• American consumer spending has been reasonably solid considering the recent political turmoil over budget tightening (“fiscal cliff”) as well as Hurricane Sandy. Further spending gains are expected. The strong positive for the US economy has been the housing recovery in 2012, so strength in housing construction would also be welcome.
• China’s see the release of critical economic activity results for the end of 2012. China’s Real GDP result for the December quarter should show that economic growth stabilised at a 7.5% pace. This comes after a slowdown in the preceding quarters from the +9% growth pace set in 2011. Industrial production & Retail Sales should show solid results for December consistent with China’s economy becoming more focused on domestic demand rather than exports.
• Australia’s labour force data for December is the key focus. Given subdued sentiment in the “Non – Mining” economy as well as significant job loss announcement in both the private & public sectors in 2012, a soft result is expected for employment for the end of 2012.  Job losses of circa -10,000 are anticipated for December while the unemployment rate is expected to rise sharply from 5.2 % to 5.4 %.  

Outlook for markets

• Global shares appear to be now entering a consolidation phase after a sharp rally with the “fiscal cliff” vote in the opening week of 2013.  America’s fiscal problems are yet to be fully resolved with further political turmoil likely over government spending and the debt ceiling. Caution will also likely prevail as   the US corporate earning reporting season for the December quarter has just started.  Europe faces significant political challenges with an Italian general election in February while Spain’s is struggling with a weak banking system and an alarming +26% unemployment rate. Hence Global Shares seem set to drift sideways over coming weeks.
• Yet 2013 should ultimately be another good year for Global Shares. Global growth should slowly improve in 2013 as America employment and housing recovery gathers speed while Europe’s economy gradually stabilises. This will create a solid corporate profit environment favourable for Global Shares. Given Global Shares are undervalued on historic measures and with investors likely to be tempted to switch from overvalued and low yielding Government Bonds, this year should be another rewarding one for share investors.
• Global Sovereign bonds are vulnerable to a rising trend in yields as global economic growth improves. American, German, Japanese and Australian Government bonds provide extraordinarily low yields currently. This would suggest low returns for the medium term. Corporate bonds are thus a better proposition for those seeking income but who are cautious about investing in shares presently.

Headline developments of the past week

• Australia’s nominal retail sales disappointed in November with a marginal -0.1% fall. Considering that the RBA had cut interest rates by 0.25% in the previous month, this is a very soft result. Over the past year, Australian nominal retail sales have recorded only modest growth of +2.9%.  For the RBA, this soft November retail sales result would suggest further interest rate cuts may be required in 2013 to revive retail spending.
• Europe’s labour markets continue to weaken given the recession conditions prevailing. November saw Europe’s unemployment rate climb to 11.8%. Within Europe, there is a dramatic divergence in jobless rates. Greece’s unemployment rate of 26.8% and Spain at 26.6% contrast sharply with Germany’s 5.4% unemployment rate. Even Italy (11.1%) and France (10.5%) are also struggling with elevated unemployment rates in November.
• In more encouraging news, China’s trade performance improved with a sharp pickup in exports. China’s export growth rose at a +14% annual pace in December which is a dramatic revival compared to November’s muted +3% pace. A pick-up in China’s export volumes would typically signal a revival in global growth. For Australia the news is considered beneficial as China’s import growth revived to a +6% annual pace signalling that demand for Australia’s commodities is gaining speed. This is particularly apparent in the sharp revival in the spot Iron Ore price from US$ 87 in August 2012 to now US$ 158 per ton.
• Japan’s new Government announced a fiscal stimulus package of Yen 10 billion (A$ 109 billion) to revive Japan’s weak economy. This stimulus should enable Japan slowly emerge from its current recession in 2013 although the government debt burden is set to surge beyond the recent estimates of 237 % of Nominal GDP.

Major global economic releases and implications

• Europe’s economic activity data released this week was also disappointing. The European Commission’s surveys of business & consumer sentiment were weak and suggest that a mild recession continues in Europe.
• However the European Central Bank (ECB) kept their key policy interest rate on hold at 0.75%. The ECB President Dr Draghi conceded that the risks “remain on the downside” for Europe given “balance sheet adjustments” and “persistent uncertainty”. Dr Draghi expected that “later in 2013, economic activity should gradually recover”.
• America’s economic releases were mixed last week. The NFIB small business survey shows soft confidence readings in December. Yet consumer credit demand is slowly reviving judging by November’s annual +6% rise. Housing mortgage applications and refinancing were strong in the opening week of this year.  
• China’s annual inflation showed a mild pickup to 2.5% in December given the recent cold weather adversely impacting vegetable prices. However price pressures seem generally well contained and below the central bank’s 4 % inflation target. So there is still scope for China to gradually relax monetary policy in 2013.                     

Australian economic releases and implications

• Job vacancies fell sharply in November 2012 by 7%. This signals that labour demand is clearly softening with the “non mining economy” struggling (sectors such as manufacturing, retail, transport and tourism are very subdued). 
• Australia’s trade performance deteriorated in November with an increased deficit of A$ 2.6 billion. This is the fourth largest monthly deficit on record. Strong capital import demand given the Mining investment boom and solid consumer good imports taking advantage of a high Australian Dollar were the key factors for the larger deficit.
• Building approvals did improve by +2.9% in November indicating that housing construction is slowly responding to lower interest rates.  

Major market moves

• Global shares were generally flat for the past week. American shares (S&P 500) rose marginally by +0.4 % given caution with the start of the corporate earnings season for the December quarter. There were also minimal changes in Europe. Australia’s ASX 200 marginally fell by -0.3% for the week. 
• US earnings reporting season commenced with Alcoa the first major company to report. Alcoa provided signs of optimism, expecting growth in aluminium demand to reach 8% in 2013. A mild US earnings season is expected with annual profit growth of circa +2% anticipated.

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) makes no representation or warranty 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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• Spain is resisting applying for assistance for several reasons, including national pride, upcoming regional elections and the fact that 2 year borrowing costs remain affordable below 4%. Our view remains though that ultimately Spain will have no choice but to apply for help, but that uncertainty may continue for a few weeks till  it does. Similarly uncertainty remains regarding Greece with ongoing differences regarding required austerity cuts and the IMF making it clear that for it to give Greece any more funds the EU may need to take a hit on its existing loans to Greece. Again, ultimately agreement is likely to be reached on both sides given the lack of interest in letting a Greek exit derail progress in Europe more generally, but in the short term there is a risk of another bout of market worries about Greece.
• In Australia, there were no surprises with the RBA taking the cash rate to 3.25% from 3.5% citing a softening global outlook, uncertainty regarding China, the need to boost non-mining demand, low inflation and the strength in the $A. The need to boost the non-mining sectors of the economy as the mining boom fades at a time when the $A remains strong and fiscal cutbacks are intensifying means the RBA will have to cut rates further.
• Post GFC caution has likely resulted in a reduction in the neutral level for bank lending rates, such that they are only just now starting to become stimulatory. Our assessment remains that standard variable mortgage rates will need to fall to around 6% (from an average of around 6.62% after the RBA’s latest rate cut), which implies that the official cash rate will need to fall to 2.5% (assuming banks continue to pass on about 80% of RBA cuts).
• We expect this to occur over the next six months, with the RBA cutting again next month by another 0.25%.
• But will rate cuts work? So far the rate cuts since last November haven’t had much impact because they haven’t come down enough to offset negatives such as job insecurity, they are only now starting to fall below neutral levels and the lags with monetary policy are long and variable. But there is no reason not to expect a positive impact over the next year. The reduction in mortgage rates that has already occurred over the last year has already reduced the interest bill on a $300,000 mortgage by roughly $2500 pa. If mortgage rates fall to 6% as expected then this saving will rise to $4500 pa. Some of this will likely be spent. The improvement in housing affordability that flows from lower mortgage rates will likely also encourage a pick up in housing construction after a long period of under building. And to the extent that lower rates take pressure off the $A it will help manufacturing, tourism, miners, farmers and retailers.

