• Positive global economic data was a mixed blessing over the last week as it combined with comments from various US Federal Reserve officials adding to expectations that the Fed will start to slow or “taper” its quantitative easing program when it next meets in September and this in turn resulted in a bit of volatility in financial markets, with share markets mostly a bit weaker.
• In terms of Fed tapering our view is that while a September timing for the first move is now looking a bit more likely, it will only occur if economic indicators continue to improve and that it won’t signal that the first Fed interest rate hike is closer. As such, while taper fears are likely to continue to periodically weigh on markets in the run up to the Fed’s September meeting, to the extent it comes with stronger economic growth it shouldn’t be a major problem for shares as any negative impact will likely be more than offset by stronger profit growth.
• In Australia, the RBA cut the official cash rate to a record low of 2.5% as widely expected and backed this up with a cut to its GDP growth forecast for this year to just 2.25%. What’s more the RBA’s comments that the $A remains “high”, that there is “considerable uncertainty” about the economy rebalancing away from mining investment to other sources of growth and that the inflation outlook remains benign leaves the door open for further rate cuts. However, its failure to explicitly retain its previous comment that there was “scope for further easing” was disappointing in that such a statement helped maintain downwards pressure on the $A without the RBA necessarily having to do anything. This partly goes to explain the bounce in the $A over the last week. For the next few months the RBA is likely to sit pat and a lot now depends on the $A. If it continues to fall with broadening signs of improvement in the economy then we have likely seen the low for interest rates, but if it remains around current levels or rises and there is little evidence of improvement in the economy then rates will likely fall to 2% over the next six months. An aggressive post election budget tightening would also increase the case for another rate cut. At the moment the risks are still skewed to the downside for official interest rates – not good news for those relying on income from bank deposits but good news for those with a mortgage.

Major global economic events and implications

• In the US, the run of better than expected economic data continued with the ISM non-manufacturing index rising solidly and better than expected trade data pointing to an upwards revision to June quarter GDP growth to around 2.5%. On top of this the Fed’s latest bank survey pointed to a further easing in bank lending conditions, and increased demand for credit, the mortgage delinquency rate fell to its lowest in five years years and unemployment claims remained low. The basic picture from the US is one of improving growth.
• The US June quarter earnings reporting season continues to impress. Its now 90% done with 72% of companies surprising on the upside regarding earnings and 56% surprising positively on revenue.
• There was also good news from the Eurozone with the final services PMI for July coming in stronger than initially reported which took the composite PMI to 50.5 which is consistent with a return to economic growth.
• Japan’s mixed run of data continued with softer than expected readings for some confidence measures but a further pick up in bank lending. Despite a mixed run of data recently and a back up in the value of the Yen, the Bank of Japan left its ongoing monetary stimulus unchanged. For the Japanese share market to resume its uptrend though some combination of structural economic reforms and further monetary stimulus is likely required.
• Chinese economic data for July mostly came in better than expected. Inflation remained low and growth in exports and imports returned to positive territory, industrial production expanded 9.7% year on year which was well up on 8.9% in June, electricity production accelerated, fixed asset investment remained solid and money supply growth and bank lending picked up. Overall, Chinese data remains consistent with a 7 to 7.5% growth rate for this year. No boom, but no bust either!
• Another interest rate hike in Brazil designed to cool inflation provided reminder though of the less favourable growth/inflation trade-off now being seen in key emerging countries.

Australian economic events and implications

• Australian economic data was a mixed bag. On the positive side housing finance continues to trend up and house prices rose strongly in the June quarter. However, we are a long way from the renewed house price bubble many seem to fear. House prices are up 5.1% over the last year, but at a similar stage following the interest rate easing cycles that started in 1996, 2001 and 2008 they were showing annual growth of 7.7%, 18.9% and 18.8% respectively. What’s more housing credit is very weak compared to past cycles. Moreover, on the soft side retail sales were flat in June and in the June quarter as a whole in real terms, employment fell in July and another fall in job ads points to more labour market softness ahead. While unemployment was unchanged in July this reflected a fall in labour force participation. The basic message remains that while rate cuts have helped the housing sector there is as yet not a lot of evidence of a flow on to other parts of the economy. This is likely to occur over time, but in the meantime a further depreciation of the Australian dollar is needed to boost sectors like manufacturing, tourism and higher education and the risks still point to further rate cuts.
• The June half Australian profit reporting season picked up pace. So far so good, with 42% of results having come in better than expected which is just below the long term average of 43%. But given that only 16 major companies have reported so far it’s too early to read much into this.

