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

Major global economic releases and implications

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

Australian economic releases and implications

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

Major market moves

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

What to watch over the week ahead?

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

Outlook for markets

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

30 July 2012

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• Sentiment levels are still down 5.2 per cent on a year ago. While the 12-month rolling average of the consumer sentiment index hit a 28-month low of 98.9 in February.
• The decision by the Reserve Bank to keep interest rates on hold resulted in “tenants” being a lot more optimistic (up 6.2 per cent) than “households with a mortgage” who were decidedly pessimistic (down 5.4 per cent).
• Sentiment rose in three of the five states with NSW (up 3.2 per cent), Queensland (up 4.1 per cent), and South Australia (up 0.5 per cent). Sentiment fell in Western Australia (down 9.1 per cent) and Victoria (down 7.9 per cent).

What does it all mean?

• While consumer confidence rose over the month, the latest result can only be categorised as mixed. Not only did confidence fall across a couple of the key states but sentiment levels are crawling off a sustained period of weakness. In fact the 12-month rolling average of the consumer sentiment index hit a 28-month low in the latest reading. Far more improvement is required to justify a turnaround in consumer perceptions.
• Keep in mind the latest improvement comes after a period where everything has gone right over the past couple of months. A stronger Aussie dollar, rising share markets, two rate cuts and a modest improvement in the outlook for the global economy have supported confidence levels.
• Interestingly the decision by the Reserve Bank to keep interest rates on hold last week played a big part in the latest result, with confidence receiving a boost from respondents who are renting, and were far more optimistic than respondents with a mortgage. It is important to highlight that just one third of Australians have a mortgage and as such rate cuts have a varied impact across households.
  Overall it is clear that the ongoing global economic troubles will dominate consumer thoughts and it is likely to entrenched the current level of cautiousness. As such we still expect the Reserve Bank to cut interest rates, particularly in light of the latest out of cycle lift in variable rates by the domestic banks.

What do the figures show? 

• The Westpac/Melbourne Institute index of consumer sentiment rose by 4.1 per cent in February after a 2.5 per cent rise in January. The consumer sentiment index is down 5.2 per cent on a year ago. But the 12-month rolling average of the consumer sentiment index hit a 28-month low of 98.9 in February.
• The current conditions index rose by 3.8 per cent, while the expectations index rose by 4.4 per cent.

All five components of the index rose in February:

• The estimate of family finances compared with a year ago rose by 7.0 per cent
• The estimate of family finances over the next year rose by 2.6 per cent
• Economic conditions over the next 12 months was higher by 0.9 per cent
• Economic conditions over the next 5 years rose by 9.9 per cent
• The measure on whether it was a good time to buy a major household item rose by 1.8 per cent. 

What is the importance of the economic data?
Westpac and the Melbourne Institute release the Index of Consumer Sentiment each month. According to Melbourne Institute: “The survey of consumer sentiment was first undertaken in 1973 and was conducted on a quarterly basis until 1976, a six-weekly basis from 1976 to 1986, and has been conducted monthly ever since.” Confident consumers may be more inclined to spend, especially on major items.

What are the implications for interest rates and investors?
Consumers still harbour reservations about what lies ahead and if consumer sentiment doesn’t lift markedly over the next few months, retailers and policymakers alike would have a genuine reason to be very worried. CommSec expects the Reserve Bank to cut interest rates once again in May in an attempt to shore up domestic confidence.

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• No finance required. The proportion of firms reporting that they did not require credit rose from 64 per cent to a record 67 per cent in January. In other words around two thirds of all businesses aren’t seeking loans at present.
• More good news for farmers: After a record winter crop, the Federal Government’s main commodity forecaster, ABARES, expects summer crop production to rise by 18 per cent. But some producers in northern NSW and southern Queensland have “suffered hardship because of the untimely heavy rainfall and flooding.”

What does it all mean?

