• The global economy is still on the mend, but it’s still a two steps forward, one step back affair. Of the major regions the US is doing the best, but Europe is lagging.
• This means occasional bouts of uncertainty, but it’s not such a bad thing if it keeps central banks supportive.
• The main implications are: we are still in the sweet spot of the global economic cycle, which is good for growth assets; the lack of global synchronisation means that fundamentals for individual regions, assets and stocks matter; constrained global growth will mean constrained returns; and the big event to watch for is when the Fed starts to hike rates – but it still looks a way off at present.

Introduction

We are having yet another year where investors started off optimistic about the global economic outlook with talk of synchronised growth only to find that the global growth story remains patchy. In fact, so much so that it’s possible to paint wildly different pictures as to the outlook – some are worried about growth and inflation taking off, whereas others warn of imminent collapse. The truth is likely to remain somewhere in between these extremes. But, in a way, this is not a bad thing as it keeps central banks supportive.

This note looks at the major regions in terms of growth, inflation and interest rates and what it means for investors.

The US – looking good but not booming

After a contraction in the March quarter driven by mostly temporary factors, the US economy rebounded in the June quarter and looks on track for growth of around 3% in the current quarter. The jobs market and business investment are improving and the shale oil boom is providing a long term boost both directly and indirectly via cheap electricity costs for business. However, while the US is looking a lot stronger it’s a long way from booming, let alone overheating, with growth seemingly stuck in a 2-3% range as the housing recovery and consumer spending have slowed a bit of late.

Which brings us to what the Federal Reserve will do. On the one hand US growth has improved enough to allow the Fed to continue “tapering” its quantitative easing program which means it’s on track to end probably in October. On the other hand it’s unclear that conditions are strong enough to warrant interest rate hikes just yet. This is something the Fed is grappling with, but the conclusion seems to be that – with inflation remaining low at just 1.5% on the Fed’s preferred measure, wages/labour cost growth stuck around 2% and broad measures of labour market slack (ie allowing for the unemployed, underemployed and discouraged workers) remaining high – its unlikely to rush into raising rates.

Our assessment is that the Fed is gradually inching towards an interest rate hike, but it’s probably not going to occur until sometime in the June quarter next year.

The Eurozone – better but not great

The Eurozone returned to growth about a year ago but it is far from robust and stalled in the June quarter with weakness in Germany, Italy and France. Uncertainty regarding Russian sanctions and Ukraine are not helping. What’s more bank lending growth has remained negative and inflation has fallen to just 0.4% year on year. This has all led to concerns that Europe is sliding into Japanese style stagnation and that the ECB needs to do more.

Our assessment though is that Europe is gradually mending: growth has returned to Spain, Ireland, Portugal and Greece; these countries have all made significant structural reforms to their economies and France and Italy look to be gradually heading down that path; the troubled countries have all seen their bond yields collapse, eg Spain’s 10 year bond yield is now just 2.17%; the ECB announced further stimulus in June, but looks to be ready to launch into quantitative easing involving the purchase of private debt in the next few months; and bank lending should improve once the ECB’s bank stress tests are out of the way in a few months.

Japan – Abenomics on track

Japan’s growth was hit in the June quarter by the pull- forward effect of the April sales tax hike. However, a range of indicators suggest that despite the volatility the Japanese economy has weathered the sales tax hike well with ultra-easy monetary policy and economic reforms providing confidence growth will bounce back from the current quarter.

However, given the uncertainty, the Bank of Japan will either have to maintain its very easy monetary conditions or possibly have to ease further.

China running hot and cold

For the last three years now Chinese economic data has been running hot and cold every six months leading to periodic worries about growth. Another slowdown in the Chinese property market is adding to these concerns.

With the Chinese Government repeatedly indicating that there is a floor to growth of around 7%, and supporting this by mini-stimulus measures as they have done this year, our assessment remains that the Chinese economy is on track for growth of around 7.5%. But don’t count on more.

Emerging world

The emerging world more generally is a lot messier than it used to be. Of the major’s, China and Mexico look ok and the election of reform oriented governments in India and Indonesia is positive, but Brazil looks to have lost the plot under the current Government, and Russia already weakened looks to have shot itself in the foot over Ukraine. A lack of structural reforms over the last decade has led to lower growth potential in the emerging world. That said it’s still on track for growth around 4.5% this year and next.

