The slump in markets over the last month naturally raises a lot of questions: what’s driving it? Are we seeing a re-run of the global financial crisis (GFC)? What’s the risk of a return to recession? Can China save the world again? Have shares bottomed? How vulnerable is Australia?
Why the sharp fall in shares (& other growth trades)?

Put simply, shares have taken a tumble on fears of a return to recession in the US and Europe, and worries this will drag down the rest of the world. A few months ago we thought that global growth was just going through a temporary soft patch (on the back of Japanese supply chain disruptions and the earlier surge in oil prices) and that even though shares might remain volatile and see further weakness through the September quarter, the trend would remain up as profits continued to rise and global monetary conditions remained easy.

But the events of the last few weeks have called this view into question. Economic data has remained weak and debt crises in the US and Europe are increasing the pressure for more fiscal austerity at a time when growth is fragile. Political bumbling on both sides of the Atlantic, Standard & Poors’ downgrade of America and fears of more downgrades to come have only compounded these fears. Furthermore, memories of the 2008-09 GFC are still fresh in the minds of investors so the attitude seems to be shoot first and ask questions later.

Are we seeing a re-run of the GFC?
It’s still early days yet, but our view is this is very different to the GFC. Public debt problems have been brewing for some time so exposures should be well known and more transparent. The leverage and complex financial engineering that caused so much trouble in the GFC is not a factor now. Interbank lending markets are much better supported by central banks. Consequently, while interbank lending spreads (the difference between what banks charge to lend to each other and expected official short term interest rates) and credit spreads (the difference between corporate and government borrowing rates) are picking up, they remain relatively low.

While it’s early days yet, the risk of a complete seizing up in lending markets – including in areas like trade finance that helped spread the GFC to emerging countries – as occurred in late 2008, seems low. However, the recent speculative attacks on French banks and moves by US money market funds to stop lending them $US funds are worth watching.

What’s the risk of a return to global recession?
The risk of recession has increased significantly in Europe and the US. Fiscal austerity is occurring much earlier than is desirable, and recent political wrangling has put public debt problems front and centre in investors’ minds and dealt a huge blow to business and consumer confidence. Europe is probably the biggest risk. It seems to be stuck in an ever worsening cycle of periodic investor panic over debt blow outs, causing more fiscal austerity causing weaker growth causing further budget deterioration causing more market panic causing more austerity and so on. This process started in the peripheral countries but now appears to be spreading into Italy and France. A fiscal union is a long way off and won’t solve current problems anyway, and the European Central Bank seems unwilling (or unable) to provide monetary relief.

And the US is now starting down the same path with fiscal austerity set to knock up to 2% from growth next year. However, there are several reasons to believe that while the risk of recession in the major industrial countries has increased substantially, it will probably just be avoided:

• The fall in oil and commodity prices generally will take pressure off household budgets and business costs. 
• Cyclical sectors that can push the US economy into recession are already at recession levels – eg housing. 
• Longer term borrowing costs in the US have fallen to extraordinarily low levels and the Fed is effectively committing to keep them there for two years. This is enabling homeowners to refinance to lower rates.
• Near zero returns on cash are making it very difficult for US companies to continue adding to their already record cash stockpiles. The incentive to get out and invest, or at least buy back shares or other companies, is huge. 

It’s looking increasingly likely the US will head down the path of another round of quantitative easing (ie QE3 – which involves pumping more cash into the US economy). While one can debate the seeming failure of QE1 and QE2 to spark a strong recovery, the US probably would have been a lot weaker were it not for these actions and at least it seems to have prevented the US from sliding into price deflation.  

We put the risk of a return to recession in industrialised countries at 40% – slightly higher in Europe, but slightly lower in the US – with fragile sub-par growth of around 1 to 1.5% being the most likely outcome at around 60% chance.

Can China save the world again?
This brings us to the emerging world and China. Providing there is no drying up in trade finance, it is likely China and the emerging world will be able to hold up. Inflationary pressures in China and the rest of the emerging world are already fading on the back of lower oil and food prices, and with growth coming off the boil this should clear the way for easier monetary policies. With short term interest rates having increased over the last two years there is plenty of scope to cut, unlike in advanced countries. Second, public debt levels in the emerging world remain low so there is still plenty of room for stimulus if need be. Overall China is likely to see growth of around 8 to 9% and emerging countries around 5.5% which implies global growth of 3 to 3.5%. This is well below IMF expectations but not disastrous. 

How vulnerable is Australia to a new global downturn?
Australia is vulnerable to any renewed global downturn, given impacts on confidence, financial flows, and potentially trade. However, Australia is far better placed to withstand a global downturn and we see the risk of recession here as low at around 20%. Interest rates have a long way to fall.