• There must be a lot of businesses sitting on their hands at present, not keen to employ, borrow or invest. And the lack of interest in finance is quite stunning. Around two in every three businesses aren’t seeking external finance at present. Either firms aren’t keen to take on debt, internal sources of funding are healthy, or firms don’t want to take on new projects at present.
• It is not as if confidence has totally dried up, rather businesses would prefer to hold fire at present – no doubt waiting to see how the European situation and domestic political situation play out. It appears that the caution expressed by consumers is infectious, with businesses also seemingly blinded by the headlights of oncoming traffic.
• The Reserve Bank Board may now see the February meeting as a missed opportunity. Credit ratings agency Moody’s has downgraded the ratings of nine European economies, raising doubts about whether the crisis is stabilising. At the same point, funding pressures have forced banks to lift rates. And it’s clear from the latest business survey that two rate cuts have done little to boost activity levels and confidence.
• Certainly the latest business survey shows that inflation is well contained, giving scope for the RBA to cut rates again.
  Australia still has a multi-speed economy with mining well in front from transport while manufacturing and retail sectors are depressed. But cracks are appearing in the high-flying mining sector with the business confidence slumping from +11 to -8 in the latest month.

What do the figures show?
National Australia Bank Business Survey:

• The National Australia Bank business confidence index rose modestly from +3.1 to an 8-month high of +4.0 in January. The business conditions index improved from +0.1 to a 4-month high of +2.1. Both readings were below long-term averages.
• The index of trading conditions rose from +1.2 to +1.3; profitability weakened from -1.3 to -3.7; employment eased from +1.2 to +0.8; but forward orders improved from -1.6 to -0.6.
• It was the 10th straight month that forward orders contracted.
• Inflationary pressures are well contained. The monthly reading of labour costs fell from a quarterly rate of 1.0 per cent in December to 0.7 per cent in January. Prices fell at a 0.1 per cent quarterly pace, down from 0.1 per cent growth in December. And retail prices fell at a 0.6 per cent quarterly rate in January. Purchase costs rose at a 0.2 per cent quarterly rate in January, following 0.5 per cent growth in December.
• Capacity utilisation rose from 80.8 per cent in December to 81.3 in January – largely in line with the long-term average but below the decade average of 81.6 per cent.
• The proportion of firms reporting that they did not require credit rose from 64 per cent to a record 67 per cent in January. In other words just under two thirds of all businesses aren’t seeking loans at present.

ABARES Crop Report:

• The Federal Government’s main commodity forecaster, ABARES, expects summer crop production of around 5.4 million tonnes (mt) in 2011/12, up 18 per cent on a year ago. The forecasts reflect higher yields for cotton and grain sorghum while area planted is expected to be unchanged at 1.6 million hectares.
• There was a record Australian winter crop in 2011-12 at 45.4 million tonnes, a 7 per cent increase from 2010-11.
• ABARES notes “Of the major winter crops in 2011-12: wheat production is estimated to be a record 29.5 million tonnes, compared with 27.9 million tonnes in 2010-11; barley production is estimated to have reached 8.6 million tonnes, 5 per cent higher than 2010-11; and canola production is estimated to have risen by 16 per cent to a record 2.8 million tonnes.”
• Of the summer crop, ABARES reports: “Cotton and grain sorghum production is forecast to increase by 20 per cent and 13 per cent to around 1.1 million tonnes and 2.3 million tonnes, respectively, with rice production forecast to increase by 27 per cent to 923,000 tonnes.”

What is the importance of the economic data?

• The monthly National Australia Bank business survey is valuable in providing a timely reading on the health of Corporate Australia. Key indicators of business conditions such as orders, employment, profitability and capacity use are covered together with a gauge on confidence levels.
• The Federal Government’s commodity forecaster, ABARES, produces a Crop Report four times a year. The report is useful in gauging conditions in Australia’s rural economy and assessing prospects for key companies dependent on the agricultural sector.

What are the implications for interest rates and investors?