Global growth – two steps forward, one back

Bringing this together, global business conditions indicators are consistent with good but not booming growth.

Although global growth is likely to pick up, it’s hard to describe global conditions as synchronised and the global economic expansion remains very much a process of two steps forward, one step back. This was clearly evident in the first half of the year with the US and Japan both having negative quarters, China slowing in the first quarter and Europe stalling in the June quarter. And of course geopolitical events continue to wax and wane and the threat from Ebola remains in the background – all of which impart a deflationary impact in terms of their dampening impact on confidence and spending. Against this backdrop it is hard to see the Fed wanting to rock the boat prematurely with talk of interest rate hikes, let alone actual hikes, and the ECB, Bank of Japan and People’s Bank of China are likely to maintain ultra-easy policy or ease further.

Investment implications

There are several implications for investors. First, gradually improving global growth, still benign inflation and easy monetary conditions tell us we are still in the sweet spot of the economic cycle which augurs well for growth assets.

Second, the desynchronised global economic and monetary cycles confirm that the “risk off, risk on” phenomenon of a few years ago where all growth assets move up and down together has faded. This should make it easier for fund managers and investors to benefit from opportunities in individual regions, assets or stocks. Eg we think there is currently good value in Chinese shares, European shares and commodities. The divergence in monetary cycles is also likely to mean upwards pressure on the $US but downwards pressure on the Yen and Euro.

Thirdly, the constrained global growth cycle provides a reminder not to expect double digit gains from growth assets year after year. It will still be a relatively constrained world in terms of sustainable returns.

Finally, the big thing globally to keep an eye out for will be when the Fed will start to raise interest rates. This, or rather its anticipation, will likely cause a few bumps (just like last year’s taper tantrum did), but it’s still a fair way off and when it does come its unlikely to spell the end of the cyclical bull market in shares as it will be a long while before monetary conditions actually become tight.

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

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Global threats are mounting: Fidelity

The hazards confronting the world economy are mounting. The US economy is recovering at an unspectacular pace of about 2%[1] and a sub-par labour market, sluggish wages growth, renewed doubts about the housing market and weak demand for the country‘s exports only portend more modest growth ahead.

On top of this, inflation is accelerating, the Federal Reserve is only months away from ending its asset buying and rate increases appear inevitable before too long. The defeat of House majority leader Eric Cantor in a Republican primary election in Virginia in June by a Tea Party candidate is expected to cement gridlock in Washington and could lead to more showdowns on raising the government’s debt ceiling. The eurozone is still in recession,[2] disinflation could fester into deflation, government debt loads are at default levels and banks are so crammed with dud loans they are restricting lending, while some are wobbling in Austria and have failed in Portugal. Even if European Central Bank Governor Mario Draghi’s bluff to protect the euro is soothing investors, the financial crunch in the eurozone has morphed into a political crisis revolving around a jobless emergency that is fanning support for nationalistic and fringe parties, the opposite environment needed to create the political jelling the euro needs to assure its survival. Housing is bubbling in countries from the UK to New Zealand.

The emerging world isn’t in much better shape, especially as it is riddled with conflicts. A civil war has broken out in Ukraine, only months after Moscow seized Crimea from its neighbour, and Russia could yet invade. Western sanctions against Moscow in response will damage more than Russia’s economy. In the Middle East, Syria’s civil war rages on. Islamists control much of northern Iraq and a third of Syria and the fighting pitting Shias and Sunnis could spread into other countries such as Jordan. Israel has been to war against Gaza for the third time in six years. Iran could still gain nuclear weapons. In Africa, Libya has become ungovernable. In Asia, China is creating tension, especially with Japan, as it seeks to broaden its ownership of the China Seas. Due to China’s flexing, military spending in Asia has inklings of an arms race. Nuclear-primed North Korea is as loony as ever while nuclear-armed Pakistan grows more unstable.

Financial and economic challenges are no-less menacing in the developing world. Argentina has defaulted for the second time in 13 years after a legal feud with “vulture funds”, an outcome that will damage South America’s second-largest economy. China’s property market is deflating, while Beijing is only making half-hearted attempts to police out-of-control lending because it worries that proper regulation might make the country miss its 7.5% growth target. So challenged are many emerging countries by current-account deficits, inflation, sluggish economic growth and plunging currencies that labels of the past such as BRICs that flagged the potential of developing nations have given way to “fragile” plus a number; i.e., the “fragile five” are Brazil, India, Indonesia, Turkey and South Africa.

