• Inflation prints below forecast. China’s annual inflation rate lifted modestly in January, from 4.6 per cent to 4.9 per cent, but was still below expectations centred on a result near 5.3 per cent.
• Most prices higher. Most categories recorded higher inflation in January with food prices up 10.3 per cent on a year ago and non-food prices up 2.6 per cent.
• Business inflation (producer prices) remained high at 6.6 per cent in January.

What does it all mean?

• China’s inflation rate remained uncomfortably high in January, but at least it didn’t lift to the highs that economists were tipping. The other solace for investors is that a change in the weighting system for the consumer price index actually boosted inflation in the month, providing some added comfort about the result.
• But while the annual inflation rate printed below forecasts in January, it was still up a solid 1.0 per cent on the month. In addition producer prices also rose over the month and the year, keeping inflation prominently in the centre of the radar screen. Food, non-food and services inflation all rose at a faster rate in January.
• Last week, China’s central bank lifted interest rates for the second time in six weeks and it is clear from today’s data that further policy tightening can be expected.
• While higher food prices have been the major driver behind the lift in inflation, the central bank will need to lean against other price pressures to ensure that they don’t become locked in.
• China is Australia’s major trading partner and it is now very apparent that when China sneezes, Australia is at risk of catching pneumonia. Provided the Chinese authorities continue to pre-emptively tighten policy to keep inflation at bay, the risk of a boom-bust scenario will similarly recede. But China’s high inflation rate is a clear and present danger.

What do the figures show?

• The annual rate of consumer price inflation rose from 4.6 per cent to 4.9 per cent in January. But the January result was below the 28-month high of 5.1 per cent in November and below forecasts centered on a result near 5.3 per cent. During January consumer prices rose by 1.0 per cent.
• Food prices rose by 10.3 per cent over the year (9.6 per cent in December) while non-food prices rose by just 2.6 per cent (2.1 per cent in December). Services inflation jumped from 2.8 per cent to 4.6 per cent.
• Producer Prices (business inflation) rose by 0.9 per cent in January to stand 6.6 per cent higher than a year ago. The annual rate of producer price inflation was an eight-month high, up from 5.9 per cent in December and higher than economist forecasts of 6.1 per cent.

Data released earlier in the month showed:

• Chinese passenger car sales fell by 10.3 per cent in January to 965,238 vehicles as tax breaks ended and authorities tightened up on the issuance of license-plate registrations to ease congestion and pollution in cities. In the 2010 calendar year passenger vehicle sales rose by 33.2 per cent to 13.76 million vehicles were sold.
• China’s trade surplus fell to a nine-month low in January, shrinking from US$13.1 billion to US$6.461 billion and short of forecasts centred on a US$10.7 billion surplus. Exports were up 37.7 per cent on a year ago (consensus +22.4 per cent) and imports were up 51.0 per cent (consensus +28.0 per cent). The results may have been affected by the early timing of Chinese New Year compared with a year ago.
• Chinese residential property prices posted solid gains in January according to private surveys. The China Real Estate Index System reported a 0.95 per cent lift in prices in January while an index from SouFun Holidays similarly noted a 1.0 per cent lift in residential prices.

What is the importance of the economic data?

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

What are the implications for interest rates and investors?

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

• Australia’s trade surplus narrowed by $636 million to $1,925 million in November. Economists had tipped a surplus near $2 billion. Exports were flat over the month while imports rose by 2.9 per cent.  Australia has chalked up trade surpluses of $17.1 billion over just the past eight months.
• Australia’s trade surpluses with both China and India soared to record highs over the past year. In the year to November, Australia sent $17.7 billion more in exports to China than it received in imports. Just under two years ago the trade surplus was close to zero.
• While the physical trade of goods is in surplus, the services account remains mired in deficit – the deficit widening from $372 million to $454 million in November. The high Australian dollar is a key culprit, depressing tourism receipts.
• Total exports from Queensland were $4,199 million in November – 21 per cent of total Australian exports. The floods in Queensland is likely to see more sedate trade surpluses take place in coming months.

What does it all mean?

