RBA Board minutes

• Reserve Bank Board minutes: Board members continue to expect a period of stability in interest rates. Board members appeared to spend a lot of attention on the labour market, commenting “that a range of indicators of labour demand suggested a modest improvement in prospects for employment, although the unemployment rate was still expected to edge higher for a time”.
• Forward-looking Reserve Bank. Board members discussed the “industry composition of output, investment and employment growth over the past two decades”, and downplayed the manufacturing job losses: “future employment growth was likely to continue to be concentrated in service industries”.
• Cautiously optimistic outlook. Policymakers noted “promising signs” of stronger home building and consumer spending to offset weaker mining investment and public spending.

What does it all mean?

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The big picture

• The Reserve Bank Board meets again on Tuesday to decide interest rate settings. But this month – as was the case last month – there is no contention: there is no need for a change in rate settings in either direction.
• First, the floods that occurred in Queensland and other states, as well as Cyclone Yasi, are still causing variable business conditions across the country. Some businesses are still not fully back up and running, while others are starting to benefit from the repair/refurbish/rebuild work.
• Second, is consumer conservatism. Consumers are still not spending like they used to, causing inventories to accumulate and thus translating into on-going discounting. The RBA Board members get sent their papers for Tuesday’s meeting on Friday, so it is unclear how much of Thursday’s and Friday’s data finds its way into the packs. Board members will also need to take into consideration next week’s results for the inflation gauge. Importantly the core measure of prices in the inflation gauge has barely moved over the past seven months.
• Third, the housing market has clearly flattened. One large builder has told us that he has cut staff from 300 to 220 and will soon shift to a 9-day fortnight. Home prices are also falling in many parts of the country. Simply, demand and supply are better balanced, making builders and vendors nervous, but providing opportunities for cashed up buyers.
• Fourth, consumers and businesses are still more inclined to put money in the bank rather than borrow. Credit demand remains soft with business lending still falling in annual terms and personal credit growing at a slower pace than the rate of inflation. Housing credit may be holding up, but it is also poised to slow in line with new
  housing loan demand.
• Fifth, there is the mixed state of the global economy. The US economy continues to improve and Asian economies are solid. China is also in strong shape, but it is battling to keep inflation under control. Europe is multi-speed though and then there is the instability in North Africa and the Middle East that is affecting activity in the region and confidence in other parts of the globe. While activity in Japan will pick up later in the year, the economy will be soft for the next few months.
• Overall it is clear that the safest place for the Reserve Bank is on the monetary policy sidelines. The next move in interest rates is still more likely to be up, not down, but given all the shocks that have occurred in 2011 so far, it would be a brave person to state these views with 100 per cent confidence.

The week ahead

• The start of the month is usually a busy time for economic data and events and April is no different. More than half a dozen key economic indicators will be released over the coming week with a decision on interest rate settings thrown in for good measure. In contrast there are only a spattering of economic indicators to be released in the US.
• On Monday the monthly inflation gauge is released together with readings on job advertisements. For seven straight months the core measure of the TD Securities inflation gauge has barely moved, either flat or up 0.1 per cent in monthly readings over the period. Another month of negligible growth would guarantee that the Reserve Bank Board leaves rate settings alone when it meets on Tuesday. The three-month annualised rate of core inflation stands at just 0.3 per cent.
• The Advantage job ads index rose by 6.1 per cent in February and the ANZ series was up by 1.2 per cent. Job ads lead employment growth by 5-6 months, so the job market should remain healthy, perhaps translating into stronger consumer spending.
• As well as a Reserve Bank Board meeting there are a couple of economic indicators to watch. Trade data for February is released together with the Overseas Arrivals and Departures information. The latter includes statistics on tourist arrivals and departures as well as migration flows. It may be too early to see the impact of the floods and cyclone on tourist arrivals. But migration should be in focus – politicians have to work out that our economy needs more skilled labour. A trade surplus of $1.2 billion is expected for February.
• The initial soundings from the Bankers Association suggest that demand for new home loans slumped in February, possibly as much as 7 per cent. Now clearly the impact of the floods and cyclone on the Queensland market should be carefully dissected. But if the weakness is more uniform across the country then the Reserve Bank will start worrying about a loss of economic momentum.
• The most interesting economic data in the coming week will be Thursday’s jobs data. Employment has gone backwards over the past two months with the number of jobs down by 10,100 in February after lifting by 7,700 in March. Clearly there is a “Queensland effect” with jobs down in that state by over 20,000 in February, but four other states and territories also lost positions. Unemployment remains low at 5 per cent. We tip job growth to rebound by 25,000 in March with the jobless rate largely unchanged, perhaps a tad lower.
• In the US, the economic indicators are few and far between in the coming week. The ISM services gauge is released on Tuesday with weekly jobless claims (new claims for unemployment insurance) to be issued on Thursday together with consumer credit data while figures on wholesale sales and inventories are issued on Friday.
• The other indicators – consumer credit and wholesale inventories – are largely of secondary importance for investors, but they deserve more attention. Consumer credit has risen for four months after 20 months of declines, so the lift in lending is clearly positive for consumer-focussed businesses. And wholesale inventories are also rising for the simple fact that they have to because sales are strong. In fact the 3.4 per cent lift in February sales was the biggest in 24 years. The stock to sales ratio is at record lows.

Sharemarket

• There have been mixed performances on world sharemarkets since the start of the year. So far 33 of the 72 bourses tracked are higher now in local currency terms while the remainder have fallen. The country with the strongest sharemarket is Russia (up 14.2 per cent) followed by Romania (up 13.8 per cent) and Ukraine (up 12.4 per cent). Also notable at the top of the leader-board is Greece, up 14.8 per cent, and clawing back some of the 35.2 per cent decline in 2010. At the other end of the leader-board the Egyptian sharemarket is down 20.3 per cent with the Tunisian bourse down 13.2 per cent.
• The Australian sharemarket is close to the middle of the leader-board, largely unchanged over 2011, putting it in 34th spot. Still, after being broadly unchanged in 2010 as well, that means the sharemarket is still little different from where it closed at the end of 2009.