• The Reserve Bank is another step closer to cutting rates again following today’s developments. The Reserve Bank has failed to outline a strong argument supporting its decision to keep rates unchanged at the start of the month.
• According to the NAB, business conditions are flat in all most states. The only exceptions are Western Australia where business conditions are solid and Tasmania, where conditions are decidedly soft.
• While Mining is generally painted as the strongest industry sector by some margin, the latest Crop Report shows that the rural sector continues to thrive, notwithstanding untimely floods affect northern NSW and Queensland. Most farmers will tell you they much prefer the rain to prolonged drought conditions. The income from the record winter crop will be spent, providing a much needed boost to economic conditions across rural and regional Australia.

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Excluding volatile items, the annual inflation rate was 2.1 per cent – at the low end of the Reserve Bank’s 2-3 per cent target band.

However, petrol prices rose sharply; according to the Australian Institute of Petroleum the national average petrol price rose by 3.1 cents to 143.4 cents a litre last week. Today the wholesale (terminal gate) price stands at a near three-month high of 136 cents a litre, up 2.6 cents a litre compared with last week. Over the past four weeks, the wholesale price has risen by 5 cents a litre. So far the pump price have only risen by 2.7 cents a litre.

What does it all mean?
The latest monthly rise in the inflation gauge is certainly not overly concerning. In fact if you look at a longer time frame inflation is well and truly contained. The three-month annualised rate of the “headline” monthly inflation gauge as well as its underlying (trimmed mean) component and core measure (excludes volatile items) are now hovering between 0.5-1.9 per cent – well below the Reserve Bank’s 2-3 per cent target band.

It’s great news for the Reserve Bank and great news for Australians more generally. Inflation is pretty much non-existent, ensuring that the Reserve Bank shouldn’t have any qualms about cutting rates to give the domestic economy an adrenaline boost.

We believe that the Reserve Bank should be cutting rates at its next board meeting in February. However given the two rate cuts that have already taken place in the past couple of months, the Reserve Bank may hold off in cutting rates till March to get a better gauge of how the economy is travelling and not willing to use up too much ammunition, too early in case there is any further fall-out from Euro region problems.

The petrol price rose sharply over the past week and unfortunately for motorists the bad news is far from over. The cheaper discount day in the ten-day petrol price cycle has just passed and it is likely that pump prices will rise in the next fortnight – especially given that wholesale prices have surged in recent weeks and are now holding near three month highs. In addition over the past month the pump prices have yet to fully reflect the rise in the terminal gate price and as such CommSec expects another 2 cent rise in petrol prices over the next fortnight.

What is the importance of the economic data?

• The TD Securities/Melbourne Institute Monthly Inflation Gauge is designed to “provide a timely and accurate monthly measure of inflation in Australia”. The Bureau of Statistics only releases the Consumer Price Index on a quarterly basis.
• Weekly figures on petrol prices are compiled by ORIMA Research on behalf of the Australian Institute of Petroleum (AIP). National average retail prices are calculated as the weighted average of each State/Territory’s metropolitan and non-metropolitan retail petrol prices, with the weights based on the number of registered petrol vehicles in each of these regions. AIP data for retail petrol prices is based on available market data supplied by MotorMouth.

What are the implications for interest rates and investors?
Inflation looks to be well contained, allowing the Reserve Bank to focus on stimulating the domestic economy over the next few months if it is required. The health of the global economy will play an important role in the Reserve Bank’s thinking and CommSec expects that interest rates will be cut again next month.

If rates do fall further, investors will need to give greater thought about where to invest funds. Term deposits are attractive, but arguably fully-franked dividends on bank stocks are even more enticing.

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First there were significant floods across eastern Australia as well as disruptive cyclones across northern Australia. Coal production in mid-north Queensland was hampered over much of the year while banana production was decimated again in north Queensland.

There were earthquakes in Japan and Christchurch, New Zealand. And it wasn’t just an earthquake in Japan, but it precipitated a tsunami and nuclear disaster. Japanese production of cars and car parts was severely disrupted, only getting back to near normal late in 2011.

