• Share markets had a rough week weighed down by a combination of worries about the Fed, tough action against US companies seeking to reduce their tax by relocating outside the US, worries about Chinese growth, geopolitical concerns and worries about the loss of breadth in the US share market rally. The poor global lead, falling iron ore prices and the retreat of foreign investors to the sidelines saw the Australian share market give up its gains for the year. Weakening share markets saw bonds rally across the board suggesting in part that investors fear that talk of US rate hikes is premature. The outlook for relatively tighter monetary policy in the US versus other major regions saw the US dollar continue to rally, leaving it up nearly 7% over the last three months, and this is also weighing on commodity prices. The falling iron ore price and the rising $US saw the $A continue its slide.
• Geopolitical threats are continuing. While the global threat from the Ukraine conflict seems to be receding a bit, the conflict with IS in the Middle East is hotting up bringing with it the threat of global terrorist activity. So far global oil supplies are not under threat, with the oil price running below the levels when IS in Iraq first started hitting the headlines. But increasing prospects for the deployment of ground forces in Iraq by the US and its allies and talk of the terrorist threat are weighing on investor confidence. Terrorist attacks are horrible in terms of their human consequences and there is no doubt that an IS terrorist attack in a western country would be taken badly by share markets. But the experience with various Al-Qaida related attacks (9/11, Bali Bombing, 2005 London bombings, etc) is worth recalling: after an initial negative impact share markets bounced back as it was clear that there would not be a major economic impact and it seemed the effect on markets weakened as the terror threat continued. It only took just over a month for the US share market to recover from its 12% post 9/11 slump and it took the UK share market 1 day to bounce back from its 1.3% fall on the day of the July 2005 London bombings.
• In Australia, the Reserve Bank’s Financial Stability Review expressed concern that the housing market is becoming too speculative and that if left unchecked poses risks to the broader economy for when the property cycle turns back down. As a result APRA has stepped up its surveillance of the banks and given the desire to avoid a rate hike at this point the RBA is discussing with APRA further steps that may be taken to ensure sound lending practices are maintained, particularly with respect to property investors. The focus looks like it may be on tougher capital requirements and interest rate tests banks apply when assessing new loans rather than restrictions on loan to valuation ratios. It’s likely that if the property market does not soon cool an announcement could be made in the next few months. To the extent that the use of macro-prudential controls might delay the first rate hike further into 2015, it could be good news for existing home borrowers.
• The term “macro prudential controls” is really just the latest buzzword for the failed credit rationing policies used prior to the 1980s. The RBA would be well aware of the risk of unintended consequences – eg, the potential impact on first home buyers many of whom are investors these days and in forcing borrowers into the shadow banking system – but it no doubt feels such controls are better than raising interest rates right now.
• The Australian dollar is continuing to slide helped by an ascendant US dollar, the continuing slide in the iron ore prices (now down 41% year to date) and the possibility that the use of macro-prudential controls to slow the housing market will further delay the first rate hike in Australia. Comments by Reserve Bank of NZ Governor Wheeler that the level of the $NZ was “unjustified and unsustainable” also helped as they apply just as much to the level of the $A. I remain of the view that by year end the $A will have fallen through the January low of $US0.8660 on its way to around $US0.80 over the next year or so. A lower $A will help rebalance the economy.

Major global economic events and implications

• US economic data remains mostly strong. While existing home sales surprisingly fell in August new home sales surged to a six year high, the Markit PMIs for September remained solid and durable goods orders continue to trend higher. While Fed officials are continuing to provide mixed messages on the timing of rate hikes its noteworthy that a couple of hawks will not be voting members at the Fed next year and so their calls for an earlier move by the Fed should be ignored. Our view remains that the Fed won’t start raising rates till around the June quarter, but the 7% gain in the $US since June has probably not been lost on Janet Yellen who would be thinking its delivering a de facto monetary tightening.
• Eurozone PMIs continued to edge down in September leaving them at levels consistent with only modest growth and ECB President Draghi described the recovery as losing momentum. There was a slight improvement in money supply and credit momentum, but not enough to allay the mounting pressure on the ECB.
• A slight fall back in Japan’s manufacturing conditions PMI for September was disappointing but leaves in place a gradual recovery after the April tax hike induced fall. Japanese core inflation excluding the impact of the tax hike is continuing to run around 0.5% year on year, which is better than deflation but not much of a buffer really. The latest leg down in the value of the Yen should help provide a further boost to inflation though.
• While Chinese officials continue to indicate there won’t be any major policy stimulus, it’s worth noting similar comments were made earlier this year before various mini-stimulus measures were introduced. An unexpected slight rise in the HSBC flash PMI for September helped relieve Chinese growth fears a bit.

Australian economic events and implications

• In Australia, job vacancies fell slightly over the 3 months to August according to the ABS but this followed  a 5.3% gain over the previous six months and skilled vacancies rose in August for the 11^th month in a row so the basic picture remains one of forward looking indicators pointing to stronger jobs growth ahead.

What to watch over the next week?

• In the US, the main focus will be on the ISM manufacturing and services indexes (due Wednesday and Friday respectively) which are both expected to remain strong and employment data (Friday) which is expected to show a 210,000 gain in payrolls for September and unemployment unchanged at 6.1%. Consumer spending data (Monday) is also expected to show that the Fed’s preferred inflation measure remained benign with a fall to 1.4% year on year.
• In the Eurozone, business confidence data (Monday) is likely to have weakened a bit further and September inflation (Tuesday) is likely to be just 0.3% year on year. Despite this, the ECB (Thursday) is unlikely to announce further monetary easing but may provide details of its proposed QE program involving asset backed securities.
• Japanese data for jobs, household spending, industrial production, labour cash earnings and housing starts due Tuesday will be watched for signs of further improvement following the impact of the April sales tax hike, but the September quarter Tankan business survey (Wednesday) is likely to have weakened slightly.
• In China, the official PMI (Wednesday) is likely to be little changed from the 51.1 reading for August.
• In Australia, given the RBA’s concern about the property market, credit data (Tuesday) and RP Data house price figures (Wednesday) for September may see greater than normal interest. Expect to see overall credit growth remaining modest but interest will be on whether growth in credit going to property investors accelerated from the roughly 10% annualised pace seen over the last few months. RP Data is expected to show that house price gains remained strong in September. Meanwhile, expect a modest gain in retail sales (Wednesday), a renewed deterioration in the August trade deficit (Thursday) and solid building approvals (also Thursday).