Interest rates, currencies & commodities

• The Australian dollar ended 2010 around US101.60c and it looks like ending the first quarter around US103c. That modest appreciation of 1.2 per cent ranks the Aussie dollar at 38th in our table of 120 currencies across the globe. So far in 2011, 59 currencies have strengthened against the US dollar, 28 currencies have been largely stable and 33 currencies have weakened.
• The strongest currency in the world so far this year has been the Paraguayan guarani (up 10.2 per cent) followed by the Hungarian forint (up 9.7 per cent) and Romanian lei (up 9.5 per cent). Interestingly eastern European and western European currencies dominate the top end of the leader-board. The Euro is 9th strongest against the greenback with a gain of almost 6 per cent with the UK pound up 3.7 per cent. At the other end of the leaderboard is the Vietnamese dong (down 7.3 per cent) followed by the South African rand (down 4.2 per cent) and Kenyan schilling (down 3.8 per cent).

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• The underlying budget deficit deteriorated in January and now stands just shy of record highs. In the 12- months to January, the budget deficit totalled $62.3 billion, an increase of almost $3.8 billion on the deficit for the 12 months to December. The record budget deficit was $63.3 billion for the 12 months to
• September 2010. CommSec estimates that the budget deficit equates to 4.6 per cent of GDP.
• The budget deficit of $40.7 billion for the seven months to January is also $2.1 billion above the “profile” or expected deficit for the period
• Over the next five months each monthly budget deficit needs to improve by over $4 billion compared with the equivalent months of 2010 ($20.8 billion in total) for the Government to meet its full year budget deficit target of $41.5 billion.
• In the past, the best improvement in the budget position over a six-month period in the past has been just $8.7 billion. Still, the biggest deterioration has been $37 billion. The target is not impossible, but still difficult given the slowdown of the economy and recent floods.
• Annual revenues dipped from seven-month highs in January but the good news was that annual expenses eased from record highs.

What do the figures show and what does it mean?

• The best way of tracking the budget position during the year is to follow the rolling 12-month totals. In that way seasonal influences and one-off effects can be accounted for. So the latest figures represent bad news for the Government. The deficit in the 12 months to January rose to $62.3 billion, just off record highs and a long way from the target of a $41.5 billion deficit in the 2010/11 year.
• Another way of looking at the deficit is to compare it with the profile – that is the estimate of where the deficit should be if the budget target is going to be met. In the 7 months to January the deficit stood at $40.681 billion, over $2 billion higher than the profile estimate of $38.504 billion.

• Whichever way you cut it, the Government has some work to do to hit the target. Clearly the floods in Queensland and Victoria have had an impact as has Cyclone Yasi in northern Queensland. And while the good news is that expenses are short of the profile estimate at present, the bad news is that revenue is falling short by an even bigger margin. It’s not just the floods but also the fact that the Reserve Bank adopted tight monetary policy settings late in 2010, serving to slow momentum in the economy.
• The government has plenty of work to do to hit its budget target. Basically for the next five months each monthly budget result needs to improve by almost $4.2 billion compared with the same month of a year ago. The annual budget deficit needs to improve by almost $21 billion in the space of five months to hit the Government target.
• The good news is that budget expenses in January were lower than a year ago. Annual budget expenses hit a record high of $353.4 billion in calendar 2010 but eased to $351.2 billion in the 12 months to January. The bad news is that budget revenues were lower than a year ago in January and annual budget revenues eased from seven-month highs.
• Annual budget revenues are up just 0.1 per cent on a year ago. By comparison annual expenses are 3.5 per cent higher than a year ago.
• GST revenues also slipped in January, a further sign that the economy has lost momentum. GST revenues totalled $47.4 billion over the 12 months to January, down from $47.6 billion in the years to November and December and below the record high of $47.9 billion in the year to October 2010. Annual GST revenues are still up a healthy 7.7 per cent higher than a year ago, no doubt a pleasing result for state and territory governments across the nation.

What are the implications for investors?

• So what does it all mean? The Federal Treasurer should advise whether the deficit target for 2010/11 is still likely to be met. That would clear the air and remove speculation. But no doubt the Treasurer will also give a commitment to hand down a very tight budget in May.
• The Federal Government is entirely committed to get the budget back into surplus. It will have to make hard decisions and reportedly this will take the form of a crackdown on welfare payments. Investors can also expect spending cuts in other areas and a possible freeze on public sector employment.
• The Government will also have to hope that the Reserve Bank does stay on the interest rate sidelines until the second half of 2011 so that the economy can motor out of the current soft patch. Consumers and businesses aren’t spending, and as a consequence margins are being constrained together with profitability and government tax collections.
• Given its minority status, the Government will have to show that it has the necessary strategy to improve the budget bottom-line or risk losing support of Independents. Certainly the Government has been thrown a curve ball from natural disasters, but it has to demonstrate that the budget numbers will start improving in the next few months.

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Greg Michel, head of fixed income at INGIM said the global appetite for Australian bonds is likely to continue with investors drawn to current yields of 5% to 6%, outstripping available yields available from global alternatives.

“The Australian economy has proven to be resilient to the effects of the GFC and continues to expand at a robust pace. The bond market has been in a bear market phase since early 2009 and bond yields are now close to long term average levels,” he said.

Global bonds are a different story, and INGIM expects flat to negative returns in 2011.

While the major European economies are expanding strongly, aided largely by a weak currency and accommodative monetary policy, the peripheral Euro markets continue to be held down by the large levels of sovereign debt and associated funding challenges.