There were also volcanic eruptions in Chile that resulted in ash clouds moving across Australia, disrupting air traffic.

And it wasn’t just natural disasters that dominated but fresh economic crises. The European Debt Crisis reigned over the second half of the year and political wrangling was also able to precipitate fresh problems for the US economy over the year, prompting one rating agency to downgrade the US credit rating.

Not only did Australian businesses, investors and consumers have to contend with overseas issues, there was also the uncertainty caused by proposed carbon and mining taxes. Is it any wonder then that Australian consumers refused to spend, that economic growth proved sub-standard, that the sharemarket failed to fire and that the Reserve Bank switched its focus from rate hikes to rate cuts?

Craig James, Chief Economist for CommSec, provides his insights on the year ahead. Click here to read more.

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In response to lower-than-expected inflation, the Reserve Bank concluded that there was scope to ease financial conditions. If passed on by banks, repayments on a $300,000 mortgage will fall by $48.65 a month.

What does it all mean?

• With the peak auction season completed, the rate cut comes too late to help the housing market in 2011. But it is certainly the tonic to kick off the New Year in fine style. The housing market is becalmed at present, but 2012 should be a different story. Rates are down, prices are flat or falling, the job market remains healthy and the rental market is tight. All the preconditions are in place for stronger housing demand and higher prices in 2012.
• While too late for housing, the rate cut isn’t too late for retailers. The rate cut should drive more shoppers into the stores with Aussie consumers more determined to enjoy themselves this year.
• There were certainly ample reasons to justify the rate cut. Inflation is under control, the job market is slowing, consumers refuse to spend or borrow and home buyers are choosing to stay on the sidelines. The only question for the Reserve Bank was whether to cut rates now or wait and see how the euro situation played out and move in 2012 instead. In the end the Reserve Bank opted to take out some insurance.
  If there were just domestic considerations for a rate cut, then the Reserve Bank may have held off on a decision to cut rates until next year. But the justification for a rate cut was compelling in terms of both domestic and global factors. Not only does Europe look to be headed for recession, but Chinese authorities will have to resuscitate their flagging economy.
• So where do we go from here? Even if banks pass on the rate cut, lending rates will still be slightly above “normal”. That is, interest settings are still slowing the economy modestly. But there are other factors to consider – the exchange rate is still high, credit growth is weak and home prices are falling. So arguably interest rates need to fall further to offset other financial indicators that aren’t providing the economy with much assistance at present.
• The Reserve Bank has made it abundantly clear what it considers “normal” interest rates – the average level of rates over the past 15 years. The mortgage rate has averaged 7.20 per cent over the past 15 years. If banks pass on the rate cut in full, then the mortgage rate will be 7.30 per cent – still a little on the high side.
• CommSec is factoring in another quarter per cent rate cut in February. Clearly with inflation under control and significant risks abroad, the Reserve Bank stands ready to cut rates and shore up Australia’s economy.

Interest rate decision and past cycles

• The Reserve Bank Board has cut the cash rate for the second straight month. The cash rate has been reduced by 25 basis points to 4.25 per cent following a similar 25bp cut in November – the first in 31 months.  The Reserve Bank had previously lifted rates seven times from October 2009 to November 2010 – a total of 1.75 percentage points, from 3.00 per cent to 4.75 per cent.
• In the last rate-cutting cycle the cash rate fell to a low of 3.00 per cent in April 2009. In the previous rate-cutting cycle the cash rate fell to 4.25 percent in December 2001. In the two previous rate-cutting cycles, the cash rate fell to lows of 4.75 per cent.
• The Reserve Bank now looks more closely at the variable housing rate to gauge how close rates are to “normal”. Currently the average bank variable housing rate stands at 7.55 per cent, still above the long-term average or “normal” rate of 7.20 per cent.

What are the implications of today’s decision?