Major global economic releases and implications

• US economic data was positive with both the ISM business conditions indexes rising, payroll employment growth remaining moderate but a strong gain in a household survey of employment seeing unemployment fall to 7.8%, auto sales rising, consumer credit rising more than expected, new weekly mortgage applications rising solidly and mortgage refinancing applications soaring. In fact, the impact of QE3 can already be seen in a collapse in 30 year mortgage rates to a record low of just 3.38% which in turn is driving the surge in mortgage refinancing. This is likely to provide a big tailwind to consumer spending. Another tailwind is coming in the form of a 15 year high in US oil production which is helping keep oil prices down in the face of Middle East tensions.
• Final Euro-zone business conditions PMIs for September came in slightly better than initially reported and continue to point to a mild as opposed to a deep recession. The ECB meeting and President Draghi’s subsequent press conference offered nothing new with interest rates remaining unchanged (not that a cut will have much impact anyway as they are already effectively zero) and Draghi reiterating that having set up its bond buying program its now in the hands of governments (ie Spain to apply for help and commit to a reform program).
• The Bank of England also announced nothing new, with the focus now shifting to its November meeting where its existing, but due to expire, quantitative easing program is likely to be extended in the face of soft economic data.
• China’s non-manufacturing PMI index fell, but it remains reasonably high. November 8 has been set for the National Congress to resolve the leadership transition, so at least the leadership uncertainty will soon be over.
• Japanese data was soft with another fall in the Tankan survey for September. The Bank of Japan announced no further changes to monetary policy. More easing is likely though as Japan’s economy has weakened significantly.
• Korean exports surprised on the upside in September rising two months in a row. Maybe too early to get too excited but a positive sign nonetheless.

Australian economic releases and implications

• Australian economic data was generally soft, pointing to more interest rate cuts ahead. While house prices rose strongly in September according to RP Data/Rismark other housing related indicators remain weak with new home sales falling to a 15 year low in August. Building approvals rose solidly in August but this was all due to approvals for volatile multi-dwelling buildings with private house approvals falling. Retail sales rose by less than expected in August with annual growth remaining in the same mediocre range it has been in for the last three years. Business conditions indicators for manufacturing, services and construction all weakened and the trade deficit deteriorated further in August highlighting the slump in export earnings. Meanwhile the TD Securities Inflation Gauge rose slightly in September and continues to suggest only a modest flow through of the carbon tax.

Major market moves

• Share markets mostly rose as US economic data was better than expected. Uncertainly regarding Spain and Greece limited gains though. Chinese shares were closed for Golden Week national holidays.
• Australian shares rose 2.4% over the past week reaching their highest since August last year, helped along by the RBA’s latest rate cut with consumer and financial stocks leading the gains, and defensives such as health and telcos lagging.
• Commodity prices were mixed with the oil price down on increased US oil production, but gold and metal prices seeing gains. The $A fell in response to the RBA’s rate cut and the fall in the US unemployment rate.
  What to watch over the week ahead?
• In the US the trade deficit for August (due Thursday) is expected to have deteriorated slightly, producer price inflation (Friday) is expected to remain benign on an underlying basis and consumer confidence (also Friday) is expected to fall slightly. The Fed’s Beige Book of anecdotal evidence will also be released Wednesday.
• The third quarter profit reporting season will kick off with Alcoa reporting on Tuesday. The analyst consensus expects a 0.6% rise in earnings over the year to the September quarter, but with profit downgrades to upgrades running at 4 to 1 actual results are likely to surprise on the upside.
• In Europe finance ministers meet on Monday and Tuesday, but are unlikely to come to any major decisions regarding Greece, banking supervision, etc which will likely await the leaders’ summit on October 18 and 19.
• Chinese economic data for September is expected to show at least a stabilisation in growth. New bank loans are expected to have remained strong and trade data (Saturday) is expected to show a slight improvement in both export and imports.
• On Thursday the Bank of Korea is expected to cut interest rates again reflecting recent soft data.
• In Australia expect business conditions and confidence in the NAB survey (Tuesday) to remain subdued, but consumer sentiment (Wednesday) to show a small bounce on the RBA’s latest rate cut. Employment is expected to have declined by 5000 in September (Thursday) resulting in a rise in unemployment to 5.3%. A speech by RBA Deputy Governor Lowe on Tuesday will be watched closely for any clues regarding interest rates.

Outlook for markets

• Global shares have been undergoing a consolidation after strong gains in the September quarter. Given uncertainties regarding Spain, Greece and China this may have a bit further to run. However, the broad rising trend is likely to remain intact. A pick up in global growth by year end and going into next year on the back of easing by the Fed, the ECB’s bond buying program and more decisive stimulus action in China once its leadership transition is resolved next month should support profit growth in 2013. Australian shares are now being given an added impetus by the resumption of RBA interest rate cuts. With shares remaining cheap, particularly against government and corporate 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. 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 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 ongoing RBA rate cuts are negatives. The likely outcome is for a volatile range of between $US0.95 to $US1.10, with the risk on the downside. We have probably seen the best for the $A.

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After committing to do whatever it takes to defend the euro a month ago, the ECB has delivered broad details about how this will work with the key elements of its plan (called Outright Monetary Transactions or OMT) being:

• unlimited secondary market bond purchases by the ECB out to 3 year maturities
• the ECB will not rank senior to other investors; no formal announced yield target, but the ECB clearly has objectives in mind
• bond buying conditional on a country applying for assistance to the Euro-zone bailout funds and agreeing and abiding by its requirements; and any bond buying to be sterilised, ie, it won’t be quantitative easing.

This has to be seen as very positive. Europe now has a well articulated and credible program to bring bond yields in troubled countries back to sustainable levels. The combination of the ECB acting in concert with the bailout funds effectively leverages up the firepower of the latter overcoming concerns that they don’t have enough resources.

Buying shorter term bonds should transmit the impact out to longer term yields as well – reflecting this Spain’s ten year bond yield has fallen below 6% for the first time since May. While it would have been nice to see the ECB announce quantitative easing by not sterilising its bond buying, the current program is focused on bringing borrowing costs back into line across Europe and making sure that current very easy monetary conditions apply for all of Europe and not just a few countries – QE is still likely at some point to deal with the ongoing recession. All that is now required is for countries like Spain to apply for assistance and agree to the terms, which it is likely to do soon ahead of a bond auction in October. In fact Spain has little choice but to apply because if it doesn’t its bond yields will rebound.

The bottom line is that the ECB is delivering on its commitment to defend the euro. The tail risk of a euro breakup triggering a rerun of a deep GFC style recession in Europe and potentially a global recession is receding. The ECB under Mario Draghi is very different to that under Trichet. Starting with last year’s bank funding operations and now with its bond buying program Draghi is proving to be a pragmatic man of action.

In Australia there were no surprises from the Reserve Bank which left interest rates on hold at 3.5% with the RBA continuing to see growth running around trend. However, the RBA does seem to be getting a bit more concerned about the slowdown in China and sharp falls in commodity prices.

Our assessment is that with the mining boom losing momentum led by sharp falls in iron ore prices and recent monthly indicators such as retail sales, building approvals and employment growth softening anew its likely that growth will slide below trend highlighting the need for lower interest rates.

Standard variable mortgage rates at 6.8% are still well above the 6% or so levels that were required to generate a decent recovery through the last two easing cycles into 2002 and 2009. Reflecting these considerations we expect the RBA to cut the official cash rate to 2.75% in the next six months, starting with a 0.25% cut in either October or November.

Major global economic releases and implications

• US economic data shows that growth is continuing but remains sub-par and not enough to satisfy the Fed.
  While the new Markit manufacturing conditions PMI rose marginally in August, the ISM manufacturing conditions index deteriorated slightly leaving it below 50 for the third month in a row and jobs growth of just 96,000 in August is way below the 200,000 a month need to sustainably reduce unemployment. Construction spending also fell in July and mortgage applications fell over the last week. On the positive side though the ISM nonmanufacturing conditions index rose in August and productivity growth was revised up for the June quarter.
• Final August business conditions PMIs for the Euro-zone confirmed a slight improvement in manufacturing but a slight deterioration in the services sector leaving the overall composite indicator little changed from where it’s been over the past few months, which is consistent with a mild recession in Europe.
• While China’s manufacturing PMIs fell in August, non-manufacturing conditions improved. Chinese authorities announced approvals for infrastructure spending focused on road and rail projects. While it’s not sure whether this is real stimulus or not given uncertainty over the financing or just the approval of five year plan projects that would happen anyway, it triggered a strong bounce in Chinese shares. After a 3 year 40% slump in share prices, the Chinese share market is primed for a rebound with a record low historic PE of 11 times.

Australian economic releases and implications

• Australian economic data was mostly soft. The good news was that GDP growth over the year to the June quarter was 3.7% which is well above that in most other comparable countries. However, growth in the quarter slowed to just 0.6% and going forward is likely to remain subdued as the Government handout driven boost to consumer spending looks to have run its course, non-mining sectors of the economy are still struggling and the mining boom seems to be rapidly losing momentum led by sharp falls in iron ore prices.
• Weakness was indicated in a range of indicators: with retail sales falling sharply in July; employment falling in August; job ads continuing to slide pointing to more labour market weakness ahead; the trade deficit widening in July; soft readings for manufacturing, services and construction sector conditions indicators; and company profits falling for the third quarter in a row. On balance we see growth running around 2.5% over the year ahead, which is not disastrous but still well below trend and consistent with further RBA interest rate cuts.