The $A would likely fall if the global economy returns to recession boosting competitiveness. Public debt is a fraction of that in other countries and so more stimulus can be applied if need be. Corporate gearing levels are low and companies are cashed up. Banks are less dependent on global markets for funding than in 2007. Australian households have also built up a large savings buffer. Finally, our key export markets in Asia are more secure than those in Europe and the US.

Key points

• The Japanese earthquake has caused terrible human suffering. In terms of the economic impact, in the short term it will likely depress Japan’s economy as a result of damage to factories, power supply, transport infrastructure and confidence. However, by the second half of the year the rebuilding effort is likely to result in a boost to growth.
• While it has added to short term uncertainty in global investment markets, we don’t expect the earthquake to derail the global economic recovery or growth in Australia. In fact, increased commodity demand associated with rebuilding will ultimately provide a boost for Australia. We continue to see the recent pull back in share markets as a correction, and not the start of a new bear market.

Introduction

It seems the string of disasters in our part of the world this year is not letting up – the Australian floods, the New Zealand earthquake, and now a massive earthquake and tsunami in north east Japan. At this stage the full extent of the damage in Japan is unknown, but it is clear it has resulted in a terrible human tragedy. Right now the focus is on the rescue effort and our thoughts are with the Japanese people and all those affected. This note looks at the likely impact on economic activity, investment markets and Australia.

Economic impact

All natural disasters follow a similar pattern in terms of their economic impact and the Japanese earthquake is unlikely to be any different. The initial impact is negative as production is disrupted as a result of damage to factories, the power supply, transport infrastructure, confidence, and to homes which means workers are focussed simply on survival. This then gives way to recovery as rebuilding kicks in and production returns to normal.

• This was seen in terms of the Kobe earthquake in Japan in January 1995, which claimed 6,434 lives. Japanese industrial production fell 2.6% that month only to be followed by gains of 2.2% and 1% respectively in the subsequent months. In fact it’s worth noting while Japan’s GDP fell 0.7% in the December quarter 2004, it actually rose 0.8% in the March quarter 2005 when the quake hit and rose another 0.8% and 1% in the June and September quarters respectively.
• It was also seen in the Boxing Day Tsunami in Asia of 2004, with initial negative economic consequences in the areas affected followed by a strong rebound. In fact it was barely a blip in the Asian growth story at the time.
• The initial negative effects from recent floods are now being felt in Australia, but there is good reason to expect a rebound in growth from the June quarter.

The areas most affected by the earthquake account for around 8% of Japan’s GDP. It is a centre for auto production with Toyota, Nissan and Honda plants being shut down. Electronics plants have also been affected and damage to fishing and agricultural production is likely to be immense.  That said, given the area directly affected by the earthquake is a smaller part of the Japanese economy than the area affected by the Kobe earthquake in January 1995 it’s possible the economic affect may be smaller this time. According to Bank of America Merrill Lynch the three worst hit prefectures in the Kobe earthquake accounted for around 12% of Japan’s GDP.

However, it is still very early days in assessing the damage and there are some reasons to be a bit more concerned this time around. First, it’s the tsunami which has caused most damage this time, wiping away whole towns and parts of cities, as opposed to just earthquake damage to buildings, roads, etc. This also means the rescue operation may be more involved as will be the clean up before rebuilding can commence. Some areas may now even be unliveable given the shift in land and sea levels. Second, as a result of problems at nuclear power stations, the interruption to power supply may be greater and longer than was the case in 1995. Third, the loss of life this time around is likely to be much greater. This will have a potentially bigger impact on confidence than was the case in 1995. Finally, there is a risk of a serious nuclear catastrophe this time around, which if it occurred would result in a far more disastrous impact.

The most likely outcome would seem to be a set back in activity over the next few months – perhaps 2% or so knocked off industrial production – before rebuilding kicks in boosting growth again during the second half of the year. Post the Kobe quake the rebuilding effort was very quick and efficient and the same is likely this time. The Bank of Japan has already committed to a “massive” liquidity injection into the Japanese banking system. This has initially taken the form of increased short term cash injections, but should also include more quantitative easing (ie using printed money to buy government bonds and foreign exchange). Fiscal stimulus is also likely to be announced soon.

There are three bigger issues for Japan though. Firstly, Japan’s recovery since the GFC has been the most fragile of the G3, ie the US, Europe and Japan. This was highlighted by the fall in Japanese GDP in the December quarter and much weaker levels for consumer and business confidence. See the next chart. The earthquake will likely only add to Japan’s fragility.