Major market moves

• Shares were mostly down over the last week partly on the back of Fed taper fears. Japanese shares were the hardest hit falling 5.9% as that market continues to consolidate after its 80% rise over six months into May and the Yen rose. US shares fell 1.1% and Australian shares fell 1.2%, but Eurozone shares gained 0.8%.
• Commodity prices generally rose though helped by better than expected Chinese trade data and a weaker $US. The combination of stronger commodity prices and the weakening of the RBA’s easing bias saw the $A bounce back to $US0.92.
• Bond yields were mostly little changed, but fell in Italy and Spain.

What to watch over the next week?

• In the US expect a 0.4% gain in retail sales (Tuesday) after a flat outcome in June, a 0.3% gain in industrial production (Thursday), continued strength in the home builders’ conditions index (Thursday) and solid gains in housing starts and permits (Friday). Manufacturing conditions according to the New York and Philadelphia regional surveys are likely to have remained solid and inflation is likely to have remained benign with signs that it may have bottomed albeit at a low level.
• In the Eurozone, the focus will be on preliminary June quarter GDP data (Wednesday) which is expected to show growth just ticking back into positive territory with a 0.1% gain, following six quarters in recession.
• Japanese June quarter GDP data to be released Monday is expected to show that the economy has continued to recover solidly with a 0.9% gain following a 1% gain in the March quarter.
• In Australia, the NAB business survey readings for business conditions and confidence in July (Tuesday) are likely to have remained weak but consumer confidence (Wednesday) may show a slight improvement after the latest interest rate cut. June quarter wages growth (Wednesday) is expected to have remained benign. The Treasury’s Pre Election Economic and Fiscal Outlook will also be published Tuesday and will be watched to see how it compares to the Government’s recent Economic Statement.
• The June half Australian profit reporting season will ramp up with 40 major companies due to report, including JB HiFi, CBA, Leightons, Worley Parsons, AMP and Wesfarmers. Consensus estimates for 2012-13 earnings growth have slipped to -0.5% from +12% earlier this year, so a lot of bad news is factored in. Resources profits may show signs of bottoming with a fall of 18%, but domestically exposed cyclicals are vulnerable to further weakness. On the positive side though, ongoing cost control and the fall in the $A are likely to be supports for the profit outlook going forward, with the fall in the $A to date potentially boosting profits by around 4.5%.

Outlook for markets

• We remain in a seasonally weak period of the year for shares and worries about the Fed tapering its monetary stimulus, US debt ceiling negotiations, growth in China, the profit reporting season in Australia and the Australian election have the potential to cause more volatility. However, the broad trend in shares is likely to remain up: valuations are no longer dirt cheap but they are not expensive either; monetary conditions will remain very easy with interest rate hikes a long way off in the US and in other developed countries and interest rates still at risk of falling further in Australia; and the gradually strengthening global growth outlook points to stronger profits ahead. So by year end we see further upside in global and Australian shares.
• Sovereign bond yields still remain low and point to low medium term returns.
• With commodity prices in a downtrend & the Australian economy deteriorating versus the US, it’s likely the $A will fall further. Given its overvaluation in terms of relative prices, expect the $A to fall to $US0.80.

