together with capital inflows data and the NAHB index. Housing starts are slated for Tuesday, the Federal Reserve Beige Book is issued on Wednesday, while both the Philadelphia Fed index and leading indicator report are released on Thursday.
• Industrial production probably lifted by 0.2 per cent in September, confirming that the economic expansion is continuing, but at a more modest pace. But housing starts probably eased for the first time in three months with activity showing further signs of settling just below a 600,000 annual rate. And the leading index probably lifted by 0.3 per cent in September, matching the gain in August.
• There will be plenty of interest in the views of Federal Reserve officials in the coming week with no fewer than 10 speeches scheduled by Fed governors or regional presidents.
• But arguably more important than the bevy of US figures to be released over the week is the latest monthly batch of Chinese data. On Wednesday China will release indicators covering production, retail spending and inflation, together with the economic growth estimates for the September quarter.

Sharemarket

• The US earnings (profit reporting) season truly takes centre-stage in the coming week with a ‘who’s who’ of Corporate America set to deliver results. Amongst those reporting on Monday are Citigroup, Apple and IBM. On Tuesday, Bank of America, Coca-Cola, Goldman Sachs, and Yahoo! are slated to report. Earnings results out on Wednesday include those from Boeing, Wells Fargo and E*Trade. On Thursday, AT&T, Caterpillar, McDonalds, Morgan Stanley, Amazon.com and American Express issue profit results. And a small group of 15 companies issue results on Friday including Verizon.

Interest rates, currencies & commodities

• The Aussie dollar bottomed in early June (June 7) when it fell to US81.50 cents. Since that time the Aussie dollar has risen by around 21 per cent. Clearly these stellar gains in such a short period of time have caused many to question whether the rally is sustainable. That is, how much of the Aussie dollar gain is due to weakness of the US dollar, and how much reflects fundamentals such as higher commodity prices.
• Unfortunately there is no fool-proof way to work it out. Certainly one of the best ways to assess the changes is to look at commodity prices in both US dollar terms and currency-neutral SDR terms. Since the start of June the Commonwealth Bank commodity index has risen by just over 11 per cent in SDR terms while lifting around 20 per cent in US dollar terms. It’s also worth pointing out that the US dollar index, which broadly measures the strength of the greenback, has lifted by around 13 per cent over the same period.
• These figures suggest that around half of the Aussie dollar gains can be attributed to commodity prices and the other half to US dollar weakness. But when the US dollar is falling, commodities become cheaper in local currency terms for buyers in Europe and Asia. So some of the gain in commodity prices would reflect greater short-term demand for a cheaper product. At the same time, the perception that Aussie interest rates are likely to rise in coming months and our strong economy would also be factors driving the Aussie dollar higher.
• All that we can say with certainty is that while there is indeed a fundamental basis to the Aussie dollar’s gains, a healthy component of the rise reflects a weak US dollar. That point is important when you consider that commodity prices have only risen by 1 per cent over the period since early June.

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