Headline developments of the past week

• Another round of strong Chinese economic activity indicators, excessive loan growth and a further rise in inflation to 5.1% in November on the back of a sharp rise in food prices have kept Chinese authorities in tightening mode with the People’s Bank of China raising bank required reserve ratios to a new record high. A further hike in interest rates is also looking imminent. Both export and import growth accelerated in November and economic activity indicators remained strong suggesting that the economy is healthy enough to be able to bear further tightening. However, the growth in economic activity indicators remains down from the blistering pace seen earlier this year, recent weekly data is showing a fall in food prices suggesting that price controls and supply boosting measures are starting to work in which case inflation is likely at or near its peak and measures to slow the property market appear to have worked with house price inflation slowing further over the year to November. As such we remain of the view that policy tightening won’t get aggressive enough to crunch the Chinese economy.
• It still has to pass through Congress, but more stimulus is likely on the way for the US economy with President Obama agreeing to a two year extension of the Bush era tax cuts including the 15% tax rate on capital gains and dividends. However, the real surprise came in the form of an agreement to temporarily extend long term unemployment benefits and cut employee payroll taxes. Coming hot on the heals of news that Fed Chairman Ben Bernanke was prepared to extend the Fed’s quantitative easing program if need be and an improvement in US economic data the latest round of fiscal stimulus adds to confidence that the US recovery may pick up pace next year. The added stimulus is not so good for the US budget deficit though and this partly explains why bond yields rose sharply over the last week.
• As had been widely foreshadowed, the Reserve Bank of Australia left interest rates unchanged at 4.75%. The accompanying statement was relatively dovish, pointing to the boost to national income from the high terms of trade on the one hand and the degree of caution in spending and borrowing on the part of households on the other. The clear implication is that the RBA sees no urgency to raise interest rates further at this stage. However, with the RBA still expecting inflation to rise over the medium term it appears to retain a bias to raise interest rates next year. Continuing evidence of a tightening labour market and the risk this poses to wages growth supports our assessment that while interest rates are likely to be on hold for the next few months, they will start to rise again in the June quarter next year.

Major global economic releases and implications

• US economic data retained its recent better tone, with a rise in consumer sentiment in early December to a six month high, a rise in job openings, a fall in initial jobless claims and another rise in new mortgage applications. A sharp decline in the trade deficit in October on the back of stronger exports points to a strong contribution to December quarter GDP growth if sustained.
• There was also more good news from German economic data with a rise in factory orders and industrial production. There were no surprises from the Bank of England which left interest rates on hold as expected.
• Japanese economic data was mixed with falls in bank lending and core machinery orders but a rise in economic confidence for the first time in four months, stronger machine tool orders and lower bankruptcies.
• A pick up in exports in many emerging countries in November – including China, Korea, Taiwan, Brazil, Chile and Vietnam – provides further evidence that the global economy is accelerating again after a mid-year soft patch.

Australian economic releases and implications

• After a run of soft economic data in recent weeks, Australian economic data was on the strong side over the past week with the TD Securities/Melbourne Institute’s inflation gauge pointing to a rise in inflation, housing finance rising again in October adding to evidence that it has stabilised after a sharp fall into earlier this year and job ads and employment continuing to rise in November. The November employment report was particularly strong with another 54,600 new jobs being created taking total employment growth over the last year to over 400,000 jobs (or +3.7%). Either the labour market data is lagging or the soft patch evident in other data isn’t for real or maybe employers don’t believe it will last. Whatever the reason, the strength in the labour market is underpinning continuing very strong growth in household income which sooner or latter could translate into stronger retail sales and secondly it adds to the risk of an acceleration in wages growth putting pressure on inflation. So while the November labour market report is unlikely to change the rates on hold message for the next few months, it remains consistent with further rate hikes from the June quarter next year.

Major market moves

• Share markets rose over the last week helped along by reasonable economic data, talk of more stimulus in the US and the absence of any new negative developments in relation to European debt problems.
• Commodity prices were mixed with a fall in gold and oil prices but gains in metal prices. The Australian dollar fell slightly after the RBA indicated no urgency to further raise interest rates and as expectations for US economic growth improved and pushed up the $US.
• Government bonds continued to sell off reflecting increased optimism regarding the US growth outlook, the boost to the US budget deficit from the latest stimulus package and reduced safe haven demand. Bond funds have seen record inflows over the last two years and this might be starting to reverse as investors re-assess the prospects for bond returns in the face of still low yields, improving growth and still high budget deficits.

