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So why is this important and why is the market selling off?

Over the past few years Hedge Funds and others have been able to make certain investments on expectation that the trends will continue. That is that QE will keep bonds yields low and that this will mean other yield orientated investments will also be attractive. These investors are now starting to unravel some of their positions which are causing an adjustment for the markets.

Implications

The implications for our market are as follows:

1. It places downward pressure on our currency as A$ bonds and high yield stocks were one of those investments that have benefited from QE. In the short term as offshore investors sell out of the Australian positions it creates some negative volatility.
2. Ultimately a pullback in the currency has positive implications for profits of the Australian market and will improve the competitive position of many companies. We estimate that at a 90 cent A$ there is a 9% positive impact to profits.
3. From a valuation perspective the Australian market has pulled back 10% so when combined with the impact of a lower currency the Australian market is nearly 20% cheaper than it was two months ago.

In addition to the QE easing the Australian market is adjusting to life after the resource boom. Some of those sectors of the economy which have done well in the past few years are likely to struggle and the RBA will be looking for other segments such as housing and non-residential construction to breathe life into the economy. A lower currency and lower interest rates will help in this regard as will an election to remove current uncertainty.

From a positioning perspective we continue to like those companies exposed to offshore earnings such as Brambles, QBE and Ansell and those companies which can benefit as money flows out of bond markets (such as QBE and Macquarie Bank). We will also be looking at opportunities that emerge from the current volatility.

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In brief:

Net immigration is the biggest driver of population growth. The birth rate has picked up recently.

• Australia’s population rose by 94.1k in QIV to 22,906 million. It is a solid 394.2k, or 1.8%, higher than a year ago.
• The natural increase (births less deaths) was 158.3k in 2012. There were 305.4k births and 147.1k deaths.
• Net overseas migration was 235.9k in 2012.
• Natural increase contributed 40% of the population rise over the past year and net migration contributed 60%.
• In annual growth terms, WA continued to record the fastest population growth of all States, with an increase of 3.5%.
• The resource rich state accounts for 10.8% of the total population.
• Over 2012, there were 147k residential.

To read the full update click here.

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Not so precious?

Markets have softened in response to two factors; these included the bombs that caused carnage during the Boston Marathon.

This occurred an hour before the close of the market and resulted in a 100 point fall. While our thoughts go out to those impacted, we would expect the impact on markets to be short lived. The other factor was continued weakness in gold (down 9%) and to a lesser extent other commodities.

We find the weakness in gold interesting. As can be seen in the chart below, gold has been a very strong asset over the past decade during much turbulence from other asset classes. It has been seen as a defence against deflation risks and a safe haven from the GFC.

With risks declining and equities improving a sell-off has begun. We note there remains many convicted gold bulls with concerns that money printing by the Fed will cause a bout of inflation.

The issue for gold is that there is a need to find even more buyers to drive the price up and after a decade of moves this has been more difficult. Furthermore, as it starts to fall investors become more conscious of the fact it does not produce any income and this is creating selling pressure in a market searching for yield.  

We see two main consequences from the gold sell off:

1. Are safe havens safe? We have seen a near bubble in perceived safety in recent years. Gold rallied, bonds rallied, and safe stocks have rallied (eg Telstra). Does a gold sell off signal that money can begin to come out of these other trades? We remain cautious of bonds but would not expect a savage sell off given Fed buying support. However we also believe the weight of money will be looking to exit these “safer” trades over the next few years and looking for investments with a better risk / return trade off.
2. Where does the money from gold go?  We do not see it as likely that money will transfer out of gold into bonds so it is likely to find its way into equities, property or infrastructure.

We do not see gold as providing much of a road map to the performance of other commodities which should run on traditional supply / demand dynamics. We have been seeing some softness in this regard and are cautious on mining service players and small miners.