• The economy may be going through a soft patch but the dollars keep rolling in. Australia has now notched up its eighth consecutive trade surplus, totalling in excess of $17 billion. Despite the boost to Australian coffers the impact has yet to have a resounding effect on the economy. The weakness in business and consumer spending suggests the additional income is being saved rather than spent.
• However as the Reserve Bank has highlighted increased savings will eventually mean a pickup in spending down the track. It is the multiplier effect that essentially the Reserve Bank is banking on to spur domestic growth over the coming year. At present the additional income is not being spent, but as the recovery gains traction it is likely that Australian businesses and consumers will follow through on spending and investment plans.
• Interestingly Australia is making strong inroads amongst its Asian counterparts. The trade surplus with China has now risen to a record high of just over $17 billion on a yearly basis. Clearly this is a phenomenal result given that just under two years ago that trade surplus was close to zero.
• Similarly the trade balance with India has also expanded. In the year to November the trade surplus with India ballooned to $14.4 billion. Australia’s trade surplus with India has been gradually building over time but it has doubled since the start of 2008.
• Higher commodity prices and increased demand for coal and iron ore has helped insulate the Australian economy. However given the floods in Queensland it is likely that trade surpluses are likely to be more moderate in coming months.
• Not surprisingly the strength of the Australian dollar continues to have a detrimental impact on the services sector. Australia’s services deficit has widened by over $450 million in just the past month. No doubt the strength of the Australian dollar is making Australia a less attractive destination for overseas tourists and potential international students. Interestingly when the Aussie fell below US70c in 2009 the services sector notched up a series of surpluses.

What do the figures show?

International trade

• Australia’s trade surplus narrowed by $636 million in November to $1,925 million. Economists had tipped a $2 billion trade surplus. Exports were flat in the month while imports rose by 2.9 per cent. It was the eighth consecutive trade surplus.
• Rural exports rose by 1 per cent in November while non-rural exports rose by 2.2 per cent and non-monetary gold fell by $325million or 21 per cent.
• Within non-rural exports, coal, coke and briquettes fell by 5 per cent. “On a recorded trade basis, between October and November 2010 exports of bituminous (thermal) coal fell $240m (19 per cent), driven by volumes. Exports of semi-soft coal fell $78m (10 per cent), with decreases in both volumes and prices. These falls were partly offset by hard coking coal which rose $16m (1 per cent), with an increase in volumes and a decrease in prices”.
• Within rural exports meat and meat preparations rose by $35 million or 6 per cent.
• Within imports, consumer imports rose 1.0 per cent in November, capital goods imports rose by 8.3 per cent while intermediate goods imports rose 3.5 per cent.
• While the physical trade of goods is in surplus, the services account remains mired in deficit – the deficit widening from $372 million to $454 million in November. The high Australian dollar is a key culprit, depressing tourism receipts.
• Australia’s trade surplus with China hit a record high of $17.1 billion in the year to November.

What is the importance of the economic data?

• The monthly International Trade in Goods and Services release from the Bureau of Statistics provides estimates on exports and imports of physical goods (such as coal, beef and computers) and services (such as travel receipts). The balance of goods and services (BOGS) is a narrower description of Australia’s external position than the current account estimates. The import data is a useful gauge of consumer and business spending while exports reflect global demand as well as domestic influences such as drought.

What are the implications for interest rates and investors?

• The Reserve Bank will point to our trade surpluses as evidence of the mining boom’s impact on the economy. As more dollars flow into the country, policy has to tighten to soak up the extra money and thus prevent inflationary pressures from building. However the sluggish level of activity at present suggests that the Reserve Bank can hold off on any near term rate hikes.

• Retail spending slumped by 1.1 per cent in October, below forecasts centred on a rise of 0.4 per cent. Nonfood retailing fell by a much larger 2.2 per cent – the biggest slide in 20 months. Over the first ten months of 2010 overall retail spending has risen by just 1.5 per cent.
• Sales by chain stores and other large retailers fell by 0.2 per cent in seasonally terms in October while sales by smaller retailers fell by 2.6 per cent – the biggest fall in ten years.
• Spending was down across over half the retail categories, with footwear and clothing retailers the worst affected, along with cafes and restaturants.
• Australia’s trade surplus widened from $1,814 million to $2,625 million in October. Economists had tipped a surplus near $2 billion. Exports rose by 1.1 per with imports falling by 2.5 per cent. Australia has chalked up trade surpluses of $15.1 billion over just the past seven months.
• Australia is becoming more and more reliant on China, creating risks for the economy. Just under a quarter of all exports are now destined for China. If China sneezes, Australia will certainly catch cold.