Major market moves

• Share markets rose as the ECB delivered details on its bond buying plan resulting in a further pricing out of the risk that the Euro-zone will blow apart triggering a global recession. Chinese and Asian shares also benefitted from infrastructure project approvals in China.
• Commodities prices also rose although the iron ore price made new lows. Renewed talk of interest rate cuts and worries about the iron ore price also saw the $A fall below $US1.02 mid week before recovering its losses.
• Bond yields rose in major countries as safe haven buying reversed, but fell sharply in Spain and Italy.

What to watch over the week ahead?

• In the US the key focus will be on the Fed’s monetary policy meeting (Thursday) where we expect the Fed to unveil more monetary easing. Given support at the last meeting for further easing unless the economy strengthened soon and Bernanke’s Jackson Hole speech which made a strong case for quantitative easing by arguing that it has worked in the past, that its costs are manageable and that unless growth improves quickly unemployment will remain too high, we expect the Fed to extend its commitment to keep rates low into 2015 and to announce more quantitative easing involving the purchase of both government bonds and mortgage backed securities. But unlike in the past where QE1 and QE2 were specified in terms of the amount and time frame, QE3 is expected to be open ended with the Fed continuing it until the economy is judged to be on a sounder footing. While the absence of a dollar value might confuse some, the lack of an end point problem and the commitment to continue until growth is stronger will be a big positive to such an approach.
• In terms of US data, it’s a quite week until Friday when we expect higher food prices drive a pick up in inflation, but core inflation to remain benign, a solid 0.5% gain in retail sales and modest growth in industrial production.
• In Europe, the German constitutional court’s ruling on the validity of the ESM bailout fund will be delivered on Wednesday and is likely to clear the fund but impose some conditions around it. Dutch elections will also be watched as another test of Euro-zone solidarity but recent polls suggest a radical antiausterity or anti-bailout result is unlikely. A Eurogroup/European finance ministers meeting on Friday may also see Spain apply for bailout fund assistance as is required under the ECB’s bond buying plan.
• Chinese August data for exports and imports (Monday) and bank lending (Tuesday) will also be released.
• In Australia, expect a modest gain in housing finance (Monday), but continued sub-par reading for business conditions and confidence in the NAB business survey (Tuesday) and for consumer confidence (Wednesday).
• In terms of consumer confidence talk of rate cuts is likely to have been offset by bleak news regarding ironore rices and a run of soft economic news. Data for June quarter dwelling starts will also be released.

Outlook for markets

• Event risk remains high for investors over the next few weeks with the Fed meeting, Spain yet to apply for
  assistance, the German constitutional court ruling, Dutch elections, and the European Union decision on Greece that may create volatility in the month ahead along with ongoing uncertainty about Chinese growth. However, with the ECB undertaking a major game changer, the Fed providing a win/win for the US share market in that either the economy improves or the Fed eases, further easing likely in China and shares cheap, we still see shares being higher by year end. It’s also a good sign that US shares have broken up to a new post GFC high. So any weakness over the next month or so will likely provide 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. Corporate debt is a better proposition for those after income but not willing to accept the volatility that comes with shares.
• In the short term the $A is vulnerable should iron ore prices continue to fall, however, overall it should remain strong as global central banks undertake further monetary easing, commodity prices bounce back into next year and as central bank reserve diversification continues.

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The star performers were Australian and global fixed interest, which returned 12.4% and 11.6% respectively, with bond yields in Australia, the US, UK and Germany falling to record lows on the back of safe haven demand and as expectations for short term interest rates were revised down.

Assets like Australian real estate investment trusts (which returned +11%) and directly held non-residential property (which returned around +8.5%) also provided solid returns.

Obviously the big question is whether the new financial year will see an improvement in share market returns. Another is whether Australian shares have lost their mojo, having underperformed global shares since October 2009.

Drivers of global weakness
The drivers of the poor ride in shares over the last year are well known, with markets hit twice with global growth worries:

• The September quarter last year saw an intensification of worries about the European debt crisis combine with a blow to confidence from the downgrading of America’s credit rating and a soft patch in US economic data at a time when emerging countries were also slowing due to policy tightening to deal with inflation problems.
• Policy stimulus saw a relief rally into year end 2011 and through the March quarter this year.

But this again gave way to renewed worries about the global growth outlook as the European debt crisis returned (for a third year), on the back of worries about a Greek exit from the euro and with the focus switching to Spain, US economic data entered another soft patch and growth in the emerging world continued to slow.

Although all of the damage was actually done during the second half of last year, with share markets actually up so far this calendar year, the end result has been a difficult financial year for most share markets and commodity prices, but the sharp rally in Government bonds in perceived safe countries resulted in strong returns for bond funds.

While US shares returned +5.4% helped by very easy monetary conditions and reasonable profit growth, European shares returned -16.2%, emerging market shares lost-6.6% and global shares generally lost -2.1%.

But why have Aust shares underperformed?
After outperforming global shares through the last decade, Australian shares have underperformed since October 2009, resulting in a three year return to June of 5.6% pa compared to 10.1% pa for global shares in local currency terms. At first glance this seems inconsistent with the relatively stronger performance of the Australian economy. However, there are essentially three reasons for the underperformance:

• Relatively high interest rates in Australia have made it attractive for Australian investors to park their savings in bank term deposits as opposed to shares and acted as a drag on demand for things like retail sales and housing. This contrasts with the US which has seen interest rates stay near zero, resulting in little incentive to invest in bank deposits and encouraging consumers to spend.
• The relatively strong $A has served to depress earnings for companies exposed to trade or with offshore operations. This contrasts with companies in the US which have benefitted from a fall in the value of the $US. (Note that the rise in the $A has also cut the returns from global shares if measured in Australian dollars over the last three years, but not over the last year.)
• Finally, worries about a hard landing in China have weighed on commodity prices & perceptions of Australia.

Real GDP growth in Australia over the year to the March quarter was a strong 4.3% and, apart from being boosted by a bounce back from last years floods, reflects strong growth in parts of the economy that the share market is not highly exposed to (such as health) or mining investment, whereas the combination of high interest rates, the strong Australian dollar and worries about China and falling commodity prices have borne down on sectors of the economy to which the share market is highly exposed such as retailing, building materials, large cap industrials and mining stocks.

Outlook – global
Global business conditions indicators point to a distinct slowing in global growth. See next chart. But they remain well above previous cyclical lows and while the risks have increased our assessment is the global recovery will continue but will remain constrained and fragile.

• The Euro-zone is the weakest link, but there have been some positive developments. The Greek election result has avoided a messy exit from the euro for now and the EU summit turned out better than expected with measures to allow bailout funds to be used more flexibly and a move towards a banking union. These moves should reduce the risk of Europe spiralling into a deep recession. However, Europe is still just muddling along: a fiscal union allowing common financing is a long way off, Greece remains a periodic threat and recession continues. So Europe remains a source of volatility. We see the Euro-zone contracting 1% this year.
• The pace of US economic growth appears to have stepped down to around 1.5% during the June quarter. However, there are several reasons to believe the fragile US recovery will continue: further soft US data will trigger more monetary easing from the Fed; the US housing sector appears to be gradually recovering; the shale oil phenomenon is potentially very positive for the US; and the slump in the June ISM may reflect the recent flow of bad news out of Europe. We see US growth running around 2%, notwithstanding the current soft patch.

• Having recovered from recession last year, Japanese indicators point to growth averaging around 1% pa.
• A big part of weakness lately relates to the emerging world. This has reflected the impact of policy tightening to control inflation in 2010 and 2011, reduced export demand as well as structural considerations with China shifting to a focus on quality growth and a lack of reforms dragging on India. However, with inflationary pressure fading and in the absence of debt problems, emerging countries have plenty of scope to ease policy and stimulate growth, which we expect to continue. Growth in the emerging world is expected to average 5% pa.

Overall this suggests something like 3% global growth. Not brilliant but enough to underpin modest profit growth over the year ahead. With shares cheap and monetary conditions easing this should see share markets move higher over the next 12 months, albeit further short term volatility is likely. The forward PE on global shares and Australian shares is now 10.8 times, which is well below historical norms and the gap between the forward earnings yield on shares and the 10 year bond yields in the US and Australia is almost as wide as it was in the GFC.

Outlook – Australia
The bad news is that more profit downgrades from Australian companies are likely in and around the August reporting season, reflecting the tough operating environment they remain in.

The good news though is that the three big drags on the relative performance of Australian shares are starting to fade. Interest rates have fallen 1.25% since last October and are likely to fall further leading to lower term deposit rates and providing a boost to spending. The $A is off its highs and the days of strong rises are behind us. And China is starting to ease, which should lead to a reduction in worries about a Chinese hard landing ahead. Combined, this should lead to a better operating environment for Australian companies into year end and through next year.