“On balance we believe the combination of improving economic growth and high sovereign debt levels will result in Euro bond yields continuing to head higher in 2011,” said Mr Michel.

Credit best performing sub-sector

Turning to fixed income sub-sectors, INGIM said credit is expected to be the best performing assuming the default cycle pans out as expected.  While underlying interest rates will rise, continued credit spread contraction should see credit perform in a relative sense.

“The rally we have seen in credit markets over the past two years has been strong, supported by improving fundamentals and monetary and fiscal stimulus in the economy.  That being said, there is a sense the rally has overshot the fair value mark and there are few catalysts to drive spreads tighter,” INGIM’s head of credit research, Scott Rundell said.

For issuers, Mr Rundell said offshore markets continue to be more competitive than the Australian bond market with some suggesting several large players are demanding unpalatable spread levels.

“It’s relatively easy for investment grade credit to issue long dated loans or bonds into the US market.  New issuance is likely to be low and we expect few first time local issuers in Australia,” he said.

Global government bond yields on rise

Looking to Australian government bonds, INGIM is expecting limited further tightening in monetary policy in 2011 and now expects government bond yields will remain at or near current levels for the rest of the calendar year. Demand for local government bonds will continue to be dominated by offshore investors.

Despite recent geo-political tensions in the Middle East and North Africa, global government bond yields are expected to continue to rise over the medium term.  US government bonds yields are also expected to continue their upward rise as the market prices in the recovery.

“We’re now seeing ongoing evidence of a broad based economic recovery in the US and government bond yields are set to continue to rise through 2011 as the global economic recovery gathers pace,” said Mr Michel.

World issues cause headwinds

Meanwhile European sovereign debt challenges will continue to cause headwinds for fixed income. In particular, forced losses (or ‘haircuts’) on Irish senior bank debt could create contagion risk to other EU banks, causing the cost of bank funding to spike.

“We also advise monitoring changing bank regulatory regimes and structures as they will impact capital flows and the cost of credit in general,” Mr Rundell said.

Other world factors to watch include Chinese growth and demand for raw materials and the impact of recent events in the Middle-East and North Africa on oil prices.

“The management of many global companies may look to appease shareholders who have experienced negligible growth with capital initiatives aimed at increasing their returns. This could also be a negative credit event,” Mr Rundell said.

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• Lending slumped in January. Total lending finance fell for the first time in the five months – down by 6.0 per cent in January. Lending totalled $52.6 billion in January, up 5.8 per cent over the year. Over the prior four months cumulative monthly gains in lending finance stood at 12.8 per cent.
• RBA Board on interest rate sidelines. The decision to leave interest rates on hold in March was due to an array of factors, however the key driver was the negative impact on the economy from the floods. The subdued level of consumer spending also provided Board members with further reason to hold off on near-term rate hikes.
• Australian new car sales recorded a modest 0.2 per cent rise in February.
• According to the Australian Institute of Petroleum, the national average Australian price of unleaded petrol rose by 3.5 cents per litre to 142.7 cents a litre in the week to March 13 – a near 29 month high. Over the past month the national average price has lifted by 7.9 cents per litre.
• Brisbane has the highest petrol price across the capital cities, while Canberra is the lowest.
• The futures market has now priced in a 55 per cent chance of a rate cut at the April meeting in light of the Japanese nuclear crisis.

What does it all mean?

• Lending finance is a forward-looking indicator of economic activity – as any rise in borrowings will eventually translate to a pickup in spending and production. The floods are clearly complicating analysis of the lending data, but the continued softness of consumer borrowing remains a concern.
• In late 2010 there were tentative signs of thawing in the conservative attitudes of consumers and businesses. Lending finance had risen for four straight months prior to the sharp 6 per cent fall in January. The key issue going forward is: how long will the weakness last? Notwithstanding the floods, the Reserve Bank would clearly want to see some improvement in lending over February and March.
• The weakness in consumer borrowings is a major concern, especially given that personal finance has fallen for five out of the last seven months. CommSec expects the Reserve Bank is likely to stay on the interest rate sidelines – especially given that inflation looks to be well contained at present.

• The latest Reserve Bank Board minutes identified the Queensland floods as a key reason for interest rates remaining on hold in March. And as the Reserve Bank has noted on recent occasions, the lack of consumer activity is not all bad news – ensuring that inflationary pressures are contained in the near term. Even the recent slide in lending is unlikely to surprise the Reserve Bank, especially given that it was expecting growth to be sluggish in the first half of 2011.
• The minutes revealed that Board members were generally optimistic about the outlook, noting strength in business investment plans as well as the sustained improvement in labour market conditions. However given that interest rate were “mildly restrictive” – in other words acting to slow the Australian economy – a rate pause seemed the most logical outcome.
• After a modest pickup in activity in the mid part of 2010, car sales are now effectively going nowhere with more signs of buyer caution once again emerging. In annual terms vehicle sales are down almost 2 per cent on a year ago. The rate hikes of late last year are no doubt resulting in potential car buyers being more circumspect about future purchases. In fact in trend terms car sales have been broadly flat for the last ten months.
• What is required in the near term is for interest rates to remain on hold, allowing consumers and businesses to adjust to the higher interest rates now in place and, in turn, start spending again.
• Brisbane was hit hard by the floods and now it has the highest petrol price of any capital city. The lofty petrol price is clearly an impediment to economic recovery.

What do the figures show?

Lending Finance:

• Total new lending commitments (housing, personal, commercial and lease finance) fell by 6.0 per cent in January after rising 4.3 per cent in December. However over the prior four months lending was up a much healthier 12.8 per cent in cumulative terms. Lending totalled $52.6 billion in January, up 5.8 per cent over the year.
• All housing finance (owner occupier & commercial) fell by 4.8 per cent in January – the first fall in seven months.
• Commercial finance fell by 5.8 per cent in January. Within commercial commitments, fixed lending fell by 4.0 per cent while revolving credit slumped by 9.7 per cent. Commercial loans are up 13.9 per cent on a year ago.
• Personal finance fell by 9.5 per cent in January – marking the fifth fall in the past seven months. Within personal commitments, fixed lending fell by 4.5 per cent while revolving credit fell by 14.5 per cent. Personal loans are down 6.2 cent on a year ago.
• Lease finance fell by 1.3 per cent in January and loans are down 6.2 per cent over the year.