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

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• Shares continued to trend higher over the past week helped by dovish central bank comments and good news from the US and Europe in particular. Perhaps the big event though was a further leg down in the Australian dollar on the back of dovish RBA comments and news of a further deterioration in the budget outlook.
• In Australia, despite little change in the economy since the May Budget the Government’s economic statement showed a surprising $33bn deterioration to the Budget outlook over the next four years as a result of the adoption weaker economic growth and revenue assumptions and new spending commitments being only partly offset by savings. The latter included an increase in tobacco excise, a bank deposit levy, public sector savings and delayed foreign aid payments. The good news is that the savings don’t kick in for two years by which time the economy should be better able to withstand them and a projected surplus is maintained for 2016-17. The bad news though is that the budget blow out is much worse than feared, uncertainty has been increased yet again as to when we will get back to surplus, our public finances after the biggest boom in our history should be in much better shape and the deteriorating budget outlook may only add to fears of an aggressive post election fiscal tightening regardless of who wins. In terms of the latter, while the latest budget tightening doesn’t commence to 2015-16 and even then is only modest at just 0.2% of GDP the continuous deterioration and uncertainty regarding the budget outlook combined with fears that more aggressive tightening is on the cards post the election is likely to further undermine business and consumer confidence. The implication is that more pressure is being placed on the RBA to support growth via interest rate cuts. While the consensus is for the cash rate to bottom out at 2.5% (following a cut on Tuesday), the odds are starting to favour a cut to 2% by year end. The deteriorating fiscal outlook also highlights the need for the $A to fall towards $US0.80.
• In the US, the basic message from the Fed was little changed: tapering of its quantitative easing program will only commence when the economy strengthens and interest rates will remain low for a long time. However, the Fed’s post meeting statement injected a more dovish tone with a downgrade in its characterisation of economic growth from “moderate” to “modest” and concerns about the rise in mortgage rates and low inflation. Overall this suggests that if tapering starts in September it could be a relatively modest one off move (say cutting asset purchases from $US85bn a month to $70bn) or that it may be pushed out to even later in the year. For tapering to commence employment growth needs to remain around 200,000 jobs a month and economic growth needs to pick up to a 3% plus pace to be consistent with the Fed’s forecasts.

Major global economic events and implications

• Forward looking US data was pretty positive. To be sure June quarter GDP data confirmed that the first half has been soft. However, growth is likely to pick up in the current half as the impact of tax hikes and sequester spending cuts fade and a strong rebound in the ISM and Markit PMI manufacturing conditions indicators along with solid jobs data adds to confidence that this will occur. Unemployment claims have in fact now fallen to their lowest since January 2008 and strong gains in house prices are providing a strong boost to household wealth.
• The improving US economic outlook is backed up by the June quarter profit results. So far of the 382 S&P 500 companies to have reported, 73% have surprised on the upside for earnings and 56% for sales revenue. Continued profit strength is good for shares and good for jobs and business investment.
• Eurozone economic confidence readings rose further consistent adding to evidence that economic growth will return in the current half year. The ECB left monetary policy unchanged but with core inflation running at just 1.1% there is plenty of scope for further easing and certainly ECB President Draghi’s comments remain dovish.
• Japanese economic data was mixed with weak data for household spending, industrial production and a manufacturing PMI. However, manufacturers expect a strong rebound in production in July, the trend in the PMI is still up strongly, and jobs data and housing starts were stronger. So overall ok.
• In China the official PMI defied the fall recorded in the flash HSBC PMI and actually rose slightly. The official PMI is probably the more reliable but taking an average of the two would suggest a gradual moderation in growth. Meanwhile Chinese authorities continue to provide assurance that growth will be held above its bottom line of 7%, while at the same time indicating a big stimulus program is unlikely.

Australian economic events and implications

• In Australia, RBA Governor Stevens gave a relatively dovish speech highlighting that increased uncertainty domestically and structural forces globally are likely to hold interest rates down at relatively low levels, that recent inflation readings were no barrier to further rate cuts and that a further fall in the $A would not be surprising.
• Meanwhile Australian data releases were pretty mixed. On the positive side house prices rose another 1.6% in the July according to RP Data taking their year on year gain to 4.9%, new home sales rose again in June having risen now in 8 of the last 9 months and credit growth picked up albeit only very marginally. But against this building approvals fell in June, the AIG’s manufacturing PMI fell and producer price inflation remained low.

Major market moves

• Share markets rose on the back of good data releases and profit results in the US and Europe along with dovish indications from the Fed and ECB. Australian shares benefitted from the strong global lead along with dovish comments from RBA Governor Stevens and Chinese shares were helped by growth supportive comments from the Chinese Government.
• Dovish comments from the RBA along with better news from the US saw the $A slide below $US0.90.
• Bond yields rose as investors continue to rotate into growth assets.

What to watch over the next week?

