Weekly Economic Briefing

Standard Life’s Global Outlook Report.

With all the negative headlines coming out of the Ukraine and Middle East in recent weeks, it has been easy to forget that the global economy is actually in fairly good shape.

Helped by generally loose financial conditions, as well as pent-up demand in most developed economies after years of tepid growth, the global composite Purchasing Managers Index (PMI) held up at 55.1 in August.

That reading is a little lower than the levels recorded in June and July, but it is still the third highest outturn since the beginning of 2011. Helpfully, the global recovery is becoming less dependent on manufacturing activity to drive growth.

Whereas the global manufacturing PMI is currently at 52.6, signalling healthy though not spectacular growth, the global services PMI is sitting at 55.5, not far from a post-financial-crisis high. Taken at face value, such levels of business sentiment are consistent with above trend global output growth, although there has been a tendency for the PMIs to overstate official GDP growth in recent quarters.

While the global backdrop is undoubtedly positive, not all countries and regions are sharing in the wealth equally (see chart 1).

Among the world’s largest economies, the US and UK continue to lead the way, reinforcing our view that the Federal Reserve and Bank of England will be the first central banks to begin raising short-term interest rates.

The US in particular appears to be accelerating into the second half of the year, led by vehicle sales and business investment. Sentiment is also holding up fairly well in Japan, although it is well below the levels recorded at the beginning of the Abe revolution and the rebound from the sales tax hike has been weaker than hoped.

However, the biggest disappointment is the Euro-zone, where the recovery is in danger of petering out before it even began. The biggest drags are still France and Italy, although even German growth has moderated of late; no prizes then for guessing why the ECB announced new easing measures last week.

The BRICs remain a mixed bag. The Chinese authorities are pushing to hit their 7.5% growth target, despite the related financial risks being generated.

Meanwhile, Russia is sinking under the weight of sanctions and Brazil has fallen into recession. Indeed, only the Indian economy seems likely to accelerate in the second half of the year.

Click here to download the full report.

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Threadneedle’s global outlook.

As summer fades and an autumnal chill enters the air in the northern hemisphere, the developing world appears to be emerging from the long economic winter that followed the global financial crisis of 2008. In this viewpoint, William Davies surveys the global economy and highlights those stocks and sectors we favour.

While the US economic recovery has been a feature of financial markets this year, it is only recently that signs of improvement have become established in other developing economies. According to figures released in August, the eurozone emerged from recession in the second quarter of 2013 after a record 18 months of economic contraction. The good news has continued – August orders for goods made in the eurozone, for example, came in at their fastest rate since May 2011.

Europe, over the worst?

Our base case for Europe remains a slow and protracted economic recovery. However, we believe the worst is now over and are taking advantage of relatively attractive valuations. We continue to avoid stocks in the periphery, and heavily indebted businesses, which are at risk should negative growth shocks emerge.

We have recently taken positions in the Swiss bank UBS and Continental, a leading German autoparts supplier. UBS has been making progress downsizing its investment banking operations, where it has lacked the scale to compete effectively. The bank is strengthening its capital position and focusing on wealth management, an area where it is a global leader – boasting a relationship with half the world’s billionaires.

Continental is benefiting from a strengthening global automotive industry, and rising auto sales. Even in austerity-hit Europe there are grounds for optimism. Car sales in Germany, France and Spain rose in July. Sales of premium cars, many of which are equipped with Continental’s safety features, have rebounded in the US, and a growing Chinese appetite for luxury brands provides further support.

Weaker yen boosting Japanese profits

We are optimistic about the efforts of Japan’s Prime Minister, Shinzo Abe, to revive the economy. His policies, known as ‘Abenomics’, include boosting the supply of money in the economy and increasing government spending. Abenomics has already had a dramatic impact, sending the stockmarket soaring, whilst Japanese firms have reported a surge in profits largely thanks to the weakening yen. In early August, for example, Toyota raised its annual profits forecast and is expected to nearly double its profitability in the 12 months to March 2014, versus a year earlier. Critically, Japanese consumer prices have started to rise, a sign that the policies aimed at ending deflation are yielding results. Consumer price inflation rose to an annual rate of 0.7% cent in July, its highest level in almost five years.

We have been overweight Japan since early this year. Initially focused on exporters who are the immediate beneficiaries of a weaker yen, we have since broadened our exposure, taking positions in a number of domestic Japanese-exposed names, including the likes of Aeon, one of the largest diversified retailers in Japan. A return to inflation would be supportive of depressed margins for the company, and management is also considering spinning off property holdings into a REIT, which would generate significant cash flow for shareholders. We have invested in domestic Japanese banks, including Sumitomo Mitsui Trust and Nomura. The latter is a global investment bank, leveraged to a recovery in Japanese M&A and financial market trading volumes.

Tapering talk signals the beginning of the end of the financial crisis

Our longstanding overweight positioning in the US has been rewarded in 2013. The housing led-economic recovery is now much more firmly established than in the rest of the world. Indeed, while markets have recently been concerned that any tapering of quantitative easing (QE) could have a negative impact on financial markets, we take a longer term view and regard the increasing momentum that is prompting discussion of tapering as a positive development. We welcome the return to normality following the adoption of unconventional monetary policies to deal with the effects of the global financial crisis.

Our positioning favours cyclical sectors, in particular, companies exposed to the shale energy revolution and to rising consumer spending. We see potential in beneficiaries of the growing e-commerce sector, such as eBay, and in companies providing non-cash payment solutions including credit card companies such as American Express, Mastercard and Discover.

Stock-picking offers value in emerging markets

Emerging markets have come under considerable pressure recently following the change in direction of US monetary policy. Those emerging economies reliant on foreign capital inflows to fund their current-account deficits have been particularly affected. Valuations appear increasingly attractive, and emerging economies in general are much better placed than they were during earlier cycles of monetary tightening, such as in 1994. Although we remain concerned about countries with large current-account deficits, such as India and Indonesia, we are more confident in those economies that are in a balanced or surplus current-account position. We believe that the differentiation in performance between countries/sectors in emerging markets will continue and prefer export-oriented economies such as Thailand and Mexico, at this stage in the cycle, as they should benefit from the consumer recovery in the developed world.