Could any of these challenges morph into a shock as damaging as the collapse of Lehman Brothers in 2008? Or could some other threat not yet evident emerge? Maybe it will be a jump in interest rates. Some analysts say it’s only a matter of time before Saudi Arabia is engulfed in the political turmoil of its neighbours. Just think what that would do to oil prices. Whatever form any shock could take, if one should occur, it’s not so much the shock that should worry investors. It’s the powerlessness of authorities to respond. There is, however, one hope that shines out from the events of recent years.

It must be said that there are always dangers to the global outlook and most of them are overhyped and fizzle out. So most likely will today’s perils. Since World War II, global politics has been far more volatile than today, even when the nuclear armed superpowers confronted each other as during the Cuban missile crisis in 1962 or the Yom Kippur War of 1973 that led to the first oil price shock of the 1970s. Even amid all the current hazards, the World Bank still expects the global economy to expand this year, even if that expected pace of growth for 2014 was reduced to 2.8% in June from the 3.2% forecast the bank made in January.[3] Other good news is that inflation is only a menace in a few countries. Japan’s radical economic experiment is going well so far. In India, the dominant election victory of BJP has sparked hopes the government can enact reforms that will rejuvenate the world’s second-most-populous country. Indonesia, the world’s biggest Muslim country that only 15 years ago was an economic and political basket case, is expected to advance further under new president Joko Widodo. US banks are better capitalised and are under tougher regulation. Across the globe, current accounts are better balanced, thus removing the savings mismatch that was a key cause of the global financial crisis of 2007-08. Any shock these days would have to be huge to outdo the jolt to consumer and business confidence that was inflicted by the collapse of Lehman Brothers, most likely a once-in-a-generation event, for people are hardened to alarms nowadays. Even allowing for all this, though, the world appears more precariously placed to cope in the unlikely event of a shock than it was six years ago.

All together now

When the US sub-prime crisis morphed into a global financial crisis in September 2008 policymakers in affected countries responded almost in unison. Central bankers slashed interest rates. They provided emergency funding to banks. Those in the US and the UK embarked on unprecedented asset buying or quantitative easing, a cure invented by the Bank of Japan in 2001. Political rulers provided massive fiscal stimulus. They nationalised banks. They guaranteed bank deposits even, mistakenly in Ireland’s case, backed bank debt.

These steps succeeded in avoiding another Great Depression, a feat in itself, but some harm was unavoidable and unintended consequences arose. The resulting Great Recession ushered in double-digit jobless rates while low interest rates fanned housing and other asset bubbles around the world. Policymakers made mistakes too. Austerity policies implemented in Europe and elsewhere have hobbled economies, boosted the ranks of the jobless and worsened government debt levels. The ECB could well turn to asset buying too late to stave off deflation.

These side effects and errors could add to the severity of the next downturn in the unlikely event of a shock. The greater problem, though, is that if another jolt comes authorities are much more handicapped than they were six years ago. Most of the steps that supported economies and banking systems in 2008-09 have lost their muscle. Major central banks already have reduced cash rates to record lows, so on this score they are immobilised. Quantitative easing has been unmasked as no miracle cure, even if it can help avoid a catastrophe or deflation. Research in 2012 out of John Hopkins University found that any reduction in interest rates from asset-buying programs was fleeting and “quite modest”.[4] While other studies might be kinder to central-bank asset purchases, it’s hard to believe that the Fed would do much for the economy if , say, it restored its monthly asset buying to US$85 billion again to limit shockwaves. Such a policy retreat might even deal another blow to confidence for the Fed and other key central banks have swelled their balance sheets to levels that approach the limits of investor tolerance, or at least to levels that provide fodder for scaremongers. The new (old) world of macroprudential controls, or financial regulation, to fight asset bubbles is fraught because it injects central bankers into the centre of political decisions.