New car sales

• New car sales rose by 0.2 per cent in February after sliding by 2.4 per cent in January. Total car sales are down 1.5 per cent on a year ago.
• Passenger car sales fell by 2.7 per cent in the month, sports utility vehicles rose by 4.1 per cent while “other” vehicles (trucks, utes etc) were 4.2 per cent higher. In annual terms “other” vehicle sales were up 1.4 per cent on a year ago.
• In rolling annual terms, 236,260 SUV’s have been sold in the 12 months to February – the second highest reading on record. Overall SUV sales are up 4.6 per cent on a year ago.

Petrol prices:

• According to the Australian Institute of Petroleum, the national average Australian price of unleaded petrol rose by 3.5 cents a litre to 142.7 cents a litre in the week to March 13. The metropolitan price rose by 3.7 c/l to 142.8 c/l, while the regional average price rose by 3.3 c/l to 142.6 c/l.
• Average petrol prices across states over the past week were: Sydney (up 4.5 cents to 143.2 c/l), Melbourne (up 3.5 cents to 142.2 c/l), Brisbane (up 4.9 cents to 145.6 c/l), Adelaide (up 1.6 cents to 141.1 c/l), Perth (up 2.7 cents to 141.5 c/l), Darwin (up 1.3 cents to 144.4 c/l), Canberra (up 3.3 cents to 137.3 c/l) and Hobart (up 1.4 cents to 145.5 c/l).

Minutes from the March 2011 Reserve Bank Board meeting

Consumer spending

• Retail sales data had shown subdued spending in late 2010, including a small fall in real spending for the December quarter. Liaison with retailers had suggested some improvement in conditions in early 2011, with sales data for January released during the Board meeting showing moderate growth in the month. Consumer confidence had softened in early 2011 to be only modestly above average levels, although it was difficult to determine how much of this decline was due to the floods and the cyclone.

Business conditions

• Most business surveys showed a deterioration in current conditions in January, and there was a substantial reduction in hours worked in Queensland. However, business confidence in late January had bounced back after falling in the previous survey taken in early January.

Employment

• There had been another solid rise in employment in January, with the unemployment rate remaining at 5 per cent. Forward-looking indicators of employment from surveys and liaison pointed to solid employment growth over the coming year. Wage growth had picked up over the second half of 2010, with the quarterly outcomes for the wage price index back at around their average rate for the 2005–2007 period. Wage outcomes had been stronger in the mining sector.

The decision

• Interest rates on loans were slightly above average, a level reached after the monetary policy decision taken in November 2010. Members judged that this mildly restrictive stance of policy continued to be appropriate. The Board therefore decided to leave the cash rate unchanged.

What is the importance of the economic data?

• Lending Finance is released monthly by the Bureau of Statistics and contains figures on new housing, personal, commercial and lease finance commitments. The importance of the data lies in what it reveals about the appropriateness of interest rate settings, confidence and spending levels in the economy.
• The Reserve Bank releases minutes of its monthly Board meeting a fortnight after the event. The minutes give a guide to Reserve Bank thinking on interest rate settings.
• The Australian Bureau of Statistics (ABS) provides monthly estimates of car sales in seasonally adjusted and trend terms after receiving the actual sales data from the car industry. The figures highlight the strength of consumer spending as well as conditions facing auto & components companies.

What are the implications for interest rates and investors?

• Overall the latest Board minutes suggest that the Reserve Bank has a degree of flexibility on the interest rate front. And while the near term domestic data looks patchy the Reserve Bank remains confident about the outlook.
• CommSec doesn’t expect a rate hike until at least May, however the risks are that the Reserve Bank will maintain stable rates for longer.
• Interestingly current futures market pricing indicates a 55 per cent chance of a rate cut at the April meeting in light of the Japanese nuclear crisis.

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• Inflation prints above forecast. China’s annual inflation rate held steady in February at 4.9 per cent, but was above expectations centred on a result near 4.8 per cent.
• Most prices higher. Most categories recorded higher prices in February with food prices up 11 per cent on a year ago and non-food prices up 2.3 per cent.
• Business inflation (producer prices) remained high at 7.2 per cent in February – a 29 month high.
• Chinese authorities seem to be having a degree of success in paring back activity. Annual growth rates for industrial production and investment were slightly above market expectations but the latest data on retail sales fell well below expectations.
• China’s central bank has also highlighted the inflationary threat, saying that it will stick to a “prudent” monetary policy and that price stability will become more of a priority.

What does it all mean?

• China’s inflation rate remained uncomfortably high in February. But there are signs that the more restrictive policy measures are cooling activity levels. The increase in interest rates and tightening of the reserve ratio seems to have had an impact on retail activity levels. Retail sales slowed sharply in the first two months of 2011 with the annualised growth rate falling to the lowest levels in five years. The timing of the Chinese Lunar New year has certainly skewed the data and as the next couple of months figures will provide a more rounded view of what exactly is taking place in the Chinese economy.
• Despite the volatility of the data given the one-week holiday, inflation clearly remains the major issue. The annual inflation rate printed above forecasts in February, it was still up a solid 1.2 per cent on the month. In addition producer prices also rose over the month and the year, keeping inflation prominently in the centre of the radar screen.
• There is no doubt that higher food prices have been the major driver behind the lift in inflation, with food inflation surging by 11 per cent over the year. Certainly the risk for the central bank is that higher prices become firmly entrenched and results in a flow on effect through the economy. Chinese authorities have in recent times increased distribution of state food reserve and if supply picks up in the second half of the year, inflationary pressures are likely to ease.