Technology and consumer discretionary sectors appeal

Turning to the sectors that we favour globally, we remain overweight consumer discretionary and technology stocks. We think the former offers good growth potential, while the latter trades on undemanding valuations with management under increasing pressure to reward shareholders through share buybacks and dividends.

We own Priceline.com, a travel comparison website. The company’s flagship website booking.com continues to expand as consumers turn to the internet to book accommodation. Further intergration with Kayak, a popular flight comparison website, has seen booking.com win market share from its largest online travel agent competitor Expedia.

Samsung remains one of our favoured technology companies. It has underperformed this year as the market fearsmargins for the key mobile division will decline. We like the company’s increasingly dominant position in the smart phone and wider technology industry, and see competitors falling by the wayside. We believe the market is pricing in an overly severe deterioration in margins, and that, at the current low valuation, the stock is attractive.

Outlook

We are concerned that any deterioration in the eurozone could once again harm global investor sentiment. There is a suspicion that potential problems in the eurozone may have been deferred until after the general election in Germany in September. The German public appears to be increasingly weary of being asked to bail-out troubled peripheral countries. Another concern is that a slowdown in the emerging economies impacts companies such as Nestle, which have been profiting from the rise of the emerging consumer.

Overall, we anticipate that global equities will encounter volatility in the final quarter of the year as investors weigh the likelihood and timing of QE tapering. The speed and scale of its implementation will be critical. However, we remain positive on the outlook for global equities given the strong underlying fundamentals in the form of increasing economic growth in the developed world. Moreover, we believe that concern over the impact of tapering may have been exaggerated, believing that it signals a return to normal conditions.

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• Global share and bond markets got a big lift over the past week as first Larry Summers dropped out of the race to replace Ben Bernanke as Fed chairman, reducing fears of a more bearish Fed, and more importantly the Fed surprised markets by maintaining its asset purchase program at $US85bn a month. The combination saw bonds, shares and commodities rally sharply and the US dollar fall.
• While the Fed may have confused investors, it clearly became concerned by the combination of mixed data recently, the rapid back up in bond and mortgage rates, the approaching government funding and debt ceiling debate and a concern that the leadership transition at the Fed may render its forward guidance less credence. As a result it elected not to taper. The key message from the Fed is very supportive of growth. It won’t risk a premature tightening in financial conditions via a big bond sell off and tapering won’t commence until there is more confidence that its expectations for 3% growth in 2014 and 3.25% growth in 2015 are on track. In terms of timing, it hard to see tapering commencing before the Fed’s December meeting and it may not come until early next year. The downside though is that the Fed has likely just delayed the inevitable and arguably an opportunity for a smooth reduction in quantitative easing has been lost with more volatility a likely consequence.
• The decision by Larry Summers to withdraw from the race to run the Fed and the re-elevation of current Fed vice-Chair Janet Yellen as the favourite has substantially boosted confidence that the Fed will continue with its current growth supportive approach. However, there is a fair way to go yet but at least the other alternatives are perhaps seen as a bit less uncertain than Summers might have been.
• In Europe, the focus in the week ahead is likely to be on the reaction to German Federal election (Sunday 22 September). This is likely to see the return of Angela Merkel as Chancellor with the main uncertainty relating to whether she will lead a coalition with the Free Democrats (as at present) or the Social Democrats (as over 2005-09). Either outcome is unlikely to pose a threat to Germany’s relationship with the rest of Eurozone and so is unlikely to have significant investment implications, beyond any initial kneejerk response.

Major global economic events and implications

• US economic data released over the last week indicated that tapering has just been delayed and is still ahead of us. Industrial production showed a nice gain and regional manufacturing surveys point to further improvement ahead. The NAHB home builders’ survey also held at a high level and existing home sales rose solidly suggesting that the softness seen in housing starts and permits is temporary. One thing is clear though and this is that inflation remains benign with August data showing headline inflation of 1.5% year on year and core inflation of 1.8%.
• In the Eurozone inflation also remained benign in August at 1.3% year on year and ECB officials remain rightly dovish.
• Chinese house prices continued to rise in August, but the authorities seem less concerned about it of late – perhaps realising that the only real solution is to address supply side constraints.
• While the pressure on India has faded a bit this month, with the Fed’s non-taper decision helping, its outlook remains problematic with inflation increasing again in August despite soft growth.

Australian economic events and implications

• It was a quiet week in Australia with the Minutes from the last RBA Board meeting being the main focus. Two key points emerged. First, the explicit easing bias is back after being absent yet again from the post meeting statement earlier in the month. While the RBA has reiterated that any move is not imminent, declining mining investment, restrained non-mining investment, soft consumer spending, rising unemployment, the bounce back in the $A and benign inflation indicate the risks are still tilted towards another rate cut. Second, the RBA looks to be getting a little bit more concerned about the risk of a new housing bubble – even though RBA Assistant Governor Edey and Board member John Edwards pointed out its not one yet – with the Board being briefed on RBNZ moves to limit high loan/valuation ratio loans, Board members agreeing it’s important banks maintain prudent lending standards and concern about property gearing in self-managed super funds. I must admit I am not a fan of old fashioned/back to the past “macro prudential controls” because they just distort the financial system. But a direct move to limit home lending growth (such as raising the capital banks are required to put aside for home lending) is preferable to raising interest rates if the property upturn is getting too hot. So far it’s not too hot (housing credit is running at just 4.7% versus 21% in 2003), but it’s worth keeping an eye on.
• Meanwhile the downgrading of WA’s credit rating to AA+ by Standard and Poors highlights how some Australian governments have squandered the mining boom. After a massive boom WA should have minimal debt and big budget surpluses but unfortunately that’s not the case. More broadly it highlights risks for the new Federal Government if it doesn’t maintain the path back to surplus. Privatisation should be back on the agenda big time as it is the quickest way to get public debt down, at the same time that it will help keep super funds in Australia and put public assets into private hands where they can be managed far more efficiently.