More fundamentally is the impact on longer term confidence. The Kobe earthquake arguably damaged Japan’s national confidence in the 1990s adding to the malaise of the last two decades. The latest quake may only add to this sense of longer term malaise.

Finally, while price deflation means Japan has plenty of potential for further monetary easing, further fiscal stimulus will add to already very high public debt levels. Japan’s budget deficit is already 8% of GDP and public debt is around 200% of GDP. This is way above levels at the time of the Kobe quake and is even far worse than Greece. Short term it’s easy to finance as the private sector in Japan is a net lender. Longer term it is more problematic as a rapidly aging population will mean households will likely become net sellers of Japanese public bonds.

What about the global economic recovery?

The Japanese earthquake is unlikely to derail the global recovery. Apart from the likelihood that the negative impact on Japan will be mainly short term, Japan’s importance globally has slipped in recent times. At only 6% of world GDP, Japan only accounted for 0.16 percentage points of the 4.5% or so increase in world GDP last year.

Australian impact

Japan is Australia’s second largest trading partner, but its share of Australian exports has slipped from 25% at the time of the Kobe earthquake to 15% today. Short term economic disruption in Japan could cause a decline in orders for coal, iron ore and other commodities in the next few months. However, this is likely to be no more than a blip as the broader impact is likely to be positive as rebuilding will add to strong global demand for raw materials. Problems with nuclear power stations as a result of the quake, and any resultant rethink of the relative attractiveness of nuclear power globally, will likely be negative for uranium demand but positive for gas and coal demand. There may also be increased demand for food stuffs as the area affected is important in Japanese agricultural production.

It is noteworthy that even though the value of Australian exports to Japan fell in the March quarter of 1995 when the Kobe quake hit, they rose solidly in total – up 13.8% in the March quarter and up 22.2% in 1995 as a whole.

Finally, imports of cars, electronic goods and other manufactured goods from Japan may see a short term disruption but this is unlikely to last long, with other global producers also likely to step into the breach given still significant global manufacturing spare capacity.
At this stage we see no reason to alter our Australian economic forecasts which see year average growth this year of 2.8% and 3.8% in 2012 and the cash rate rising to 5.25% by year end.

Financial market implications

For Japan, the earthquake is negative for shares on the back of worries about the short term economic impact, positive for bonds on “safe haven” demand and probably positive for the Yen as Japan repatriates funds, particularly by Japanese insurance companies. This is pretty much how it played out immediately after the Kobe quake. So far it appears to be playing out this way as well, particularly for the share market which has fallen sharply.

However, after the initial reaction, which the post Kobe experience suggests may last several months, expect the Japanese share market to rebound as rebuilding kicks in and production returns to normal. There is a bit more uncertainty around the Yen – past experience suggests it will strengthen initially but this could be short circuited if the Bank of Japan intervenes (as it should) to help exporters.

Short of a nuclear catastrophe, we don’t see the Japanese earthquake derailing the global economic recovery and nor do we see it derailing the cyclical recovery in global share markets. However, it has come at time when the worry list for investors has suddenly expanded again – to include unrest in the Middle East and oil prices, renewed concerns about European debt and Asian tightening – and so only adds to short tem uncertainty. In this sense it’s too early to say whether the correction in shares that began last month is over or not.

The same applies for Australian shares. The initial reaction in the Australian share market has been negative, but any negative economic impact on Australia is likely to be minor and short lived and Australia is likely to be a key beneficiary of increased raw material demand as Japan rebuilds. With the Australian share market now trading on a forward price to earnings multiple below 12 times, Australian shares are well placed to rebound once the correction in global shares has run its course.

In terms of sector specific impacts the earthquake is likely to be negative for insurers and uranium producers, but positive for gas and thermal coal producers. It should ultimately be positive for commodity producers more broadly as rebuilding demand kicks in.

So far the Japanese quake has taken pressure off oil prices, on the assumption refinery closures in Japan may reduce oil demand. This may be true short term but ultimately it will mean Japan may import more refined fuel. So overall the impact on the oil price is ambiguous, with events in the Middle East likely more important.

Concluding comment

The events in Japan are heartbreaking. However, like all natural disasters the negative short term economic impact should hopefully be less than feared and will give way later this year to rebuilding which will help boost growth.

Key points

• While mainstream global shares may be due for a short term correction, the cyclical recovery still has further to go. Shares are still cheap, confidence in the sustainability of the global recovery is continuing and share market liquidity remains favourable.
• US shares are in the “sweet spot” of the investment cycle and are likely to outperform for a while.