Outlook for markets

• Shares remain at risk of further short term weakness particularly ahead of the end of US quantitative easing next month, the US mid-term elections in November and as we are still in a seasonally weak part of the year for shares. Australian shares are also vulnerable in the short term to further falls in the iron ore price and as foreign investors stay on the sidelines as the $A falls.
• However, this is likely to be nothing more than a healthy correction, allowing shares to let off a bit of steam, and should be seen as a buying opportunity as the cyclical bull market in shares likely has further to go. We still don’t see the signs of shares being over valued, over loved and over bought normally seen at major market tops. Valuations remain okay, global earnings are continuing to improve on the back of gradually improving economic growth, global monetary conditions are set to remain easy and there has been no sign of investor euphoria.
• Although the falling $A is initially a drag on the Australian share market as foreign investors retreat to the sidelines, after a while it will start to become a source of support as it flows through to upwards revisions to earnings expectations. Roughly speaking each 10% fall in the value of the $A boosts company earnings by 3%.
• Low bond yields will likely mean soft returns from government bonds, particularly as we continue to edge closer to the start of a gradual interest rate tightening cycle in the US.
• The combination of soft commodity prices, the likelihood the Fed rate hikes before the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. Expect to see it fall to around $US0.80 in the next year or so.

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

———–

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.

The post Weekly market & economic update – week ending 26 September, 2014 appeared first on AdviserVoice.

• Share markets were mixed over the last week with Eurozone shares up on the ECB’s monetary easing and talk of a ceasefire in Ukraine, Japanese and Chinese shares up but US shares down partly on worries that strong data might bring forward a Fed rate hike and Australian shares down. Bond yields mostly rose, but yields in peripheral Eurozone continued to slide. The ECB easing saw the euro continue to slide with the rising $US weighing on commodity prices, but the $A remaining stubbornly strong despite a sliding iron ore price.
• ECB announces quantitative easing (QE). In response to poor growth and the rising risk of deflation the ECB eased more than expected in announcing a 0.1% cut to its official interest rate taking it to just 0.05% and that it will begin buying asset backed securities with the aim of expanding its balance sheet by €1 trillion. The ECB won’t announce the details of its asset buying program till next month, but by indicating it will include mortgage backed securities and covered bonds it has effectively allowed a much larger scale program. It’s not US style QE as the ECB will not be buying government bonds (at this stage anyway), but it will have the same effect in pumping cash into the economy, displacing investors from relatively low risk investments and forcing them to take on more risk which will lower the cost, and improve the availability, of funding throughout the economy. And its latest rate cut will lower the cost of cheap four year funding for the banks to just 0.15% pa. Will it work? It will certainly help, particularly all the talk of money printing will head of a deflationary mentality taking hold.
• Ukraine is not over yet. While there was a bit of hope regarding a possible cease fire in Ukraine, this may be Russia’s attempt to look constructive ahead of a NATO summit. At this point the two sides still look far apart and so it’s too early to get optimistic. There are essentially three scenarios worth considering for investors regarding Ukraine. First a peaceful resolution soon, which would probably see Ukraine stay out of the EU and NATO to appease Russia. Second, an escalating war between Ukraine and Russia. Third, an escalating war that draws in direct military involvement from the West led by the US and Europe. Of these: the first would be a minor positive for global share markets but would quickly be forgotten; the second would be a source of volatility but like now would only be a major issue if sanctions get ramped up, but would ultimately not derail the global economic expansion; and the third would be a major concern for the global economy and hence could see a sharp fall in share markets. However, the chance of third scenario occurring – ie direct conflict between the West and Russia occurring is very low. The West may respond with escalating sanctions and NATO sabre rattling but it’s very unlikely to engage in anything approaching direct conflict with Russia for the same reason it didn’t through the Cold War (ie Russia is a nuclear power). So we remain of the view that Ukraine will likely remain a source of uncertainty for investors (and slower growth for Europe), but it’s unlikely to derail the global economic expansion.
• In Australia, there was nothing new from the RBA which left interest rates on hold for the 13th month in a row and reiterated that a period of stability remains prudent with this message effectively backed up by a speech by Governor Stevens. Right now the uncertainty around the economic outlook and the strong $A preclude any thought of a rate hike, but by the same token signs the economy is responding to lower rates and the risk of boosting financial risk and house prices preclude rate cuts.
• Meanwhile, there seems to be lots of doom and gloom on Australia lately with talk of the economy in the “danger zone” and even ads on my iPad apps screaming “Australian recession 2014 – why it’s unavoidable…” This is way over the top! Sure the fall in commodity prices and specifically the iron ore price is a blow to national income. But thankfully lower interest rates are helping to drive a bounce back in the sectors of the economy like housing and retailing that were suppressed by the mining boom. And there is still plenty of scope for interest rates to fall further if needed and for the Australian dollar to fall, which I think it will over time, providing a shock absorber for the economy. But the real story on the Australian economy – as evident in the data seen over the last week – is that the shift back to a more balanced economy is proceeding.
• It’s been a somewhat messy week for policy making in Australia. The mining tax hit the dust, but the increase in the super levy has been delayed yet again, leaving likely super retirement savings inadequate for most workers needs and there’s talk of a fund to bailout failing companies. While the latter is nice in theory, in practice such government intervention rarely works, so hopefully the Government will reject it.

Major global economic events and implications

• US economic data was pretty solid with the ISM indexes rising to very strong levels, construction activity and auto sales rising solidly and labour market indicators remaining strong. This is all keeping alive the prospect of a Fed rate hike coming earlier than mid next year.
• In Europe, economic news was mixed with a downwards revision to August PMIs albeit to levels still consistent with modest growth but a sharp rebound in German factory orders.
• The Bank of Japan made no changes to its super stimulatory monetary easing program. But there was good news on the economic front with nominal cash wages up 2.6% over the year to July suggesting wages growth and inflationary expectations are responding to the BoJ’s campaign to end deflation.
• Chinese economic data was mixed with the manufacturing conditions PMI for August falling back a bit, but services conditions PMIs strengthening suggesting that overall growth remains okay.

Australian economic events and implications

• The avalanche of economic data in Australia over the last week painted a reasonably hopeful picture for the economy. Sure the ongoing slide in the terms of trade is a blow and growth slowed in the June quarter, but the growth slowdown was nowhere near as bad as many feared and there are clear signs of improvement in the non-mining economy. Given that the main reason for the slump in quarterly growth from 1.1% in the March quarter to 0.5% in the June quarter relates to volatility in exports and imports it makes sense to average the two quarters which gives 0.8% quarter on quarter or 3.2% annualised, which is a pretty good outcome given the circumstances. More fundamentally, July data for retail sales point to a bounce back in consumer spending growth in the current quarter, the trade deficit also improved in July suggesting that net export volumes are likely to bounce back and continued strength in building approvals points to ongoing growth in dwelling construction.
• The June quarter National Accounts also included a couple of long term positives for Australia. First, productivity growth is solid at 3.2% year on year in the market sector, which will help minimise the hit to living standards from the fall in the terms of trade. Second, the household saving rate remains strong at 9.4% indicating households have a good buffer against shocks to income and are continuing to improve their net debt position.

What to watch over the next week?