Major market moves

• Share markets had a strong week as investors celebrated good news from the Fed.
• Commodity prices were also buoyed by the continuation of QE3 at its current pace as did the $A.
• Bond yields fell sharply on the back of dovish news from the Fed.

What to watch over the next week?

• Monday is PMI day with preliminary business conditions PMIs being released in China, Europe and the US. All are expected to show a continued trend improvement consistent with improving global growth prospects.
• In the US, expect further gains in house prices (Tuesday) and rises in new home sales (Wednesday) and pending home sales (Thursday) after falls in July. Durable goods orders (Wednesday) are also likely to see a bounce after a fall in July, consistent with a broad recovery in business investment.
• The focus is now turning to Congressional negotiations regarding a new Budget (required by October 1) and an increase in the debt ceiling (required by mid-October). Expect the usual cantankerous argy bargy between both sides of politics to cause bouts of financial market nervousness ahead of the usual last minute deal. With the US budget deficit having fallen to 4% of GDP (from a 2010 peak of above 10%) it will be harder for the Republicans to push too hard without risking alienating the public, which they probably don’t want to do ahead of mid-term elections next year.
• Along with Eurozone PMI’s for September, the German IFO index (Tuesday) is expected to show a further improvement. Confidence indicators will also be released Friday and will likely show a further gains.
• Japanese inflation data (Friday) is expected to show further evidence that deflationary pressures are fading.
• In Australia, the RBA’s financial stability review (Wednesday) is expected to show that Australia’s financial system remains sound with banks seeing improvement in asset performance and funding, business balance sheets in good shape and households exercising prudence. However, the RBA is likely to reiterate the need for banks to maintain “prudent lending standards” and that it is keeping an eye on the increase in property gearing in self-managed super funds. August job vacancies (Thursday) are likely to have remained soft.

Outlook for markets

• Shares are still at risk of hitting a speed bump in the month ahead as we go through the seasonally weak September/October period with potential triggers being the budget and debt ceiling negotiations in the US and a return of Fed taper fears.
• However, any pullback is likely to be just another bull market correction which should be seen as a buying opportunity as the broad trend in shares remains up. Valuations remain reasonable, monetary conditions are set to remain easy, and profits are likely to improve next year as global and Australian growth picks up. So by year end we see further upside in global and Australian shares with gains continuing next year.
• Government bond yields are falling after having risen too far too fast, but are likely to resume a gradual upwards trend as it becomes clear that the global economy is picking up momentum and as Fed tapering comes back into focus. Low yields and an unwinding of years of massive inflows into bond funds point to poor sovereign bond returns ahead.
• The short covering rally in the $A was given a boost by the Fed’s decision not to taper, but the downtrend is likely to resume once extreme shorts have been squeezed out, tapering comes back into focus and as the RBA retains an easing bias.

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

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

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We continue to expect that the economic outlook will be difficult and that the overhang of debt will cast a very heavy shadow for an extended period. However, we believe there may be a few grounds for expecting some improvement in the near future. In the US, there have been a number of economic surprises on the upside and the housing market appears to be showing a useful recovery, even before any beneficial impact from the Federal Reserve’s recently announced QE3 policy, which is aimed at lowering mortgage costs.

While the earlier uncertainty over the outcome of the US presidential election has now been resolved, and President Obama is back in the White House, the fiscal cliff continues to cause concern and has led to the postponement of investment decisions. We expect more details of measures to tackle the fiscal cliff shortly, and this may release some pent-up demand in the more predictable environment that should follow. 

Meanwhile, the news from China shows signs of the economic slowdown having bottomed. The latest purchasing manager’s index of manufacturing activity was above 50, indicating expansion, and the recent destocking phase appears to be largely over. In addition, the leadership transition is underway and this could lead to some stimulatory activity by the new administration.

We also have generally lower than consensus forecasts for corporate earnings growth. Whilst the current reporting period has been a fairly mixed one, with a higher percentage of disappointments than we have seen for some time, the pace of downgrades to forecasts appears to have slowed.

Another of our long-held views has been a strategic underweighting of bank shares. This month we undertook extensive in-depth analysis of the sector and concluded that the ‘tail risk’ scenario of wide-scale failures had largely passed and that the sector would perform more in response to regional conditions rather than as a global group.

The situation in the US is increasingly positive, with relatively robust balance sheets and a recovering housing market. The outlook for the UK and Europe is less encouraging with further balance sheet adjustments required and a sluggish economic background. Emerging economy banks appear fairly well placed in light of economic expansion and lowly-leveraged consumers.

On balance, we are more constructive on the sector, but there are still significant issues and the local situation and stock specific factors will be increasingly important for performance.

Elsewhere, we expect the search for income to continue, which will be beneficial for higher yielding bond classes and for companies with high, well-funded dividends. The yield on equities, combined with the likely impact of quantitative easing around the globe, should act as a support for shares.

However, opposing this are the risks from the eurozone, the fiscal cliff and the difficult economic background, which leads us to adopt a neutral position on equities. We are cautious on UK commercial property despite a reasonably attractive yield; demand is weak and a huge refinancing operation needs to be undertaken.

We expect commodity markets to be pulled in different directions, with quantitative easing most likely to benefit precious metals. We see tight supply conditions in the oil market, and a shock to production cannot be ruled out given Middle East tensions. However, buoyant agricultural markets will lead to heavy planting, which may limit future gains. Furthermore, the sluggish global economy and the shift in China from investment-led growth towards greater emphasis on consumption are negative for industrial metals. We have a neutral view on commodities overall.”