• Overall it does seem that activity levels are being pared back and it was even more encouraging that non-food inflation was relatively benign. In fact non-food prices rose by just 0.1 per cent in the month with the annualised rate falling from 2.6 per cent to 2.3 per cent. More importantly it is looking likely that the recent rate hikes will continue to have a dampening effect on activity levels in the near term.
• Going forward, China’s policymakers will remain vigilant against the inflationary threat and if necessary will continue to tighten policy. And while equity markets may react adversely to a slowdown in activity levels it will lead to a more sustainable growth story in the longer term. Keep in mind that if the economy slows too quickly authorities have ample tools available to turn on the stimulus tap.
• China is both Australia’s largest trading partner and top export destination, so solid, sustainable growth is very much in our interests. If the latest rate hike is unable to curb the rapid pace of bank lending further policy tightening may be on the agenda. And while equity markets are likely to react in a knee jerk fashion, the longerterm outlook looks a lot more favourable for Australian mining and energy stocks.

What do the figures show?

• The annual rate of consumer price inflation remained steady at 4.9 per cent in February. The February resultwas above forecasts centered on a result near 4.8 per cent. Inflation in the cities grew at a 4.8 per cent annual  rate, while inflation in rural centers’ grew at a 5.5 per cent rate.
• Food prices rose by 11.0 per cent over the year (10.3 per cent in January) while non-food prices rose by just 2.3 per cent (2.6 per cent in January). Non-food prices rose by just 0.1 per cent in the month, while food prices gained by 3.7 per cent. Fresh vegetable prices rose by 15.2 per cent in the month.
• Producer prices (business inflation) rose by 0.8 per cent in February to stand 7.2 per cent higher than a year ago. The annual rate of producer price inflation was a 29-month high, up from 6.6 per cent in January and higher than economist forecasts of 6.9 per cent. Prices of raw materials rose by 10.6 per cent, Food prices were up 7.3 per cent, however consumer durables fell by 0.8 per cent.
• Industrial output expanded at a 14.9 per cent annual pace in February, and 14.1 per cent in January /February, ahead of forecasts centred 13.3 per cent. Production is still well off the highs of 20.7 per cent annual growth in January/February 2010.
• China’s urban fixed asset investment, such as spending on roads and power plants, grew at a 24.9 per cent annual pace in January/February, ahead of consensus forecasts (23.3 per cent).
• Retail sales grew at a 11.6 per cent annual rate in February and up 15.8 per cent in January/February. The result was well below forecasts centred on 19.0 per cent.
• Chinese passenger car sales rose by 2.6 per cent to 967,200 in the year to February – the slowest annual growth pace in two years. Authorities have continued to tighten up on the issuance of license-plate registrations to ease congestion and pollution in cities. Total vehicle sales rose by 4.6 per cent to 1.27 million in February compared with a year ago.
• China’s recorded its largest trade deficit in seven year in February. The trade balance fell from a surplus of US$6.45 billion to a deficit of US$7.30 billion and was well short of forecasts centred on a US$4.90 billion surplus. Exports were up 2.4 per cent on a year ago (consensus +27.1 per cent) and imports were up 19.4 per cent (consensus +32.6 per cent). The results may have been affected by the early timing of Chinese New Year compared with a year ago.
• Dow Jones report on Chinese monetary policy: “China’s central bank said Friday it will stick to a ‘prudent’ monetary policy and that the country’s macroeconomic controls will make price stability more of a priority, echoing Beijing’s official line as inflation is increasingly viewed as a threat to economic growth and social stability.

• In a statement ahead of a news conference by People’s Bank of China’s Gov. Zhou Xiaochuan, the central bank said it will strive to keep liquidity in the banking system at a “reasonable” level and continue to use interest rates, banks’ reserve requirements and money market operations to achieve the goal.
• The PBOC said it will adopt a differentiated reserve requirement management mechanism for banks this year to make credit growth stable and appropriate. It also reiterated familiar rhetoric on the yuan policy, saying it will continue to make the exchange rate more flexible but also maintain its basic stability.

What is the importance of the economic data?

• China’s National Bureau of Statistics releases its monthly economic statistics around the middle of each month. Quarterly GDP data is released around the 16th of January, April, July and October. China is Australia’s largest trading partner and changes in the Chinese economic have major implications for the Aussie economy.

What are the implications for interest rates and investors?

• Inflation still remains uncomfortably high in China, meaning that further tightening measures will be required. Aussie investors will need to carefully monitor the situation. The risk is that authorities may need to apply more aggressive tightening – clearly negative for Australia’s resources sector.
• However if China did pick up the pace of monetary tightening, that could actually serve to keep Australia’s Reserve Bank on the policy sidelines for longer. Clearly an exacerbated slowdown of the Chinese economy would be negative for our economy.

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• The Reserve Bank Board has left the cash rate at 4.75 per cent at its second meeting for 2011. The next meeting is on April 5 2011.
• The Reserve Bank Board provided a relatively short accompanying statement. The statement suggested that the Reserve Bank remains comfortable with how labour market conditions are evolving at present – noting that “reports of skills shortages remain confined, at this point, to the resources and related sectors. After the significant decline in 2009, growth in wages has returned to rates seen prior to the downturn.”

