Headline developments of the past week

The past week saw a bit of volatility return to risk trades early in the week on worries that China’s 7.5 per cent growth target for this year is too low, uncertainty about Greece’s bond swap and news Brazilian GDP growth had slowed to 1.4 per cent last year. Markets steadied later in the week though as the Greek bond swap got solid support indicating it will likely go ahead in a move that will reduce the value of privately held Greek public debt from €206bn to around €100bn and help clear the way for Greece to get its next tranche of bailout money in order to make a bond payment on 20 March. So a messy Greek default has been headed off yet again (for now).  

China’s 2012 growth target of “just” 7.5 per cent is not worth worrying about. First, it’s entirely consistent with the current 5-year plan which envisages seven per cent per annum growth that was unveiled last year. More importantly, China’s annual growth target should be seen as a minimum bound of what is considered acceptable. Its annual growth target has been exceeded every year for the last decade or so by at least one per cent per annum. We continue to see Chinese growth this year of around  eight per cent. Meanwhile, China’s inflation target of four per cent is probably likely to prove too pessimistic with inflation already having fallen to 3.2 per cent in February. And its budget deficit projection of 1.5 per cent of GDP amounts to a slight easing in fiscal policy compared to the smaller deficit achieved for 2011 and looks likely to be an underestimate of the actual affect as unspent local government spending will likely be carried forward into 2012. I can’t see much threat to the growth outlook in any of this.

Global central banks are still in easy mode. The US Fed looks to be toying with the idea of another round of quantitative easing, with the aim of buying bonds to keep down borrowing costs but soaking up the liquidity to ensure no impact on inflation. The Brazilian central bank cut by 0.75 per cent with further easing likely as growth has slowed sharply and its cash rate is 9.75 per cent. The Bank of Canada left rates on hold but there appears no urgency to tighten. While both the Bank of England & ECB left monetary policy unchanged more easing is likely for both.

In Australia, the Reserve Bank left interest rates on hold, reiterating that with growth expected to be close to trend and inflation close to target, monetary policy remains appropriate for now. However, RBA Deputy Governor Philip Lowe signalled that were the unemployment rate to rise persistently the RBA may cut rates. Our assessment remains that interest rates need to be cut and that they will be some time in the next few months. GDP growth is currently running well below trend, while mining-related activity is booming (up 27 per cent year-on-year according to Goldman Sachs’ estimates) the non mining economy is contracting (by 1.1 per cent year on year), the jobs market has stalled and were it not for a sharp fall in labour force participation over the last year unemployment would have risen to around six per cent, inflation is benign and the strong Australian dollar along with hikes in bank mortgage rates have delivered a de facto monetary tightening when the economy needs the opposite. And finally, given cautious consumer and business attitudes to debt following the GFC we see the neutral level for the cash rate as being 0.5 per cent below current levels. We anticipate the RBA will cut interest rates in May.

The Australian floods are terrible from a human perspective, but their economic impact is likely to be minor compared to last year’s floods as they are not affecting big coal mines, they have not affected a big capital city and appear to have only a modest negative short term affect on food supply (unlike last years hit to the banana supply). Over the medium term it’s a godsend given full dams and replenished ground water.

Major global economic releases and implications

US economic data was mostly solid with a rise in the ISM non-manufacturing conditions index, solid labour market indicators, solid growth in consumer credit and a further gain in weekly mortgage applications. Productivity growth data was disappointing though.

European data was soft with a fall in a PMI services conditions index for February below the initial flash reading and a sharp fall in German factory orders. At least, German industrial production rebounded in January.

Japanese news was positive with December quarter GDP revised up and a rise in economic sentiment.

Chinese economic data for February revealed a further sharp fall in inflation to 3.2 per cent. This is well down from the peak of 6.5 per cent seen in July last year and provides plenty of scope for the People’s Bank of China to further ease monetary policy in order to ensure that the economy has a soft landing.

Australian economic releases and implications

Australian GDP growth in the December quarter was just 0.4 per cent GDP or 2.3 per cent growth year-on-year as weakness in consumer demand, housing and business investment all bore down on spending and softness in profits and employee compensation bore down on income. While mining capex is likely to drive stronger business investment in the current quarter, non-mining capex, consumer spending and housing activity are all likely to remain weak. What’s more the jobs market has virtually stalled and conditions in the services and construction sectors weakened in February. And just to cap off a bad week on the data front, the trade balance swung back into deficit in January driven by a slump in gold and iron ore exports. Fortunately, a return to surplus is expected in February as iron ore exports return to previous levels and gold exports are normally very volatile.

Slumping tax revenues further confirm the tough times the economy is going through. However, talk of a new round of spending cuts to ensure a budget surplus for 2012-13 is concerning as fresh fiscal austerity will only make life tougher for the non-mining economy. Hopefully the Government will choose to rely more on timing tricks around spending and measures such as the sale of telecommunications spectrum to achieve the surplus. 

Major market moves

Share markets had a somewhat volatile week, initially falling on global growth worries to then recover on optimism regarding Greece’s bond swap. Australian shares continued to underperform their global counterparts, dragged down by more poor economic data and the RBA’s decision to leave interest rates on hold.

Commodities prices were generally softer and this combined with soft Australian data weighed on the Australian dollar.

Sovereign bond yields were mixed. Down in Australia, up in the US and flat in Germany. The good news is that Italian 10-year bond yields made new lows for the year highlighting that fears of a flow on from Greece’s partial default to core Europe have receded.

What to watch over the week ahead?

In Europe the focus is likely to be on the settlement of the Greek bond swap and an EU finance ministers meeting on Monday in terms of progress towards Greece getting initial tranches of its second bailout.

In the US, the Fed is unlikely to unveil any changes to monetary policy following its meeting on Tuesday. Rather the post meeting statement will be gleaned for any clues regarding the prospects of QE3. Meanwhile expect February retail sales to increase by one per cent (Tuesday), industrial production to increase by 0.5 per cent (Friday), manufacturing conditions in the Philadelphia and New York regions to have remained solid (Thursday) and inflation to have been boosted by rising fuel prices (Friday).

The Reserve Bank of India may cut its cash rate to 8.25 per cent (from 8.5 per cent) when it meets Thursday.

In Australia expect recent news of rising unemployment, soft economic growth and rises in bank mortgage rates to have resulted in a fallback in consumer sentiment after several months of solid gains (Wednesday). Data for housing finance and starts will also be released.

Outlook for markets

Shares are still vulnerable to a further correction in the short-term given high levels of investor sentiment, strong gains year to date and the oil price surge. However, any pullback globally is likely to be mild and the broader trend is likely to remain up. Valuations are attractive, particularly against very low bond yields, the risk of a Euro-zone meltdown continues to fade, momentum in global economic indicators is positive, global monetary conditions are getting easier and easier and there is lots of cash on the sidelines. We continue to see the S&P/ASX200 pushing up to 4800 by year-end, but thanks to tougher monetary conditions in Australia and the strong Australian dollar, the Australian share market is likely to remain a relative laggard.

Low global bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies. Good quality Australian corporate debt is a better bet.

Beyond the current consolidation/correction, the broad trend in the Australian dollar is likely to remain up, helped by more global quantitative easing, solid commodity prices & better global confidence. A retest of 110 US cents is likely.

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