What to watch in the week ahead?

• In the US, the Fed meets on Tuesday and while it is likely to acknowledge an improvement in recent economic data it won’t be enough to alter the Fed’s assessment that interest rates will likely need to stay near zero for an extended period and that it will need to complete its recently announced quantitative easing program. US November data for retail sales (due Tuesday) is likely to show a decent rise based on various private surveys, inflation data (Wednesday) is likely to remain benign and housing starts and permits (Thursday) are likely to show modest gains adding to evidence that the US housing sector has stabilised. Data for industrial production and surveys of homebuilders and manufacturers in the Philadelphia and New York regions are also due for release.
• In Japan, the Tankan business survey for the December quarter (due Wednesday) is likely to show a further deterioration in Japanese business conditions. By contrast the German IFO business survey (Friday) is expected to show that German business conditions remain strong.
• In Australia, the NAB business survey (Tuesday) and Westpac’s consumer confidence survey (Wednesday) will be watched closely as a guide to how long the current soft patch in the economy will last. Given interest rates were left on hold this month and the good news on the labour market it’s possible that consumer confidence will recover some of the fall posted in November. Housing starts data (Tuesday) is likely to show weakness reflecting earlier falls in building approvals and data for car sales, skilled vacancies and imports will also be released.

Outlook for markets

• Share markets often have a soft patch into mid December before seasonal strength, known as the “Santa Claus” rally, kicks in pushing them higher into year end and into January and this is pretty much how we see share markets playing out over the next few weeks. More broadly, while the ride will likely remain volatile as GFC aftershocks continue to impact, shares are likely to post solid gains over the year ahead. 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 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.
• 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 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 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 as investors realise that bond returns are likely to be poor going forward. The back-up in bond yields over the last few weeks is possibly a warning of things to come.

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• There is no doubt that there is only one game in town – one ‘hot button’ issue, if you like – and that’s quantitative easing. In essence the term refers to the printing of more money; but as you would expect economists ‘poohpooh’ that kind of simplification saying that it is more complicated than that. But with interest rates in the US effectively at zero and concerns that the economic recovery is at risk of stalling, many of the US Federal Reserve members believe that another round of quantitative easing – or QE2 – may be necessary.
• In the first round of QE, the Federal Reserve bought US$1.7 trillion of mortgage-backed securities and Treasuries. Now Federal Reserve policymakers say that another round of QE may be necessary “before long” – they are just working out how much will be needed and how they should explain what’s going on. Of course the Fed didn’t actually say it like that; it said they “wanted to consider further the most effective framework for calibrating and communicating any additional steps to provide such stimulus.”
• As mentioned, economists don’t like to use the term “printing money” to describe quantitative easing. They prefer to say that the Federal Reserve is making use of its balance sheet to apply more stimulus to the economy. But when you buy securities from financial institutions in exchange for cash, that cash has to come from somewhere.
• How did the Fed get to this situation? Well it’s largely because it has fired all their traditional bullets. That is, interest rates are near zero – the range for the federal funds rate is between zero and 0.25 per cent. If the Fed believes the economy requires more assistance to get going, there is not much else it can do.
• Note that Federal Reserve chief, Ben Bernanke, has done a lot of research on the Great Depression and is determined that the economy avoids going down that path. Bernanke famously goes by the title “Helicopter Ben”, after a speech he gave in 2002 where he said that deflation (falling prices) should be avoided at all costs even if it required the government to drop money from a helicopter to get people spending.
• Will it work? The problem is that you can put dollars in people’s pockets but that doesn’t mean they have to spend. Corporate America is already sitting on US$2 trillion of cash (in a US$14 trillion economy) but they aren’t confident to employ or invest. Companies want certainty – that is, if they do start to do business again, that the rug won’t be pulled from under them. In other words, that policy won’t go from ‘loose’ to ‘tight’ too quickly.
• What are the risks? One risk is that it doesn’t work, undermining confidence. But there is another risk – it works too well – that all that extra money in the system creates inflation. With inflation near 1 per cent currently, that is not a risk. Of course all those extra US dollars in the system reduce the value of the currency and that means other currencies like the Australian dollar go up. Our currency strategists believe that is just a matter of time before the Aussie dollar hits parity with the greenback, and a key reason is QE.