Click here to download this document (pdf)

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Headline developments of the past week

• China continued to tighten the monetary screws with another interest rates hike. This should not really have been a surprise to anyone and further tightening is likely as Chinese authorities move to vacuum up liquidity being pumped into the economy by their efforts to slow the appreciation of the Renminbi and as part of an ongoing effort to control inflation. However, we remain of the view that China’s growth will slow back to a more sustainable pace but it will not be crunched. Most of the inflation problem in China is food related and likely to reverse later this year. Moreover China’s economy is not particularly interest rate sensitive with the bulk of fixed investment financed by corporate earnings and household debt is very low.
• RBA Governor Glenn Steven’s Parliamentary testimony reinforced the message that, beyond the short term disruption caused by the floods, the RBA has an upbeat medium term economic outlook but that for the time being its comfortable with current settings for interest rates. Our view remains that interest rates will remain on hold until mid year before rates start to head slowly higher again.

Major global economic releases and implications

• US economic data was generally solid. Weekly mortgage applications fell but against this consumer credit, small business confidence and weekly retail sales data rose by more than expected and weekly jobless claims fell to their lowest level since July 2008. With the US economy looking stronger and stronger it wouldn’t surprise to see increasing market talk of the first rate hike from later this year.
• US earnings results continued to surprise on the upside, with so far 70% of results coming in better than expected. December quarter 2010 profits are on track to come in 32% above year ago levels. The driver of stronger profits has shifted from cost savings to revenue growth, with revenue growth running around 6.8%.
• European data was a bit on the soft side with a sharp fall in German factor orders and industrial production, but the former followed a very strong rise the previous month. Japanese economic data was generally positive with gains in the December leading index rose, consumer confidence, housing finance and machine orders.

Australian economic releases and implications

• In Australia, the December half earnings reporting season has kicked off on a relatively solid note with good results from companies such as Boral, Commonwealth Bank, Stockland and Rio. So far 47% of companies have come in above expectations compared to a norm over the last seven years of 46% and 73% of companies have reported a rise in profits on a year ago. However, it’s early days yet with only 35 major companies having reported. Two themes are readily apparent. First, the outstanding strength of the resources sector compared to non-resources stocks. Second, several companies announced plans to return capital to shareholders via increased dividends and share buybacks. With corporate cash holdings at record levels and gearing low there is plenty of scope for further increases in dividends and buybacks going forward.

Source: AMP Capital Investors

Source: AMP Capital Investors

• Australian economic data was mixed. Retail sales rose but only marginally in December and business conditions softened in January mainly due to the floods. Against this February consumer confidence recorded a small rise and despite the floods both employment and job advertisements rose again in January indicating that the labour market remains reasonably solid, although forward looking indicators continue to point to some softening in employment growth going forward, albeit from exceptionally strong levels over the last year. There is now a high risk of negative December quarter GDP growth and thanks to a 1% or so flood related detraction from growth in the March quarter its probable March quarter growth will be negative. So two quarters in a row of negative growth in Australia is distinctly possible. However, given the key driver will be the floods it would be dangerous to read much into this as growth is likely to come roaring back from the June quarter as production returns to normal levels, flood and cyclone rebuilding kicks in and mining investment really starts ramp up.

Major market moves

• Share markets continued to move higher over the last week on increasing takeover activity, more confidence in the global growth outlook and on reduced concerns about Egypt. In Australia, the All Ords rose through the 5000 level for the first time since April reflecting good profit results and several companies announcing increased dividends and share buybacks. We expect the S&P/ASX 200 Index to hit 5,500 by year-end, which would translate to 5600 for the All Ords. Bonds continued their sell off as investors continued to bail out and confidence in the global growth outlook continued to improve.
• Industrial commodity prices generally softened on Chinese/Asian monetary tightening. Oil prices were also weighed down by increased oil stockpile levels in the US and an easing of political tensions in Egypt. Soft commodity prices continued to rise though on ongoing global supply disruptions. Softer commodity prices also weighed a bit on the Australian dollar.

What to watch in the week ahead?

• In the US, the focus will be on retail sales for January (due Tuesday) which are expected to record a modest rise but are subject to greater than normal uncertainty due to the impact of snow storms. Housing starts and permits data due will be watched closely for signs the housing sector has bottomed. While headline inflation in the US is likely to have been boosted by higher food and energy prices in January, core inflation is likely to remain benign supporting the Fed’s assessment that monetary policy should remain easy.
• In China the focus will be on inflation data for January (due Tuesday) which are expected to show a rebound to around 5.4% (from 4.6% in December) as a result of another weather related boost to food prices. Property price data for January is likely to show another slowdown in residential property price growth to around 5.5%, from 6.4% in December.
• In Australia, the minutes from the Reserve Bank’s February policy meeting and a speech by Assistant RBA Governor Lowe are likely to confirm the rates on hold for now but with a tightening bias message. Meanwhile, housing finance for December (due Monday) is likely to leave intact the impression that housing finance has stabilised after an earlier fall. January car sales data (Wednesday) may attract greater than normal attention as it may be depressed as a result of the floods.
• In Australia, the December half earnings reporting season will continue with about 60 major companies due to report including AXA, Brambles, BHP Billiton, CSL, Westfield, Qantas and Fortescue. The results are likely to continue to reflect the two speed Australian economy with resources and related stocks doing very well on the back of the surge in commodity prices but non-bank industrials likely to be much more constrained and at risk of further earnings downgrades reflecting the slowing housing and retail sectors and the strong $A.

Outlook for markets

• After months of strong gains globally, and with measures of investor sentiment running at high levels and February normally being a soft month, the risk of a short term correction or consolidation in share markets is high. However, any pullback in shares should be seen as a buying opportunity as the fundamental backdrop for shares is very positive. Valuations are reasonable, the global economic recovery is looking stronger, the global liquidity backdrop is very favourable with very low interest rates in key countries, the corporate sector is cashed up, and investors are only just starting to switch from bond funds into share funds.
• The broad trend in the $A is likely to remain up as the US dollar and the euro remain under downwards pressure, interest rates in Australia remain relatively high, and high commodity prices keep the terms of trade near early 1950s highs. By year-end, the $A is likely to have reached $US1.10.
• The risk of a sharp back-up in global bond yields this year is very high. Bond yields in key advanced countries are still below longer-term sustainable levels and bond funds are now starting to see outflows.