However we remain positioned in the larger miners for the following reasons:

1. They are taking steps to reduce capex and cut costs and as they free up free cash flow they will increase returns to shareholders. We note we have seen Woodside cut their proposed capex on their Browse project and we expect a significant capital return from them as a result.
2. They have world class assets, low on the cost curve which means they can ride out cycles.
3. They are already priced at a discount to valuation reflecting the market cautiousness towards commodities at present. While it is difficult to identify a catalyst at present, we could envisage a turnaround on the back of further Chinese stimulus.

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• Spain’s Federal Government continues on the “Road to Nowhere” with another round of budget tightening. The Rajoy Government announced austerity measures that include a wage freeze, a -8.9% cut to public spending and a consumption tax increase (VAT). A sign of desperation is that “lottery wins” over Euro €2,500” will be taxed at 20%. These austerity measures aim to move Spain’s budget deficit from circa 6% GDP in 2012 towards 4.5% GDP for 2013. So considerable pain for marginal gain. Spain’s central bank has ominously warned this week that Spain’s economy keeps “falling at a significant rate”. This “road to nowhere” of European budget tightening in the midst of a recession is the main downside risk to the Global economy. 
• European economic data this week was also disappointing and frustrating. The European Commission’s surveys of business & consumer sentiment were weak and suggestive of a mild recession. The EC industrial sentiment fell to its lowest level in the past 33 months.  The EC consumer sentiment result was at a 3 year low. The European Central Bank (ECB) measure of private sector credit shows that European banks remain reluctant to lend. Private sector loans have fallen by -0.6% over the year to August.
• In more encouraging news, American house prices show signs of a sustainable recovery. The S&P Case Shiller “10 Major Cities” measure rose by +0.4% in July. Over the past year, American house prices have risen +0.6%. American consumer confidence is now running at a warmer temperature after a chilly period mid year. The Conference Board‘s consumer confidence survey rose to a 7 month high in September.

Australian economic releases and implications

• Australia’s central bank indicates that Australian banks have limited direct asset exposure to troubled European nations. The RBA’s Financial Stability Review (FSR) highlights that most of the Australian bank’s asset exposures are to France, Germany and The Netherlands for A$ 38.9 billion while the troubled nations (Spain, Portugal, Greece Ireland and Italy) are only A$ 4.7 billion. However there is an impact through “swings in global financial market sentiment” and Europeans banks cutting their lending to Australian commercial property.
• The RBA’s assessment is that Australian households appear to be “coping well with its debt levels”. Australian “household borrowing has also slowed in recent years”. The RBA notes that “many households are choosing to repay their existing debt more quickly than required”. Around 50% of “borrowers are repaying their mortgages ahead of schedule and are thereby building up buffers”. These “buffers” are “estimated to be equivalent to around 1½ years of scheduled repayments (principal plus interest).” 

Major market moves

• Global shares recorded mild falls during the week but considerable volatility with European concerns. American shares declined by circa 1%. There were sharper falls in Europe with Spain recording with a -2 % fall.
• Australian shares were more resilient with a marginal fall of circa 0.5%. The prospect of the RBA cutting interest rates appears to be contributing to the resilience.
• American and Australian bond yields fell with the intensification of Spain and Greece’s woes. The scene of public protests in Madrid & Athens has generated some “safe haven” buying in 10 year bond yields. 

What to watch over the week ahead?

• The Reserve Bank should cut the Australian cash rate by another 0.25% to 3.25% on October 2nd.  Given subdued business & corporate sentiment, slowing jobs growth, sluggish retail spending and a high Australian Dollar that is weighing “more heavily” on the economy, there is a strong case to cut interest rates next week.
• The European Central Bank’s Governing Council meets on October 4th and should also cut interest rates by another 0.25%. Given that the European banking system is reluctant to lend, that European Governments are committed to severe budget tightening and the broader European economy is in recession, there is a robust case for the interest rate to fall to a record low of 0.5%.
• America sees the release of key September data on employment and business surveys. Sedate jobs growth and a stubbornly high unemployment rate have been the major concern for America’s central bank as well as the Presidential contenders. A marginal improvement in September is expected after Augusts’ disappointing +96,000 job gains and unemployment rate at 8.1%. The ISM business surveys for manufacturing should also modestly improve for September after the subdued results over the last 3 months.
• China’s financial markets are essentially closed next week for holidays. 