There are already tentative signs that lower interest rates are working in Australia with better data for housing approvals and retail sales. Australian shares as indicated in the previous chart remain cheap, particularly at a time when the yields on bonds are at record lows and term deposits rates are falling.

Historical context
Some historical context may be of use. The table below compares top to bottom falls in all bear markets in Australian shares since 1900. I have defined a bear market as a 20% or greater fall that is not fully reversed within a year of the low. So unless the All Ords index rises above its April 2011 high of 5065 by early September then the 22% slump from April 2011 to last September’s low constitutes a new bear market.

Since 1900, bear markets in Australian shares lasted an average 19 months with an average top to bottom fall of 35%. The average time taken to reach a new high once the low is in is 41 months but with deep bear markets tending to take longer. The bear market that began in April last year was relatively short at 5 months and saw a lower than average fall. This is probably because a lot of damage was already done by the bigger bear market from 2007, from which we are yet to fully recover.

In terms of the recovery from the GFC bear market, the recovery from the 1973-74 bear market is relevant. Back then it took 59 months (or nearly 5 years) to make a new high. So far we have completed 39 months, suggesting we are maybe two thirds of the way there. But these historical statistics are only a very rough guide and I suspect it will take longer than 20 months to get back to the 2007 high.

Concluding comments
After worries about the global growth outlook and added constraints on Australian shares, share markets are now very cheap compared to traditional defensive assets like bonds and should benefit over the next financial year even though the broad environment is likely to remain one of constrained growth and volatile returns. By contrast very low bond yields point to very constrained returns from bonds.

5 July 2012

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The past week has been dominated by the European Union leaders’
summit, with Germany insisting that centralised controls of budgets and banking be in place before agreeing to any form of common funding or a Euro-zone wide banking guarantee, but Italy, Spain and, their new ally, France insisting it should be the other way around. In the event, while Euro-zone leaders made no progress on a fiscal union, they have agreed to a move to centralised Euro-zone supervision of banks, with proposals to be considered by year end, and more importantly agreed to open up the use of its bailout funds and agreed on a growth pact worth €120bn. While the agreed growth pact may actually have little impact, the announcements in relation to the use of the Euro-zone bailout funds are very positive.

• The key changes are that bailout funds provided to Spain for its banks will not have preferred credit status (which should help boost investor interest in Spanish bonds), that banks may be recapitalised directly from the ESM bailout fund once a single supervisory arrangement for banks is in place (which means that any funds provided to a country’s banks won’t boost that country’s public debt) and that the bailout funds can be used to buy bonds in countries, such as Spain and Italy, as long as such countries are respecting their deficit reduction timelines. The opening up of the use of the bailout funds is very positive and should help reduce Spanish and Italian bond yields. In fact Spanish ten year bond yields fell 60 basis points in response to the news.
• An obvious concern is that the €500bn left in the combined EFSF and ESM bailout funds (or €400bn after allowing for money earmarked for Spanish banks) will not be enough to “bailout” both Spain and Italy (whether its via a direct bailout or bond purchases) and that Europe is still no closer to a fiscal union and common debt issuance. In this sense the summit is just another example of muddling through. But the outcome is arguably far more positive than investors had expected – with some even talking about some sort of bust up – and the moves
  regarding the use of the bailout funds, if implemented quickly, should keep Europe from going over the abyss into a deep recession and full blown financial crisis rivalling the GFC that many feared it was sinking into.
• The past financial year has been very disappointing with Australian shares down around 11% and global shares down around 6% as worries about Europe and global growth generally weighed in the September quarter last year only to return in the June quarter this year and Australian shares were additionally hit by the impact of relatively high interest rates which have kept investors in cash and depressed spending and profits, the strong $A which has weighed on companies that compete internationally and worries about a hard landing in China which has weighed on commodity prices and resources stocks. Resources shares have been the worst performers along with IT and consumer discretionary stocks whereas defensive sectors like telcos, utilities and health performed strongly. While earnings downgrades are set to continue in Australia for the next few months, the shift to lower interest rates in Australia and easing in China should help improve the relative performance of Australian shares over the next 12 months.

Major global economic releases and implications

• US economic data was reasonable. Good gains in home sales and another rise in house prices add to the evidence that the US housing sector has bottomed and is starting to recover. Durable goods orders also rose in May, but consumer confidence slipped. Regional business surveys were mixed – up in the Texas, Chicago and Milwaukee regions but down in the Richmond and Kansas regions. It’s worth noting falls in mortgage rates and gasoline prices have helped spur in the past and we have now seen sharp falls in both recently.
• European data was soft with falls in economic sentiment, albeit not by as much as feared, and falls in German, Italian and Spanish retail sales. German and French consumer sentiment readings were little changed.
• Japanese economic data was mixed, consistent with underlying growth running around 1%. Industrial production fell sharply in May and small business confidence fell, but household spending was solid and the jobless rate fell slightly. Meanwhile, price deflation continues highlighting that the Bank of Japan has little chance of meeting its 1% inflation objective unless it pumps in a lot more monetary stimulus.
• In China, a leading economic indicator rose again in May, contradicting soft readings from other indicators.

Australian economic releases and implications

• Australian economic data remained soft with new home sales staying depressed, job vacancies falling and credit growth remaining subdued. While private credit growth improved a notch this was all due to business credit which may reflect a switch from internal to bank funding, with annual growth in housing credit falling to its lowest since records began in 1977. That we have yet to see any impact on timely indicators like consumer sentiment and auction clearance rates from interest rate cuts so far demonstrates how subdued and cautious Australian households are and supports our view that further interest rate cuts will be required.

Major market moves

• Share markets were little changed in the run-up to the EU leaders’ summit, but then bounced sharply on news that the summit had agreed to a more flexible and aggressive use of bailout funds in terms of recapitalising banks and stabilising bond markets in troubled countries. As a result share markets saw strong gains on Friday, resulting in solid gains over the last week.
• Commodity prices were also boosted by the outcome of the EU summit, with strong gains in oil and metal prices. The Australian dollar also rose strongly on the news out of Europe, as did the euro.
• Bond yields were mixed in the US and Australia but Spanish bond yields fell sharply on the EU summit news.

What to watch over the week ahead?

• The week ahead will no doubt see further reaction to the outcome of the EU leaders’ summit, but with the focus now likely to shift to the ECB meeting on Thursday. The deterioration in the European economic outlook is likely to see the ECB cut its official interest rate by 0.25% taking it to 0.75% and some reduction in the deposit rate it pays to banks (currently 0.25%) to encourage them to lend.
• In the US, regional surveys point to a fall in the key ISM manufacturing conditions index (Monday) to 51 from 53.5 in May and payroll employment (Friday) is expected to rise by a subdued 90,000 leaving unemployment at 8.2%. Construction activity is also likely to be soft and the ISM non-manufacturing index (Thursday) is also likely to fall slightly. The bottom line is that the US soft patch is likely to continue for a bit longer.
• In the UK the Bank of England is expected to announce more quantitative easing on Thursday.
• In Australia, it’s a big week with the carbon and mining taxes commencing and the RBA meeting on Tuesday. The mining tax should be well and truly factored into investor expectations and for most households the commencement of the carbon tax will initially feel like a bit of a non-event as most consumer prices will be little affected. Average price levels are expected to rise by just 0.7%, but most of this will occur via higher electricity prices so the real shock won’t come until the next power bill which will rise sharply in most states led by NSW where electricity prices are set to rise by 18%, 8% of which is due to the carbon tax. Meanwhile household spending power should see a decent boost thanks to carbon tax compensation, July 1 tax cuts, the school kid bonus and the ending of the flood levy. That said the boost will be less than seen through the GFC.
• On the interest rate front we expect the RBA to leave rates on hold on the grounds that after the last rate cut GDP and employment data surprised on the upside and after cutting two months in a row it would prefer to wait and see what the impact has been. However, we remain of the view that further rate cuts lie ahead thanks to combination of global weakness, soft commodity prices, weakness outside the mining sector, benign inflation and still high borrowing rates at a time when households and businesses are feeling cautious about spending. Rate cuts are likely to resume in August and by year end we see the cash rate at 2.75%.
• On the data front in Australia, expect a bit of a bounce back in building approvals (Tuesday) following a sharp fall in April and continued soft retail sales (Wednesday).

Outlook for markets

• Shares are likely to remain volatile in the short term on the back of worries about the growth outlook, but with a lot of bad news already factored in as indicated by attractive valuations and Europe starting to move in the right direction they stand to benefit if policy makers undertake more policy stimulus and/or the economic news becomes a little less bad. As such, while the short term outlook is uncertain we remain of the view that share markets 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.
• The Australian dollar remains vulnerable in the short term, reflecting worries about the global growth outlook. However, it is likely to receive a boost during the second half of the year as global central banks undertake further monetary easing.