• In the US, August retail sales data (Friday) are expected to show modest growth after the disappointingly flat outcome for July. This is likely to be supported by a further lift in consumer confidence (also Friday).
• In China, the focus will be on data releases for August. Expect trade data (Monday) to show exports up 10% and imports up 4%, lending and credit data to show a bit of a bounce back after weakness seen in July, CPI inflation (Wednesday) falling back to 2.2% year on year and slight moderations in growth for retail sales, fixed asset investment and industrial production (Saturday).
• In Australia, expect ANZ job ads (Monday) to show a further trend gain, housing finance (Tuesday) to rise 1%, the NAB business confidence and conditions measures (also Tuesday) to remain around the reasonably solid levels seen in July, consumer confidence (Wednesday) to show a further slight improvement and employment to show a 10000 gain with unemployment falling back to 6.3% after July’s partly statistical spike.

Outlook for markets

• While shares have seen a strong recovery from the early August mini-slump, the correction season consistent with the old adage “sell in May, go away and come back on St Leger’s Day” is still upon us with September historically being the weakest month of the year for US shares and the September-October period often being tough in Australia.Relatively high short term optimism readings in the US also warn of the risk of a correction and there is no shortage of potential triggers including worries about the Fed and Ukraine.
• However, despite the risk of another correction the cyclical bull market in shares likely has a lot further to go as we still don’t see the signs of shares being over valued, over loved and over bought normally seen at major market tops.Valuations remain okay particularly once low interest rates and bond yields are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In fact, in terms of the latter there still seems to be a lot of wariness regarding shares.
• Low bond yields, eg 10 year yields of just 0.5% in Japan and 3.4% in Australia, will likely mean soft returns from government bonds.
• The combination of soft commodity prices, the likelihood the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. Expect to see $US0.80 in the next few years, but getting the timing right is hard.

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

————

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.

The post Weekly market & economic update – week ending 5 September, 2014 appeared first on AdviserVoice.

• The past week has seen shares and growth related trades rally strongly as the US budget crisis came to an end. As a result, all of the major policy and geopolitical threats facing investors a couple of months ago – Syria, Italy, the German election, the Fed’s taper decision, the replacement of Bernanke at the Fed, the US fiscal threats – have been consigned to the rear view mirror for now, clearing the way for further gains in share markets and other related trades into year end.
• While the budget and debt ceiling deal in the US is only a temporary solution – funding the Government out to January 15 pending agreement on a new budget and raising the debt ceiling out to February 7 – it would be wrong to expect a re-run of the latest budget fight early next year. The odds are that Republicans, who got most of the blame, will not want to push things too hard next year as it is a mid-term election year and they risk losing control of the US House of Representatives.
• Overall, the decision to end the US budget impasse is good news. Its shows that when push comes to shove US politicians will do the right thing (which is another reason not to be too fearful of the deadlines early next year), it means the impact of the shutdown on US growth once workers get back pay and government spending plays catch up will be minor and a threat to global economic growth has been averted. In short, the global economic recovery can continue and this is positive for growth assets. The increased likelihood that the Fed will delay tapering its monetary stimulus into early next year only adds to the positive investment back drop.
• The US debt ceiling debacle has seen the usual calls to “de-Americanise” the world. Sure the events in the US of the last few weeks were not great. But which other major countries don’t have their own policy imperfections (usually worse)? Europe was painfully slow in bringing its crisis under control, Japan took 20 years to get serious about fixing its problems, Russia has actually defaulted in the past and while China has no problems with democracy that’s only because it’s not a democracy.

Major global economic events and implications

• US economic data was a bit soft, possibly reflecting the impact of the partial Government shutdown. The New York and Philadelphia regional manufacturing conditions surveys both slipped in October, new mortgage applications fell, initial unemployment claims remained elevated and the NAHB home builders’ conditions index slipped. However, the damage looks to have been minor and its worth noting that the fall in the Philadelphia manufacturing index was trivial with several components actually rising, unemployment claims are likely to fall as Federal public servants return to work and the fall in the NAHB index just looks like normal volatility with the broad trend remaining up strongly. So overall expect the shutdown to knock about a bit off December quarter GDP growth but not enough to derail the economic recovery.
• The US September quarter profit reporting season is looking good. Out of 100 S&P 500 companies to have reported so far 70% have exceeded earnings expectations and 55% have exceeded sales expectations.
• In Europe, industrial production rose in August although but a bit less than had been hoped for, investment analyst sentiment rose and car sales rose the most in over two years
• Chinese data presented a pretty benign picture with September quarter GDP growth bang in line with expectations at 7.8% year on year, up from 7.5% in the June quarter, and healthy gains in September data for retail sales, industrial production, fixed asset investment and electricity production. While a slight loss of momentum in the September data suggests that GDP growth will slow a touch in the current quarter the strength in money supply and lending growth suggest growth will remain solid. Overall growth for 2013 looks like coming in around 7.7% which is slightly above the official 7.5% target. While inflation rose in September, this was mainly due to higher food prices with non-food inflation benign at just 1.6% year on year.
• India continues to disappoint with inflation rising in September making it hard to justify any central bank monetary easing despite recent weak industrial production data.

Australian economic events and implications

• In Australia, the RBA reinstated its easing bias in the minutes from its last meeting after appearing essentially neutral on the rate outlook in its last post meeting statement. This has been the pattern over the last 3 months now leading one to wonder whether the RBA has become schizophrenic. What is clear though is that the RBA feels no urgency to act on its easing bias. In fact our view remains that with various domestic indicators showing signs of responding to past rate cuts the RBA will remain on hold ahead of the next move being a rate hike, but not till around next September/October.
• While it’s not our base case one factor that could bring on another rate cut is a continued strong rise in the $A, say back above parity. The RBA would prefer a lower currency with Governor Stevens commenting Friday that “a lower currency would be helpful”. This didn’t stop it rising to $US 0.9676 on Friday night though.
• On the data front housing finance fell in August but the trend remains up and finance for construction rose strongly. This all suggests the housing recovery remains on track.

Major market moves

• Share markets surged higher as the US budget crisis came to an end. US shares rose 2.4%, Eurozone shares gains 2%, Japanese shares rose 2.6% and Australian shares gained 1.7%. The rally in shares over the last week as the US budget crisis came to an end has been very impressive: US shares have broken out to new record highs, global and Australian shares have surged to new cyclical highs and the gains have come on good volumes and breadth. In other words the rally has good support from investors searching for higher returns than is available from cash. This all points to further gains ahead.
• While the oil price fell, most commodity prices gained on the back of the ending of the US budget crisis and the fall in the $US, partly on the back of an increasing likelihood that Fed tapering will be further delayed. This saw the $A rise strongly, pushing towards $US0.97.
• Bond yields also fell, but particularly in the US as the small risk of default was priced out. Credit spreads narrowed further.