Politicians and the executives they control appear just as toothless. Many governments are so debt laden they would be challenged to pursue the fiscal stimulus matching that of 2008 to 2010. Net debt sits at 74% of GDP for advanced economies, about where the average stands for the 18-member eurozone.[5] The US government net debt has reached 82% of output, while Japan’s ratio has soared to 137%. The straightjacket that such ratios put on governments is shown by events in Japan. Fiscal pressures forced Tokyo to raise the sales tax by three percentage points in April this year, a move that acts against the consumer spending that propels the economy, thus jeopardising the gains won so from the radical monetary experiment to engender inflation and economic growth. The US debt pile is the defining restriction on Washington’s ability to stimulate the US economy, which post-2008 was helped by annual fiscal deficits averaging 9.2% of GDP from 2009 to 2011.[6] The fight over US government finances has already produced the brinkmanship over the so-called fiscal cliff and two debt-ceiling showdowns that took the country to the brink of default. Perhaps more worrying, austerity advocates are winning the political battle in countries where government debt is low. There would be few better examples than Australia, which promoters of smaller government claim is facing a budget emergency (rather than just a persistent gap between outlays and revenue) when net government debt is all of 16% of GDP. Consumers won’t be able to rescue economies either. Households are still burdened with near record debts as a percentage of GDP and, come a shock, will own plunging housing assets.

What hope then for the world if a thunderbolt materialises? Most likely this. Policymakers the developed world over know they are at the limits of their power. They must have thought of possible remedies if something bad happens. If not, they have proved they can whip up palliatives if economies and banking systems shudder. The years after the global financial crisis struck ushered in unprecedented amounts of quantitative easing and emergency lending to banks under central-bank lender-of-last-resort facilities and massive fiscal stimulus. The era produced soothers such as zero interest rates and the invention of negative interest rates, which Sweden introduced in 2009 followed by Denmark in 2012 and the ECB this year. Central banks entered into bilateral currency swaps with the Fed to ensure enough US dollars to support banks in their spheres. Other central-bank tonics were so-called forward guidance to soothe any concerns about rate increases, ECB repurchase agreements designed to shove massive amounts of money at banks, Fed purchases of mortgage-backed securities to help revive housing, Fed lending facilities for borrowers and investors in crucial credit markets and cunning bluffs such as timely pledges by policymakers to do “whatever it takes” to save this and that, as the ECB did for the euro. These cures may not be enough if strife hits again but they give hope that policymakers have the inventiveness to limit the damage in the unlikely event that a threat materialises.

Financial information comes from Bloomberg unless stated otherwise.

 by Michael Collins, Investment Commentator at Fidelity

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Dominic Rossi

The US equity market is poised to rise in coming years and the S&P 500 Index could reach 2,300 from just under 1,900 now, says Dominic Rossi, the Chief Investment Officer, Equities, at Fidelity.

Amid the challenges facing the world and the US economy, equity investors are not fully recognising how rapidly the US economy is strengthening in many areas and that government finances are improving, Mr Rossi says.

“US economic growth is going to surprise on the upside and we will be discussing 3%-plus growth again,” he says. “The speed of the improvement in the US federal budget deficit is remarkable. Since 2009, the fiscal deficit has shrunk to around US$600 billion (A$640 billion) from US$1.5 trillion. It is not implausible that President Barack Obama will finish his term with a fiscal surplus.

“In which case, we are looking at a US equity market that is similar to the late 1990s (when we had the Clinton fiscal surplus), where equities should be well supported by liquidity.”

It is prudent to consider the standard counter-argument to the buy case for the US, which has lately become commonplace, Mr Rossi says. This argument points out that the US is on a price-earnings ratio of 16 times yet corporate profitability is at record highs. And if we cyclically adjust for peak profits, then the price-earnings ratio is 22 times.

“Profit margins may well be at record highs, but they can move higher,” Mr Rossi says. “The distribution of profits between capital and labour in the US is going through a fundamental shift. It’s hard to see why margins need to mean revert; for this to happen, labour’s share of profits would have to move higher. Unless we go back to highly unionised workforces, which is unlikely, profits are going to remain at high levels.

“If labour’s share of profits were to fall further, we could expect to see some political pressure. Overall, however, the outlook for corporate earnings remains favourable. Combined with healthy liquidity, these two drivers should sustain a multi-year bull market in US equities,” Mr Rossi says. “I believe the S&P 500 could move to 2,000 to 2,300 from its current level.”

The S&P 500 Index finished at 1,896.65 on May 12.

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Inflationary impact on resources market

The resource sector continues to be under pressure despite the raging bull market in the US.