The week ahead

• The Reserve Bank seems to hog the spotlight most weeks and the situation is no different in the week ahead. The Reserve Bank releases minutes of the last Board meeting on Tuesday, and given the brevity of the statement released immediately after the meeting, analysts will be scouring the latest document more closely than normal.
• The interest rate announcement gave few insights into the Reserve Bank’s thinking on the Australian economy, especially key issues like the tight job market, consumer spending and the housing market. If the Reserve Bank believes that the economy is patchy, with inflation likely to remain in the 2-3 per cent target band, then it won’t be in a rush to change policy settings.
• In terms of economic data, there are no ‘top shelf’ items on the calendar. Car sales figures are released on Monday with skilled vacancies, private sector wealth and imports on Wednesday. Reserve Bank Head of Financial Stability Department, Luci Ellis, is a panel discussant at the Finsia Annual Financial Services Conference on Wednesday. And data on export and import prices is released on Friday.
• Car sales have proved quite healthy with more than a million vehicles sold in the past year. But a key influence has been last year’s tax break with deliveries of vehicles still trickling in. Car dealers were telling clients late last year that deliveries could take up to a year for custom vehicles. But low car prices are also an attraction for budding buyers, with lower tariffs and the firmer dollar the key influences.
• The data on private wealth will probably show some stabilisation with lower share prices offsetting higher home prices. Wealth is at record highs, highlighting the good position of household balance sheets.
• In the US, a consistent flow of indicators awaits investors over the coming week. On Monday industrial production figures are released together with capital inflows data and the NAHB index. Housing starts are slated for Tuesday, the Federal Reserve Beige Book is issued on Wednesday, while both the Philadelphia Fed index and leading indicator report are released on Thursday.
• Industrial production probably lifted by 0.2 per cent in September, confirming that the economic expansion is continuing, but at a more modest pace. But housing starts probably eased for the first time in three months with activity showing further signs of settling just below a 600,000 annual rate. And the leading index probably lifted by 0.3 per cent in September, matching the gain in August.
• There will be plenty of interest in the views of Federal Reserve officials in the coming week with no fewer than 10 speeches scheduled by Fed governors or regional presidents.
• But arguably more important than the bevy of US figures to be released over the week is the latest monthly batch of Chinese data. On Wednesday China will release indicators covering production, retail spending and inflation, together with the economic growth estimates for the September quarter.

Sharemarket

• The US earnings (profit reporting) season truly takes centre-stage in the coming week with a ‘who’s who’ of Corporate America set to deliver results. Amongst those reporting on Monday are Citigroup, Apple and IBM. On Tuesday, Bank of America, Coca-Cola, Goldman Sachs, and Yahoo! are slated to report. Earnings results out on Wednesday include those from Boeing, Wells Fargo and E*Trade. On Thursday, AT&T, Caterpillar, McDonalds, Morgan Stanley, Amazon.com and American Express issue profit results. And a small group of 15 companies issue results on Friday including Verizon.

Interest rates, currencies & commodities

• The Aussie dollar bottomed in early June (June 7) when it fell to US81.50 cents. Since that time the Aussie dollar has risen by around 21 per cent. Clearly these stellar gains in such a short period of time have caused many to question whether the rally is sustainable. That is, how much of the Aussie dollar gain is due to weakness of the US dollar, and how much reflects fundamentals such as higher commodity prices.
• Unfortunately there is no fool-proof way to work it out. Certainly one of the best ways to assess the changes is to look at commodity prices in both US dollar terms and currency-neutral SDR terms. Since the start of June the Commonwealth Bank commodity index has risen by just over 11 per cent in SDR terms while lifting around 20 per cent in US dollar terms. It’s also worth pointing out that the US dollar index, which broadly measures the strength of the greenback, has lifted by around 13 per cent over the same period.
• These figures suggest that around half of the Aussie dollar gains can be attributed to commodity prices and the other half to US dollar weakness. But when the US dollar is falling, commodities become cheaper in local currency terms for buyers in Europe and Asia. So some of the gain in commodity prices would reflect greater short-term demand for a cheaper product. At the same time, the perception that Aussie interest rates are likely to rise in coming months and our strong economy would also be factors driving the Aussie dollar higher.
• All that we can say with certainty is that while there is indeed a fundamental basis to the Aussie dollar’s gains, a healthy component of the rise reflects a weak US dollar. That point is important when you consider that commodity prices have only risen by 1 per cent over the period since early June.