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• The Reserve Bank of India’s easing may in part be a response to recent stepped up reform efforts by the Indian Government but it was fairly modest and its failure to cut its official interest rate reflects the constraint imposed by persistently high inflation.
• The Bank of Japan’s move is more significant and highlights the pressure that US QE3 is putting on countries around the world to ease monetary conditions further if they want to prevent their currencies from rising against the $US. Unfortunately, based on recent experience it’s doubtful whether Japan’s QE program will be enough to match the Feds or to meet its 1% inflation goal for this year.
• In terms of the European debt crisis the main outstanding issues at present are Greece and Spain. Spain seems to be hoping that new reforms (possibly to be announced on September 27) and the threat of ECB action will enable it to avoid seeking formal assistance. Our view remains that this is unlikely though, but we could easily go through another bout of short term market nervousness where a rebound in Spanish bond yields then forces it to seek help from the Euro-zone bailout fund and the ECB. However, whether Spain does it proactively or reactively the end result is likely to be the same in triggering ECB bond buying. Reports that it is in talks with the European Commission regarding proposed reforms necessary to obtain assistance are a positive sign.
• Greece has taken a back seat lately, but it still risks hitting the headlines again. The Greek PM is having difficulty reaching agreement with his coalition partners on budget cuts as required by the troika of the EU, ECB and IMF. Ultimately agreement is likely though and in return Europe is likely to grant it more time to meet its commitments because it doesn’t want to take risks with a Greek exit from the Euro-zone. But this may not be resolved for another month or so.
• Tensions between China and Japan have clearly escalated again with disputed islands being the focus this time around. While scary, it’s hard to see the issue going too far as both sides are pragmatic and unlikely to want to risk their trade relationship, eg Japan is China’s third biggest export market. On top of this, uncertainty is continuing to build regarding the Chinese leadership transition ahead of the National Congress in October.

Major global economic releases and implications

• US economic data remained consistent with continued moderate growth. The bright spot remains housing where home builder conditions rose to their highest level in six years and housing starts, permits and home sales are continuing to trend higher all adding to confidence that the housing recovery is continuing to gather steam. Manufacturing conditions surveys were a bit more mixed though – falling slightly for the New York region, but improving slightly in the Philadelphia region. The flash PMI produced by Markit for the US remained at 51.5 indicating that manufacturing conditions remain sub-par but reasonable and a bit better than suggested by the widely followed ISM index. Jobless claims fell but have been stuck in a range all year showing little improvement, which is consistent with why the Fed announced QE3 on an open ended basis.
• In Europe, investment analyst sentiment as measured by the ZEW index picked up substantially in September, but flash business conditions PMIs remained soft with a fall in services conditions offsetting an improvement in manufacturing resulting in a slight fall in the composite PMI taking it to a new cycle low. The overall readings for Euro-zone PMIs are at levels consistent with our expectations for a 1% GDP contraction in the Euro-zone this year, but hopefully should start to pickup by year end to be consistent with our expectation for modest positive growth next year.
• Japanese economic data remained soft with another fall in exports and a weak activity index for July.
• HSBC’s flash Chinese manufacturing PMI was little changed in September indicating that while conditions haven’t deteriorated they haven’t picked up yet either. One positive though was that new orders picked up a bit. Meanwhile average house prices continued to rise in August after a few months of gains, but the gains seem to be losing momentum again which may be a positive sign if it allows the authorities to become a bit more aggressive in providing stimulus for the broader economy.
• The softening in Asian exports continues and was highlighted by a falls in Singaporean and Korean exports.

Australian economic releases and implications

• In Australia, the minutes from the RBA’s last rate setting meeting revealed a significantly more dovish tone than was evident in the statement released straight after the meeting, with significant discussion regarding the risks to global growth, and China in particular, and the risks to the mining boom and a closing observation that the benign inflation outlook provides scope to ease policy if needed. We remain of the view that the RBA will cut the cash rate to 2.75% over the next six months, starting with a 0.25% rate cut next month. The ongoing strength in the $A at a time when the mining boom is loosing momentum and the rest of the economy is weak is only adding to the urgency for more rate cuts.
• It was pretty quite on the data front in Australia. Car sales were strong in August and the Westpac Leading Index continued to point to subdued annual growth.

Major market moves

• After rising almost 5% in response to the ECB’s bond buying plan and QE3 from the Fed over the previous two weeks, global shares took a breather, slipping slightly over the past week on profit taking not helped by soft data in Europe and China and a bit of uncertainty regarding Greece. Chinese shares fell sharply not helped by the dispute with Japan and uncertainty about the leadership transition. Australian shares rose slightly though helped by a rebound in iron ore prices, which boosted miners, and heightened expectations for interest rate cuts following dovish comments from the RBA.
• Just like global share markets, commodity prices slipped with a sharp fall in the oil price on the back of higher US inventories. Softer commodity prices and expectations for RBA rate cuts saw the $A fall back below $US1.05.
• Bond yields fell back in the US, Germany, the UK and Australia and continued to fall in Spain.

What to watch over the week ahead?

• In the US, expect a modest further gain in home prices for July (due Tuesday), a rise in consumer confidence (also Tuesday), further gains in new home sales (Wednesday) and pending home sales (Thursday) but a fall back in headline durable goods orders (also Thursday). Data for personal income and spending and a Chicago regional manufacturing conditions survey will be released Friday.
• In the Euro-zone, September readings for economic confidence are likely to remain subdued consistent with an ongoing “mild” recession.
• Japanese data to be released on Friday is expected to show softness in retail sales and industrial production along with ongoing price deflation.
• In Australia, it will be a quite week on the data front. Expect new home sales (Monday) and private sector credit growth (Friday) to have remained soft. On Tuesday the RBA’s six monthly Financial Stability Review is likely to conclude that the Australian financial system remains in pretty good shape and speeches by RBA officials on Tuesday and Wednesday will be watched closely for any clues on interest rates.

Outlook for markets

• After the strong bounce in shares on the back of recent policy moves by the ECB and Fed, shares are vulnerable to a short term pause or pull back particularly given outstanding issues regarding Spain and Greece and ongoing uncertainty regarding China. However, it’s doubtful that the broad rising trend in shares since early June will be derailed. The ECB’s bond buying program is likely to see the European debt crisis gradually settle down, the Fed is providing a huge shot in the arm for the US economy and global share markets, more decisive policy easing is likely in China once the leadership transition is resolved next month and in Australia the RBA is on track for more interest rate cuts. With shares remaining cheap, particularly against bonds, we see further gains into year end. If there are any set backs in the weeks ahead they should be seen as a good buying opportunity.
• While sovereign bonds in safe countries are a good diversifier, bond yields in major countries remain very low and point to low medium term bond returns as investor confidence returns over time. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
• The short term outlook for the $A is somewhat messy. US QE3, foreign central bank buying and prospects for improved global growth and higher commodity prices into next year are positive. But against this, uncertainties regarding China, soft bulk commodity prices and the likelihood of RBA rate cuts are negatives. The likely outcome is for a volatile range of between $US0.95 to $US1.10.