• Investors will now have more choices. The question is whether they stay with term deposits or move back into the share or property markets. If banks cut mortgage rates, they may in turn cut term deposit rates. But arguably investors would get healthy full-franked dividends in the sharemarket. And there are likely to be attractive propositions in the housing market after today.
• “Forgotten” parts of the sharemarket will now come back into focus such as the Consumer Discretionary sector – companies like clothing and department stores. Consumers have got reason to spend again with the two rate cuts largely offsetting rising utility costs. Certainly there are few other negatives for consumers as food, clothing, cars and household goods have been getting cheaper, not dearer.
• Today’s rate cut provides opportunities for businesses, consumers and home buyers. Over the past year most people have focussed on the risks and as a result spending, investment and hiring have proved sub-standard. Now is the time for Australians to become confident again.

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In the absence of any plan to the contrary, the game in town is austerity, time will tell whether the people truly have the stomach to see through the tough reforms required.

Currently, the consensus expectation is that the Spanish economy was stagnant during the third quarter which, if correct, would mean that the real growth rate over the prior 12 months was a mere 0.8%. Now some might claim this is a result, given the current global slowdown. But this is an economy in need of much more.

Industrial production continues to contract (see Chart 3) and unemployment has breached 20% (see Chart 1); nearly 50% of young men are unemployed.

Small wonder then that retail sales are tumbling (see Chart 2). If all of this wasn’t bad enough, inflation –whether measured at the headline or care level – continues to eat away at disposable income (see Chart 4).

All things considered, it is perhaps easy to see why people voted for a change but there is little that the government can do. Like Italy, Spain has to finance material amounts of their national debt over the next two years (see Chart 5) but the market is exacting a ruinously high price for the capital needed (see Chart 6). No economy can afford to borrow at interest rates twice its nominal growth rate, Spain included.

The task of trying to find a way out of this mess isn’t helped by the fact that the new administration will only become operational on the 13 December. One of its first challenges will be to approve the 2012 budget (due before the year-end). Whether Spain, like the Irish and Greeks, has to first present, cap in hand, its plans to the German government remains to be seen. 

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• The value of all Australian homes hit a record $1,500.6 billion at June 30.
• Australia is a nation of savers again. Net national saving hit a record high of $119.9 billion at June 30 or 8.6 per cent of GDP.
• The largest industry sector is Finance & insurance services (11 per cent of gross valued added). Mining was next largest (10 per cent) from manufacturing (8 per cent).
• Labour productivity in the market sector fell by 0.3 per cent in 2010/11 after a strong 2.7 per cent increase the previous year. Productivity was best in agriculture (up 15.2 per cent) while it was worst in mining (down 16.4 per cent).

What does it all mean?

• Unlike many other countries across the globe, Australia’s balance sheet is in great shape. Not only did Australia’s net worth or wealth hit record highs over the past year, but also the 2.8 per cent lift in net assets was the strongest gain in the 20 years of records.
• Australia is a nation of savers again. Net national saving is at record highs and hovering near the highest levels since the late 1980s as a proportion of GDP.
• The annual national accounts contain a treasure trove of data detailing the financial position of the broader economy as well as key sectors. In addition there is a break-up of wealth held in Australia as well as the productivity performance of Australian industries.
• Latest data suggests that analysts have over-reacted to Australia’s productivity performance. While market sector productivity slipped 0.3 per cent last year, the previous year’s performance was the best in six years. While productivity fell last financial year, it did so because businesses were taking on more staff and equipment at a time when weather events were taking a toll on production. Productivity hasn’t been great but if the increase in employment and investment pay off in higher output in coming years, it will be well worth it.
• Still, with productivity near 1.5 per cent rather than 1.0 per cent, if interest rates are to stay at lower levels, workers need to get used to 3.5 per cent wage increases a year, rather than 4 per cent. Either that or inflation needs to trend closer to 2.0 per cent a year rather than 2.5 per cent.

What do the figures show? 