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About 135 million people around the world are estimated to have escaped from poverty between 1999 and 2004. That means that a population greater than Japan’s (126 million) was added to the pool of global consumers in just five years.

Over the next few decades, the number of people considered to be in the “global middle class” is projected to jump from 430 million a decade ago to 1.2 billion by 2030, according to the World Bank. Most of the new entrants will come from China and India, where consumption is surging. The World Bank predicts that by 2030, 93% of the global middle class will be from developing countries, up from 56% ten years ago. (The bank defines the global middle class as individuals earning an income between the per capita income of Brazil and Italy.)1

These facts explain why so many companies are developing presences in emerging markets; from Asia to Brazil, from sub-Saharan Africa to Russia. They want to capture rates of consumption growth that are unimaginable in mature western economies.

Asia’s potential consumption is huge. The outlook, though, is complicated by a preference for saving that is partly due to the lack of a social safety net. China’s government, for instance, boosted the incentive to save when it privatised housing and the pension system in 1999 and suggested households should be responsible for their own education and healthcare needs.

As a result of the global credit crunch, however, countries including China have conducted massive stimulus programs and many governments are under pressure to implement social reforms. A combination of income growth and social reform would ignite Asian consumption in coming decades.

While China may be one country everybody is watching to see the consumer revolution take hold, private consumption in India accounts for a higher share of GDP than in China – about 55% versus around 50% in China and about 70% in Australia. In India, rising incomes and readily available retail credit have encouraged consumption growth of 5% to 7% a year over the past decade.2

The outlook for further growth is compelling thanks to India’s rising proportion of young workers. McKinsey forecasts that India’s middle class will grow from 5% of the overall population now to 41% by 2025.

As this occurs, Indian spending habits are likely to change. At present, spending in shopping malls is a tiny percentage of total spending because most money is spent with small traders in public markets. The difficulty for foreign retailers is that India bans foreign investment in multi-brand retailing, so local players such as Reliance, Bata India and Pantaloon Retail are gaining footholds in the expanding formal shopping market.

While consumerism is still to fully grip China and India, it is embedded is some emerging markets such as Brazil, the most western of the BRICs. The South American country, for example, is now the third-biggest market for beauty products after the US and Japan.

Changing patterns

As incomes grow in emerging markets, the proportion that is spent on necessities shrinks. As the disposable income of emerging consumers grows, so too does the allure of the coolest fashions and the latest gadgets. Consumption patterns in emerging markets are already changing as this trend develops.

While western consumers grow resistant to advertising, forcing companies to be more innovative, multinationals are using time-tested aspirational advertising to build brands in emerging markets.

Guinness, for example, is what the upwardly-mobile Nigerian man ought to be drinking, according to an advertising campaign in the African country. And drinking it he is. Nigeria has recently become the largest market for Guinness in the world.

Another area reliant on advertising that is growing strongly in emerging economies is western-style fast food. Yum! Brands, whose portfolio includes Pizza Hut and KFC, has opened 200 restaurants in India that are achieving revenue growth of 40% a year. In China, the company has around 3,000 KFC outlets and 500 Pizza Huts. Incredibly, it sees the potential for 20,000 restaurants in China.3

Tourism and leisure are classic areas of discretionary spending that are set to surge thanks to the growth in the middle class. Companies such as Ctrip.com, which is China’s dominant online and telephone travel agency, stand to benefit. Li Ning is the leading player in sports apparel in the mid-end segment, just below the high-end names of Nike and Adidas. So it’s well placed to capture consumers trading up from the low-end of the sports clothing market.

And then there’s the potential for the luxury goods market. The elite in emerging markets are happy to indulge in ostentatious purchases to underline their status and reward themselves for their endeavours. This invariably means luxury western brands are in great demand from a relatively small, but high-spending, portion of the population.

The western luxury goods companies have noticed. They have expanded their presence in key financial centres where wealth has accumulated, such as Shanghai and Moscow.