Unfortunately the currently tepid recovery in the US. economy, as a serviced based economy, is not strong enough to lift metals prices, which are being hampered by weaker Chinese economic growth and investment demand as well as high inventory levels.

At some point can see the potential for all the monetary stimulus that the US Federal Reserve has been feeding the market will result in an inflationary spiral, in which case hard assets would return to favor. Otherwise global economic growth could rebound on its own right without the need for stimulus, boosting the demand for metals.

Click here to read the full update by Ascenta Asset management’s Rodney Stevens.

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He warns that the austerity conditions tied to Portugal’s bailout are leading to a “recessionary spiral” that is “socially unsustainable”[1].

Cavaco Silva’s attack on austerity policies that have led to unemployment of 16% in Portugal is almost uncontroversial these days in terms of economic thinking. It’s clear to most that removing government stimulus from a weak economy undermines economic growth and, consequently, further fouls government finances.

Eurostat data shows how deep reductions in spending and sharp increases in taxes in Greece, Ireland, Portugal and the UK have shrunk their economies to such an extent that government finances are in worse shape. [2]

Even the IMF, a long-term fan of austerity for wobbly developing countries, has recanted. It now concedes that a dollar taken out of a troubled economy in recent years shrank that economy by more than one dollar. In economic jargon, the fiscal multiplier was greater than one, whereas proponents of austerity assumed the number would be about around 0.5. [3]

The worry for investors is that the US is imposing austerity. Politicians there are removing government stimulus from the economy in steps as they clash over Washington’s finances. Looming fights this year over the fiscal deficit, government debt, financing the government (a temporary measure allowing this expires on March 27) and the debt ceiling will no doubt heighten political anxiety and reduce business and consumer confidence in the US economy, which shrank at an annual pace of 0.1% in the fourth quarter.

There’s no question Washington’s finances need fixing. The US federal government is running a fiscal deficit equal to about 8% of GDP. Government debt has doubled to 73% of GDP in the past six years and is set to soar due largely to spending on health. Ideally, what the country needs is a plan to trim the debt-to-GDP ratio towards 60% over the next decade.

This proposal would entail phased spending cuts and higher taxes, timed so as not to sink the economy, while allowing for investment in infrastructure and education. No such plan is likely to emerge from the clashes timed around the latest artificial deadlines US politicians have imposed on themselves.

Sequester verdict

The best slant that can be cast on the deal over the so-called fiscal cliff that Congress passed on January 1 was that the expiring 112th Congress avoided the 3% to 4% hit to the US economy the associated spending cuts and tax hikes would have delivered over 2013.

But the decisions to boost income taxes on the richest 1% of taxpayers, raise the capital-gains tax, let the payroll tax reductions expire and allow cuts in discretionary and military spending will still trim government stimulus over 2013 by about 1% to 1.5% of GDP.

The US austerity hit will more or less match the self-imposed austerity blows on the UK in 2011 and 2012 that have sent its economy stumbling towards its third recession in four years. But the US austerity jolt won’t be as savage as the punches received by Greece, Ireland and Portugal. [4]

Not yet anyway. One unfortunate aspect to the fiscal-cliff negotiations was that a decision on one of the threats to short-term economic growth was postponed. The fate of the “sequester” involving US$1.2 trillion in automatic cuts over the next decade or so to military and domestic discretionary spending must be sorted out by the end of February.

The sequester came about when the Republicans insisted on spending cuts to match the increase in the federal government’s debt limit they allowed in 2011. They were designed to be draconian enough to prompt lawmakers to negotiate gentler ways to reduce government spending, as in it was never the intention they take effect.

But Republican resolve to let these spending reductions come to pass is hardening, especially since they backed down in January during the negotiations to raise the debt ceiling again. They agreed to suspend the debt limit for three months until May. Their retreat came with a requirement that Congress pass a budget by then so that both chambers of Congress can focus on lowering fiscal deficits over the long term.

Such negotiations promise to be fraught as Tea-Party Republicans appear intent on securing sweeping (but largely unspecified) spending cuts and have forced their party leadership into declaring Republicans won’t sanction any more tax increases. The Democrats appear determined to protect welfare spending, even though its ballooning cost in coming years is one of the biggest threats to sound government finances.