What to watch over the next week?

• In the US the highlight is likely to be the delayed September employment report now due to be released on Tuesday which is expected to show a 185,000 gain in payrolls and unemployment holding at 7.3%. In terms of other data, expect a slight fall back after strong gains in August for existing home sales (Monday) and new home sales (Thursday), a continuing gain in house prices (Wednesday), a fall in the Markit manufacturing conditions PMI (Thursday) reflecting the impact of the Government shutdown and debt ceiling uncertainty and a soft final reading for October consumer sentiment (Friday). Durable goods data due to be released Friday may be delayed because of disruptions to data collection due to the shutdown.
• The US earnings reporting season for the September quarter will continue. Consensus expectations for 2% growth year on year are likely to be surpassed after the usual upside surprise and come in around 4 to 5%.
• In the Eurozone, preliminary business conditions PMIs (Thursday) will be watched for a continuation of the rising trend evident over the last year or so.
• Japanese inflation data (Friday) is likely to show further signs of a return to inflation.
• The October HSBC flash manufacturing PMI for China will be released Thursday and is likely to show that growth has stabilised or maybe even slowed a notch rather than continued to accelerate.
• In Australia, September quarter inflation data is likely to show a sharp rise in the quarter of 0.8% reflecting a 6% rise in petrol prices due largely to the mid-year fall in the $A, but because the impact of the start of carbon pricing a year ago will drop out the annual rate of inflation will fall to around 1.8%. Despite these gyrations the underlying measures are expected to show a quarterly increase of 0.6% as pricing power remains weak and annual inflation of just 2.2% year on year indicating that inflation remains benign and is certainly not a constraint to further monetary easing if that proves necessary.

Outlook for markets

• The ending of the US budget crisis has cleared the way for shares to have a solid rally into year end with further gains next year. Share market valuations remain reasonable, monetary conditions are set to remain easy and profits are likely to improve next year as global and Australian growth picks up. Australian shares look on track to hit 5500 or even higher by year end, with a little help from a Santa rally.
• Government bond yields are likely to resume a gradual upwards trend as the global economy continues to pick up momentum and as Fed tapering eventually comes back into focus either later this year or early next. Low yields and an unwinding of years of massive inflows point to poor sovereign bond returns ahead.
• Signs that Australian interest rates are bottoming, a delay in Fed tapering, stable growth in China and improving global growth at a time when short $A positions remain extreme suggest that in the months ahead the $A is likely to see more upside, probably up to around $US0.98, before the medium term downtrend resumes.

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

——–

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

The post Weekly market & economic update – week ending 17 October appeared first on AdviserVoice.

Key points

• Rising inflation is becoming a major concern in Asia and other emerging countries. So far it’s largely due to higher food prices. Non-food inflation remains reasonably benign.
• However, with strong growth having used up excess capacity and monetary conditions remaining easy, a flow on to higher non-food inflation is a growing risk.
• As such, expect further monetary tightening in Asia and the emerging world.
• This is positive for Asian and emerging country currencies generally, but is likely to continue to act as a dampener on emerging market (EM) shares relative to traditional global shares over the next six months.
• However, our cautious short term stance on EM shares doesn’t alter their favourable longer term outlook.

Introduction

Rising inflationary pressures in Asian and emerging countries are clearly starting to worry investors. Many are fretting policy makers in these countries will be forced to tighten aggressively, threatening a key driver of the global recovery and the performance of share markets in the emerging world. These concerns are most evident in China and India. Coming at a time when the US outlook is improving this has seen Asian/emerging market shares underperform developed market shares since November. But how big a threat is it?

Rising inflation so far mainly limited to food

Emerging world inflation is on the rise. So far the main driver has been higher food prices and to a lesser extent higher energy prices. The next chart focuses on Asia, but it’s a similar picture in emerging countries generally.

Source: Bloomberg, AMP Capital Investors

World food prices have now surpassed their 2008 record high largely reflecting adverse weather.

Source: IMF, AMP Capital Investors

While higher food prices have also boosted headline inflation in developed countries, the impact there is much smaller as food has a greater weight in Asian and emerging country CPI baskets than in rich countries. Food has a CPI weight of 31% in Asia and 26% in Latin America compared to 15% in Europe, 8% in the US and 16% in Australia.

Higher energy prices have also played a role but so far non-food price inflation has remained reasonably benign.

Will there be a flow on to non-food prices?

Food price inflation comes and goes. Even though food stockpiles are low, better weather in the year ahead could well see it abate – despite longer term structural forces of rising per capita incomes in emerging countries and bio fuel demand which are positive. So the key issue is whether there will be any flow-on to core inflation? Here the key determinant is the amount of spare capacity as this will determine whether companies have the pricing power to pass on increases in raw material costs and workers have the power to demand higher wages to compensate for food price increases. On this front the risks are rising, albeit from a low base. Output gaps, which show the difference between the level of actual and potential GDP or output, are a good guide to inflationary pressures. Right now they are benign. Output gaps in the emerging world have closed indicating that spare capacity has been used up, but output gaps are not as positive as was the case in 2007 and 2008. See the next chart for Asian countries.

However, if economic growth continues at its current pace, output gaps are likely to become positive leading to increasing price and wages power and potentially a pick up in core inflation over the next two years. The risk is probably greater in Brazil, India and China. Wages growth has been picking up in China and Vietnam, although it’s mainly minimum wages and overall wages growth is still low relative to nominal GDP growth. High capacity utilisation and rising labour costs are already resulting in significant upwards pressure on non-food inflation in Brazil.

Source: IMF, AMP Capital Investors

A major concern for Asia and the emerging world is that monetary policy is still relatively easy. Many countries in Asia have resisted exchange rate appreciation following China’s lead and while interest rates have been increasing because of uncertainty about the strength of the global recovery they have generally not kept up with the increase in inflation. As a result real interest rates remain negative. Relatively easy monetary policy at a time when domestic demand is strong and spare capacity has been used up add to the risk of the uptick in headline inflation flowing into underlying inflation across Asian and emerging countries, as is already occurring in Brazil.

Source: Bloomberg, AMP Capital Investors

What is the likely policy response?

The upshot is that further monetary tightening is likely in emerging countries to head off a broader based inflation threat. Central banks across Asia and emerging markets generally have been tightening but more may be required over the next six months or so. There is also likely to be a greater tolerance for currency appreciation as it will help control food prices and inflation generally.

Fortunately, the inflation threat is not as great as it was in 2007-08 as output is still close to potential and capacity pressures are not as intense (except in Brazil, amongst the majors). The surge in food prices will also act as a bit of a constraint on household spending power. As a result we don’t see the need for monetary tightening to become excessive to the extent it threatens continued growth. Rather what is required is for growth to slow back to more sustainable levels – around 9% in China and 5 or 6% in the rest of Asia.

What are the implications for EM share markets?