2 July 2012

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To be sure there has been some more bad news, such as another downgrade to Spain’s sovereign rating and more soft European economic data, but the mid week rebound in share markets was driven by several factors.

• Firstly, monetary easing in China and Australia and indications Europe and the US are heading towards more monetary easing.
• Second, Spanish banks are likely to be recapitalised by the European bailout fund, possibly in the week ahead following reports as to how much will be required.
• Third, signs Europe appears to be moving towards “more Europe” (with greater fiscal union and centralised banking controls) in return for greater support from Germany.
• Finally, share markets and currencies like the $A had become very oversold and were due for at least a bounce.
• However, while the global policy developments of the last week have been welcome, whether we have seen the bottom or not for share markets remains to be seen and at this stage is contingent upon sensible outcomes from the Greek and French elections and concrete policy moves from European leaders towards supporting banks (both in terms of recapitalisations and bank deposit insurance or guarantees) and reducing bond yields in troubled countries, along with easier monetary policy from the ECB and possibly the Fed.
• It’s ironic that over the last week it was China and Australia, with 8.1% and 4.3% economic growth respectively that eased monetary policy whereas the ECB and Bank of England with zero growth left policy on hold!

Major global economic releases and implications

• US economic data was mixed with a slight rise in the ISM non-manufacturing conditions index in May, a fall in weekly jobless claims, modest growth in weekly chain store sales and the Fed’s Beige Book suggesting the economy is growing at a moderate pace, but weekly mortgage applications falling for the fourth week in a row and factory orders coming in below expectations in April. Reflecting the softer conditions seen recently in the US various Fed officials have raised the prospects of more monetary stimulus. Fed Chairman Bernanke left the door open for more stimulus, but was predictably non-committal and this led to a bit of market disappointment with some investors clearly looking for a green light to QE3 at the Fed’s June 19-20 meeting. The most likely scenario though is that the Fed will extend Operation Twist (selling short term and buying long term bonds) before considering QE3. A rapid deterioration in Europe though would make QE3 more certain.
• European economic data was weak with greater than expected falls in industrial production, German factory orders & exports and retail sales. Despite this the ECB maintained its usual ‘head in the sand and wait for things to get worse’ stance and left rates on hold. Fortunately, some ECB council members supported the case for a rate cut suggesting the ECB may be getting ready to cut, probably at its next meeting. The Bank of England also left monetary policy unchanged, but more QE is likely going forward.
• In contrast to the dithering Europeans, China has moved to ease monetary conditions again by cutting interest rates by 0.25%, confirming a heightened focus on boosting growth. Importantly the central bank gave banks the flexibility to charge up to 20% below the benchmark lending rate, which will take the 1 year lending rate down to 5.05%, which is around or below previous cycle lows. Chinese May data for industrial production, retail sales and investment confirm a further mild growth slowdown. However, inflation fell more than expected to 3% and is likely to fall further in response to soft growth and falling producer prices indicating there is plenty of scope for further monetary easing. We expect another two 0.25% cuts in interest rates, another two or three 0.5% cuts in bank required reserve ratios and more fiscal stimulus ahead. This will help ensure Chinese economic growth bottoms out at soft landing levels, ie around 7.5%. China’s accelerated easing is ultimately very positive as monetary tightening from late 2009 through to last year drove a 38% bear market in Chinese shares, so an easing cycle is likely to help set the scene for a cyclical bull market.

Australian economic releases and implications

• In Australia, it was a good news week with the RBA cutting interest rates by 0.25%, shortly followed by news that the economy was booming with GDP growing a very strong 1.3% in the March quarter, or 4.3% year on year, and employment rising strongly in May. Trade data revealed a sharp reduction in the trade deficit as exports recovered after several weak months, and housing finance rose but the trend remains weak.
• While the strength in growth and employment questions whether an interest rate cut was needed, our inclination is to treat the GDP and employment figures with a bit of scepticism for several reasons. First, there are a number of oddities in the March quarter national accounts including: surging growth in consumer demand for food and a range of consumer services which sits uneasily with the general feeling of consumer caution; cost increases for engineering construction are a modest 2.1% year on year despite constant talk of surging mining costs; the financial and insurance sector in the economy is up a strong 5.4% in volume terms over the last year which doesn’t gel with the tough times in this sector and nominal GDP growth was less than real GDP growth partly explaining why things don’t feel that good and raising some questions about sustainability. In short, it’s doubtful that most Australian households and businesses can relate to the news of this sort of growth.
• Second, the strength of employment in recent months is mainly in NSW and Victoria and not in WA, which is hard to reconcile with sub trend growth in both states. Soft job ads suggest the jobs market remains subdued.
• Third, the boom in GDP doesn’t fit comfortably with most partial indicators on the performance of the economy including for retail sales, house prices, housing activity, business conditions indicators, profits, etc.
• So taken together with very soft readings for inflation our view is that the RBA was right to ease. While the strength in GDP and employment may see the RBA sit tight for the next month or so and an upbeat speech by Governor Stevens quite clearly highlights the RBA will not be cutting in order to try and reignite a boom in borrowing and asset prices, our assessment is that the combination of uncertain global conditions, a likely slowing in Australian growth and benign inflation will still see the RBA cut interest rates further by year end.

Major market moves

• After a poor start, share markets had strong mid week gains on hopes for policy stimulus and signs Spain is getting closer to a bailout to recapitalise its banks. However, Asian and Australian shares slipped later in the week as investors were disappointed Fed Chairman Ben Bernanke didn’t commit to more monetary stimulus. US & European shares rose strongly, Australian shares were flat and Asian shares were flat to down.
• It was a similar pattern for commodity prices and the Australian dollar, with the latter having a decent rise over the week on stronger than expected Australian economic data.
• Consistent with an improvement in confidence, bond yields rose from record lows. Yields fell in Spain.

What to watch over the week ahead?

• In the US, expect soft retail sales (Wednesday), a fall in headline inflation on lower gasoline prices and benign core inflation (Thursday), soft industrial production (Friday) after a strong gain in the previous month and slight falls in the New York region manufacturing conditions index and consumer sentiment (Friday).
• Euro-zone industrial production (Wednesday) and employment (Friday) are likely to be weak and inflation data (Thursday) are likely to be benign. French voters go to the polls on June 10 and 17 in National Assembly elections, where a strong showing by Nicholas Sarkozy’s party could help ensure President Hollande chooses a centrist for his prime minister which could help avert any leftward lurch in France.
• The Bank of Japan (Friday) is expected to leave monetary policy on hold, but should be easing.
• In Australia, the NAB’s business survey (Tuesday) and the Westpac consumer sentiment survey (Wednesday) will be watched for any boost from recent interest rate cuts. The consumer sentiment survey is likely to record some bounce with news of lower interest rates, strong economic growth and a strong labour market likely to have offset ongoing gloomy headlines coming out of Europe.

Outlook for markets

• It’s too early to say that share markets have bottomed and the next few months are likely to remain volatile as worries about a deep recession in Europe linger and slower growth in China and the US linger.
• However, shares are likely to be higher by year end. Shares are very cheap relative to bonds, cash and term deposits and we are likely to see another round of monetary easing in the US and Europe and significant policy stimulus in China which will add liquidity to financial markets and boost confidence that global growth will continue. More rate cuts from the RBA are also likely to help boost the Australian share market into year end.
• Bond yields in major countries around record lows suggest very low medium term bond returns. The Australian ten year bond yield of 3% is the return an investor will get if they hold such a bond to maturity.
• The correction in the $A may still see it fall to around $US0.95 in the short term, reflecting worries about the global growth outlook. However, it’s likely to receive a boost during the second half of the year as global central banks, led by the Fed, undertake further monetary easing.

12 June 2012

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• Share markets have been resuming their slide following a brief bounce, the $A continuing to fall and safe haven flows driving falls to record lows for bond yields in the US, UK, Germany and Australia. Australian Government ten year bond yields at around 2.77% have now fallen below their previous post Federation record low of 2.99% (Jan 1941) and their pre Federation low of 2.9% (Sept 1897).
• While the Irish backed the Euro-zone fiscal compact, the mess in Europe is evident on several fronts. Opinion polls regarding the June 17 Greek election are bouncing around all over the place. Spain urgently needs to recapitalise its banks, but to do so will need a bailout from the Euro-zone bailout fund. And of course, economic data in Europe is continuing to worsen. Reflecting investor nervousness, Spanish and Italian bond yields rose further into unsustainable territory and an Italian bond auction went off poorly.
• So what should Europe do? First, use the Euro-zone bailout fund to immediately recapitalise Spanish banks. Second, provide a Europe wide guarantee of bank deposits to stop bank runs. Third, act to reduce bond yields in troubled countries to sustainable levels, initially via aggressive bond buying from the ECB or bailout fund but ultimately using Euro-bonds or the German redemption fund concept. Finally, the ECB should aggressively ease monetary policy by cutting interest rates to near zero and engaging in aggressive quantitative easing.
• All these concepts appear to be gaining increasing support in Europe, but Germany is still dragging the chain and there appears to be an inclination to wait till the June 28-29 leaders’ summit before acting on many of them. But waiting till then may be too late. It’s also worth noting that Germany is gaining immensely from the current crisis via the lower euro and a collapse in its borrowing costs (to zero for two year bonds!). Ultimately Europe will move to stabilise things, but unfortunately we may have to get closer to the brink before this occurs.
• However, its not just Europe that’s a worry but also the mounting evidence of another soft patch in the US. While data for US house prices rose, pending home sales fell, weekly mortgage applications fells, consumer confidence fell, the ISM manufacturing index slowed, weekly retail sales fell, labour market indicators were softer than expected and March quarter GDP growth was revised down from 2.2% to 1.9%. A slowdown in US jobs growth for the third month in a row and a rise in unemployment is particularly concerning. QE3 here we come.