Introduction

Improving confidence in the global recovery has seen mainstream global share markets post strong gains since mid last year. However, many fret that it is unsustainable with high unemployment, high public debt and unsustainably easy monetary policy hanging over advanced countries and emerging markets increasingly subject to inflationary pressures.

Cyclical recovery has further to go

While, as always, there is lots to worry about, our assessment is the cyclical recovery in shares is panning out broadly as expected and has much further to run. After a major bear market ends the recovery in shares often goes through several stages: an initial rebound during the first year, a period of correction or consolidation in the second year and then a continuation. This is illustrated in the table below for Australian shares which shows strong average gains in the first year, typically poorer performance in the second year and then strong gains in the third year.

Post bear market recoveries, Australian shares

Source: Bloomberg, AMP Capital Investors

So far so good with the correction in share markets last year being consistent with this pattern. Of course, markets don’t always follow a precise 12 month pattern, but if history is any guide this would suggest strong returns over the next six to 12 months. More fundamentally, the broad cyclical backdrop for shares and other growth trades remains fundamentally positive.

First, share valuations are still attractive. The forward price to earnings multiple for global shares is 12.9 times which is well below longer term averages for the low inflation period. Similarly, the forward price to earnings ratio for Australian shares is 13 times compared to a longer term average of 14.6 times. Emerging market and Asian shares are only trading on 11 to 12 times forward PEs.

Source: Thomson Financial, AMP Capital Investors

Second, while some of the heat is starting to come out of emerging countries, leading indicators for the US, Europe and to a lesser degree Japan have moved back up after a soft patch mid last year. This is evident in business conditions indicators as shown in the next chart.

Source: Bloomberg, AMP Capital Investors

In fact, the US is leading the charge on this front. The US ISM business conditions indicators are about as strong as they ever get. Corporate profits are up strongly and this is boosting business investment. Various labour market indicators point to a big resurgence in jobs growth and unemployment is already falling. Finally, US consumers are starting to feel more confident again and this is boosting retail sales. Similarly in Europe, strength in Germany is more than offsetting weakness in peripheral debt troubled countries. So there is good reason for confidence in the sustainability of the global recovery.

Third, the liquidity backdrop for shares is very positive with: easy money in the US, Europe and Japan;  cashed up corporates starting to undertake takeovers and share buybacks and boost dividends; and individual investors starting to switch back from bonds to shares. At the moment the latter is particularly noticeable in the US with the record inflows into bond mutual funds of recent years now starting to flow back out into equity mutual funds. Given the size of the bond inflows in recent years this might have a way to go before it is complete. If history is any guide and share markets do continue to rise then the same is likely to become evident amongst Australian individual investors.

In fact the US and northern Europe are arguably in the classic “sweet spot” in the investment cycle – with rebounding growth and surging profits but plenty of spare capacity such that inflation is not really a problem and central banks can keep interest rates low and money easy. This period in the cycle is usually very positive for shares.

The US is in the “sweet spot” in the investment cycle

Source: AMP Capital Investors

Finally, there are no signs of the excesses that normally mark the end of cyclical recoveries in shares. Inflation is still benign in advanced countries and even in emerging countries it is mainly reflective of higher food prices, not excessive demand. Prices for assets such as shares and property are still far from being overvalued.

But what could go wrong?

Essentially there are four main areas of concern.

Firstly, there is a risk of a short term pull back in shares. Many technical indicators suggest US shares are overbought and measures of short term investor optimism are at levels that often precede corrections. However, while there is the risk of a consolidation or a 5% pullback, the positive fundamental outlook outlined above suggests any short term dip should be seen as a buying opportunity.

Secondly, longer term structural issues clearly remain in major advanced countries. The threat remains from very high public debt levels, still fragile household balance sheets, ongoing issues in the US housing market and poor demographics. However, our assessment is that while these are likely to be medium term constraints for major advanced countries they are unlikely to cause a blow up in the next year or two;

• Europe seems prepared to do whatever it can to stop its debt problems spreading. And the US is having no trouble financing its budget deficit.
• Household balance sheets in the US remain worrying but rising share prices and the fall in household debt ratios mean they are becoming less fragile.
• While the US housing market is still a threat, rising home sales suggest it has found a floor and in any case the significance of housing activity in the US economy is half what it used to be.
• Finally, demographics are certainly poor and will be a long term constraint in major advanced countries, but this is a very slow moving event.

Thirdly, worries about inflation and growth in emerging countries could start to weigh on major share markets. Asian and emerging market shares generally have had a bad start to the year reflecting the need for monetary tightening in response to inflationary pressures. Basically Asia and other emerging countries are further advanced in their economic cycle (see earlier chart) and so have less spare capacity and less justification for very easy monetary conditions. As a result, monetary tightening is required to take monetary conditions back to neutral – as has already occurred in Australia – and this is seeing emerging markets go through a period of under performance relative to the US and Europe. This is likely to continue for the next six months or so, but with underlying inflation in these countries a long way from getting out of control and policy makers already responding, a hard landing is unlikely in the emerging world. Nor does it change the favourable strategic outlook for Asian/emerging share markets.