• The net worth (wealth) of Australia amounted to $8,089.8 billion at 30 June, up 2.8 per cent in real terms – the fastest growth rate in 20 years of records. Household wealth rose by just $7.1 billion but still hit record highs of $6,000.9 billion. The net worth of Australian businesses (non-financial) hit a record $884.9 billion at June 30.
• The value of all Australian homes stood at a record $1,500.6 billion at June 30.
• National net saving rose from $90.7 billion (7.0 per cent of GDP) to $119.9 billion (8.6 per cent of GDP) in 2010/11.
• Labour productivity fell by 0.8 per cent in 2010/11 after rising by 2.3 per cent the previous year. In the market sector, productivity fell by 0.3 per cent in 2010/11 after a strong 2.7 per cent increase the previous year (best in six years).
• Productivity was strongest in agriculture (up 15.2 per cent) followed by professional, scientific and technical services (up 3.8 per cent). Productivity fell the most in mining (down 16.4 per cent) followed by rental hiring and real estate services (down 13.4 per cent).
• Real unit labour costs in the non-farm sector fell by 0.1 per cent in 2010/11 – the third year of declines.

What is the importance of the economic data?

• The Australian Bureau of Statistics releases the Australian System of National Accounts publication each year. The data includes the national balance sheet, estimates of productivity and a comprehensive assessment of Australia’s performance over the last financial year.

What are the implications for interest rates and investors?

• Corporate and household balance sheets are in great shape in Australia. While other parts of the globe are experiencing some pain in deleveraging, the same pain doesn’t need to be endured by Australians. The results may seem surprising but not only is wealth at record highs in Australia, but it grew at the fastest real pace on record last year. The Reserve Bank may view the performance as yet another reason to stay on the interest rate sidelines.
• Australia’s productivity performance is worthy of greater investigation by governments, policymakers and investors alike. While productivity fell last year, new estimates showed it soared in the previous year. And if this year is another year of consolidation of employment and investment, but stronger output, then productivity could emulate the 2009/10 performance. And that would suggest that there is little to worry about.
• The Reserve Bank must be bemoaning the constant data revisions. The latest figures show that real unit labour costs continue to fall. If that is the case, then there is less reason to worry about inflation. Latest figures suggest that inflation is well under control and doesn’t stand in the way of a rate cut, if needed.
• Mining productivity hasn’t just been poor over the last year, but it has weakened for some time, dragging down the national result. It is a result deserving of more attention.

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Headline developments of the past week
After much delay Europe finally delivered its latest response to its sovereign debt crisis. As pretty much expected the key elements are:

• a write down in Greek debt by 50% for private investors
• a recapitalisation of banks
• a boost to the firepower of its bailout fund to around €1 trillion
• better integration of fiscal policies.

While its still a work in progress with the details far from being finalised, it does provide confidence that Europe will avoid a near term financial blow resulting in a deep recession and a big threat to global growth.

However, we are still a long way from the end of Europe’s problems. It’s doubtful the bank recapitalisation plan or the enhanced firepower of the EFSF will be big enough, France is at high risk of a ratings downgrade and Europe is likely to remain in a vicious cycle where fiscal austerity continues to depress growth, causing budget blowouts, more ratings downgrades and market panic, more austerity, etc. What Europe needs is monetary easing and a much lower euro to offset the impact of fiscal austerity, and an unlimited buyer of bonds in troubled countries to put an end to speculative attacks on otherwise solvent countries such as Italy and Spain. The ECB holds the key to this, but notwithstanding a likely rate cut on Thursday, it is likely to keep dragging the chain.

And don’t forget that America’s sovereign debt woes are a long way from solved. The next month is likely to see the focus return to this as the US Congressional super committee charged with finding ways to reduce America’s long term budget deficit is due to report by 23 November, but current indications are that it is deadlocked on the issue of tax increases. If it can’t reach agreement then $US1.2 trillion in spending and defence
cuts will be triggered and if this is watered down a further ratings downgrade is possible.