The most likely short-term outcome of the row over government finances is that the spending cuts tied to the sequester become law on March 1 – for it would take a new law, thus compromises by both sides, to prevent this happening. That would mean another US$100 billion of government stimulus disappears from the economy each year over the next decade or so, an estimated hit of about 0.5% to GDP in 2013. Obama, sensing the danger of another austerity hit, in early February proposed that Congress pass a US$85 billion package of spending cuts and tax changes to offset the damage the sequester would have for the rest of 2013.

Politician-proof

Austerity can be a sound government response to prevailing economic conditions. Classic Keynesian economics would tell a government to run fiscal surpluses when the economy is humming to keep inflation under control. Austerity is just not optimal policy-making when a country’s export partners are in recession, an economy is recovering from a financial crisis, confidence is fragile and unemployment high. (The composition of austerity matters, too. Policies that hit the richer harder than the poor are less damaging that ones that do the opposite.)

How will the US economy handle austerity in coming years? It’s instructive to note that federal government spending supported the US economy from 2009 to 2012, at a time when many state and local governments were forced by law to slash spending and raise taxes to balance budgets.

Over the same period, the Federal Reserve set interest rates at zero and used unconventional means such as quantitative easing to ensure maximum thrust from monetary policy. The result of these efforts was that after the US economy contracted 3.5% in 2009, it expanded 3% in 2010, 1.6% in 2011 and is expected to have grown 1.3% in 2012. [5]

These numbers suggest the US recovery is sluggish and that it will have trouble coping with austerity shaving 1%-plus off GDP growth.

The US economy, though, may be more resilient than recent numbers suggest. The US government’s overspending is supporting growth, easy monetary policy is virtually assured in coming years and bright spots are emerging across the economy. The most sparkle is coming from housing due to low interest rates – thanks especially to the Federal Reserve’s purchases of mortgage-backed securities as part of its quantitative-easing program.

House prices nationwide rose for the fifth consecutive month in December from a year earlier, while housing starts and new home sales are rising while the number of foreclosures is dropping. Banks are lending more to home buyers, giving builders more confidence to invest in new homes – residential investment surged at an annual pace of 15.3% in the fourth quarter. Home building, which historically has accounted for about 4.5% of US GDP, is expected to make a substantial contribution to economic growth in 2013, an impact that will be magnified because a robust housing market gives home-related industries a boost.

More good news is that big-data technology, cheaper energy from fracking shale and wage restraint have made US manufacturing more competitive. Companies such as Apple and General Electric are shifting production home. A better trade performance due to reduced oil imports thanks to fracking and the weaker US dollar helping exports is expected to add to GDP, even if exports struggled in the fourth quarter.

If consumer and business confidence and jobs growth survive the political dramas, domestic demand is likely to hold up – consumption rose at a 2.2% pace in the fourth quarter while business investment set a 12.4% tempo. The extra 1.84 million people employed in the US over 2012 will add to overall demand. Don’t underestimate how much pent-up demand there is in the US after five sluggish years of growth – the release of pent-up demand is capitalism’s way of triggering self-sustaining recoveries. (There’re only so many years old cars and fridges can keep going.)

Add on the US’ long-term economic advantages – the ability of its citizens to innovate, the country’s large natural resources and mobile population – and the US recovery is more likely than not to withstand the challenges thrown at it by politicians. US stocks at five-year highs suggest investors think this way too.

Perhaps the best perspective to view the antics in Washington is to realise that whether or not the US escapes a recession this year is a sideshow in terms of the biggest risks investors face in 2013. As the US-based Stratfor Global Intelligence says, high unemployment and social discontent in the US will not lead to the disintegration of the republic into 50 countries with their own currencies. [6] Whereas, the damage austerity is wreaking in countries such as Portugal could do just that to the eurozone.

Financial information comes from Bloomberg unless stated otherwise.

Important information

References to specific securities should not be taken as recommendations.