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Most people tend to regard the national accounts as just an update on economic growth. But the publication is far more comprehensive than that, covering indicators such as inflation, productivity, savings and wage costs. So from a big picture perspective what can we conclude?

Well if we were to sum the economy up in one word it would be ‘patchy’. The economy is growing, but certainly not uniformly. For instance 11 of the 19 industry sectors actually went backwards in the September quarter. And if you stripped out the rural sector, the non-farm economy also went slightly backwards.

Still, we shouldn’t panic. The economy is still expanding, and given the firm result in the June quarter we should have expected some softening in the September quarter. However the soft result is clearly a wake-up call.

All we have been hearing about over the past year is our booming terms of trade (rising export prices and falling import prices). The concern has been that this income boost would filter across the economy boosting wages and prices. Certainly that is a risk, but it is not the full story. As the Reserve Bank has previously suggested, if the income boost is saved, not spent, it is less of a concern. And that is happening. Businesses are cautious about spending and borrowing and cautious Aussie consumers have been saving more.

If you measure the household savings ratio in trend terms, the result for the September quarter is the highest in 23 years. Now if there were signs of this conservatism coming to an end that would be a concern for policymakers. But there is no evidence of slippage. Threats of higher interest rates, rising living costs, media hype about housing affordability, a soggy sharemarket and global concerns are all causing people to squirrel away more of their income.

And while it is important to focus on the effect of the mining boom across the broader economy, it is also important to focus on the broader effects of factors like higher interest rates and the stronger Aussie dollar. These factors also have multiplier effects across the economy and at present they appear to be nullifying the impact of the mining boom.

Certainly one piece of good news in the latest national accounts was the low reading for inflation – the household consumption deflator was only up by 0.3 per cent in the quarter and 2.0 per cent for the year (well below the decade average of 2.5 per cent). Then there were labour costs. In real terms, real unit labour costs were down by 2.2 per cent on a year ago – no wonder employers have been looking to take on staff.

But all the extra people added to the workforce over the last year have been at the cost of weaker productivity. Productivity has lifted just 0.5 per cent over the year. There are more people with jobs but at present it isn’t translating to more output across the economy.

The week ahead

Ordinarily the Reserve Bank Board meeting would be the dominating influence in the coming week. But with rates up in November, inflation under control and the economy losing momentum in the past quarter, clearly now is not the time to be lifting rates further. The Reserve Bank Board meets Tuesday and the final meeting for 2011 should be relatively uneventful.

Still, even with the Reserve Bank firmly camped on the interest rate sidelines there is still a swathe of economic figures to be dissected over the week. On Monday, TD Securities and the Melbourne Institute release the monthly inflation gauge for November while the Performance of Construction index is released and various surveys of job advertisements will be released. Also on Monday the latest data on tourism arrivals and departures is published.

In an underlying sense inflation is well contained, with significant discounting by retailers keeping price pressures in check. And while job ads probably rose in November, recent data suggests that businesses were becoming a little more circumspect about putting on staff.

On Tuesday, estimates of industry productivity are issued – one for the data aficionados.

On Wednesday, housing finance figures for October are released while Reserve Bank Assistant Governor Lowe also delivers a speech. We suspect that new home loans fell again in October – highlighting the softness of the sector – with the value of loans down 2 per cent.

And on Thursday the November employment report is issued. In October the jobless rate surprisingly rose from 5.1 per cent to 5.4 per cent as more people went in search of work. We suspect that the labour force participation rate may have eased modestly from 65.9 per cent to 65.8 per cent in the month. And with employment estimated to have lifted by 25,000, this would cause the jobless rate to return to 5.1 per cent.

In contrast to Australia, economic data will be thin on the ground in the US in the coming week. Consumer credit figures are released on Tuesday with data on wholesale inventories issued on Thursday together with the weekly figures on claims for unemployment insurance. On Friday monthly trade figures are released alongside the monthly budget data and the survey of consumer sentiment.

The trade deficit is expected to be largely unchanged at US$44 billion while consumer sentiment may have improved from 71.6 to 72.2 in December.

Apart from the US data, investors will also be focussed on new Chinese economic indicators to be released on Friday. Trade figures for November are slated for release together with figures on property prices. Also data on money supply and fixed direct investment are slated for release over the period December 10-15.