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• The Reserve Bank Governor has delivered the clearest message yet that interest rates are on hold for some time. The tone and comments from the testimony is consistent with CommSec’s view that the cash
  rate will remain on hold until at least mid-year and possibly even longer.
• “I’m fairly content with where we are at the moment, We are in a good position. We are ahead of the game which is where you want to be and that’s the thing that affords you periods of sitting, waiting and watching and sometimes they can be reasonably lengthy periods of time.”
• The key focus for the Reserve Bank is massaging the domestic economy through the unprecedented terms of trade boost that is currently taking place. The Governor admitted that “it is a difficult environment for retailers. But not entirely unwelcome in the current circumstances” given it would be harder to avoid the economy overheating if all sectors of the economy were firing.
• The Governor anticipated that the impact of the floods and cyclone will result in the inflation rate rising to “around 3 per cent in the June quarter”. However “These effects should begin to reverse in the second half of the year and should have largely dissipated by the end of 2011.”

What does it all mean?

• The Reserve Bank Governor has delivered his clearest statement yet that interest rates are on hold at least until mid year and possibly even longer. There wasn’t anything that was overly new in the Reserve Bank Governor’s commentary compared with what was released last week’s Monetary Policy Statement. Rather his comments today provided more clarity and reinforced our view that interest rates are solidly on hold in the near term – especially given that over the medium term inflation is well contained. Financial markets are not pricing in a rate hike in the near term and interestingly the Reserve Bank Governor did point out that he is “not particularly seeking to dissuade people from that view.”
• The clear sense from today’s testimony to the Parliamentary Economics Committee is that Reserve Bank officials are extremely comfortable with current settings. Interest rate settings are tighter than normal, but about right for the times. Prices may go up as a result of the floods, but the Reserve Bank thinks this will just be temporary. And while unemployment is low, the perception is that businesses aren’t finding it overly difficult to find workers at present.
• In the jargon, the Reserve Bank Governor has delivered an extremely “dovish” testimony – that is, Governor Stevens has ruled out interest rate hikes, saying that he is “fairly content with where we are at the moment.”
• The Reserve Bank remains quietly confident that the Australian economy is on a sustainable recovery path but the key is ensuring that growth remains robust while keeping inflation remains in check. The focus for the central bank is clearly the “once in a century” boost to the terms of trade – largely driven by higher iron ore and coal prices – and the resulting impact on the economy. In fact it may just be that the Reserve Bank has underestimated the increase in Australia’s terms of trade, with the Governor saying that:“it is higher than assumed three months ago and look like they will peak higher and later than we had previously assumed.”
• There is certainly no perception that the Reserve Bank maintains either an overly optimistic or overly pessimistic view. The Reserve Bank officials basically believe that they have settings right to handle future challenges – be it the impact of the floods, high terms of trade, tight job market or rising global commodity prices.
• While acknowledging that there has been a big change in household behaviour toward greater conservatism, RBA officials are unsure how long the trend will last for. Effectively people have been handed a huge fright from the global financial crisis and they are still adjusting. But while this makes it harder for retailers, from a broader economy-wide perspective it is not a bad thing that consumers are more conservative on spending and borrowing.

Key excerpts of the Reserve Bank officials’ testimony

Interest rate outlook

• “I’m fairly content with where we are at the moment, We are in a good position. We are ahead of the game which is where you want to be and that’s the thing that affords you periods of sitting, waiting and watching and sometimes they can be reasonably lengthy periods of time.”

Tightening of job market

• Stevens & Lowe both rejected suggestions that the labour market was tightening markedly. From RBA liaison, both indicated that mining firms were finding it more difficult to find staff but for businesses generally it was “not particularly hard to find workers at present”. Both said there isn’t the same sort of aggressive bidding for staff as there was back in 2007.

Inflation expectations

• The Reserve Bank Governor is confident that the floods-induced lift in fruit and vegetable prices shouldn’t lift inflationary expectations. The RBA will seek to ensure that people’s expectations of inflation don’t go up. Stevens: “I think we have a pretty good chance of doing it”.
• “It is worth recording that a combination, on the latest figures, of a 5 per cent unemployment rate and an inflation rate clearly ‘in the 2’s’ is a pretty favourable one by the standards of recent decades.”

Commodity Prices

• “Managing these pressures (rising commodity prices) is shaping up as one of the major international economic policy challenges of 2011.”

Terms of trade

• “Australia’s terms of trade are higher than assumed three months ago and look like they will peak higher and later than we had previously assumed.”
• …”we are experiencing a terms of trade event of very large size, of the type that happens only once or twice in a century. Our job is to try to manage this so as to avoid, as far as possible, the instability that has accompanied most previous such episodes.”

Cautious behaviour of households

• “This is quite a difficult environment for retailers. But from a macroeconomic point of view, perhaps it is, on balance, not entirely unwelcome in the current circumstances. If consumption were to boom at the same time as we try to expand the resources sector, upgrade urban infrastructure and increase our pace of housing construction to house a growing population, it would be harder to avoid the economy overheating.”
• “The simple story is that households have had a terrible fright. They have learnt – guess what – housing prices can fall and that having a lot of debt can be dangerous and that not saving anything out of your current income on the assumption that asset values going up is going to take care of your saving for you is possibly not a sustainable strategy and so they are changing behaviour, seeking to get debt down and so on and save more.”

Impact of floods and Cyclone Yasi

• “The result of this is likely to be a temporary rise in the CPI inflation rate, to around 3 per cent in the June quarter. This is higher than the figure in the Statement because the impact of Cyclone Yasi could not be included in that forecast. The combined contributions to this outcome of all the summer flooding and the cyclone add up to about half a percentage point or a little more. These effects should begin to reverse in the second half of the year and should have largely dissipated by the end of 2011.”