While monetary tightening across Asia and EMs generally is unlikely to get so aggressive that it crunches growth, it is still likely to worry investors. As such, further tightening is likely to be a continuing drag on the relative performance of share markets in Asia and the emerging world over the next six months, until it is clear inflation is back under control. This relative underperformance is being accentuated by a somewhat idyllic combination (at least for now) of improving growth, low inflation and easy money in the US and northern Europe right now which is starting to be recognised by investor flows (away from bonds and emerging market shares towards US shares).

It is important to stress though that inflation in Asia is modest by past standards. For example, in China it is now running around 5% compared to the situation in the late 1980s and mid 1990s when it reached 25 to 30%. So while it is a short term concern it is unlikely to threaten the positive longer term outlook for these countries. And finally, from a strategic perspective share valuations in the emerging world are not demanding. EM shares are trading on a forward price to earnings multiple of 11.3 times and Asian shares on 12 times, which is slightly below the global share average of 12.5 times.

What about inflation in developed countries?

Concerns about inflation have also arisen in developed countries but the risks are much lower here. As already noted, food has a much lower weight in developed countries. Secondly, there is still plenty of spare capacity in the US, Europe and Japan. This is evident in unemployment still running around 10% in Europe and the US. Finally, while monetary conditions are very easy in advanced countries, money and credit growth remains very low. So while high food and energy prices may cause occasional inflation scares in developed countries this year, headline and, particularly, underlying inflation is likely to remain benign overall at least for the next year or so.

Source: Thomson Financial, AMP Capital Investors

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Headline developments

• An acceleration in Chinese economic growth in the December quarter to an estimated annualised pace of around 12% along with ongoing inflation worries have reinforced the case for further Chinese tightening in the months ahead. While inflation fell back to 4.6% in December from 5.1% in November this looks like a temporary reprieve with higher food prices this month and the Lunar New Year holidays likely to push inflation back up again in the months ahead. We expect another three interest rate hikes and bank required reserve ratio increases over the next six months. However, there is still nothing indicating that the Chinese are going to crunch their economy. First, while non-food inflation rose to 2.1% in December it is still low. Second, fixed asset investment is already moderating and a further slowing is likely this year as real estate construction slows and stimulus projects complete. Finally, much of the tightening measures we are now seeing are necessary just to mop up the liquidity the Chinese authorities are pumping into their economy to stop a more rapid appreciation in the Renminbi. Monetary conditions are still a long way from being tight. As such, investor fears that China will crunch its economy evident in a 5% or so fall in Chinese shares so far this year coming on the back of a 23% fall last year are overdone. While the Chinese share market may remain vulnerable until tightening stops, Chinese domestic shares are trading on a price to earnings ratio of 18 times which is well below their historic average of 34 times suggesting that a lot of bad news is already factored in.
• In Australia, flooding continues to wreak havoc with now nearly a third of Victoria flood affected. As a result expectations of the damage bill and the hit to economic growth in the March quarter continue to escalate. We now expect the damage bill to property, equipment, infrastructure, etc, to be around $15bn with the floods likely to detract 1% from economic growth concentrated in the current quarter. Fortunately, growth should rebound starting next quarter as the rebuilding effort kicks in and production returns to normal. While the floods will add 0.5% to 0.75% to March quarter inflation, we expect the RBA to look through this and hold off raising interest rates again until it becomes clear that growth is recovering from the impact of the floods. This suggests that interest rates will be on hold out until around May at least.

Major global economic releases and implications

• US data released over the last week remained consistent with an acceleration in the US economy. Surveys of manufacturers remained strong, jobless claims fell sharply and the US leading indicator rose strongly. Housing indicators were mixed with housing conditions flat according to a survey of home builders and housing starts fell due to bad weather but existing home sales rose very strongly. Our overall view remains that the US housing sector has found a base, but its also worth noting that housing activity is now only around 2.5% of US GDP compared to 6% in 2005 so its impact on the US economy is far less than it used to be.
• The US December quarter earnings reporting season got underway in earnest over the last week with 50 major companies reporting. So far 69% of results have come in better than expected including for JP Morgan, Apple and IBM. While upside surprise is down compared to recent quarters this appears to be because analyst expectations have finally caught up to the recovery in earnings with earnings growth estimates for the year to the December quarter already very strong at +32%.
• Japanese economic data was generally upbeat with gains in machine tool orders, a tertiary activity index and Tokyo condominium sales. Against this, consumer confidence fell slightly in December.
• While interest rates are well and truly on hold in key advanced countries, monetary tightening is continuing in emerging countries as part of an effort to deal with inflationary pressures. This is clearly evident in China, Indonesia, Korea and Thailand which all tightened last week but in the past week Brazil also tightened, raising its key policy rate by 0.5%. Inflationary pressures in the emerging world point to further tightening in these countries ahead. So far the increase in inflation is mainly food related so tightening is unlikely to be aggressive but it is worth keeping an eye on.
  Australian economic releases and implications
• Australian economic data was mixed.  New vehicle sales for December rose solidly in December and the TD Securities/Melbourne Institutes’ Inflation Gauge showed significant inflationary pressure in December. But against this, consumer sentiment and skilled vacancies both fell sharply in January, presumably in response to the impact of the severe flooding. Both are likely to rebound once the flood waters subside. While a sharper fall in export prices than import prices implies a fall in the terms of trade in the December quarter, it should be noted that it is likely to rebound this quarter as the flood boosts coal prices.

Major market moves

• Global share markets fell over the past week reflecting a combination of profit taking after strong gains in recent months and worries about the impact of Chinese tightening. While the Australian share market briefly broke out to its highest level since last April, it was knocked back down again in response to a fall back in US shares and worries about the impact of Chinese tightening on commodity demand.
• Worries about the impact of further Chinese tightening also weighed on commodity prices and the $A.
• Bond yields rose as global economic data continued to surprise on the upside.

What to watch in the week ahead?

• In the US, the main focus is likely to be on December quarter GDP data (due Friday) which we expect to show an acceleration in growth to a 3.5% annualised pace after 2.6% annualised growth in the September quarter. US data for consumer confidence (Tuesday) is likely to improve slightly after a soft reading in December, data for new home sales (Wednesday) and pending home sales (Thursday) are likely to rise modestly and durable goods orders (Thursday) are likely to remain solid. Meanwhile, following its meeting on Tuesday and Wednesday the Fed is likely to signal greater optimism about the outlook for the US economy but not enough to warrant any imminent tightening in monetary policy. The December quarter profit reporting season in the US will also continue with 150 or so S&P500 companies due to report.
• Japanese data for inflation, the labour market and retail sales will be released on Thursday.
• In Australia, the importance of December quarter inflation data (due for release on Tuesday) for monetary policy has been somewhat reduced by flooding in Queensland and other states. Increases in prices for food, housing costs and petrol prices are expected to push up the consumer price index by 0.7% in the December quarter pushing the annual rate of inflation up to 3%. Underlying inflation is likely to also rise by around 0.7% in the quarter or 2.5% year on year.