Finally, the eventual reversal of easy money policies in the US, Europe and Japan and easy fiscal policy in the US will likely cause gyrations in share markets. However, this is unlikely to be a major issue for markets until later this year at the earliest or more likely through next year. Excess capacity in the US, Europe and Japan suggests underlying inflation is likely to remain benign for some time heading off the need for a quick return to more normal monetary conditions in these countries.

Concluding comments

The cyclical recovery in global shares has further to run, but with Asian and emerging markets further advanced in their economic cycles and US shares still in the “sweet spot” in the investment cycle, the next six months or so may see further short term outperformance by US shares. Australian shares are likely to be in between: monetary tightening in Asia may act as a short term constraint on Australian shares but with monetary conditions already normalised in Australia and the RBA ahead of the curve, Australian shares are likely to continue to benefit from the positive lead flowing from US shares.

Top financial services experts provided investors with an optimistic view of the current financial climate at the PortfolioConstruction Forum Markets Summit 2011 which took place in Sydney yesterday.

Having reflected on the current economic position of the world, experts from around the globe provided the high profile attendees with their unique insight into what is – and what is not – an investment bubble, and what that means for constructing portfolios.

Joe Bracken, Head of Macro Strategies, BT Investment Management

“Classic mean-variance optimisation may not protect you during bubbles since it tends to put you into assets with higher expected returns – typically the inflating one!  Adding alternatives to your portfolio should help with performance stability. Overweight equities and alternatives and underweight bonds seems to be a sensible starting point.”

Bob Baur, MD & Chief Economist, Principal Global Investors

“The US and world economies have embarked on an economic expansion that has the potential to be better and last longer than the consensus expects.  The biggest risk is inflation, now in emerging markets and within a couple of years in developed countries.  Portfolios should be adjusted to account for the new environment.”

Steve Keen, Associate Professor, University of Western Sydney

“The dominant economic force is OECD nations deleveraging from excessive private debt, and Australia avoided as serious a downturn as the rest of the OECD by delaying the deleveraging process. Renewed deleveraging now that the house price bubble is ending will counter the stimulus from China.

“Our house price bubble dwarfs that of the USA, and Australian households are now more debt-encumbered with much higher interest rates. Government policy helped light the fuse and Ponzi lending by the financial sector provided the fuel. Prices will deflate as the rate of growth of mortgage debt slows, with negative impacts on aggregate demand and employment.”

Kumar Palghat, Managing Director, Kapstream Capital

“The US economy is turning the corner – the housing back log will be cleared and employment data is improving. The FED will continue to maintain easy monetary policy. Risk assets should continue to do well (equities, commodities, hedge funds, High Yield, etc) but bond markets are starting to sell off as safety of bonds is no longer required.  Solutions for European debt problems are in the works, and the US recovery continues to be very bullish for Asia which already has overheating economies.”

Anthony Kirkham, Head of Investment Management, Western Asset Management

“Investors need to be aware that there is a difference with bonds – it is important that they do not confuse Aussie bonds with those of other Governments. There is opportunity in Australian bonds and corporate bonds.”

Chris Joye, Managing Director, Rismark International

“It is absurd to suggest that it is likely Australian house prices will fall by 40%, or that house price declines will accelerate. While the next year or so will be relatively weak, Australia’s housing market will yield investors solid through-the-cycle total returns, as it has done over the last 30 years.”

Jacob Mitchell, Portfolio Manager, Platinum Asset Management

“There is real inflation risk not being addressed by governments in emerging markets in part. This needs to be factored into our investment planning.”

Sean Fenton, Portfolio Manager, Tribeca Investment Partners

“The outlook for the Australian equity market is positive with all of the key drivers remaining supportive.  Valuations are attractive, liquidity is abundant and economic growth around the world is either stable or improving.  The growth recovery leads us to generally favour cyclicals, but mainly those with global exposure.  The tightening moves in China do raise the risk of a near term correction in commodities so we remain neutral on resources.  The commodity boom is a boost for the Australian economy, but comes with higher rates and acts as a brake on a highly geared consumer.  We tend to favour mining services and financials for domestic exposure.”

Ric Deverell, Director – Commodities, Credit Suisse

“We are currently seeing major structural change as a result of, for example, another 3billion people entering the global economy in the last 10 or so years and consequent demand. This is going to last for multi decades until supply ultimately meets demand.”