• In the US, the ISM non-manufacturing index (Monday) is expected to show a modest rise and the trade deficit (Tuesday) is expected to narrow slightly. A speech by Fed Chairman Bernanke on Wednesday will be watched for more clues regarding the start of tapering, although its doubtful he will say anything new.
• The Bank of Japan meets Thursday, but is unlikely to announce any changes to monetary policy.
• The focus globally though, will likely be back on China with July export and import data (Thursday) likely to show continuing softness and data for industrial production, investment and retail sales (Friday) likely to have remained relatively subdued by Chinese standards. Inflation is expected to rise slightly to 2.8%.
• In Australia, the RBA is expected to cut the cash rate to an historic low of 2.5% on Tuesday. Since the last RBA Board meeting we have seen more weak readings for consumer and business confidence, a further rise in unemployment, benign inflation and more uncertainty regarding the outlook for China. With the economy still struggling and budget uncertainty escalating, more monetary stimulus is needed. This should ideally come in the form of both lower interest rates and a lower $A. Following a relatively dovish speech by Governor Stevens in the last week the money market has priced in a 90% chance of a rate cut on Tuesday. While a weekend announcement from the Government setting the Federal election for September 7 could cause the RBA to hold back this would be dangerous as it would effectively mean delaying the rate cut till October, and may risk triggering a rebound in the $A. As a result we would see such a delay as being unlikely. The RBA will also release its Statement on Monetary Policy on Friday which is expected to retain a dovish tone.
• On the data front, expect retail sales (Monday) to show continued modest growth, but with flat retail sales in the June quarter in real terms, June house prices (Tuesday) to show a 2% rebound after a flat March quarter, housing finance data (Wednesday) to show an ongoing rising trend and labour force data (Thursday) to show a 15,000 loss of jobs in July resulting in a rise in unemployment to 5.8%.
• The June half Australian profit reporting season will also ramp up with 40 major companies due to report, including CBA, Leightons, Worley Parsons, AMP and Wesfarmers. Consensus estimates for 2012-13 earnings growth have slipped to a fall of 0.5% from +12% earlier this year, so a lot of bad news is already factored in. Resources profits may show signs of bottoming, but domestically exposed cyclicals are vulnerable to further weakness. On the positive side though, ongoing cost control and the fall in the $A are likely to be supports for the profit outlook going forward, with the fall in the $A to date potentially boosting profits by around 4.5%.

Outlook for markets

• We remain in a seasonally weak period of the year for shares and worries about the Fed tapering its monetary stimulus, US debt ceiling negotiations, growth in China and the profit reporting season in Australia have the potential to cause more volatility. However, the broad trend in shares is likely to remain up: valuations are reasonable; monetary conditions will remain very easy with interest rate hikes a long way off in the US and rates still likely to fall further in Australia; and the gradually strengthening global growth outlook points to stronger profits ahead. So by year end we see further upside in global and Australian shares.
• Sovereign bond yields still remain low and point to low medium term returns.
• With commodity prices in a downtrend & the Australian economy deteriorating versus the US, it’s likely the $A will fall further. Given its overvaluation in terms of relative prices, expect the $A to fall to $US0.80.

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• However, it’s hard to see Berlusconi getting enough votes to return as PM with the most likely outcome being a Social Democrat led government relying on the support of Mario Monti and his party. In Spain the worst case outcome is likely to be a new PM, but the same Government. In other words, although the risks have gone up a bit the most likely outcome remains a continuation down the reformist path and gradual further settling of Euro-zone risks.
• In Australia, there were no surprises from the Reserve Bank which left interest rates on hold, but with downwards revisions to its growth forecasts and benign inflation forecasts indicating a clear easing bias. With global conditions improving, China looking stronger, share markets up, house prices starting to rise and the cash rate having fallen by 175 basis points we are likely nearing the end of the easing cycle. However, another couple of rate cuts taking the cash rate to 2.5% are still likely to be required.
• The mining investment boom is slowing rapidly and most bank lending rates still look too high to drive a decent recovery in sectors like housing and retail at a time when the $A remains strong. As table below highlights, most economic indicators remain far weaker than they normally are this far into an interest rate easing cycle, suggesting monetary conditions are still too tight. Over the past week this was highlighted by poor readings for retail sales, dwelling approvals and job ads.
• 