Sharemarket

We have made no adjustment to our sharemarket forecasts for four months and we remain comfortable with the current view. CommSec expects the All Ordinaries and S&P/ASX 200 indexes to end the year at 4,800, before rising over 2011 to end the year around 5,400 points. It’s worth noting however that when we last adjusted our forecasts, that the All Ordinaries and ASX 200 were much closer together. But currently the All Ordinaries is around 90 points above the ASX 200. The widest gap on record was 129 points on June 3 2008. The All Ordinaries tends to out-perform in a flat to falling market, so the gap with the ASX200 may ease over 2011 should the market lift as we expect.

Interest rates, currencies & commodities

The Reserve Bank is constantly watching so-called “market pricing” to determine what traders and investors are pricing in for the cash rate in coming months. There is no definition about what this “market pricing” is, but the main guides are the overnight indexed swap (OIS) rate and 90 day bank bill futures.

The current 1-year OIS quote is 4.93 per cent, meaning that financial market traders and investors believe that there may be one rate hike over the next twelve months, but they aren’t yet totally convinced. In terms of the bank bill market, the implied yield on December 2011 bills is 5.30 per cent. Given that the current physical 90 day bill rate stands at 5.00 per cent, this again highlights current thinking that there may be just one rate hike over the next year.

Certainly economists have tended to have a more bearish view of where rates will be in 2011 – in other words, they expect a few more rate hikes. The current consensus view is that the cash rate will be around 5.50 per cent in late 2011. Still, this consensus estimate hasn’t been adjusted since the Reserve Bank Governor delivered testimony last Friday as well as the soggy figures on economic growth and retail trade. No doubt the consensus view is more likely to gel now with so called “market pricing.”

The spot iron ore price has posted a stunning rebound over the past 4½ months. In mid July the price hit lows of US$117.50 a tonne. It was a case of two steps forward, one step back, through to mid September with a similar trend through to the current day. Currently the iron ore price stands at a 6½ month high of US$167.80 a tonne and is again within sight of the record high of US$186.50 a tonne posted in late April. Recent data shows that the Chinese economy continues to expand strongly, suggesting further upside in commodity prices.

Payment Adviser was one of a select handful of global IT vendors invited to showcase its unique electronic payments solution to delegates at the 37th annual Sibos trade event, held in Amsterdam last week.

Executives from Payment Adviser have subsequently planned follow-up talks with a number of central and corporate banks, pension funds, custodians and system providers, and other interested parties across Europe and the United States.

“While Payment Adviser is well-known for its application to the pension and superannuation market in Australia, we are thrilled to have demonstrated the universal capability of this technology,” said Payment Adviser global head of marketing and sales, Brad Rosenthal.

“For example, we have seen approaches from representatives of several emerging economies, who see benefits from leveling the playing field when competing in established international export markets.

“In other words, these emerging nations can see how Payment Adviser will enable them to grasp a much-needed efficiency boost and ‘leap frog’ traditional barriers to entry – which means competing immediately for lucrative procurement contracts on the global stage,” he said.

“Our technology complements all known transaction models to facilitate simple and efficient trade. But the key here is also to enable participants to, in effect, ‘talk the talk’ of their trade partners and meet the specific payment characteristics, data standards and other unique market practices of both procurer and supplier.

“Sibos is the world’s premier financial services and payments event, and proved an opportunity to demonstrate our unique technology while interacting with senior decision makers from around the globe.

“We are thrilled to have had the opportunity to present what represents years of intensive research and development, with the message that we have unlocked a constituent code for all global financial payments,” said Mr Rosenthal.