The Summit was a platform for many debates and attendees were witness to diverse presentations throughout the day. However, in summing up, Tim Farrelly, Principal, farrelly’s noted a big shift from previous expectations that emerging markets would lead recovery. The discussion instead outlined surprise improvements in developed markets with potential risks in the emerging markets.

The overall outlook throughout the Summit was one of cautious optimism. The global financial leaders expected positive economic conditions in the three to five year outlook, with expected bumps further down the line.

The Australian Exchange Traded Fund (ETF) market is expected to grow to more than A$6bn in assets under management (AUM) in 2011 Russell Investments said in an analysis of ETF market trends released today. According to Russell, the surge will be driven by providers taking advantage of broader investor community understanding of ETFs and more flexible regulatory conditions.

Since their first appearance in Australia in 2001, ETFs have really begun to experience strong growth in the past year, with almost A$4bn in AUM as of December 2010 (see figure 1 in attached document).

Up to 15 new ETFs and at least three new providers are predicted to hit the market in 2011, Russell said. There will also be more asset classes available and more customised options.

“A year ago ETFs were still regarded as a new product, but we are now seeing a lot of interest from a range of users,” said Amanda Skelly, director ETF product development at Russell Investments. “In addition to their continued popularity in the core market of SMSFs, ETFs are likely to win more acceptance from advisers and investment platforms in 2011, and also make inroads into institutions.”

A more focused approach

Russell believes the trend for ETF in 2011 will be for more focused, targeted products. For example ETFs will continue to expand across different assets such as bonds and currency.

ETFs based on equities will continue to target exposures to specific sectors and sub-sectors. There should also be new implementation methods for ETFs, such as derivatives-based approaches, where a greater portion of the ETF is invested in instruments such as futures, forwards and swaps. Whether Australian investors embrace this type of ETF will be something to watch. While derivative based ETFs have seen strong growth in Europe, growth has slowed in the U.S. More customised approaches will also be popular, for example the use of ETFs in income-based strategies which became popular last year, the first of which was the Russell High Dividend Australian Shares ETF.

“The market is evolving quickly, there is not only a wide range of ETFs but ETFs are increasingly being used to implement more sophisticated strategies,” said Ms Skelly.

Potential global entrants to the Australian ETF market are likely to be assisted by more flexible rules allowing them to enter the local market.

“The success of newcomers will be driven by their ability to leverage existing capabilities and develop relevant solutions for Australian investors,” said Ms Skelly.

Meanwhile within the top 15 existing ETFs, secondary market liquidity is likely to improve.

Asian exchange mergers could be game changer

ETF providers will also be watching developments with regards to proposed exchange mergers, which Russell believes will have a positive effect on the local market, by delivering secondary market liquidity and product diversification as well as cost and operational efficiencies.

“If the proposed Singapore Stock Exchange (SGX) takeover of the Australian Securities Exchange (ASX) succeeds it will be an absolute game-changer for the ETF market,” said Ms Skelly.

“However if the takeover does not go ahead, Asian-based exchanges will continue to expand their ETF capabilities, attracting larger institutional investors which may potentially limit the longer term growth of ETF assets in Australia.”

“In the year ahead, we are likely to see a lot of activity in the ETF space and the increased variety and competition will hopefully broaden the appeal of ETFs,” Ms Skelly concluded. “Russell is planning to capitalise on this activity and is actively investigating how to build on the success of our first ETF to bring more products to market.”

Headline developments of the past week

• Sovereign debt issues in Europe raised their ugly head again over the last week. While the Irish austerity package was passed by its Parliament, investors were kept on edge by Moody’s putting Spain and Greece on credit watch, Standard and Poors doing the same for Belgium and bickering amongst euro-zone politicians about whether to increase the size of its bailout fund and about a longer term crisis resolution mechanism. This issue is likely to keep flaring up periodically for years, until public debt levels are clearly heading back towards more sustainable levels. In the meantime, the European Central Bank will continue to have to play a big role in keeping investor panic at bay by buying the bonds of troubled countries and ensuring that liquidity conditions remain easy. In this regard it is helpful that the ECB will receive an extra 5 billion euro of capital.
• Global bond yields continued to push higher as investors revised up their global growth expectations, with an unwinding of the record inflows of recent years into bond funds likely exaggerating the size and the speed of the sell off in bonds. Australian bond yields were little changed though and as they are well above global yields and are already around long term sustainable levels and so therefore are at much less at risk of a sharp sell-off.