Major global economic releases and implications

• There was some good German retail sales and jobs data but the overall picture in the Europe is bleak. Business confidence fell, unemployment is 11%, lending is weakening and Spanish retail sales are down 10%.
• Japanese economic data was mostly soft with higher unemployment, soft retail sales, a fall in small business confidence and soft industrial production. But there were some positives with a manufacturing business conditions indicator unchanged in May and gains in construction orders and housing starts.
• Xinhua said the China will not roll out another massive GFC style stimulus plan. But why should it? The Chinese economy is not as weak as it was back then and the RMB4 trillion GFC stimulus plan was overkill. That said we are still likely to see significant stimulus ahead with maybe a RMB2 trillion fiscal stimulus and more monetary easing. A fall back in China’s manufacturing PMI for May has confirmed the slowing in China’s economy already evident in other indicators and house prices fell for the ninth month. Expectations for policy easing partly explain why Chinese A shares only fell 1% last month versus a 7.5% fall in global shares.
• Adding to global gloom, March quarter Indian GDP growth slowed to 5.3% and Brazilian GDP growth slowed to 0.7%. Brazil cut official short term interest rates by 0.5%, taking them to a record low of 8.5%.

Australian economic releases and implications

• Australian economic data was consistent with sub-par economic growth. Construction activity and business investment rose more than expected in the March quarter. However, the surge in construction and investment is being driven by mining related activity in WA with everything else pretty weak. Other indicators were all soft. New home sales bounced in April but this wasn’t enough to reverse the previous month’s slide.
• Meanwhile, retail sales and building approvals fell in April, private credit growth remains soft, AIG’s manufacturing PMI fell further in May and house prices fell 1.4% May according to RP Data/Rismark resuming their slide after a couple of months of stability. So the overall picture is one that is very lopsided in its dependence on the mining sector, but with the rest of the economy really struggling.

Major market moves

• After a bounce into the early part of the week, share markets resumed their slide as worries about Europe intensified and economic data in the US, China, India and elsewhere deteriorated. The slide accelerated after US payroll growth for May came in at less than half expectations and unemployment rose.
• Worries about global growth also weighed on commodity prices and this combined with soft Australian data saw the $A fall further. Gold gained though on increasing expectations for US quantitative easing.
• Safe haven demand saw sovereign bond yields in perceived safe countries continue their slide pushing Australian ten year bond yields down to record lows. The collapse in Australian bond yields has been driven by expectations for RBA rate cuts and global investors taking advantage of relatively high yields in Australia.

What to watch over the week ahead?

• In the US, expect a slight fall in the non-manufacturing ISM business conditions index for May (due Tuesday). The Fed’s Beige Book of anecdotal evidence along with productivity data will also be released.
• On Wednesday the European Central Bank should and hopefully will cut its official short term interest rate to 0.75% from 1% as it is increasingly clear that recession in the Euro-zone will be far deeper than ECB forecasts allow for. The Bank of England may announce more quantitative easing when it meets on Thursday.
• Chinese data for industrial production, investment, retail sales and trade due Friday will be watched nervously to see whether the slowdown evident in April has intensified. Fortunately, Chinese inflation is expected to fall further to 3.2% from 3.4%, providing scope for a likely imminent and significant policy easing.
• In Australia, our view is that the RBA should and will cut rates by another 0.5% on Tuesday as conditions have worsened substantially since the last Board meeting and the RBA needs to be bold to get ahead of the worsening outlook in order to bolster the economy. Europe is threatening to implode, China is slowing more than expected – a fact acknowledged by Governor Stevens – and this is taking the edge off the mining boom and the non-mining economy is struggling very badly. And of course the inflation outlook remains benign. But whether it’s this month or next, the cash rate will go lower, ultimately falling to around 2.75% by year end. Bank mortgage rates at around 7% are only just below their long term average of 7.25%, but probably need to fall closer to 6%.
• March quarter GDP is expected to confirm Australian growth remains below trend. While the annual growth rate is expected to bounce up to 3.2% as last year’s flood impact drops out, quarterly growth is expected to be just 0.5% as a detraction from net exports offsets strong retail sales volumes and business investment.
• Expect Australian labour force data due Thursday to show a 20,000 contraction in employment after two surprisingly hard to explain strong months and a rise in unemployment to 5.2%. Housing finance (Friday) is likely to have remained soft in April and the April trade balance (also Friday) is likely to show another deficit.

Outlook for markets

• I have been looking for a 5-10% correction in shares which we have now seen, but shares look like they will still fall further over the next few months as worries about a break up in the euro and Spanish banks continue with Euro-zone policy makers continuing to fiddle, made worse by slowdowns in China and the US.
• However, shares are likely to be higher by year end. Shares are very cheap relative to bonds, cash and term deposits and we are likely to see another round of monetary easing in the US and Europe and significant policy stimulus in China which will add liquidity to financial markets and boost confidence that global growth will continue. More rate cuts from the RBA are also likely to help boost the Australian share market into year end.
• Bond yields in major countries are now at record lows suggesting very poor medium term bond returns. The Australian ten year bond yield of just 2.77% is the return an investor will get if they buy and hold such a bond to maturity. That might be fine if Australia slips into Japanese style deflation, but it’s hard to see the RBA allowing this. If the RBA is successful and achieves its inflation target of 2-3% pa over the next decade, then a 2.77% ten year bond yield implies little or no real return.
• The correction in the $A may see it fall to around $US0.95 in the short term, reflecting worries about the global growth outlook. However, it’s likely to receive a boost during the second half of the year as global central banks, led by the Fed, undertake further monetary easing.

4 June 2012

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• A further run of soft Australian economic data also weighed on the $A. The simple “risk on/risk off” trade where shares, commodities and currencies like the $A all move together seems to be breaking down a bit reflecting the different stages of the economic cycle key countries are in.
• Perhaps the biggest development though was the break up in bond yields in the US on the back of stronger economic data and diminishing expectations for QE2 which in turn drove bond yields higher in Germany, Australia and elsewhere. Sovereign bonds in core countries are terrible value with yields recently plunging to multi decade lows and in some cases record lows. At the least this points to poor returns ahead. At worst we could see a repeat of the bond crash of 1994. The latter seems unlikely though given that the economic recovery is still fragile and the Fed would intervene at some point to keep bond yields down. Either way though the outlook for returns from sovereign bonds in major countries is poor. The realisation of this could see a lot a money come out of sovereign bond funds looking for a home going forward.
• The much stronger position of the US banking system compared to three years ago was highlighted by the US Federal Reserve’s latest bank stress tests. While four banks failed the test, the scenario they failed was absurdly tough involving 13% unemployment, a 50% share market plunge and a 21% further plunge in house prices. What’s more two of the four banks that failed would pass with a slightly different capital action plan (eg lower dividend payments) and one is more an insurer than a bank. Bank and financial shares rose sharply, helped along on news that JP Morgan is to increase its dividend. With the stronger capital position of US banks and signs of an impending upturn in the US housing sector the outlook for US financials is looking healthy.
• Comments from Chinese Premier Wen Jiabao that house prices are still too high and that its premature to relax property controls contrasts with news that China was easing lending restrictions on the four biggest banks and an easing of restrictions on loans for first home buyers. Meanwhile the key message from the National People’s Congress was one of focusing on quality over quantity in terms of growth. Our take is that policy easing will remain selective consistent with ensuring a soft landing in the economy but avoiding any sort of unsustainable rebound leading to renewed imbalances as occurred in 2009-10. In short policy easing is likely to remain gradual, with property controls being the last to ease.
• European debt news was mostly favourable with Italian and Spanish bond yields remaining under control despite a rise in global bond yields generally, Spain agreeing to cut back its budget deficit target for this year, the IMF committing €28bn to Greece’s second bailout and signs that the Eurogroup would agree to increase the size of the €500bn European Stability Mechanism rescue fund later this month.