In Australia, benign underlying inflation strengthened the case for an interest rate cut. This came after the normally hawkish RBA Deputy Governor Ric Battellino delivered a somewhat more dovish speech than normal.

Major global economic releases and implications

• US economic data continued to please with solid gains in underlying capital goods orders, new home sales, and weekly mortgage applications and a further drift down in unemployment claims. September quarter GDP came in at 2.5% annualised confirming a pick up from the weak growth of the first half of the year. However, there was some soft news: house prices were flat in August and pending home sales were weak. While consumer confidence fell sharply it has been a poor guide to retail sales which have stayed solid. Basically the US economy is continuing to grow, albeit not strongly enough to reduce unemployment, but still a long way from recession.
• US earnings continue to come in on the strong side with 71% of results coming in better than expected.
• And its not just due to cost cutting – revenue growth over the year to September is coming in just below 10%.
• There was also good news in China with a manufacturing conditions indicator rising in October and Chinese Premier Wen Jiabao signalling a further move towards easing.
• Europe looks much weaker, with Euro-zone business conditions and confidence readings continuing to deteriorate consistent with mild recession. The UK also looks weak.
• Japanese economic data was mixed with stronger than expected exports and household spending and a fall in unemployment but a steeper than expected fall in industrial production and continued underlying price deflation.
• The Reserve Bank of India raised interest rates again, but signalled a pause. If growth continues to slow, the next move is likely to be a cut. The Bank of Japan slightly increased the pace of quantitative easing.

Australian economic releases and implications

• Headline September quarter inflation came as expected at 0.6% or 3.5% year on year. However, the key is that the underlying inflation measures came in at just 0.3% in the quarter, which was half market expectations for a 0.6% gain. What’s more the average of the year ended underlying measures has now fallen to 2.45%, ie, // 2 below the mid point of the RBA’s target range. Quite clearly weakness in domestic demand combined with the dampening impact on import prices from the strong $A has combined to push underlying inflation pressures back down after a brief pick up during the first half of the year.
• Meanwhile Australian Property Monitors confirmed the ongoing softness in the housing market with national average capital city house prices falling 1.6% in the September quarter and 3.5% over the last year.

Major market moves

• Share markets surged again (with US shares having their best month since 1974) as Europe delivered its debt rescue plan contrary to the fears of many that they wouldn’t get it together, US and Chinese data surprised on the upside and US profit results remained positive. Australian shares were given an additional lift by heighted expectations for an interest rate cut.
• With fears of a European financial meltdown, a US recession and a Chinese hard landing fading, commodity prices have surged higher and this is flowing straight through to $A, which has now broken its downtrend since end July. The return to risk taking also saw a further sell off in bonds, except in troubled European countries.

What to watch in the week ahead?

• Globally the focus will be on the G20 leaders meeting in Cannes on Thursday and Friday for evidence that world leaders back Europe’s latest public debt rescue plans. Specifically, indications that individual countries via sovereign wealth funds and also the IMF are prepared to help fund the proposed Special Purpose Vehicle in buying debt in troubled countries will be looked for.
• In the US the ISM manufacturing conditions index for October (due Tuesday) is expected to have improved slightly to 52 from a reading of 51.6 in September and October employment due Friday is expected to show a 100,000 gain but with unemployment remaining at 9.1%. The Fed meets on Wednesday and is expected to leave monetary policy unchanged but indicate it stands ready to do more (read QE3) if inflation falls.
• In Europe, the ECB is expected to at last cut its cash rate by 0.5% taking it to 1% to reflect the reality of deteriorating growth in Europe.
• In China the official and HSBC manufacturing conditions indicators due Tuesday are likely to confirm the slight improvement indicated in the HSBC preliminary index for October.
• In Australia we expect the RBA to cut the official cash rate by 0.25% taking it to 4.5% when it meets on Tuesday. Of course, a cut is not assured as the RBA may take the view that the moves in Europe have reduced the risks to the global outlook, so as such we attach a 60% probability to a cut occurring.
• However, the case to cut is very strong. Despite the European debt rescue plan, the global growth outlook is still much weaker than when interest rates were raised a year ago to 4.75%. Likewise domestic demand has been weaker than expected with unemployment now drifting higher. And the much anticipated September quarter inflation figures have confirmed that the inflation outlook is far more benign than the RBA was assuming a few months ago. Current settings for interest rates – which assumed much stronger global and Australian growth and a worsening profile for underlying inflation – are too high. So if it’s not on Tuesday we would anticipate a cut in December. Out of interest the last five Melbourne Cup days have seen interest rate moves.
• The RBA will also release its latest Statement on Monetary Policy on Friday which we expect to show a downwards revision to underlying inflation forecasts from around 3% to around 2.5%. Expect private credit growth data (Monday) to remain soft, ABS September qtr house price data (Tuesday) to show a 1.5% fall, and soft outcomes for building approvals (Wednesday) and retail sales (Thursday) after strong gains in both in August.