Major global economic events and implications

• Most US data releases remain consistent with reasonable growth. The ISM non-manufacturing conditions index remained strong in January, weekly mortgage applications are continuing to trend up, weekly consumer confidence readings are strong, the trade deficit fell sharply in December pointing to an upwards revision to December quarter GDP growth and banks are continuing to ease lending standards.
• US December quarter earnings remain reasonable. With 340 S&P 500 companies having reported 75% have beaten expectations on earnings and 67% have beaten on sales, both of which are above long term averages.
• Both the Bank of England and the ECB made no changes to monetary policy, but retained easing biases and ECB President Draghi expressed concern that strength in the Euro could hamper growth. The Euro’s recent strength reflects tighter monetary conditions in Europe than elsewhere and reduced risk that it will fall apart. While the ECB is unlikely to intervene to push the Euro lower, continued strength could be a trigger for further monetary easing. For now Draghi’s jawboning has helped cap it. Final European business conditions PMIs for January were revised reinforcing their rising trend and German factory orders also came in better than expected.
• Strong Chinese exports, imports and lending growth in January add to evidence of an upswing in China, but also need to be interpreted cautiously given distortions often caused by the Chinese New Year.
• A surge in Japanese economic confidence adds to evidence that policy reflation may be working. The Finance Minister wants to see a slower pace of Yen depreciation but it’s still likely on its way to 105 against the $US.

Australian economic events and implications

• While Australian house prices rose solidly in the December quarter and the trade deficit shrunk other data was pretty weak. Retail sales fell for the third month in a row in December with annual growth falling back to just 2.3%, building approvals unexpectedly fell, job ads fell again and part of the reason for the fall in the trade deficit was a sharp fall in capital goods imports.
• While employment surprisingly rose in January, full time employment actually fell and total employment growth is running at just 0.9% year on year. While unemployment was unchanged at 5.4%, its worth bearing in mind that if the participation rate had not fallen from its 2011 average of 65.5% to now 65%, unemployment would now be 6.1% highlighting the underlying weakness in the labour market. Weak job advertisements point to further softness in employment ahead.
• While December half profit results were ok with 61% beating expectations (against a norm of 44%) and most reporting profit gains, it’s too early to draw any conclusions as only a few companies have reported so far.

Major market moves

• While European shares fell over the past week on concerns regarding Spain and Italy, US shares rose another 0.3% and are now just 3% away from a record high. Chinese and Japanese shares rose but Asian shares were mixed. Australian shares rose 1% on the RBA’s easing bias, a lower $A and good news on China.
• Commodities were mixed and talk of more rate cuts weighed on the $A. The Euro fell on the back of ECB President Draghi’s concerns about Euro strength.
• Bond yields backed up in Spain and Italy, but fell a bit in the US, Germany and Australia on investor caution.

What to watch over the next week?

• In the US expect soft January retail sales (Wednesday) reflecting the increase in payroll tax but modest gains in industrial production, consumer sentiment and the New York Fed’s regional manufacturing index (Friday).
• Euro-zone GDP (Thursday) for the December quarter is likely to show a continued mild recession. Fortunately, PMI and confidence readings suggest the recession may be starting to be weaken.
• Japanese December quarter GDP (Thursday) is expected to show a return to modest growth with a 0.1% gain. The Bank of Japan also meets Thursday, but is unlikely to announce further quantitative easing until the new Governor takes over in April.
• In Australia, expect a modest gain in housing finance (Monday) continuing a gradually rising trend. Both the NAB’s business confidence survey (Tuesday) and Westpac’s consumer sentiment survey (Wednesday) will be watched for further signs as to whether interest rate cuts are starting to get more traction.
• December half profit results will start to flow in earnest in Australia with 30 major companies due to report. Overall, expect earnings to remain weak with conditions starting to stabilise.
• Resources sector earnings are expected to have fallen further as commodity prices fell to their lows during the December half, but financials and industrials are likely to see modest positive growth. After sharp downgrades to earnings expectations for 2012-13, to show near zero growth, the risk of another round of significant earnings disappointment is low.