Outlook for markets

• Share markets are vulnerable to a short term correction. After very strong gains since August last year many technical indicators show that shares generally are overbought, measures of investor sentiment are at high levels suggesting that a lot of good news is factored in and the seasonal tendency is for share market strength in December and January to be followed by weakness in February. Further Chinese tightening could be the trigger for a further short term correction in shares.
• However, shares are likely to put in good gains through 2011 as a whole so any short term pullback should be seen as a buying opportunity.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that 2011 is on track for strong economic growth which should in turn drive another year of solid profit growth, the global liquidity backdrop is highly favourable underpinned by very low interest rates in key countries & quantitative easing in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. By end 2011 we see the Australian ASX 200 index rising to 5500, once it shrugs off the current malaise which appears to reflect a combination of worries about the floods and Chinese tightening.
• The Australian dollar is at risk of a further correction in response to ongoing uncertainty about the impact of Chinese tightening on commodity prices and as a result of the negative impact on local growth from the floods. However, the broad trend is likely to remain up as the $US 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 at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels, at some point market expectations are likely to swing back towards monetary tightening in the US and Australia and the record inflows into bond funds seen in recent years are at risk of becoming record outflows. Fortunately, bond yields in Australia are more in line with long term sustainable levels so the risk of a sharp back up in Australian bond yields is less than is the case for global bonds.

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Headline developments of the past week

• Worries about Europe’s debt problems and tightening in China were again key issues for investors over the last week, and had the effect of initially pushing share markets down ahead of a reversal later on as some of the fears receded. Europe seems to be moving pretty quickly this time to try and limit the contagion from Ireland to other European countries – in fact, a bailout package for Ireland from the IMF and European Union looks imminent.
• Concerns about an aggressive tightening in China receded a bit after Chinese authorities announced a range of administrative measures to curb inflation. These involved measures to boost the supply of key foodstuffs, subsidies for low income households, temporary price controls on necessities and a crackdown on speculation. While the merits of price controls can be debated, to the extent that China is relying on targeted administrative measures to control inflation it may help take pressure of blunter less targeted measures such as interest rate hikes. However, Friday’s hike in the banks’ required reserve ratio – the fifth this year – highlighted that macro tightening is still on the agenda. The increase in the reserve ratio is necessary to mop up the increase in the money supply being generated by the current account surplus and the managed exchange rate. We still anticipate a few interest rate hikes and a further increase in the banks’ required reserve ratio going forward, but remain of the view that they will not be aggressive enough to crunch the Chinese economy.

Major global economic releases and implications

• US economic data over the last week was all over the place. Housing starts, weekly mortgage applications and a survey of home builders were all soft – but at least still seem consistent with housing activity having found some sort of bottom. Industrial production was flat and manufacturing surveys were mixed – weaker in the New York region but much stronger in the Philadelphia region. Clearly positive though were weekly jobless claims essentially sustaining the sharp fall seen in the previous week, a fall in mortgage delinquencies in the September quarter and a better than expected rise in a leading index for October. Producer and consumer price inflation both came in on the soft side. In fact, core consumer prices have now been flat for three months in a row and the annual rate was the lowest level every recorded (with data back to 1957). Quite clearly all of this provides support for the Fed’s commencement of QE2 – mixed economic indicators suggest that growth is still too low for comfort and inflation is verging on deflation. It is now more than 18 months since the Fed started QE1 and yet there is no sign of the hyperinflation that many were predicting when it was first announced.
• Meanwhile, a forceful defence of the Fed’s latest round of quantitative easing (QE2) by Ben Bernanke provided confidence that the Fed will not be abandoning it, as investors might have been starting to fear given the heavy criticism it has attracted in both the US and globally since first announced.
• In Japan, the big surprise was a rise in annualised GDP in the September quarter of 3.9% driven mostly by strong consumer spending. However, it is hard to see this pace being sustained as consumer spending falls back and the strong Yen constrains exports.
• The pressure from rising food prices on inflation was also evident in Korea which raised its short term interest rate for the second time since the GFC to 2.5%. Further rate hikes are likely next year.  Meanwhile, GDP growth remained strong in Taiwan and Singapore in the September quarter with both growing around 10% year on year, underlining the continued strength in Asia.

Australian economic releases and implications

• In Australia two things stand out from the minutes from the last Reserve Bank Board meeting and a speech by Deputy Governor Ric Battellino. The first is that the RBA does not see any urgency to raise interest rates again: the November move itself was finely balanced; the over and above rate hikes from the banks were probably more than the RBA expected; housing has slowed and consumers remain cautious; and we have seen a renewed intensification of worries about sovereign debt in Europe. However, the second point is that the RBA still retains an inclination to raise interest rates further. This is clearly evident in Ric Battellino’s comments that the challenge going forward will be to manage the economy in a way that contains inflation in the face of the large amount of money likely to flow into the economy in the next few years as a result of the mining boom and that over the medium term inflation is more likely to rise than fall. So putting it all together while we don’t see the next rate hike coming until February at the earliest, in a year’s time the cash rate is likely to have increased to around 5.5%.
• Over the last week though, Australian economic data provided a messy picture. On the one hand car sales and skilled job vacancies came in on the soft side but on the other wages growth on the RBA’s preferred measure showed further signs of acceleration.

Major market moves

• Global share markets had a roller coaster week, initially falling sharply before recovering some lost ground as a bailout for Ireland seemed to be nearing, worries about an aggressive tightening in China receded a bit, economic data and profit news came in better than expected, the successful General Motors IPO helped boost confidence and Fed Chairman Bernanke provided a strong commitment to quantitative easing. While Asian and Australian shares fell over the week, US shares were flat and Japanese and European shares actually rose. Japanese shares now seem to be benefitting from the weaker Yen.
• It was a similarly rough ride for commodity prices and the Australian dollar with initial sharp falls giving way to some recovery as global growth concerns receded a notch.
• It’s interesting to note that despite the gyrations in growth trades such as share markets over the past week bond yields have moved higher. While this may reflect traders unwinding excessively long positions built up through the mid year growth scare and in anticipation of QE2 it is also consistent with a greater degree of confidence in the global growth outlook.

What to watch in the week ahead?

• In the US, October home sales data are likely to slip back a notch after strong gains in September, September quarter GDP growth is likely to be revised up slightly from the 2% annualised pace initially reported and durable goods orders are likely to have remained solid in October. The minutes from the last Fed meeting may also shed some more light on the thinking behind the Fed’s adoption of another round of quantitative easing.
• Various European business conditions surveys for November will be watched to see how well Europe is holding up.
• In Australia, data on construction spending and business investment will help firm up estimates for September quarter GDP growth to be released on 1st December. Capex spending is likely to show a decent rebound after a fall in the June quarter and capex plans are likely to remain strong. Meanwhile, RBA Governor Glenn Stevens’ testimony before a Parliamentary committee on Friday will be watched closely for more clues regarding the interest rate outlook.