Outlook for markets

• Shares may be due for a bit of a pull back having rallied by 12% or more since early October. However, there is a good chance we will see further gains into year end. Europe’s latest debt rescue plan has helped head off a much feared financial meltdown which could have dragged the world down with it, the US economy appears to be a long way from the double dip recession many were fearing, monetary conditions globally are getting easier (with the RBA likely to be next to ease and China edging towards easing), shares are still cheap
  and October is often the spring board for market gains into year end. What’s more investors have been caught short by the recent surge in shares and may now likely want to get on board. However, the ride is likely to remain volatile particularly with Europe’s debt problems likely to continue next year and the US facing its own issues.
• The $A is also vulnerable to a pullback after a 12% rise since early October. However, the medium-term trend is likely to remain up as the $US remains under long-term downward pressure, not helped by its debt woes and the prospect of more quantitative easing, Chinese commodity demand remains strong over the longterm and Australian interest rates will remain well above US rates even if the RBA cuts rates.
• Government bonds in major global countries are a good diversifier. However, yields are still extremely low so expect modest medium-term returns.

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More than two thirds of all global growth this year and next is expected to come from the developing world. The main downgrades to growth are all in the developed world. Citibank recently slashed its forecast for growth in the US this year from 2.3% in July to 1.6%. Next year it expects growth in Europe of only 0.6% (versus 1.2% previously). By contrast, its reduction in the expected growth rate for emerging markets from 6.3% to 6.0% shows the extent to which they are increasingly able to stand on their own two feet.

The main worry in emerging markets – inflation and the prospect of higher interest rates – is likely to fade as the West flirts with a double-dip recession and commodity prices ease. The recent rate cut in Brazil was a straw in the wind pointing to an end of the tightening cycle in the developing world. With inflation still relatively high in many emerging markets, it might be too much to expect rates to start falling but even if they only tread water this would be a positive for markets.

The multiples of earnings on which emerging market shares trade are now – at about nine – back to the levels reached at the bottom of the 2000/03 bear market. They very briefly dipped lower in late 2008 but, that moment of panic aside, emerging market shares are cheaper on this measure than at any point in the past 10 years. They are also cheaper compared with the other main asset class, bonds, than they have been over the same period.

While shares have become cheaper, emerging market sovereign debt has become more expensive, dragged ever higher on the coat-tails of US Treasuries as investors have run for what they perceive to be safe havens.

For these three reasons, I think emerging market shares as a whole will outperform for the rest of this year and into 2012.

However, I don’t expect the indiscriminate sell-off to unwind in the same blind manner. Greater discrimination is already in evidence, with Korea for example a notable laggard as investors rightly took the view that its export-heavy economy would suffer more from a slow-down in the West.

If markets decouple, as underlying economies already have, the winners will be those companies exposed to rising domestic demand in emerging markets and not those dependent on a recovery in the West which remains a dim light at the end of the tunnel.

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