Headline developments of the past week

• The focus over the past week was on China which undertook a surprise 0.25% increase in benchmark lending and deposit rates. This caused a blip in global financial markets as investors pondered whether this is the start of another round of policy tightening in China which might threaten Chinese growth. Our take is that Chinese authorities have simply taken the view that the growth outlook globally and in China has become a bit more favourable and so it is appropriate to take a step towards normalising interest rates while at the same time ensuring that term deposit rates keep up with inflation making it easier to keep a lid on potential asset bubbles. However, it’s hard to see Chinese tightening becoming aggressive. GDP growth slowed further to 9.6% in the year to the September quarter from 10.3% in the June quarter, signalling that the threat of overheating has well and truly receded. At the same time, while retail sales continued to accelerate in September and industrial production moderated this is consistent with the authorities desire to rebalance the economy. Secondly, its hard to say that there is an inflation problem – while inflation picked up to 3.6% in the year to September this was driven by higher food prices with non-food inflation actually falling to just 1.4%. Finally, it’s hard to see Chinese interest rates rising too far as it will make it harder to control hot money inflows. Rather Chinese policy will remain focussed on using quantitative and administrative measures to soak up the liquidity being generated by its efforts to limit the rise in the Renminbi. Overall, our take is that Chinese the rate hike is just a tap on the brakes to ensure the economy will remain under control, rather than an attempt to further crunch growth. Over the year ahead we see growth stabilising around the 9.5% level, which will be positive for the continuation of the global recovery and commodity demand.
• After a 16% rise in Chinese shares since late September, they had become overbought and due for a correction. However, with valuations remaining attractive, ongoing evidence that the economy has avoided a hard landing, hot money flooding into the country as China tries to limit Renminbi appreciation and property measures likely to make shares relatively more attractive, strong gains in Chinese shares are likely over the next six to 12 months.
• In Australia, the Minutes from the Reserve Bank’s last rate setting meeting indicated that the decision to leave rates on hold was a close one with the key drivers being that near term growth was running around trend, soft credit growth, the rise in the $A and continuing risks to the global outlook. However, the clear message remained that more interest rate hikes were likely on the way, with the RBA also noting that it could not wait indefinitely to see whether risks materialised suggesting that the case to raise rates again has already been made. Since the meeting in early October, global economic data has improved a bit, local employment and consumer confidence data have been stronger and the $A is only marginally stronger suggesting that barring an underlying September quarter inflation outcome below the RBA’s 2.5 to 2.75% expectation then a 0.25% rate hike following the November meeting is a good chance.

Major global economic releases and implications

• US economic data was mixed, again consistent with an economy muddling along at a sub-par 2% pace. On the positive side jobless claims fell, a leading index rose, a survey of home builders improved in October and housing starts rose slightly. Against this, the Philadelphia Fed manufacturing survey improved only marginally, new mortgage applications fell, permits to build new homes fell and industrial production fell 0.2% in September. Meanwhile the Fed’s Beige Book of anecdotal evidence removed references to a deceleration as had been evident in previous months but indicated continued growth, albeit at a modest pace.
• The earnings news out of the US remained positive with so far 79% of results exceeding expectations including those from Boeing, Yahoo, Goldman Sachs, EBay and McDonalds.
• European business conditions fell in October with a slight improvement in manufacturing conditions being offset by a fall in the services sector. Conditions remain consistent with growth but momentum is clearly slowing and the rebound in the euro combined with fiscal tightening is likely to lead to a further softening ahead ultimately setting the scene for renewed easing from the European Central Bank. Disruptions associated with protests against government cutbacks, as seen in France over the last week, won’t help.
• In the UK, the Conservative-led coalition provided more detail of drastic spending cuts over the next four years, which are projected to take the budget deficit down from 10.1% of GDP this year to 2.1% in the 2014-15 fiscal year. Meanwhile protests against an increase in the pension age to 62 continued in France.

Australian economic releases and implications

• Australian economic data was mixed. While motor vehicle sales rose in September skilled vacancies fell in October and the Westpac leading index fell slightly in August. Meanwhile, the terms of trade saw another big surge in the September quarter with import prices rising just 0.7%, but export prices surging another 7.8% leaving them up 27.7% over the last year. This will take the terms of trade to a new 49 year high. The continuing surge in Australia’s terms of trade is providing a huge boost to national income, employment and investment which will require further interest rate increases if it is not to spill over into higher inflation and underlines the RBA’s observation that it cannot wait indefinitely to resume raising interest rates.

Major market moves

• Global share markets were mixed in volatile trading, rising in the US and Europe, flat in Asia but weaker in Japan and Australia. In the US, stocks were buoyed by better than expected earnings results but gains were limited as the mortgage foreclosure debacle in the US continued to weigh on bank stocks. Australian and Asian shares were adversely affected by the Chinese tightening which weighed on resources stocks.
• Commodity prices generally fell in response to worries that the Chinese tightening will weigh on commodity demand and as the $US bounced from oversold levels.
• After very strong gains taking it briefly up to parity against the $US at the end of the previous week, the Australian dollar fell back as the Chinese tightening triggered profit taking and lower commodity prices, the RBA cited the strong $A as a reason not to tighten earlier this month and as the $US bounced higher.

What to watch in the week ahead?