Outlook for markets

• February is often a soft month for shares after January strength and several hurdles may constrain markets in the month ahead including negotiations around US spending cuts due to kick in on March 1, Italian elections, corruption allegations regarding Spain’s PM and uncertainty around the earnings reporting season in Australia.
• However, any short term set back in share markets should be seen as a buying opportunity as shares are likely to head much higher this year. The positive momentum seen in recent months in share markets is indicative of a bull market, during which corrections are usually short lived and mild. The global growth outlook is steadily improving which should result in better momentum for profits.
• Global monetary conditions are ultra easy and getting even easier. Shares are likely to benefit from investors switching out of low yielding cash & bonds. Share market valuations remain reasonable. Australian shares will also benefit from RBA rate cuts starting to drive a pick up in the key cyclical parts of the economy. So notwithstanding the usual bumps along the way this all adds up to a positive backdrop for share markets.
• Our year end target of 5000 for the ASX 200 is already within striking distance, and while it’s likely to provide some short term resistance, it’s looking too conservative and likely to be breached soon. 5200 to 5300 is looking more likely for year end. Similarly the US share market is likely to hit a new record high within the next few months.
• Sovereign bonds have been a great diversifier and a great investment in recent years but are now very vulnerable as the year ahead is likely to see a rising trend in bond yields as global economic growth improves which will result in capital losses for investors in sovereign bonds.
• The outlook for the Australian dollar remains messy. Softish Australian data is a negative but growing quantitative easing in the US and now Japan is a positive. The likely outcome is for a $US0.95 to $US1.10 range.

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

Major global economic releases and implications

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

Australian economic releases and implications

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

Major market moves

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

What to watch over the week ahead?

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

Outlook for markets

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

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Other headline news included:

• China has joined other central banks in easing monetary conditions by cutting its required reserve ratio for banks. Further easing is likely as the slowdown in economic growth and money supply growth leads to a further slowing in inflation. The onset of an easing cycle in China will add to confidence that it will avoid a hard landing and after a two year bear market in which Chinese A shares fell 33% largely due to policy tightening is likely to see Chinese shares start to outperform on a relative basis and removes a big drag from Australian shares.
• The US Federal Reserve, along with the ECB and four other central banks announced a 0.5% cut in the cost of borrowing $US funds and an extension in the provision of cheap US dollar funding from August next year to February 2013. This should help alleviate some bank funding pressures for European banks, ie if banks were starting to have trouble getting US dollar funding from the private sector not helped by recent bank rating downgrades they can now get it very cheaply from the Fed without having to sell US dollar assets which could have helped spread the crisis into the US. However, while it underlines the point that the Fed will do whatever it takes to keep the US recovery going it does nothing to help alleviate the underlying problem in Europe.
• However, there are signs that Europe is getting closer to a point of resolution. Much uncertainty surrounds the Merkel-Sarkozy plan for a fast tracked fiscal union – how long will it take to set up? which countries will be involved? Etc. However, the ECB appears to be seeing a fiscal union, and the firm commitment it would entail to reducing budget deficits, as helping to clear the way for stronger action from it in terms of supporting troubled bond markets. At the same time the deteriorating economic outlook across Europe is getting to the point where it will be easy for ECB to justify buying bonds more aggressively, simply on the grounds of implementing monetary policy to avoid price deflation. If all goes well the ECB will cut rates again at its meeting on Thursday and the EU leaders summit on Friday will see key core countries along with Italy and Spain commit to a fiscal union with all that entails in terms of shrinking budget deficits which should all hopefully put the ECB on a path to more aggressive bond buying and quantitative easing.
• In Australia, the Federal Government’s mid year budget review saw downwards revisions to the growth outlook, a blow out in the underlying budget balance for this financial year and a return to a wafer thin surplus in 2012-13. While maintaining the surplus commitment will help maintain Australia’s fiscal credentials when many countries have lost theirs, it comes with the risk that fiscal drag will hit the economy hard in 2012-13.
• While Moody’s warned the European debt crisis threatened downgrades to sovereign debt credit ratings across Europe, S&P downgraded several global banks and Australian banks and Fitch put America’s sovereign rating on a negative outlook, Australia became one of only a few countries to have a AAA rating from all three major credit rating agencies, after Fitch upgraded its rating from AA+. So while one can quibble whether the Australian Government has or hasn’t cut spending enough and whether or not a return to surplus by the next financial year is necessary there is no denying Australia’s public finances are in good shape.