Major global economic releases and implications

• US economic data continued to surprise on the upside, with strong gains in retail sales and new mortgage applications, further gains in manufacturing business conditions in the New York and Philadelphia regions, a rise in small business optimism and a continuing fall in unemployment claims. What’s more the Fed sounded slightly more optimistic, upgrading its description of the growth outlook from modest to moderate, but at the same time maintaining its commitment to keeping interest rates low through to late 2014 at least. It also viewed the recent increase in oil prices as having only a temporary impact on inflation. 
• European economic data was mixed with a smaller than expected rise in industrial production in January and a sharp fall in Spanish house prices, but a further sharp rise in economic expectations regarding Germany in a ZEW survey of financial analysts. Norway cut interest rates again on the grounds inflation is below target.
• Japanese economic data was mixed with a rise in machine orders, but falls in consumer confidence and a tertiary activity index. What’s more the Bank of Japan didn’t follow through with any further increase in its asset purchase (or quantitative easing) program.
• The Reserve Bank of India left interest rates on hold following a higher than expected inflation reading and a surge in industrial production in January. While the RBI retained a bias towards cutting interest rates, it has become a bit more concerned about inflation risks and in any case an easing had become less likely following the surprise cut to banks’ required cash ratios the week before. With core inflation still falling we still expect a rate cut but it may be a few months away.

Australian economic releases and implications

• Economic data releases in Australia remained soft. While business conditions improved slightly in February according to the NAB business survey, business confidence actually fell as did consumer sentiment, housing finance and housing starts. Consumer sentiment has now fallen back to its lowest level since December and housing finance may go through a soft patch as first home buyer demand in NSW falls after the ending of a stamp duty concession in January.

Major market moves

• Share markets rose solidly on the back of more good news regarding the US economy, with the US share market breaking out to its highest level since June 2008. Australian shares also rose but remain constrained by the 4300 level on the ASX 200 which has proved to be stiff resistance over the last four months as a result of the higher RBA interest rates, the strong $A and concerns about a hard landing in China.
• Commodity prices were mixed on good news from the US but uncertainty about China. Mixed news on commodity prices, diminishing expectations for further Fed easing & soft data in Australia all weighed on the $A.
• Bond yields rose sharply on stronger US economic data and diminishing US QE expectations.
• Friday trading in Europe and the US was pretty quite with European shares up 0.6% and the US S&P 500 up just 0.1%, with energy and financial shares gaining but overal gains constrained on fears rising oil prices are dampening consumer sentiment which fell slightly in March. Friday night futures trading nevertheless suggests a 30 point or 0.7% gain in the ASX200 when it opens on Monday morning, possibly reflecting a partial catchup as Australian shares rose just 1.5% last week against a 2.4% gain in US shares.

What to watch over the week ahead?

• In the US, expect the NAHB housing conditions index (Monday) to show a further improvement, housing starts (Tuesday) to fall back slightly after recent gains and a further recovery in existing home sales (Wednesday) and new home sales (Friday). Data for house prices and leading indicators will also be released.
• In the Euro-zone business conditions indicators (PMIs) will be published (Thursday) as will data for consumer confidence, industrial orders, the current account and construction output.  
• In China, the flash HSBC PMI for manufacturing will be published (Thursday) and is likely to show ongoing evidence of stabilisation around the 50 level, which is consistent with GDP growth of around 8-9%.
• In Australia, it will be a quiet week on the data front with the main focus being on the RBA, with a speech by Governor Glen Stevens (Monday), the minutes from the last Board meeting (Tuesday) and speeches by Assistant Governors Edey and Debelle (Tuesday and Thursday respectively) all likely to be watched closely for clues regarding the interest rate outlook. The minutes are now arguably somewhat dated given recent data releases, so Governor Steven’s speech on “Economic Conditions and Prospects” is likely to be watched particularly closely to see whether the RBA has become a bit more predisposed towards a rate cut following recent soft readings for GDP and employment.

Outlook for markets

• While there will be numerous pullbacks along the way the broad trend in global shares is likely to remain up. Valuations remain attractive, particularly against very low bond yields, the risk of a Euro-zone meltdown has faded, momentum in global economic indicators is positive, global monetary conditions are getting easier and easier and there is lots of cash on the sidelines.
• Rising global share markets are likely to pull the Australian share market higher but it is likely to remain a laggard on the back of high interest rates in Australia, the strong $A and worries about a hard landing in China. 
• Low global bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies.
• The current correction in the $A may have further to go reflecting soft data in Australia and the receding odds of more US quantitative easing. However, the $A is likely to remain strong overall as the improving global growth outlook supports commodity prices and as Australian interest rates remain above US rates.

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• Greece looks to have fulfilled the conditions required off it to get another bailout but European reluctance to grant the bailout ahead of elections in April is causing the process to be dragged out.
• Our assessment is that a deal is more likely than not as both sides have potentially too much to lose, but the risks are high and in any case it could drag on a bit. An interim outcome could well be bridging finance to cover the upcoming March 20 €14.5bn bond payment ahead of a finalisation of the bailout package post the election along with tougher monitoring of Greece.
• In a broader sense there was mostly good news regarding the European debt issue over the last week. Moody’s played catch up in downgrading various European countries. Against this, the ECB appears to be moving closer to forgoing profits on its Greek bond holdings in order to help ensure Greece’s debt falls to 120% of GDP by 2020, Spain is now a third of the way through its planned bond issuance for this year, China gave its strongest assurance yet that it would help out and German officials signalled a willingness to provide more assistance to Portugal. Most importantly bond yields in Spain, Italy, France and Portugal were little affected by the Greece debacle of the last week, suggesting investors are becoming less concerned about contagion.
• Meanwhile, global reflation remains an ongoing theme with the Bank of Japan announcing extra quantitative easing, a short term inflation target of 1% and a medium term target of 2%. This is very significant. If Japan is serious about meeting its inflation targets it means more monetary easing in order to break the psychology of deflation and it could mean a fundamental turn in the Yen (down) and the relative performance of Japanese shares (up). Such a move adds to quantitative easing by the US, UK and ECB and is ultimately positive for financial assets generally.

Major global economic releases and implications

• US data releases remained mostly upbeat. January retail sales and industrial production were a little softer than expected, but against this there was a slight rise in small business optimism, solid gains in manufacturing conditions in the New York and Philadelphia regions, a further fall in unemployment claims, another fall in mortgage delinquency, further gains in housing starts and permits and a further recovery in home builders’ conditions. The latter is very positive and adds to evidence the US housing sector is recovering.. And finally GM, the maker of my favourite cars, posted a record annual profit adding to the renaissance now underway in US manufacturing, and a deal to extend payroll tax relief for the remainder of this year is looking highly likely.
• The Euro-zone contracted 0.3% in the December quarter, likely signalling the start of a recession. Fortunately, the decline was less than feared and recent indicators suggest it will be a mild recession.
• Japan’s economy also contracted in the December quarter. Gains in industrial production, a tertiary activity index and a likely rebound in public demand point to a return to positive growth in the current quarter.
• Growth in Malaysia remained strong in the December quarter boosted by robust domestic demand. Slowing exports are likely to see growth slow to a still reasonable 4% this year, ahead of renewed strength next year.

Australian economic releases and implications

• Australian data was refreshingly strong over the last week with gains in housing finance, business confidence, consumer sentiment and employment. However, there are some grounds for caution. The strength in housing finance is likely to have been distorted by the pending expiration of home buyer support in NSW and Queensland. The business and consumer surveys were largely undertaken before recent bank rate hikes.
• And there are several reasons for caution regarding the January employment report. First, the labour force report is volatile at the best of times but seasonal adjustment problems are at their worst in January. Secondly, hours worked actually fell significantly. Finally, the pace of job layoff announcements has picked up. So we continue to see unemployment rising in response to tough conditions outside the mining sector.
• Given this along with the de facto monetary tightening being delivered by the strong $A and recent bank mortgage rate hikes, we still think there is a strong case to cut official interest rates further but the strong January jobs data and the RBA’s relatively relaxed stance suggest the next cut may be several months away.
• Roughly a third of companies have reported, so its still early days in the December half profit reporting season, but the results are soft. So far only 36% of companies have exceeded expectations (versus a norm of 45%) and 29% have come in worse than expected (versus a norm of 25%). 64% of companies have reported positive year on year profit growth but outlook statements are cautious and investors have greeted the results negatively with the majority of stocks seeing their share prices fall after results were released.