• In the US, data for home sales are likely show a small bounce but house price data, which lags, is likely to soften. Durable goods orders are likely to show reasonable gains confirming that the corporate sector remains a source of strength in the US. US September quarter GDP growth is likely to come in around 2.2% annualised, ie no double dip but not strong enough to bring unemployment down. Data for consumer confidence and business surveys from the Texas, Richmond and Chicago Fed regions will also be released. A speech by Fed Chairman Bernanke will also be watched closely for clues regarding quantitative easing.The US profit reporting season will also continue.
• Australian September quarter inflation data will be watched closely as a guide to what the RBA might do on interest rates next month. We expect headline inflation to rise 0.7% quarter on quarter or 2.8% year on year and underlying inflation to rise by 0.6% quarter on quarter and 2.6% year on year. Expect sharp rises in prices for alcohol, tobacco and utilities to be partly offset by falls in petrol prices, health and clothing and footwear. Comments from retailers indicate that price discounting is likely to have remained a key dampener on inflation. However, unless the underlying inflation rate is below the RBA’s expectation of 2.5% to 2.75% its unlikely to have a big impact on the RBA’s next interest rate decision.
• Australian credit data will likely have remained soft in September and a speech by RBA Governor Glenn Stevens will also be watched closely.

Outlook for markets

• Shares are vulnerable to more corrective activity in the short term as the gains from late August are digested and with US quantitative easing now largely factored in. However, 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 the surge in global liquidity on the back of the latest round of quantitative easing getting underway in the US and elsewhere should provide a positive boost for shares.
• The Australian dollar is vulnerable to a further correction in the short-term – particularly with speculative positions and investor sentiment towards it now high. However, a further rise above parity against the $US is likely in the months ahead as commodity prices remain strong, the $US remains under pressure and Australian interest rates continue to rise well above global rates.
• 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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Headline developments of the past week

• The focus over the past week was on China which undertook a surprise 0.25% increase in benchmark lending and deposit rates. This caused a blip in global financial markets as investors pondered whether this is the start of another round of policy tightening in China which might threaten Chinese growth. Our take is that Chinese authorities have simply taken the view that the growth outlook globally and in China has become a bit more favourable and so it is appropriate to take a step towards normalising interest rates while at the same time ensuring that term deposit rates keep up with inflation making it easier to keep a lid on potential asset bubbles. However, it’s hard to see Chinese tightening becoming aggressive. GDP growth slowed further to 9.6% in the year to the September quarter from 10.3% in the June quarter, signalling that the threat of overheating has well and truly receded. At the same time, while retail sales continued to accelerate in September and industrial production moderated this is consistent with the authorities desire to rebalance the economy. Secondly, its hard to say that there is an inflation problem – while inflation picked up to 3.6% in the year to September this was driven by higher food prices with non-food inflation actually falling to just 1.4%. Finally, it’s hard to see Chinese interest rates rising too far as it will make it harder to control hot money inflows. Rather Chinese policy will remain focussed on using quantitative and administrative measures to soak up the liquidity being generated by its efforts to limit the rise in the Renminbi. Overall, our take is that Chinese the rate hike is just a tap on the brakes to ensure the economy will remain under control, rather than an attempt to further crunch growth. Over the year ahead we see growth stabilising around the 9.5% level, which will be positive for the continuation of the global recovery and commodity demand.
• After a 16% rise in Chinese shares since late September, they had become overbought and due for a correction. However, with valuations remaining attractive, ongoing evidence that the economy has avoided a hard landing, hot money flooding into the country as China tries to limit Renminbi appreciation and property measures likely to make shares relatively more attractive, strong gains in Chinese shares are likely over the next six to 12 months.
• In Australia, the Minutes from the Reserve Bank’s last rate setting meeting indicated that the decision to leave rates on hold was a close one with the key drivers being that near term growth was running around trend, soft credit growth, the rise in the $A and continuing risks to the global outlook. However, the clear message remained that more interest rate hikes were likely on the way, with the RBA also noting that it could not wait indefinitely to see whether risks materialised suggesting that the case to raise rates again has already been made. Since the meeting in early October, global economic data has improved a bit, local employment and consumer confidence data have been stronger and the $A is only marginally stronger suggesting that barring an underlying September quarter inflation outcome below the RBA’s 2.5 to 2.75% expectation then a 0.25% rate hike following the November meeting is a good chance.