Major global economic releases and implications

• US economic data retained the positive tone we have seen over the last couple of months. On the soft side the Fed’s Beige Book of anecdotal evidence reiterated that the US economy is growing at a slow to moderate pace and house price surveys were mixed. But against this business conditions indicators including the ISM index improved, employment indicators were solid, pending and new home sales rose and various surveys suggest strong post Thanksgiving sales as Americans battled their way into good old retail therapy armed with mace spray and guns. No sign of any double dip recession here.
• Euro-zone data was mostly soft with weak economic sentiment readings, unemployment rising to 10.3% in October and super soft money and credit supply growth data. Lots of double dip signs here!
• Japanese economic data was mixed with a solid rise in industrial production and vehicle sales but a fall in a business conditions or PMI index, a rise in unemployment and soft household spending.
• China’s official manufacturing conditions index fell in November, but is still consistent with a soft landing. A slowdown was also evident elsewhere in Asia with Indian GDP growth slowing to 6.9% over the year to the September quarter (from 7.7%) and an unexpected fall in Korean industrial production. Apart from the monetary easing in China, central banks in Thailand, Brazil and Israel also cut interest rates.

Australian economic releases and implications

• Australian economic data over the last week ranged from the very strong to the very weak. Business investment surged in the September quarter with investment plans pointing to a 36% rise this financial year. Retail sales also rose again in October, but outside of food are a bit soft. Private credit growth is soft with annual growth in housing credit at a 30 year low. While new home sales rose solidly in October they remain below GFC lows and what’s more house prices are continuing to slide. At the very weak end of the spectrum building approvals fell another 10.7% in October and have now fallen to their lowest level since the GFC.

Major market moves 

• Share markets surged on central bank action, hopes that a fiscal union in Europe will clear the way for more aggressive ECB intervention and better US economic data.
• Commodity prices and the $A followed shares higher. Bond yields were mixed – up in the US and Australia on reduced safe haven buying, but down in Europe on hopes it may be edging to a new solution to its problems.

What to watch in the week ahead?

•  Europe will likely remain the focus for investors in the week ahead with the European Central Bank meeting on Thursday and the EU leaders’ summit on Friday. In view of the increasing deterioration in the European economic outlook and rising evidence of a credit crunch we expect the ECB to announce another cut in its key short term interest rate taking it from 1.25% to 1% and new measures to ease bank access to funding. The EU leaders’ summit is expected to announce concrete measures to move towards greater fiscal integration, which will hopefully clear the way for the ECB to get more confident in playing a lender of last resort role.
• In the US, expect a slight improvement in the ISM non-manufacturing conditions index (Monday) and an improvement in consumer sentiment (Friday).
• Chinese economic data for November due Friday are likely to show a further moderation in the pace of economic growth and a slowing in inflation to 4.5% reflecting softening food and non-food price inflation. Cooling economic growth and slowing inflation will underpin further policy easing in the months ahead.
• In Australia, the RBA is expected to cut interest rates again by another 0.25% taking the cash rate down to 4.25%. While recent better than expected data in Australia, notably for business investment, make it a close call, the threat from Europe and rising bank funding costs at a time when the inflation outlook is benign, strongly argue in favour of another rate cut. Waiting two months till the next Board meeting in February is too big a risk to take given the deteriorating situation in Europe. So the RBA’s policy of “least regret” would argue strongly in favour of a precautionary rate cut in the week ahead.
• Expect a solid 1% or more gain in the September quarter GDP (Wednesday) on the back of surging business investment and solid consumer spending. Expect a +10,000 gain in employment (Thursday).

Outlook for markets

• The European debt debacle means the short term outlook for shares still remains highly uncertain. However, long term value is good, the US and China are looking okay, global monetary easing is positive, we are in a seasonally stronger period of the year and there are signs that Europe may be getting closer to a solution.
• The $A, like all risky assets, remains vulnerable in the short term to the European debt debacle. However, the medium-term trend is likely to remain up as the US and Europe are eventually forced into more quantitative easing, Chinese long term commodity demand remains strong and Australian interest rates will remain well above US rates even as the RBA cuts rates by more.
• Government bonds in countries like Australia with secure AAA ratings are a good diversifier and with short term interest rates likely to remain low indefinitely it’s hard to see much sustained upwards pressure on bond yields for the foreseeable future. However, yields are extremely low so expect modest medium-term returns.

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

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

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

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

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

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

Major global economic releases and implications

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

Australian economic releases and implications

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

Major market moves

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

What to watch in the week ahead?

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

Outlook for markets

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

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