These companies benefit from the fact they have no local competition. In the low- and mid-market areas, there are abundant local competitors who can compete on price. The top end, however, enjoys the exclusivity and allure that comes with high prices. Companies such as Burberry, LVMH and Richemont are poised to benefit as the top strata of the emerging middle class expand.

While industrial investment themes may reward investors only over specific parts of the investment cycle, the steady growth in consumption represents a compelling and enduring theme over the 21st century that deserves long-term inclusion in any equity investor’s portfolio. After all, every few years there’s another Japan worth of new middle-class consumer to target around the world.

Massive growth in the global middle class

World Bank. 2009

1 World Bank. worldbank.org. As quoted by Citigroup. “Emerging market consumerism”. 15 September 2009
2 DataStream. National statistics. June 2010
3 Citigroup. “Emerging market consumerism”. 15 September 2009
All information comes from Bloomberg and Citigroup unless stated otherwise.

Important information

References to specific securities should not be taken as recommendations.

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Only a week earlier on July 15, US central bank minutes show that Bernanke expects the US economy to stagger along below its average growth rate for up to six years.

The less-than-glowing assessments from the US central bank chief and disappointing economic indicators on the US and global economies are feeding pessimism among investors and have undermined global stock markets of late.

Investors are concerned that the world’s biggest economies – the US, Japan, the eurozone and China – are slowing. And that even if another global recession is avoided, it might feel like one anyway.

While a return to another recession cannot be ruled out, five factors suggest that investors may be too pessimistic about the outlook.

The first is that the global banking system is more stable now because western banks are in better shape. In the US, loss rates on most types of loans seem to be peaking, while bank capital ratios have risen to new highs. In Europe, while some have questioned the worth of the stress tests on banks, the results showed that only seven out of nearly 100 banks have problems. The improved health of western banks and the higher bank earnings should promote the lending that lubricates the economy. Although evidence on credit conditions is mixed, it seems reasonable to say that conditions are at least not worsening any more.

The second factor is that US companies are cash rich. Past US recessions have been associated with weak corporate cashflows, which has forced companies to lay off workers and reduce spending. Today, however, according to the latest quarterly data from Bloomberg, Russell 3000 companies have around US$2.9 trillion in cash and short-term investments, 19% more than a year earlier. Companies have already made significant cost reductions during the recent recession and are reaping some of the benefits of this in higher cash flows. There should, therefore, be less pressure on them to make further cuts that detract from economic growth.

Market fillip

Thirdly, self-correcting markets are changing relative prices in a way that supports economic growth. Oil prices, for example, are around half their peak reached in mid-2008. That helps keep costs under control for businesses and consumers.

Another factor is that emerging economies are humming. Many emerging markets, especially in Asia, are confident enough of the future to have started winding back stimulus measures to ensure that inflation stays under control. China, a key driver of the global economy, is cooling its property markets and allowing greater flexibility in its exchange rate to moderate its export growth and boost domestic demand. India in July raised interest rates for the fourth time since March. Despite such actions, the IMF expects the economies of China and India to expand 10.5% and 9.4% this year, while fellow BRIC member, Brazil, is forecast to expand 7.1%.

Lastly, more stimulus is possible. While many European countries are installing austerity measures to rein in budget deficits, this is not a universal strategy. Many countries retain significant scope, at least on the monetary side, to prod their economies if conditions turn bleak. In his prepared statement to Congress, Bernanke said central bankers “remain prepared” to act if circumstances required. With the US cash rate near zero, policy options in this regard would include the Fed buying more Treasury, federal agency and mortgage-backed debt securities.

While the pessimists could be proved correct, the greater likelihood remains that the global economy is moving to a new phase of slower growth rather than any kind of renewed downturn.

From a technical perspective, it is worth noting that heightened volatility at this stage of the recovery cycle is not unusual. Past crisis periods have quite often been followed by extended periods of choppy consolidation, such as that which occurred in 2004 when markets, after some bouts of gloom, eventually pulled out of the technology bust. Such thoughts might engender some optimism in Bernanke and others.

China’s, India’s and Brazil’s economic growth since the start of 2007 (quarterly, year on year)

DataStream

Financial information comes from Bloomberg unless stated otherwise.

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