Major global economic releases and implications

• US economic data was mixed, again consistent with an economy muddling along at a sub-par 2% pace. On the positive side jobless claims fell, a leading index rose, a survey of home builders improved in October and housing starts rose slightly. Against this, the Philadelphia Fed manufacturing survey improved only marginally, new mortgage applications fell, permits to build new homes fell and industrial production fell 0.2% in September. Meanwhile the Fed’s Beige Book of anecdotal evidence removed references to a deceleration as had been evident in previous months but indicated continued growth, albeit at a modest pace.
• The earnings news out of the US remained positive with so far 79% of results exceeding expectations including those from Boeing, Yahoo, Goldman Sachs, EBay and McDonalds.
• European business conditions fell in October with a slight improvement in manufacturing conditions being offset by a fall in the services sector. Conditions remain consistent with growth but momentum is clearly slowing and the rebound in the euro combined with fiscal tightening is likely to lead to a further softening ahead ultimately setting the scene for renewed easing from the European Central Bank. Disruptions associated with protests against government cutbacks, as seen in France over the last week, won’t help.
• In the UK, the Conservative-led coalition provided more detail of drastic spending cuts over the next four years, which are projected to take the budget deficit down from 10.1% of GDP this year to 2.1% in the 2014-15 fiscal year. Meanwhile protests against an increase in the pension age to 62 continued in France.

Australian economic releases and implications

• Australian economic data was mixed. While motor vehicle sales rose in September skilled vacancies fell in October and the Westpac leading index fell slightly in August. Meanwhile, the terms of trade saw another big surge in the September quarter with import prices rising just 0.7%, but export prices surging another 7.8% leaving them up 27.7% over the last year. This will take the terms of trade to a new 49 year high. The continuing surge in Australia’s terms of trade is providing a huge boost to national income, employment and investment which will require further interest rate increases if it is not to spill over into higher inflation and underlines the RBA’s observation that it cannot wait indefinitely to resume raising interest rates.

Major market moves

• Global share markets were mixed in volatile trading, rising in the US and Europe, flat in Asia but weaker in Japan and Australia. In the US, stocks were buoyed by better than expected earnings results but gains were limited as the mortgage foreclosure debacle in the US continued to weigh on bank stocks. Australian and Asian shares were adversely affected by the Chinese tightening which weighed on resources stocks.
• Commodity prices generally fell in response to worries that the Chinese tightening will weigh on commodity demand and as the $US bounced from oversold levels.
• After very strong gains taking it briefly up to parity against the $US at the end of the previous week, the Australian dollar fell back as the Chinese tightening triggered profit taking and lower commodity prices, the RBA cited the strong $A as a reason not to tighten earlier this month and as the $US bounced higher.

What to watch in the week ahead?

• In the US, data for home sales are likely show a small bounce but house price data, which lags, is likely to soften. Durable goods orders are likely to show reasonable gains confirming that the corporate sector remains a source of strength in the US. US September quarter GDP growth is likely to come in around 2.2% annualised, ie no double dip but not strong enough to bring unemployment down. Data for consumer confidence and business surveys from the Texas, Richmond and Chicago Fed regions will also be released. A speech by Fed Chairman Bernanke will also be watched closely for clues regarding quantitative easing.The US profit reporting season will also continue.
• Australian September quarter inflation data will be watched closely as a guide to what the RBA might do on interest rates next month. We expect headline inflation to rise 0.7% quarter on quarter or 2.8% year on year and underlying inflation to rise by 0.6% quarter on quarter and 2.6% year on year. Expect sharp rises in prices for alcohol, tobacco and utilities to be partly offset by falls in petrol prices, health and clothing and footwear. Comments from retailers indicate that price discounting is likely to have remained a key dampener on inflation. However, unless the underlying inflation rate is below the RBA’s expectation of 2.5% to 2.75% its unlikely to have a big impact on the RBA’s next interest rate decision.
• Australian credit data will likely have remained soft in September and a speech by RBA Governor Glenn Stevens will also be watched closely.

Outlook for markets

• Shares are vulnerable to more corrective activity in the short term as the gains from late August are digested and with US quantitative easing now largely factored in. However, 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 the surge in global liquidity on the back of the latest round of quantitative easing getting underway in the US and elsewhere should provide a positive boost for shares.
• The Australian dollar is vulnerable to a further correction in the short-term – particularly with speculative positions and investor sentiment towards it now high. However, a further rise above parity against the $US is likely in the months ahead as commodity prices remain strong, the $US remains under pressure and Australian interest rates continue to rise well above global rates.
• 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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