Outlook for markets

• Allowing for Europe’s budget tightening obsession and recession woes, the rest of the Global economy is in a modest slowdown phase. Global growth momentum should stabilise by the end of this year given the extraordinarily low interest rates and assertive commitment by the American & European Central Banks’ to purchase assets. China’s economic activity is cooling at a steady pace while inflation pressures have dissipated, thereby allowing further policy stimulus after the leadership transition in October.
• For Australia, the RBA is likely to lower interest rates over coming months given the softer Global growth profile, the strong Australian Dollar and mild inflation pressures. These interest rate cuts should provide strong support for Australian Shares over coming months as well as supportive of the struggling “Non-Mining” economy.
• Global Shares are now in a consolidation phase after a strong rally in the September quarter. While the last week saw a disappointing pullback in Global Shares, this comes after robust gains for the quarter. Yet the medium term prospects for Global Shares is still favourable.
• Global Shares are cheap on comparisons to corporate earnings as well as relative to Government Bonds. Any significant pullback over coming weeks should be seen as a great buying opportunity for Global Shares for the medium term. Global Shares should end 2012 on a strong note.
• American and Australian Government bonds provide extraordinarily low yields currently. This would suggest low returns for the medium term. Corporate bonds are a better proposition for those seeking income but who are cautious about investing in shares presently. 

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While new coalition governments in Italy and Greece look set to approve new austerity measures the risks in Europe remain high. Forward indicators point to a slide into recession ahead, fiscal austerity will only worsen the economic and public debt situation, elections early next year in both Italy and Greece will only prolong the uncertainty and increasing talk of countries leaving the euro is adding to fears of defaults.

The slide into the abyss by Italy since July is particularly concerning. While Italy’s level of public debt (120% of GDP) and budget deficit (4% of GDP) are far better than Greece’s, investors are starting to fear that it is heading down the same path ultimately requiring a debt write down. And these fears are in danger of becoming self fulfilling. Italian bond yields at 6.42% – having fallen from a mid week peak of over 7% – are well above sustainable levels (which is probably around 4% or less) and risk turning a liquidity crisis into a solvency crisis.

Italian bond yield spreads to Germany remain around levels that ultimately forced Ireland and Portugal to seek a bailout. The trouble is that Italy accounts for 17% of Euro-zone GDP and 23% of its public debt, and European banks have a near $US800bn exposure to it (nearly six times their exposure to Greece). The enhanced European bailout fund is unlikely to be big enough to deal with Italy as well as other countries and in any case it’s not yet up and running.

While European Central Bank purchases of Italian bonds helped push Italian bond yields back down late last week, on its current approach this is likely to be temporary and insufficient to make a lasting impact. The ECB should be committing to unlimited purchases of Italian bonds in order to ward off speculators and push yields back down to sustainable levels of around 4%. Unfortunately it remains reluctant to do this. In short the news out of Europe is likely to remain poor, albeit interspersed by brief bouts of relief and optimism.

However, it’s not all bleak globally. The US is continuing to grow despite numerous headwinds, China looks to be on track for a soft landing and various countries are continuing to ease monetary conditions, with the latest being Indonesia.

Major global economic releases and implications
US economic data was mostly positive over the last week with a rise in consumer sentiment, slight rise in small business confidence, a further fall in weekly jobless claims, a rise in weekly mortgage applications and a narrower than expected trade deficit. What’s more the September quarter profit reporting season is now largely complete with profit growth coming in at a much stronger than expected 18% year on year. The only negative was that a Fed survey pointed to fewer banks easing lending standards and signs that credit demand is weakening. Overall the picture remains of continuing growth in the US, albeit around a sub par 2-2.5% pace.