Major global economic releases and implications

• Signs continue to build that the US economic recovery is gathering momentum with retail sales up strongly in November resulting in a gain of 7.7% over the last 12 months – so much for the US consumer being wiped out! On top of this industrial production rose solidly in November, business conditions in the New York and Philadelphia regions were solid, small business optimism rose to its highest level since December 2007 and unemployment claims continued to fall. Housing indicators remained softish though with a modest rise in housing starts but a further fall in permits to build new homes, demand conditions remaining poor according to home builders and new mortgage applications falling over the last week. At least housing seems to have found a floor though. Inflation remains down and out with the core CPI up 0.1% in November resulting in an annual gain of just 0.8%. While the Fed sounded a little more optimistic on the economy, it signalled that it remains in no rush to raise interest rates and will continue with quantitative easing as growth remains insufficient to bring down unemployment and inflation remains below levels that it is comfortable with.
• European data was generally favourable with another improvement in manufacturing conditions in November, led by Germany. While conditions in the services sector fell in November they remain levels consistent with reasonable growth. Euro-zone inflation remained benign at 1.9% year on year, or just 1.1% on a core basis.
• Japanese data was mixed with a softening in the Tankan business survey but a rise in a tertiary activity index.
• China reportedly raised its 2011 inflation target to 4%, from 3% for 2010, suggesting that it will allow time for inflation to fall back. This along with the likely maintenance of a reasonably high target for new loan growth in 2011 adds to confidence that China is not willing to crunch its economy in the face of higher food prices. While China maintained its growth target at 8%, this should be seen as more of a floor to growth rather than an actual objective.

Australian economic releases and implications

• Australian economic data was mixed over the last week. While dwelling starts fell sharply in the September quarter reflecting the earlier fall in building approvals and skilled vacancies fell in December, consumer sentiment edged up slightly and remains well above long term average levels, and new vehicle sales rose slightly in November. While the NAB business survey showed that business confidence fell in November reflecting last month’s rate hike, business conditions actually improved slightly and both remain at levels consistent with reasonable economic growth.

Major market moves

• Share markets continued to rally on the back of good global economic and corporate news.
• Commodity prices were mixed with gold down possibly on investor concerns that with the global outlook improving again the liquidity backdrop might become tighter and demand for a safe haven might recede, whereas base metal prices continued to benefit from improving confidence in the economic growth outlook.
• The Australian dollar rose modestly helped by the news that China left interest rates on hold despite fears last week that it would raise them.
  What to watch in the week ahead?
• In the US, data for existing home sales for November (due Wednesday) are likely to show a strong rise reflecting a 10% gain in pending home sales in October. New home sales (Thursday) are also likely to rise solidly. September quarter GDP growth (Tuesday) is likely to be revised up to 2.8% annualised and durable goods orders for November (Thursday) are likely to rise after a sharp fall in October.
• In Australia, the minutes from the Reserve Bank’s last rate setting meeting (due Tuesday) are expected to simply reinforce the message that interest rates are likely to remain on hold for several months.  We remain of the view that the RBA won’t start to tighten monetary policy until April next year at the earliest.

Outlook for markets

• Share markets are likely to benefit from seasonal strength over the next few weeks. The period from mid December into early January is normally positive for shares reflecting new year optimism, the absence of new capital raising and the investment of year end bonuses. Over the last 15 years, over this period the US share market has risen 11 times and the Australian share market 14 times.
• While GFC aftershocks will continue to cause volatility and shares may become vulnerable to a correction in January/February after several months of very strong gains, shares are likely to put in good gains through 2011 as a whole.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that the global economic recovery remains on track 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 and 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.
• Notwithstanding inevitable volatility, the $A is likely to head higher 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 end 2011 the $A is likely to have reached $US1.10.
• While low inflation, central bank government bond purchases and the absence of any near term monetary tightening should help keep bond yields in key advanced countries reasonably low in the short term, the risk of a sharp back up in bond yields at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels and sooner or later the record inflows into bond funds seen in recent years are at risk of becoming record outflows. The back up in bond yields over the last few weeks may be a warning sign of things to come.

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Headline developments of the past week

• Sovereign debt issues in Europe raised their ugly head again over the last week. While the Irish austerity package was passed by its Parliament, investors were kept on edge by Moody’s putting Spain and Greece on credit watch, Standard and Poors doing the same for Belgium and bickering amongst euro-zone politicians about whether to increase the size of its bailout fund and about a longer term crisis resolution mechanism. This issue is likely to keep flaring up periodically for years, until public debt levels are clearly heading back towards more sustainable levels. In the meantime, the European Central Bank will continue to have to play a big role in keeping investor panic at bay by buying the bonds of troubled countries and ensuring that liquidity conditions remain easy. In this regard it is helpful that the ECB will receive an extra 5 billion euro of capital.
• Global bond yields continued to push higher as investors revised up their global growth expectations, with an unwinding of the record inflows of recent years into bond funds likely exaggerating the size and the speed of the sell off in bonds. Australian bond yields were little changed though and as they are well above global yields and are already around long term sustainable levels and so therefore are at much less at risk of a sharp sell-off.