1 The Telegraph. “Portugal warns EU-IMF troika to back off on austerity demands.”
2 Eurostat new release. “Euro indicators. Provision of deficit and debt data for 2011 – second notification.” 22 October 2012. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22102012-AP/EN/2-22102012-AP-EN.PDF
3 IMF Working Paper. “Growth forecast errors and fiscal multipliers”. Olivier Blanchard and Daniel Leigh. January 2013. http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf
4 European Trade Union Institute. Working papers. “Withdrawal symptoms: an assessment of the austerity packages in Europe. 2011. Table 2, page 14. http://www.etui.org/Publications2/Working-Papers/Withdrawal-symptoms-an-assessment-of-the-austerity-packages-in-Europe
5 IMF. World Economic Outlook. October 2012. Table A1. http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/tables.pdf
6 Stratfor Global Intelligence. “Europe in 2013: a year of decision.” 3 January 2013. http://www.stratfor.com/weekly/europe-2013-year-decision?utm_source=freelist-f&utm_medium=email&utm_campaign=20130103&utm_term=gweekly&utm_content=readmore&elq=f8595d076faa43899a87ff356f78fec

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• The US deal to avert the fiscal cliff combination of tax hikes and spending cuts is not the long term “grand bargain” that could have been hoped for to address America’s long term budget and debt problems.
• Such issues will come up again in February in negotiations to raise America’s debt ceiling, possibly resulting in another bout of market volatility around then.
• However, by scaling back the bulk of the huge recession threatening fiscal cutbacks that would otherwise have occurred this year, the fiscal cliff deal means that the US economy will likely be able to pick up speed to around 2.5% helped in particular by a housing recovery.
• This is great news for the global economy and growth assets such as shares. By year end I continue to see the Australian share market rising to around 5000, resulting in a total return for investors of around 12%. This wouldn’t be too bad given that Australian shares returned 20.3% in 2012.

To read this edition of Oliver’s Insights, click here.

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• Open ended quantitative easing (QE3) in the US is likely to continue into 2014. While it can’t solve all America’s problems it should help economic growth recover to 2.5% in 2013.
• Notwithstanding inevitable corrections, QE3 is positive for shares, commodities, gold and cyclical stocks.
• QE3 is likely to result in modest upwards pressure in bond yields.

Meanwhile in Australia, the minutes from the RBA’s last rate setting meeting revealed a somewhat more dovish tone than indicated by the post meeting statement released straigh after the meeting, with significant discussion regarding the risks to global growth and China in particular, the risks to the mining boom and even the observation that the benign inflation outlook provides scope to ease policy if needed.

We remain of the view that the RBA will cut the cash rate to 2.75% over the next six months, starting with a 0.25% rate cut next month. To read the full article, click here.

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The big picture

• Our central view is that the US economy is undergoing a mid-cycle pause and that growth will start to lift again late in 2011. As such, we believe that the Federal Reserve won’t provide additional monetary stimulus and will in fact start to withdraw the stimulus in early 2012. The gradual withdrawal of stimulus is expected to translate to a firmer greenback over 2012.
• We tip the Aussie dollar to ease from US104 cents at the end of 2011 to US102 cents by March 2012 and US97cents by June 2012. The Aussie is also expected to ease from 70.75 Euro cents in December 2011 to 70.30 Eurocents in June 2012.
• The weaker Australian dollar should cause foreign investors to become more positive about the Australian sharemarket. Around 40 per cent of all our listed shares are owned by foreign investors, so the stronger Aussie dollar caused some investors to become overweight Australian shares, prompting some to lessen their exposure. In the March quarter foreign investors sold $1.9 billion of Aussie shares – the first fall in just over eight years.
• But while a weaker currency should improve interest in Aussie shares, other factors such as proposed taxes on carbon emissions and mining profits, as well as a potential ban on the live animal trade, may also serve to restrain interest by foreign investors.
• Valuations on the Australian sharemarket remain broadly favourable. Currently share prices stand at 13.6 times historic earnings – below the long-term P/E ratio of 15. At face value the sharemarket appears cheap, but given investor preference for liquid investments such as cash and bank deposits, it may actually just be regarded as fairly valued in these more conservative times. CommSec expects the ASX 200/All Ordinaries to end 2011 at 5,000 before lifting to 5,500 points by the end of 2012.
• Shares are expected to out-perform other asset classes over 2011/12. Returns on residential property are expected to remain modest at 0-3 per cent given that supply and demand for property has become more balanced. Cash is expected to provide returns of around 5 per cent over the coming year with Government bonds also earning close to 5 per cent.
• The $64 question is when will the “new conservatism” come to an end. Unfortunately no one has the answer. We expect cash to rise from 4.75 per cent to around 5.25 per cent over the coming year. However, just like 2010/11,the risk is that “new conservatism” results in rates remaining stable for longer