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Yet share markets and other risk trades have almost said “ho hum”. So what’s going on? Our take is the markets are telling us that a lot of the bad news has already been factored in. The ratings downgrades were flagged back in early December and the World Bank/IMF growth forecasts downgrades have only just caught up to private sector economists.

This is not to say we are out of the woods, or that volatility will disappear. But it does seem the risk of a global financial meltdown has receded somewhat and that the global economic recovery appears to be continuing.

Europe – reduced risk of a financial blow up
Europe is on track for a mild recession but the risk of a financial blow up resulting in a deep recession seems to have receded a bit. The provision of cheap US dollar funding by the Fed and very cheap euro funding for three years by the ECB under its long term refinancing operations appears to have substantially reduced the risk of liquidity crisis causing banking collapses. It has also reduced pressure on European banks to sell bonds in troubled countries.

We would have preferred the ECB to have directly stepped up its buying of bonds in troubled countries, but its back door approach has nevertheless seen a sharp expansion in the ECB’s balance sheet. In other words, it appears to have embarked on quantitative easing, albeit it wouldn’t admit it.

Reflecting this, bond yields in Spain, Italy and France and spreads to Germany – which were surging towards end last year – have settled down. Similarly European bank stock prices appear to have stabilised.

This is not to say Europe is no longer a source of risk. It still is – it’s doubtful that even with the proposed debt restructuring Greece’s public debt is on a sustainable path, fiscal austerity is still bearing down on growth across Europe, more ratings downgrades are likely and monetary conditions are still too tight. But the risk of a meltdown appears to have receded. What’s more European business conditions indicators have picked up in the last two months.

In November, we referred to three scenarios for Europe:

1. Muddle through – ie a continuation of the last few years of occasional crises temporarily settled by last minute bare minimum policy responses.
2. Blow up – in which a financial crisis and deep recession see a break up of the euro.
3. Aggressive ECB monetisation – with quantitative easing heading off economic calamity, albeit not quickly enough to prevent a mild recession.

Recent action by the ECB appears to have reduced the chance of the “Blow up” scenario (probably to around 25%). The costs of leaving the euro for countries like Greece (which would include a likely banking crisis as Greek citizens rushed to secure their current bank deposits, which are all in euros, and default on its public debt anyway) still exceed the likely benefits, so it still looks like the euro will hang together. Overall, the most likely scenario appears to be some combination of “Muddle Through” but with more aggressive ECB action preventing it from spiralling into a “Blow up”.

The US – no double dip (again)
During the September quarter a big concern was that the US economy would “double dip” back into recession. This, along with escalating worries about Europe and the loss of America’s AAA sovereign rating, combined to produce sharp falls in share markets. Since then, US economic data has turned around and surprised on the upside:

• Retail sales growth has hung in around 7% year on year despite a sharp fall in consumer confidence
• Jobs growth has picked up
• Housing related indicators have stabilised and in some cases started to improve
• GDP growth has picked up pace again after a mid year softening.

Earlier concerns about a 1.5 to 2% of GDP fiscal contraction in 2012 dragging growth down have faded as Congress has agreed to extend payroll tax cuts and expanded unemployment benefits for another two months, with a good chance they will be extended for the full year.

More fundamentally, the US appears to be starting to enjoy something of a manufacturing renaissance (in stark contrast to Australia!). There are numerous anecdotes of global companies moving manufacturing to the US including Electrolux, Siemens, Maserati and Honda (which chose to build a new “super car” in Ohio rather than in Japan). Furthermore, GM is now the world’s top selling car maker again. Could a decade long fall in the $US and very strong productivity growth be sowing the seeds of a long term turnaround in America’s fortunes?

China – so far so good
Chinese economic growth has slowed to 8.9%, but there is no sign of a hard landing. Export growth has slowed sharply but so too has import growth and in any case net exports have not been a contributor to growth in recent years. Moreover, retail sales growth has held up well and fixed asset investment has slowed only slightly.

Furthermore, falling inflation (from 6.5% in July to 4.1% in December) and a cooling property market, evident by falling prices in 52 of 70 major cities in December, and falls in sales and dwelling starts provide authorities with the ability to ease the economic policy brakes. And there is plenty of scope to ease. Large banks are currently required to keep a record high 21% of their assets in reserve, the key one year lending rate is at 6.6%, the budget deficit was just 1.1% of GDP last year and net public debt is around zero once foreign exchange reserves of $US3 trillion and other assets are allowed for.

After doubling between October 2008 and August 2009 on GFC related stimulus and a growth recovery, Chinese shares fell 38% to the low early this month as investors feared tightening policy would result in a hard landing. With Chinese price to earnings multiples having fallen back to bear market lows and policy starting to ease again, decent gains are in prospect over the next few years.

Global growth
The next chart highlights the improvement recently in global economic indicators. Manufacturing conditions in most major countries were in decline into the September quarter, but in recent months have either stabilised or begun to improve.

What does this mean for investors?
None of this is to say it will be smooth sailing going forward. Europe’s problems are a long way from being solved, uncertainty remains regarding fiscal policy in the US, Chinese authorities will need to ease soon to ensure a soft landing and the Reserve Bank in Australia also needs to cut more. On top of this, after a solid start to the year shares are getting a bit short term overbought, some short term sentiment measures are a bit elevated and the hot and cold pattern of US data releases warns we may soon see a cold patch. So shares are vulnerable to a short term setback (with February often a soft month in contrast to the seasonal strength seen in January).

However, the improved global economic outlook and reduced tail risks regarding Europe suggests 2012 should be a better year for shares and other risk assets. This is also supported by the fact shares are starting the year on share market valuations well below year ago levels.