Major market moves

• Most major global share markets moved slightly higher over the last week thanks to strong US data and optimism Greece won’t default next month. The stand out was the US share market which is flirting with last year’s highs. By contrast Australian shares fell and  are struggling on the back of much tougher monetary conditions as rate cut expectations have been dampened, mortgage rate have risen and the $A remains strong.
• The Australian dollar rose on the back of stronger than expected jobs data and improved global confidence.

What to watch over the week ahead?

• In the US, expect modest further gains in existing home sales data (due Wednesday) and new home sales (Friday) and flat December house prices (due Thursday). Data for consumer sentiment will be released Friday.
• In Europe, the focus will stay on Greece with finance ministers to consider the bailout package Monday. PMI business conditions indicators (Tuesday) and the German IFO index (Thursday) will be watched closely.
• In Australia the focus is likely to remain firmly on interest rates with the minutes from the RBA’s last Board meeting (Tuesday), and a speech (Tuesday) and Parliamentary testimony by Governor Stevens (Friday)  all likely to be watched closely in order to gain guidance as to the RBA’s inclinations on interest rates. Wages data will be released on Wednesday and is likely to show wages growth remaining pretty benign at around 3.5% pa. Its also peak week in the profit reporting season with over 100 major companies due to report.

Outlook for markets

• Shares are vulnerable to further consolidation or correction in the short term given high levels of investor sentiment, strong gains year to date and Greek worries. However, any pullback globally is likely to be mild and the broader trend is likely to remain up. Valuations are attractive particularly against very low bond yields, the risk of a Euro-zone meltdown has receded, momentum in global economic indicators is positive, global monetary conditions are getting easier and easier and there is lots of cash on the sidelines. We continue to see the ASX 200 pushing up to 4800 by year end, but thanks to tougher monetary conditions in Australia and the strong $A the Australian share market is likely to remain a relative laggard.
• Low global bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies. Australian corporate debt is a better investment proposition if one needs income or is worried about shares.
• Beyond the current consolidation/correction the broad trend in the $A is likely to remain up helped by more global quantitative easing, solid commodity prices and improving global confidence. A retest of $US1.10 is likely.

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• Its been like Ground Hog day over and over again with each day bringing news that a deal was imminent only to see it delayed another day. And when a deal involving further austerity measures equal to around 1.5% of GDP and economic reforms finally was agreed to by Greek political leaders concerns then arose that it may not be approved by the troika (with Germany demanding more) or by the Greek Parliament amid ministers resigning, street protests and a general strike. The associated uncertainty saw shares, commodity prices, the euro and the $A fall late in the week.
• A second Greek bailout by March 20 is still more likely than not because both sides have too much too loose if agreement isn’t reached, but the bickering might continue well into March and the risk of disorderly Greek default has clearly stepped up a notch in the last few days. The Greek Parliamentary vote on passing the agreed deal into law is due in the next few days and Euro-zone finance ministers are scheduled to meet on Wednesday. Longer term, Greece is likely to continue to struggle to meet its deficit targets as austerity bears down on its economy which is already in tatters, as evident by a 20.9% unemployment rate.
• In Australia, the Reserve Bank left interest rates unchanged, resulting in many home borrowers seeing a hike in their mortgage rates as some banks passed on higher funding costs. While it appears the RBA retains a bias to ease, its hurdle to do so looks higher than earlier thought, requiring a “material” weakening in the domestic economy. Our assessment remains that there is a strong case to cut rates further. Yes the mining sector is doing well, but retailing, housing construction, manufacturing and tourism are all doing a lot worse than need be. What’s more the rise in the Australian dollar this year has delivered a de facto monetary tightening as has a rise in mortgage rates from some banks. Given the rise in funding costs faced by the banks there is no point blaming them, but its nevertheless bad news for borrowers and bad news for the economy as mortgage rates should be going down not up. To get mortgage rates down and deal with unnecessary weakness in key parts of the economy, we still expect a further 0.25% to 0.5% in rate cuts by mid year.
• Other global central banks continued to ease with more quantitative easing from the Bank of England, another easing in collateral requirements from the ECB and another rate cut in Indonesia. Global reflation is continuing.

Major global economic releases and implications

• While China’s inflation rate hooked up to 4.5% in January, it’s unlikely to change the outlook for further policy easing in China. Most of the rise was due to higher food prices which in turn was largely driven by the New Year holiday, non-food inflation fell further to 1.8%, upstream producer price inflation continued to slow in January and the trend for inflation is still down from last’s July’s peak of 6.5% and is likely to remain so reflecting cooling economic growth and last year’s slow down in money supply growth. Selective monetary easing appears is continuing with talk of help for first home buyers and some banks cutting first home mortgage rates. Chinese January data for exports, imports, lending and money supply were also distorted by the New Year holiday and should be treated with caution.
• US data was mostly solid, with a further fall in unemployment claims, a strong gain in consumer credit solid weekly chain store sales and a modest rise in weekly mortgage applications. A $US25bn settlement between banks and the US Government was announced that will provide some modest relief for struggling home owners.
• US earnings news was favourable. So far 64% of companies to have reported have exceeded expectations, which is up from 47% a few weeks ago. While financials, basic materials and telcos’ have been week, tech, industrial and consumer services stocks have done very well. In Europe only 49% of companies have surprised on the upside, compared to a norm of about 57%.
• The news out of the rest of Asia was mixed with weak export data in Taiwan but robust GDP growth in Indonesia.

Australian economic releases and implications

• Australian economic data was mixed. The ANZ’s measure of job ads rose solidly in January, but this is often a month distorted by seasonal factors. More importantly retail sales remained depressed and a construction activity index weakened. TD Securities’ Monthly Inflation Gauge remained benign on an annual basis in January.
• Only a handful of companies have reported, but so far the December half profit reporting season in Australia is off to a mixed start with better than expected results from 47% of companies (compared to a norm of 45%) but worse than expected results from 40% (versus a norm of 25%). 64% of companies have reported positive year on year profit growth but outlook statements have come in on the cautious side and investors have greeted the results negatively with most stocks seeing their share price fall after results were released.

Major market moves

• Share markets fell late in the week, as positive news regarding a Greek deal on its second bailout package was replaced by fears that it was unravelling. 
• Greek concerns also knocked commodity prices, the euro and the $A lower late in the week. This came after the Australian dollar reached a high of $US1.0845, it’s highest since last August.

What to watch over the week ahead?

• In the US, expect January retail sales (due Tuesday) and industrial production (Wednesday) to show further gains, various surveys of manufacturers, home builders and small businesses to show continued recovery, housing starts and permits (Thursday) to rise and inflation data (Friday) to be reasonably benign. The minutes from the Fed’s last meeting (Thursday) will be watched closely for further clues on the monetary policy outlook but are unlikely to offer anything new beyond the clearly dovish stance already signalled by the Fed’s post meeting statement.
• Euro-zone GDP (Wednesday) is likely to show flat to slightly negative growth in the December quarter. The Greek parliamentary vote on the austerity package will be watched closely. Euro-zone finance ministers will then meet on Wednesday to hopefully approve the Greek bailout package.
• In Australia, expect housing finance data (Monday) to show a small rise, the NAB’s business confidence and conditions indices (Tuesday) and consumer sentiment (Wednesday) to have remained soft and January employment data to show a modest 5000 job rebound after the 29300 fall in December to see the unemployment rate rise to 5.3%.  Speeches by the RBA’s Debelle and Lowe on Tuesday and Thursday will be watched closely for any clues on the outlook for interest rates.
• The December half profit reporting season will ramp with over 50 major companies due to report including Leightons, the Commonwealth Bank, AMP, Qantas and Wesfarmers. Overall results are likely to be weak with soft domestic demand, cost pressures, falling commodity prices and the strong Australian dollar all weighing. Retailing, manufacturing and housing related sectors are all likely to be particularly hard hit and while underlying profits in the resources sector will remain strong, growth will be sluggish thanks to high base effects and lower commodity prices. Profit growth in the December half is likely to be near zero. The downside risks are seen to be high, but everyone is expecting that suggesting there is scope for a positive surprise or for the market to look beyond current soft results.

Outlook for markets

• Shares are vulnerable to a short term pullback after strong gains so far this year, and this may now be occurring on the back of Greek worries. However, the broader trend is likely to remain up. Valuations are attractive particularly against very low bond yields, the risk of a Euro-zone meltdown has receded, momentum in global economic indicators has turned positive, global monetary conditions are easing and there is lots of cash on the sidelines. We continue to see the ASX 200 pushing up to 4800 by year end, but given the RBA’s more hawkish stance and the strong $A the Australian share market is likely to remain a relatively underperformer for now.
• Low global bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies. Australian corporate debt is a better investment proposition if one needs income or is worried about shares.
• Like shares, the $A is also due for a correction but the broad trend is likely to remain strong helped by more quantitative easing in the US and Europe, solid commodity prices and improving global confidence. A retest of $US1.10 in the next few months looks likely.

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