Outlook for markets

• After strong gains since late August, shares were vulnerable to a correction, which we have certainly seen over the last two weeks. While it’s too early to say whether we have seen the bottom or not, we continue to expect solid gains in shares into year end and through next year. Shares are cheap, particularly relative to government bonds, the risk of a double dip back into recession appears to have receded, the global liquidity backdrop is highly favourable underpinned by QE2 in the US and the corporate sector is cashed up which is likely to result in a further pickup in merger and acquisition activity, share buybacks and dividends. In the past week we have seen BHP announce a resumption of share buybacks and Nike increase its dividend payout.
• Notwithstanding normal bumps along the way, the $A is likely to head higher as the $US and the euro remain under downwards pressure, interest rates in Australia continue to trend up, and commodity prices resume their rising trend. It’s likely that the $A will settle around $US1.10 in the year ahead.
• Deflation worries, along with central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

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Headline developments of the past week

• Shares, commodities and commodity currencies like the Australian dollar have had a tough week partly on renewed European debt concerns and worries that further Chinese monetary tightening in response to rising inflation will threaten China’s economy and hence the global recovery.
• European sovereign debt problems have reared their ugly head once again partly triggered by proposals several weeks ago that bond holders should share some of the cost of any debt restructuring and on concern that Ireland will require a bailout. As a result bond yields in Portugal and Ireland reached new crisis highs in the last week, which in turn prompted European leaders to assure existing bond investors that any crisis resolution mechanism that would force bond holders to share the cost of a bailout won’t apply to existing debt and would only apply after 2013. Hopefully, there shouldn’t be as big a flow-on to global financial markets from the latest concerns as there was six months ago because economic indicators are not falling like they were earlier this year and Europe has in place a European Financial Stability Facility which can be tapped by countries in difficulty. Nevertheless, the risk of the latest European crisis sparking a deeper correction in shares and other growth assets is worth watching. At the very least the issue highlights that it’s premature for the European Central Bank to be thinking of exiting its easy liquidity policies. It’s also clear that Europe cannot stand a stronger euro.
• The G20 leaders’ summit failed to come up with anything that will quickly deal with global imbalances and currency tensions. The commitment to move toward market determined exchange rates and to refrain from competitive devaluations is vague enough to allow countries to just continue doing what they have been doing. In particular, the US will feel no compulsion to stop quantitative easing even though it has the effect of pushing down the US dollar and China will feel no compulsion to speed up the appreciation of the Renminbi.  While the G20 gave a green light to capital controls in emerging countries with overvalued flexible exchange rates that are facing strong capital inflows, it is hard to see emerging countries with undervalued managed exchange rates not continuing to apply them as well.
• Of longer term interest the G20 did provide a commitment to develop early warning indicators of economic imbalances. However, while this may be helpful in shifting the focus away from the US-China dispute about the level of the Renminbi it is worth noting that there has been plenty of information around about current account imbalances for years and yet key countries have rarely moved to address them, except when a crisis has erupted. So it’s hard to believe that a new set of indicators will make any difference. So overall, it’s hard to see the outcome from G20 leaders’ summit having any major impact on financial markets. But at least there is one thing to be thankful for and that is that the tensions between countries evident in the run-up to the summit did not spill over into open conflict.

Major global economic releases and implications

• US economic data was generally positive with a rise in consumer sentiment, a further easing in bank lending standards, a slight improvement in small business optimism, another rise in weekly mortgage applications, a fall in weekly jobless claims which took its four week average below the low reached in March and an improvement in the trade deficit in September.
• European data was a bit disappointing with euro-zone GDP growth slowing to 0.4% in the September quarter after a 1% rise in the June quarter. After the unexpectedly strong growth in the June quarter a slowdown was inevitable. While Germany grew by 0.7% Greece contracted by 1.1%. the sluggish recovery in Europe highlights that it too should be thinking of joining the US in quantitative easing.
• UK data was mixed with a rise in industrial production and a positive reading for October retail sales but weak indications for house prices and a Bank of England report which lowered growth forecasts but raised inflation forecasts.
• Chinese activity indicators remained strong, albeit down on growth rates seen late last year or earlier this year, bank lending came in stronger than expected and inflation rose to 4.4% as the authorities announced a further increase in bank reserve requirements and new measures to control hot money inflows. Further interest rate hikes and bank reserve requirement increases are to be expected in order to ensure that inflation expectations remain under control. However, with activity indicators down from the blistering pace seen late last year and non-food inflation running at just 1.6%, additional tightening is likely to remain focussed on fine tuning and mopping up any boost to liquidity from foreign capital inflows as opposed to crunching the economy.

Australian economic releases and implications

• Australian economic data was mixed. Both business and consumer sentiment fell, although both remain above long term averages and consumer confidence virtually always falls after a rate hike often to then bounce back the next month. Against this, housing finance rose slightly and employment saw another month of decent gains. Interestingly the unemployment rate rose, although this reflected new entrants to the workforce which took the participation rate to a new record high. Maybe more Australian’s are returning to the workforce on the back of reports that demand for labour has strengthened.
• Meanwhile the Government released its mid year economic and fiscal review which saw only modest changes to growth and inflation forecasts and little change to budget projections with a return to surplus still expected by 2012-13.

Major market moves

• The last week has seen most share markets fall on worries about Chinese tightening, renewed European public debt worries and lowered earnings guidance from Cisco Systems. After big gains the previous week and double digit gains since late August share markets had become overbought and due for a bit of profit taking.
• European sovereign debt woes also weighed on the euro which fell sharply against the $US. Chinese tightening fears also weighed on commodity prices and the Australian dollar which has fallen back below parity against the $US.

What to watch in the week ahead?

• In the US, data for retail sales, inflation and housing starts will be released along with surveys of manufacturers in the New York and Philadelphia regions and a survey of home builders’ conditions. Housing starts will be watched closely to see if the recent stabilisation is maintained and inflation data is likely to remain benign.
• In Australia, the focus is likely to be on trying to glean any indications about the strength of the RBA’s tightening bias from the release of the minutes from its last meeting and a speech by Deputy Governor Ric Battllino. Meanwhile, it will be a slow week for economic data releases, with the highlight being wage data, which is expected to show a slight uptick in wages growth, and skilled vacancies data due mid week.