Signposts investors should watch include: the size of any share market setback in the seasonally weak month of February; bond yields in Italy, Spain and France; the US ISM manufacturing conditions index; and Chinese money supply growth.

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The Russian default, itself an echo of the previous year’s Asian Tiger crisis, sent Latin America into a tail spin that took five years to stabilise. Countries many thousands of miles from Moscow, and with few trade links, were caught up in the crisis, their leaders at first either unwilling or unable to comprehend the impact a Russian default might have on their own credit-worthiness.  The crisis roamed from one country to the next, causing havoc in financial markets.

For Russia read Lehman. For Argentina read Greece. For Menem read Papandreou. For Brazil read Italy. For IMF read IMF.  There are differences, of course, but the combination of surging sovereign yields, frail banks, ever-larger IMF-backed stabilisation plans, austerity, no growth, falling equities, volatility and bewilderment are common to both episodes. The lesson of the 1990s crisis is to prepare for the worst because it will happen.  Countries that did, such as Brazil, recovered, while those that never came to terms with what had happened, such as Argentina, still struggle.

The role of the private sector was key to recovery in those Latin economies which have since prospered. During the crisis years, Latin governments, led by Brazil, adopted a range of financial and economic policies that sought to promote private sector involvement in economic recovery . Asset sales, price liberalisation, fiscal consolidation, all heavily promoted by the West and the IMF at the time, focused on expanding the private rather than the public sector. I do not recall the Brazilian Central Bank ever buying government bonds.

In southern Europe today it is not clear what role the private sector is expected to play in economic recovery. The current ECB policy of purchasing sovereign debt is stabilising sovereign yields but it has an unintended consequence, encouraging the banking system to off-load its bond portfolios and abandon southern Europe with dire consequences for economic growth. In the next few months, the extent of the recession in continental Europe will become clear and debt dynamics will further deteriorate.  This is not what policy makers are assuming. But what else should we expect? We should pursue policies that seek to encourage private sector finance in southern Europe rather than offer it a means of escape.

Before southern Europe can return to growth we need private sector involvement and finance. The experience of the Latin American crises can guide us in Europe today.

Firstly, governments in southern Europe need to commit to primary surpluses and halt the drain on private sector resources.  Fifteen years ago, developed countries (and the IMF) demanded that emerging countries such as Brazil run large primary surpluses to stabilise their debts. It is hardly surprising similar calls are heard from emerging economies now that roles are reversed. It will be a pre-condition of BRIC support as it was of ours.

Secondly, the ECB should stop buying sovereign bonds. The purchases should be replaced with a Brady-style plan that “incentivises” the banking sector to renew its lines of credit to southern Europe, while simultaneously lowering the overall debt burden.  The creation of a 30-year zero-coupon “Trichet bond” would collateralise the principal of new Greek sovereign securities which would be the centre-piece of a debt-swap plan. The swap, old Greek securities for new, would simultaneously reduce the overall quantity of Greek sovereign debt and extend its duration. Banks would enter the swap voluntarily as the discount to the old bonds would be more favourable than current prices and the new securities would be backed by the Trichet bonds. The Greek government would be responsible for all coupon payments, maintaining fiscal discipline.

Thirdly, banks will require more capital to absorb the financial impact of the debt swap. Accounting standards could be relaxed temporarily to facilitate this, but there will be calls for fresh capital. (This was necessary in Mexico but not Brazil.) Equity markets may not be prepared to provide this capital at current share prices, but the banks have alternatives.  European banks can sell their non-European subsidiaries to local competitors. They can sell off non-banking businesses, such as asset management, insurance or leasing operations. Some troubled banks can be sold to foreign banks in their entirety.  American and European banks hoovered up much of Latin America’s banking system 15 years ago, when the shoe was on the other foot.

It is difficult to see an end to this crisis in southern Europe, but it can be solved if policies are crafted to encourage private sector involvement.

At the moment the private sector is disengaging from southern Europe and the ECB’s purchases of sovereign bonds is accelerating the process. This can only mean that economic growth will continue to disappoint.

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“The key to the global economic outlook is whether the resolution of the European financial stresses evolves in an orderly, semi-orderly or disorderly way,” Hoey states.  “We expect a semi-orderly pattern, which should be consistent with a global slowdown at a subdued pace rather than a full-scale global recession.”

Hoey regards the global economy as fundamentally recuperative after the Great Recession, but vulnerable to shocks since private sector deleveraging and fiscal consolidation in developed countries is not yet complete.

“Our interpretation is that the U.S. is ‘short-funding’ a persistent U.S. budget deficit rather than financing it by the sale of long-term bonds to the private sector,” Hoey says.  “We view the sale of new bonds by the Treasury followed by Federal Reserve purchases of Treasury bonds in the secondary market as the Federal government selling bonds to itself.  After all, the profits of the Fed flow to the Treasury.  At some point in the future, persistent deficits will need to be funded by increased sale (net of Fed purchases) of long-term Treasury bonds to the private sector.” 

“The Federal Reserve has now taken responsibility for the yield on long-term Treasury bonds, some 60 years after it won its independence from the need to support the long-term Treasury market,” Hoey concludes.