The week ahead

• A busy week lies ahead in terms of domestic economic data with a Reserve Bank interest rate decision thrown in for good measure. In the US, the spotlight shines brightly on Friday’s jobs data.
• In Australia, the first full week of the new financial year begins with a barrage of economic data. On Monday, data on job advertisements is released together with the TD Securities/Melbourne Institute inflation gauge, retail trade and building approvals data.
• We expect that retail trade rose by 0.6 per cent in May with the colder weather providing a spur to seasonal purchases. Building approvals are expected to have risen by 3 per cent in May, but approvals are up one month and down the next, so little should be read into the gain. The other data is also worth watching. Job ads fell in May while underlying inflation fell to near 6½ year lows. If the June readings produce similar results, the Reserve Bank won’t be in any rush to lift rates.
• The Reserve Bank Board meets to decide interest rate settings on Tuesday with the monthly trade figures and Performance of Services index released the same day. No change in rate settings is expected or justified. The next big test for most analysts is the June quarter inflation data to be released on July 27.• In terms of the economic data, the Performance of Services index was below 50 in May, pointing to a contraction of activity across the sector. Another weak reading would further water down the chances of a rate hike in coming months. And the trade surplus may have expanded to $1.7 billion in May.
• Data on engineering construction is released on Wednesday while the June jobs report is issued on Thursday. We expect that employment grew by 15,000 people in the month – largely in line with the number of new entrants. As a result, the jobless rate probably remained unchanged at 4.9 per cent. Over the past two months, full-time positions have been cut by almost 80,000, and another fall in jobs in June would raise doubts about the fundamental health of the economy.
• In the US, markets are closed for the Independence Day holiday on Monday. On Tuesday, data on factory orders is released, while the ISM services sector index is issued on Wednesday alongside the Challenger job lay-off series. Economists believe that the services sector is still growing – a reading above 50 is expected – but the index probably eased from 54.6 to 54.3 in June.
• The ADP survey of private sector employment is released on Thursday while the non-farm payrolls (employment) report is issued on Friday alongside figures on consumer credit and wholesale inventories.
• Economists tip a modest 60,000 lift in the ADP survey and then project a modest 90,000 lift in non-farm payrolls. But whichever way you cut it, job gains are modest. The unemployment rate is tipped to remain high near 9.0 percent, albeit down from 9.1 per cent in May.
• The European Central Bank and Bank of England have rate-setting meetings on Thursday.

Sharemarket

• It may not seem like it, but the sharemarket had one of its least volatile years during 2010/11. Over the past financial year, there were just 56 trading days where the All Ordinaries either rose or fell by more than one percent. In fact it was the least volatile 12-month period in almost four years.
• Looking back over the past 15 years, on average the sharemarket has risen or fallen by more than one percent on 63 days in a year, or around once every 4-5 days. No surprises for the most volatile period – it was the time of the global financial crisis. Over the year to January 2009, the All Ordinaries moved up or down by more than a percent on 163 days or around two in every three days. The least volatile period was the year to January 2005 when there were just nine days where the sharemarket rose or fell by more than one per cent.

Interest rates, currencies & commodities

• The past year has been the most stable year for interest rate changes in six years – since 2004/05. Contrary to the forecasts of most private sector economists, the Reserve Bank hasn’t had to lift rates more than once over the financial year as a slowdown in non-mining sectors together with the effects of floods and cyclone have offset solid growth in the resources sector. The only rate change was a 25 basis point increase delivered on November 3. The last time there was just one rate change in a financial year was 2004/05 when rates rose 25 basis points on March 2 2005. That was the only official rate change between January 2004 and April 2006.
• Interestingly, financial markets have again changed their view on the next move in rates. In five months time, the cash rate is tipped to be at 4.70 per cent – or below the current 4.75 per cent cash rate. In other words, financial markets have priced in a 20 per cent chance of a rate hike late this year.
• Over the past year the Aussie dollar has held between US83.14 cents and US110.11 cents – a range of almost US27 cents or a 32 per cent movement between the highs and lows. It sounds a lot, but is this normal? Over the2 7½ years since the currency floated, the Aussie dollar has moved on average by US13.6 cents over a year, or a change of around 21 per cent. The 2010/11 financial year was actually the second most volatile year on record behind 2008/09 (range of US38.45 cents).

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