European economic data was soft with a fall in euro-zone retail sales, sharp falls in German, French and Italian industrial production and flat industrial production in the UK. Business conditions indicators point to further shape falls in European industrial production ahead.

Chinese economic data for October confirmed the picture of moderating growth and cooling inflation. While industrial production, export growth, money supply growth and the property market continue to slow, retail sales, fixed asset investment and imports remain strong. Overall, there remains no sign of a hard landing in China.  What’s more inflation is continuing to cool, falling to 5.5% in October from a cyclical peak of 6.5% in July. While food inflation is coming off the boil, non-food inflation is also slowing and falling producer price inflation and slowing growth all point to a further fall in inflation ahead. The moderation in growth and inflation is likely clearing the way for monetary easing in the next few months.

While the general picture across Asia remains one of moderating growth and slowing exports, there was some strong news out of Indonesia with GDP growth holding up at 6.5% over the year to the September quarter. However, with global uncertainty on the rise and inflation cooling, Indonesia cut interest rates again by another 0.5% taking them to 6%. Further interest rate cuts are likely across Asia in the months ahead.
Australian economic releases and implications

Australian economic data continued the somewhat more positive tone seen over the last month with gains in consumer and business confidence, housing finance and employment and another solid trade surplus for September. That said, it’s worth noting that this doesn’t mean the economy is suddenly booming. Both business and consumer confidence have just bounced back to average levels and housing finance remains low. While employment growth remains positive it is worth noting that trend monthly employment growth is now running around 6000 jobs a month compared to 30000 jobs a month a year ago. What’s more job ads and various business surveys and anecdotes point to labour market softness ahead.  This combined with the intensifying risks coming out of Europe means that the outlook for interest rates is still skewed to the downside.

Major market moves
Share markets had another volatile week with markets falling sharply mid week on the blowout in Italian bond yields and fears that Italy will knock Europe into an even deeper recession before staging a rebound later in the week as the political situation in Greece and Italy improved. Share markets were up in the US, Europe and Australia, but closed down in Asia.

Commodity prices also had a volatile week and ended mixed with oil and gold up, but metal prices down. Mixed commodity prices and the uncertainty over Europe also weighed on the Australian dollar.

Bond yields were generally mixed. A concern remains that despite an improvement later in the week, French and Italian bond yield spreads to German yields remain wide. 

What to watch in the week ahead?
In the US, October retail sales (due Tuesday) are likely to show modest growth, manufacturing conditions surveys (Tuesday and Thursday) are expected to show an improvement, inflation (Wednesday) is expected to be benign and housing starts & permits are expected to continue the basing action seen over the last year. Data for industrial production and consumer sentiment will also be released.

In Europe, September quarter GDP growth (Tuesday) is expected to come in around 0.2%, the same as in the June quarter.

In Japan, GDP data (Monday) is expected to have recorded a solid 1.5% rebound in the September quarter following three quarters of contraction partly due to the earthquake.

In Australia, the minutes from the RBA’s last Board meeting and a speech by RBA Governor Stevens will be watched closely for clues as to whether there will be another interest rate cut next month. Of particular interest will be any guidance as to how seriously the RBA views the European crisis. Wages data due for release on Wednesday is expected to remain benign with a gain of 0.8% in the September quarter and 3.7% year on year.

Outlook for markets
The mess in Europe continues to cloud the short term outlook for shares. Long term value is good for shares, the US and China are looking okay, global monetary easing is positive, we are entering a seasonally stronger period of the year and investors generally are short shares, but the event risk around Italy and Greece and the slide into recession in Europe generally are likely to keep the ride volatile in the short term.

The $A, like all risky assets, is likely to remain vulnerable in the short term to the ongoing European debt debacle. 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 long-term and Australian interest rates will remain well above US rates even if the RBA cuts rates by more.

Government bonds in major global countries 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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