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• Confused about where the economy is heading? You’re in good company, with the boffins from the Reserve Bank also seemingly scratching their collective heads about where things are going. Earlier in the year the policymakers appeared confident that the economy would rebound strongly after the floods and cyclones and flagged the risk that this stronger growth would prompt the Bank to lift interest rates to keep inflation under control. But the economy hasn’t bounced as the Reserve Bank expected, reducing the inflation risk.
• So where did the Reserve Bank go wrong? Essentially it under-estimated the “new conservatism” mood that has taken hold among Australia’s consumers. The Bank thought – with jobs relatively plentiful and wages rising –that consumers would start spending again. But a raft of negative influences swamped the strong labour market outcomes, causing people to either save or just leave the dollars in their pockets.
• Not only are people still feeling the effects of the global financial crisis, but there have been the unprecedented floods across Australia, earthquakes in Japan and New Zealand, proposed carbon and mining taxes and the sharp increase in the cost of living such as higher food, electricity, gas and water prices.
• So where do we go from here? Well the positives are still out there. The global economy is still recording above trend growth, led by China and India. Incomes in Australia are being boosted by higher commodity prices. Mining companies are also pushing ahead with key projects. And the job market still generally remains in good shape. So it still seems more than likely that the domestic economy will pick up pace over time. And that means that interest rates are still more likely to rise rather than fall – but it may take a little longer than expected. And it depends whether any new factors come from left field to delay the process even further.
• The big mistake has been to assume that all the extra money coming into Australia was going to be spent. Miners are funnelling the extra dollars into new projects, many of which are capital, rather than labour intensive. Mining still accounts for a relatively small portion of our economy. Sure, the Aussie dollar has gone up, and that means more people are travelling offshore and buying foreign goods. But that doesn’t help our businesses. And while the rising share prices and higher dividends from our resource companies boost compulsory superannuation accounts, most can’t access the savings for decades.

The week ahead

• Investors are constantly trying to build a picture on the economy. Some pieces are big, others small, but each piece is useful. In Australia, some of the smaller pieces of the puzzle are provided in the coming week. Overseas,the focus is on the larger pieces of the puzzle including the latest economic growth figures from China.
• In Australia, the week kicks off with the May housing finance figures on Monday. The number of loans rose by 4.8per cent in April, but it was only the first gain in four months. And while the number of loans could have risen as much as 6 per cent in May, it probably has more to do with refinancing than loans to build new homes. As such it won’t suggest that stronger housing activity lays ahead.
• On Tuesday NAB issues its latest business survey. Both confidence and business conditions remain weak. And judging by recent surveys by Sensis and ACCI, little change in the soft readings is expected. Also on Tuesday the Reserve Bank releases the latest data on credit and debit card lending. Debit cards are favoured at present as consumers prefer to use their own money to buy goods. It would be good if the Reserve Bank started to provide the break-up between domestic and overseas purchases. If card purchases lift, but the dollars are going abroad,then this is hardly positive for Australian retailers.
• On Wednesday the latest consumer confidence figures are issued. With uncertainty about the carbon tax pervading, the latest sentiment figures are unlikely to be positive. On the same day lending finance data is released together with the “Modeller’s Database.” The lending data covers housing, business, personal and lease loans, so the figures provide a good guide to activity in the banking and finance markets. The “Modeller’s Database” includes the latest estimates on private sector wealth. You may not believe it, but Australians have never been wealthier.
• And on Thursday the Bureau of Statistics will provide some greater detail on the labour market such as state and demographic trends and figures on the number of hours worked.
• In the US, the first piece of market-moving economic data is issued on Tuesday in the shape of the latest trade data. The US has a major budget deficit and it also has a significant and persistent trade deficit. Investors aren’t too worried about the trade deficit just yet, but it’s important to note that the deficit remains large even with the weaker US dollar and soft US economy – factors serving to boost exports and constrain imports. A trade deficit near US$44 billion is expected in May. Also on Tuesday minutes of the June 21/22 Federal Reserve meeting are released, so more insights into policymaker thinking will be revealed.
• On Wednesday, Federal Reserve chairman, Ben Bernanke, delivers his semi-annual testimony on the economy.This statement takes on huge importance – Bernanke needs to be sufficiently upbeat on the economy without over-doing it to ensure that confidence and economic momentum is maintained. Also data on import and export prices is released on Wednesday together with the monthly budget figures.
• On Thursday in the US, data on retail spending, business inflation (producer prices) and new claims for unemployment insurance are released. Retail sales are stronger than in Australia and analysts tip a 0.2 per cent lift in non-auto sales. Business inflation is now “normal” with a 0.2 per cent lift in core prices (excludes food and energy) expected for June.
• And on Friday in the US, consumer sentiment, consumer prices and industrial production figures are releases with the Empire State survey thrown in for good measure. Economists tip a 0.2 per cent lift in core inflation and 0.4 percent rise in production. Overall these figures, together with those from earlier in the week, should confirm that the US economy is emerging from its “nap”.
• In China, the monthly download of key economic data occurs on Friday. As well as figures on production and spending, the June quarter economic growth figures are issued. Economists estimate that annual growth slowed a touch from 9.7 per cent to 9.4 per cent.

Sharemarket

• US earnings season kicks off on Monday. As is traditional, Alcoa gets the proceedings underway with analysts expecting earnings of US35 cents a share, up from US13 cents a share last year. Of the 27 other companies scheduled to report over the week, YUM! Brands issues its report on Wednesday with JP Morgan Chase and Google on Thursday and Citigroup on Friday.
• US earnings have been strong over the past year but the effects of the Japanese tsunami, the Greek debt crisis and the slowdown of the US economy will be influences on the results and outlook statements for companies during the earnings season. Overall Brown Brothers Harriman is tipping earnings of Standard & Poor’s 500 companies to be up 13.6 per cent on a year ago.

Interest rates, currencies & commodities

• The semi-annual testimony from the US Federal Reserve chairman, on-going debt woes in Europe, the start of US earnings season and Chinese economic data should be the key influences on financial markets in the coming week. Overall, we are tipping strength, not weakness, with the Aussie holding near US107 cents and commodity prices generally higher over the week.

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Reserve Bank Board meeting

• The Reserve Bank Board has left the cash rate at 4.75 per cent for the eighth straight month (covering seven formal meetings). The next meeting is on August 2 2011.
• The Reserve Bank has become more “dovish” – that is, it has backed away from rate hikes. Economic growth “is now unlikely to be as strong as earlier forecast.” And the Reserve Bank has reiterated its view that only a gradual lift in underlying inflation is “expected over time.”

What does it all mean?