Major global economic releases and implications

• Signs continue to build that the US economic recovery is gathering momentum with retail sales up strongly in November resulting in a gain of 7.7% over the last 12 months – so much for the US consumer being wiped out! On top of this industrial production rose solidly in November, business conditions in the New York and Philadelphia regions were solid, small business optimism rose to its highest level since December 2007 and unemployment claims continued to fall. Housing indicators remained softish though with a modest rise in housing starts but a further fall in permits to build new homes, demand conditions remaining poor according to home builders and new mortgage applications falling over the last week. At least housing seems to have found a floor though. Inflation remains down and out with the core CPI up 0.1% in November resulting in an annual gain of just 0.8%. While the Fed sounded a little more optimistic on the economy, it signalled that it remains in no rush to raise interest rates and will continue with quantitative easing as growth remains insufficient to bring down unemployment and inflation remains below levels that it is comfortable with.
• European data was generally favourable with another improvement in manufacturing conditions in November, led by Germany. While conditions in the services sector fell in November they remain levels consistent with reasonable growth. Euro-zone inflation remained benign at 1.9% year on year, or just 1.1% on a core basis.
• Japanese data was mixed with a softening in the Tankan business survey but a rise in a tertiary activity index.
• China reportedly raised its 2011 inflation target to 4%, from 3% for 2010, suggesting that it will allow time for inflation to fall back. This along with the likely maintenance of a reasonably high target for new loan growth in 2011 adds to confidence that China is not willing to crunch its economy in the face of higher food prices. While China maintained its growth target at 8%, this should be seen as more of a floor to growth rather than an actual objective.

Australian economic releases and implications

• Australian economic data was mixed over the last week. While dwelling starts fell sharply in the September quarter reflecting the earlier fall in building approvals and skilled vacancies fell in December, consumer sentiment edged up slightly and remains well above long term average levels, and new vehicle sales rose slightly in November. While the NAB business survey showed that business confidence fell in November reflecting last month’s rate hike, business conditions actually improved slightly and both remain at levels consistent with reasonable economic growth.

Major market moves

• Share markets continued to rally on the back of good global economic and corporate news.
• Commodity prices were mixed with gold down possibly on investor concerns that with the global outlook improving again the liquidity backdrop might become tighter and demand for a safe haven might recede, whereas base metal prices continued to benefit from improving confidence in the economic growth outlook.
• The Australian dollar rose modestly helped by the news that China left interest rates on hold despite fears last week that it would raise them.
  What to watch in the week ahead?
• In the US, data for existing home sales for November (due Wednesday) are likely to show a strong rise reflecting a 10% gain in pending home sales in October. New home sales (Thursday) are also likely to rise solidly. September quarter GDP growth (Tuesday) is likely to be revised up to 2.8% annualised and durable goods orders for November (Thursday) are likely to rise after a sharp fall in October.
• In Australia, the minutes from the Reserve Bank’s last rate setting meeting (due Tuesday) are expected to simply reinforce the message that interest rates are likely to remain on hold for several months.  We remain of the view that the RBA won’t start to tighten monetary policy until April next year at the earliest.

Outlook for markets

• Share markets are likely to benefit from seasonal strength over the next few weeks. The period from mid December into early January is normally positive for shares reflecting new year optimism, the absence of new capital raising and the investment of year end bonuses. Over the last 15 years, over this period the US share market has risen 11 times and the Australian share market 14 times.
• While GFC aftershocks will continue to cause volatility and shares may become vulnerable to a correction in January/February after several months of very strong gains, shares are likely to put in good gains through 2011 as a whole.  Shares are cheap, the run of better than expected global economic data is continuing suggesting that the global economic recovery remains on track 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 and 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.
• Notwithstanding inevitable volatility, the $A is likely to head higher 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 end 2011 the $A is likely to have reached $US1.10.
• While low inflation, central bank government bond purchases and the absence of any near term monetary tightening should help keep bond yields in key advanced countries reasonably low in the short term, the risk of a sharp back up in bond yields at some point is very high. Bond yields in key advanced countries are still well below longer term sustainable levels and sooner or later the record inflows into bond funds seen in recent years are at risk of becoming record outflows. The back up in bond yields over the last few weeks may be a warning sign of things to come.

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