Outlook for markets

• After strong gains since late August shares are vulnerable to a further correction, with European debt concerns and further Chinese tightening posing obvious risks. However, beyond any near term volatility, we continue to see further solid gains as being likely into year end and through next year. The global liquidity backdrop is highly favourable for shares underpinned by QE2 in the US, the soft patch in global growth appears to be over, the corporate sector is cashed up and this is likely to result in a further pickup in M&A activity, and shares remain very cheap relative to government bonds.
• Notwithstanding normal bumps along the way, the Australian dollar is likely to head higher as the $US and now the euro remain under downwards pressure, interest rates in Australia continue to trend up and commodity prices remain strong. It is likely to settle around $US1.10 in the year ahead.
• Deflation worries, along with central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

The post Weekly market & economic update – 12 November 2010 appeared first on AdviserVoice.

Headline developments of the past week

• After 28 years in the dogbox on the back of falling commodity prices and poor economic management the Australian dollar spiked above parity against the $US, briefly reaching $US1.004 before falling back to just above $US0.99. The return to parity has taken a bit longer than I first thought back in 2007 but we have finally got there. But is it sustainable? Currencies are always volatile and normal volatility suggests a pull back at some point particularly after such a strong run up since late August. However, with the $US likely to remain under pressure, the RBA remaining on track to raise interest rates further and Australia’s terms of trade at a near sixty year high it is likely that the $A will settle above parity over the year ahead – probably around the $US1.10 level. Of course, if global growth collapses anew then all bets are off and a plunge back below $US0.80 would be possible – but this is unlikely.
• Talk of a global currency war continues with some emerging countries intervening and imposing capital controls to try and stop their currencies from rising against the $US. The IMF meeting last weekend provided nothing more than the usual hot air on the topic – but nothing more was likely anyway. The bottom line is that major advanced economies need lower currencies to rebalance their economies towards greater exports and to ease their debt burdens. For this to occur emerging countries need to consume more and export less and a rise in their exchange rates would help facilitate this. Intervening and resisting will only mean that easy US monetary policy will spread globally – into emerging countries for which it is completely inappropriate and will just cause asset bubbles. Hong Kong – with its fixed currency peg to the US – is an extreme example of this.
• The past week has seen a range of better news globally: the odds of QE2 in the US have continued to increase; we have seen solid profit results for US companies; Chinese economic data has remained solid; Chinese shares have gained 12% over six trading days; and growth sensitive markets such as copper, the $A and oil have remained strong.

Major global economic releases and implications

• US economic data remained consistent with an ongoing sub-par recovery. On the positive side there was a stronger than expected gain in retail sales, a solid rise in manufacturing in the New York region, a slight rise in small business optimism, a rebound in weekly chain store sales and strong gains in mortgage refinancing. Against this, consumer sentiment slipped further in early October, new mortgage applications fell, weekly jobless claims unexpectedly rose and the trade deficit widened. On top of this core inflation fell to just 0.8% in September, well below the level that the Fed regards as consistent with price stability. All of which is consistent with a move towards more quantitative easing by the Fed, with the minutes from the Fed’s last meeting and comments by Fed Chairman Bernanke clearly pointing in this direction unless economic data strengthens soon.
• A moratorium on US mortgage foreclosures in response to various irregularities may weigh on US banks, but it could help provide a bit of temporary relief for US home owners and so buy more time for the market to absorb the excess supply of housing.
• The US September quarter profit reporting season is off to a solid start with so far 73% of results coming in better than expected including for JP Morgan, Google and Intel.
• In Europe, industrial production beat market expectations in August while UK inflation was unchanged in September. Also in the UK, consumer confidence fell sharply in September, jobless claims rose and housing data remained weak all pointing to more quantitative easing from the Bank of England.
• In Japan, consumer confidence fell in September but machine orders jumped more than 10% in August and bank lending was only slightly lower in September.
• September data in China indicated ongoing strong growth with slightly faster than expected loan growth, increased business confidence and strong gains in car sales. Export and import growth was a bit softer than expected but this may be due to holiday effects. Meanwhile, the People’s Bank of China raised reserve requirements for major banks for a two month period in a sign that it still wants to see loan growth remain under control. Its hard to see a major impact though as banks still retain reserves in excess of requirements.

Australian economic releases and implications

• Australian data was generally solid with gains in consumer confidence and business conditions, with the highlight being a big rebound in new orders, and still solid business confidence. Housing finance remained mixed though with falls in investor finance but an increase in owner occupied finance.

Major market moves

• US, European and Asian share markets continued to move higher over the last week helped in particular by strengthening expectations for more quantitative easing in the US and also better than expected earnings results.
• Australian shares saw a volatile week with a few profit warnings weighing on investors along with worries about the impact of the strong $A.
• Commodity prices remained strong on the back of ongoing $US weakness with the gold price making a new record high.

What to watch in the week ahead?

• The global focus in the week ahead is likely to be on China where September quarter GDP data and September activity data will be released. Reflecting the drop out of double digit quarterly growth a year ago we expect year on year GDP growth to have slowed to around 9.5% which is where we expect growth to settle over the year ahead. Growth in retail sales, industrial production and investment is likely to have remained strong. Food price increases are likely to have pushed inflation up to 3.6% year on year (from 3.5%) but non-food inflation is likely to have remained very soft. Overall, upcoming Chinese data is likely to confirm that growth remains solid and a hard landing in China is not on the cards.
• In the US, data for industrial production, housing starts, a survey of home builders and a survey of manufacturers will be released. Housing data is likely to confirm the picture of stabilisation, albeit at a low level. The Fed’s Beige Book of anecdotal evidence on the economy will likely confirm that the pace of US economic growth has slowed. The US profit reporting season will move into top gear with 118 S&P 500 companies due to report. Consensus expectations are for earnings to have grown 24% over the year to the September quarter, but if reports continue to surprise as they have done so far then this is likely to be revised up.
• In Australia, the minutes from the RBA’s last Board meeting are likely to confirm that the Bank retains a strong bias to raise interest rates again. Data for car sales, skilled vacancies and trade prices will also be released. The AGM season will also continue with the main focus likely to be on earnings risk for internationally exposed companies.
  

  Outlook for markets

• While shares are at risk of a near-term correction, further decent gains are likely into year-end and through 2011. Share markets have been tracing out a rising trend since the lows in early July, which points to a resumption of the cyclical bull market which started in March last year. More fundamentally, shares are very cheap relative to government bonds, investors are still wary which is positive from a contrarian perspective, and once it becomes clear that the US/global recovery is continuing, albeit slowly, there is likely to be a big reversal of investment flows – out of government bonds and back into shares.
• Like shares, the Australian dollar is also vulnerable to a short term correction – particularly with speculative positions and investor sentiment towards it now running very high. However, a further rise above parity against the $US is likely as commodity prices remain strong, the $US remains under pressure and Australian interest rates continue to rise well above global rates.
• Double dip and deflation worries, along with the prospect of more central bank government bond purchases in the US and elsewhere, are likely to keep bond yields low in the short term. However, medium-term returns are likely to be poor, reflecting low yields and excessive public debt levels in many developed countries.

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