• The Reserve Bank has discovered its “dovish” side, acknowledging the weaker outlook for the economy and inflation. You only lift interest rates if you feel that a strongly-performing economy will generate inflationary pressures. And that is clearly not the case at present. Employment has been falling, home prices are going backwards and consumers refuse to spend. As a result, most businesses are cutting prices to move stock, resulting in lower margins and profits. And as a consequence, the underlying rate of inflation has continued to fall – not rise – hitting a 6½-year low.
• The Reserve Bank finally gets it. While the Bank continues to note the positive broader benefits to the economy of the ‘terms of trade’ boom, it realises that people can’t see the gains. For instance our trade surplus with China has increased by over $14 billion over the past year or around $650 for every man, women and child. Now if those dollars were actually paid out, it may be different. But the increased profits for miners boost share prices and dividends and are reflected in the average worker’s compulsory superannuation. Unfortunately for many people they won’t see those gains for 30 years.
• For the past 14 months consumers and businesses have been on tenterhooks, bracing for the Reserve Bank to lift interest rates. But the Reserve Bank Board has seen fit to lift rates only once in that 14 month period. And, in hindsight, that decision is looking more and more questionable.
• A nirvana situation would be where a boom in mining areas was offset by weakness in consumer spending in capital cities, leaving the Reserve Bank with nothing to do but monitor the situation. It may not be nirvana, but so far that nice balance between hot and cold areas of the economy has been playing out.
• Last week we changed our interest rate views. It turns out to be the right move. Previously we envisaged that rates could rise twice over the second half of the year, but now we are only pencilling in one move over the next five months. The Reserve Bank is weighing up a number of factors and much depends on how the balance of forces behaves.

Interest rate decision and past cycles

• The Reserve Bank Board has left the cash rate at 4.75 per cent for the eighth straight month. In October 2009 the cash rate stood at a 49-year low of 3.00 per cent. But then the RBA embarked on a process to remove the emergency stimulus, lifting the cash rate by a quarter of a percent in October, November and December 2009, and then in March, April, May and November 2010. There has been only one rate hike in the past 14 months.
• In the last rate-cutting cycle the cash rate fell to a low of 4.25 percent in December 2001. In the two previous rate-cutting cycles, the cash rate fell to lows of 4.75 per cent.
• In response to funding pressures, banks were forced to lift rates above the cash rate. As a result, 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 7.80 per cent, well above the long-term average or “normal” rate of 7.15 per cent.
• Financial market pricing suggests that there is a 17 per cent chance of a 25 basis point rate hike within the next five months. Most economists tip at least one rate hike over the coming year. Conditions can change quite quickly – a case in point was when markets factored in a rate cut after the Japanese earthquake and tsunami. CommSec currently factors in just one 25-basis point rate hike over the remainder of 2011 but this would require signs of stronger economic growth and higher inflation for the forecast to be validated.

What are the implications of today’s decision?

• The focus now shifts to June quarter inflation data (Consumer Price Index) to be released on July 27. The TD Securities/Melbourne Institute Monthly Inflation Gauge has indicated that underlying inflation stands at a 6½-year low of 1.6 per cent. If that result is reflected in the official inflation data then the Reserve Bank will have no reason to move rates in any direction.
• The extended period of interest rate stability should benefit housing-dependent companies. In the building materials sector our analysts have BUY recommendations on Adelaide Brighton, CSR and James Hardie. Our analysts also maintain a BUY rating for REA Group. Our analysts continue to favour Consumer Staples over Consumer Discretionary stocks with BUY ratings on both Wesfarmers and Woolworths.

The Statement

• The statement from today’s July 2011 meeting is below. Emphasis has been added to significant changes in wording in the recent statement.

MEDIA RELEASE

STATEMENT BY GLENN STEVENS, GOVERNOR

MONETARY POLICY

At its meeting today, the Board decided to leave the cash rate unchanged at 4.75 per cent.

The global economy is continuing its expansion, but the pace of growth slowed in the June quarter. The supply-chain disruptions from the Japanese earthquake and the dampening effects of high commodity prices on income and spending in major countries have both contributed to the slowing. The banking and sovereign debt problems in Europe have also added to uncertainty and volatility in financial markets over recent months.

A key question is whether this more moderate pace of growth will continue. Commodity prices have generally softened of late, though they remain at very high levels. Despite the challenging international environment, the central scenario for the world economy envisaged by most forecasters remains one of growth at, or above, average over the next couple of years. A number of countries have tightened monetary policy but, overall, global financial conditions remain accommodative and underlying rates of inflation have tended to move higher.

Australia’s terms of trade are now at very high levels and national income has been growing strongly, though conditions vary significantly across industries. Investment in the resources sector is picking up strongly in response to high levels of commodity prices and the outlook remains very positive.  A number of service sectors are also expanding at a solid pace. In other areas, cautious behaviour by households and the high level of the exchange rate are having a noticeable dampening effect. The impetus from earlier Australian Government spending programs is now also abating, as had been intended.

A gradual recovery from the floods and cyclones over the summer is taking place, though the resumption of coal production in flooded mines continues to proceed more slowly than initially expected. The recovery will boost output over the months ahead, and there will also be a mild boost to demand from the broader rebuilding efforts as they get under way, but growth through 2011 is now unlikely to be as strong as earlier forecast. Over the medium term, overall growth is still likely to be at trend or higher, if the world economy grows as expected.

Growth in employment has moderated over recent months and the unemployment rate has been little changed, near 5 per cent. Most leading indicators suggest that this slower pace of employment growth is likely to continue in the near term. Reports of skills shortages remain confined, at this point, to the resources and related sectors. After the significant decline in 2009, growth in wages has returned to rates seen prior to the downturn.

Credit growth remains modest. Signs have continued to emerge of some greater willingness to lend and business credit has expanded this year after a period of contraction. Growth in credit to households, on the other hand, has slowed. Most asset prices, including housing prices, have also softened over recent months.

Year-ended CPI inflation is likely to remain elevated in the near term due to the extreme weather events earlier in the year. However, as the temporary price shocks dissipate, CPI inflation is expected to be close to target over the next 12 months. In underlying terms, inflation has been in the bottom half of the target range, though a gradual increase is expected over time.

At today’s meeting, the Board judged that the current mildly restrictive stance of monetary policy remained appropriate. In future meetings, the Board will continue to assess carefully the evolving outlook for growth and inflation.

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