Medium-term outlook

• “Assessment of medium term outlook wouldn’t be overly different than what was discussed at the Board meeting.”

Inflation & unemployment

• “It is worth recording that a combination, on the latest figures, of a 5 per cent unemployment rate and an inflation rate clearly ‘in the 2’s’ is a pretty favourable one by the standards of recent decades.”

Monetary Policy Outlook

• “So, overall, financial conditions are on the firm side. In view of the general outlook that I sketched at the beginning, that seems to us to be appropriate. Having reached that position in a fairly timely fashion, the Board has judged it to be sensible of late to leave the cash rate steady.”
• Financial markets don’t assume a near-term rate hike: “I’m not particularly seeking to dissuade people from that view.
• “It’s about right for them (monetary policy settlings) to be where they are.”
• “ I think the current level (of cash rates) is about right for the medium-term”
• “The medium-term outlook is similar to last meeting.

State & Federal debt

• Stevens rejected suggestions that an increase in federal and state debt levels was complicating monetary policy decisions.
• “The question really is the availability of real productive resources to do the work.”
• Stevens rejected suggestions that Australian interest rates were too high – historically or globally.
• “The presumption that lower interest rates is always better I don’t think is right.”
• Stevens noted that our rates were “about normal” while rates in other advanced economies were still much lower than normal.

Wages

• On wages, Stevens noted that 3.5 per cent annual wage growth “is not inflation break-out territory”. “If it stays there I don’t think we have a problem with overall price pressures.”
• Stevens notes that the RBA expects the unemployment rate to ease over the next couple of years and that is expected to see wages lift modestly as well as underlying inflation.”

Tightness of policy

• Stevens says that the financing costs faced by borrowers including interest rates, charges and margins are “slightly higher than the 15-year average”. Stevens estimates that the estimate of “slightly higher” is around 50 basis points

Bank rates & margins

• Both Stevens & Battellino have rejected suggestions that bank competition has been insufficient to keep down rates and margins.
• Stevens: “There’s a lot of competition in the banking space it’s in the area of raising money in deposits and so on.”
• Battellino: “The key point is that the net interest margins of banks hasn’t really changed in the past five or six years.”
• “The return on equity of banks is actually lower than what it was a few years back.

November rate hike

• “I think it was the right call.”

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• The Westpac/Melbourne Institute index of consumer confidence rose modestly in February following the sharp slide in January. The index rose by 1.9 per cent to 106.6 in February.
• In trend terms confidence levels have been falling for the past five months and are holding at the lowest levels in 20 months.

What does it all mean?

• The improvement in the latest consumer sentiment reading is certainly a welcome sign, particularly considering the sharp slide in the prior month. The modest bounce in sentiment levels can be put down to a whole host of factors but the receding floods, and cyclone Yasi avoiding significant damage in major population centres, would have to be the key drivers.
• The destruction wreaked by the floods and cyclone no doubt had a profound effect on all Australians. However given the backdrop of a stronger Australian dollar, rising equity markets, sliding unemployment and the Reserve Bank leaving interest rates on hold, it could be argued that sentiment levels would have jumped sharply had the natural disasters not taken place.
• Overall it’s hard to argue that sentiment levels are upbeat or buoyant at present, especially when you look at the raw data across gender, with both male and female respondents actually noting a slide in sentiment levels. Even across the three age categories sentiment levels fell by an average of 3.5 per cent. The seasonality of the data seems to be the clear driver of the latest improvement. Even in trend terms confidence levels have been falling for the past five months and are holding at the lowest levels in 20 months.
• Looking forward retailers will still need to discount in the near term but it is likely that the worst is behind – especially for some of the Queensland retailers. The other good news is that it is looking more likely that the Reserve Bank Board will be sitting on its hands until mid 2011. Interest rates are already modestly restrictive and there are good grounds to argue that the last move to a tighter monetary policy was a little premature. The Reserve Bank would be best served by allowing confidence and spending to repair. The strength in the labour market is also a positive and likely to drive spending in the midterm.

What do the figures show?

Consumer sentiment

• The Westpac/Melbourne Institute index of consumer sentiment rose by 1.9 per cent in February to 106.6 after sliding by 5.7 per cent in January. The index is now down 8.9 per cent on a year ago.
• The current conditions index fell by 1.2 per cent, while the expectations index rose by 4.1 per cent.

• Four of the five components of the index rose in February:
  • The estimate of family finances compared with a year ago fell by 4.4 per cent;
  • The estimate of family finances over the next year rose by 1.4 per cent;
  • Economic conditions over the next 12 months was higher by 1.1 per cent;
  • The measure of economic conditions over the next five years rose by 10.2 per cent;
  • The measure on whether it was a good time to buy a major household item edged up by 0.8 per cent.

What is the importance of the economic data?

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

What are the implications for interest rates and investors?

• The rate hikes over the past year are having a profound impact on consumer spending patterns. The housing sector is cooling while businesses continue to highlight weak trading conditions. CommSec believes that the next interest rate hike is unlikely to take place until mid 2011.
• Looking forward, it is clear that Aussie consumers are holding on to their conservative attitudes and any further talk of rate hikes will be detrimental to modest improvements in levels. Interest rates need to remain on hold for an extended period to tempt consumer to part with their cash.
• Retail discounting will continue to be a theme in coming months to generate consumer buying interest. However the outlook for retailers is likely to modestly improve as construction activity levels pick up. In particular the massive rebuilding phase that will take place in Queensland will boost spending across an array of sectors.
• Our retail equity analysts have reiterated the buy recommendation on Myer. “The stock is now trading at a around a 20 per cent discount to the ASX200 industrials compared to the retail sector and at a 15 per cent discount to market and is now reasonable value on the downgraded earnings base.”

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