The big picture
Investors have plenty of reasons to feel frustrated by the performance of the Australian share market over the past 18 months. While the Australian economy has out-performed every major developed nation, our share market has closely tracked the under-performing US market.
In fact, the measure of the relationship (correlation) between the Australian and US share markets is extremely tight. The correlation (r-squared) ratio between the Australian All Ordinaries and the US Dow Jones index since January 2008 stands at 0.97 where a ratio of 1.0 would signify that both markets have been moving in perfect unison.
Investors would rightly conclude that – unlike the US – Australia hasn’t had a banking crisis or an explosion of bad debts. And again – unlike the US – there isn’t an oversupply of homes in Australia, rather an under-supply of property that has served to push prices higher.
So why haven’t local and overseas fund managers distinguished between Australian and US fundamentals?
The first point is that the close link between the Australian and US markets isn’t a peculiar situation. Rather, investors in Japan, Europe and the UK have had the same preoccupation with the US, hoping that improvement in the US economy would lead to better times for the globe. Share markets in Japan, the UK and Germany all have correlation ratios with the US Dow Jones above 0.93.
It is important to remember that the US economy represents just over 21 per cent of world GDP (on a purchasing power parity basis), double that of China. Australia accounts for just 1.2 per cent of GDP.
The second point is that while the US still dominates the global economy, its share of capital markets is even greater. Economic consultancy group, Capital Economics, estimates that the US accounts for a third of debt securities, real estate and equities. By comparison, Australia is in 11th spot with 1.7 per cent of world assets.
Then there is the high proportion of our listed equities owned offshore: the latest data shows that almost 45 per cent of Australian equities are owned by foreigners.
The question is whether institutional investors are opting for a passive approach to managing their investments, that is content to track benchmarks.
So, have Australian investors been short-changed over the past 18 months? It could be argued that the strength of our economy has warranted a more positive view by fund managers. The Chinese economy has certainly performed better than the US and so has its share market, up 84 per cent from the November lows. While developed nation share markets are highly correlated with the US, the correlation between the Chinese and US share markets stands at just 0.49.
Inflation is probably best thought of the “forgotten” indicator in the GFC era – at least here in Australia. The focus has clearly been on activity indicators such as retail spending, investment and employment rather than price trends.
So with inflation indicators dominating in the coming week, it will be interesting to see how much scrutiny the data gets. Certainly there is no suggestion of the Reserve Bank lifting interest rates in response to a higher-than-expected inflation reading. And with our economy reviving, a low inflation reading similarly won’t prompt the Reserve Bank to cut rates.
Data on producer prices are released on Monday with the consumer price index (CPI) on Wednesday. Movements in the Australian dollar, coal and iron ore prices are likely to dominate the producer price figures. Overall, we tip a modest 0.3 per cent rise in prices.
Petrol has been a key influence on the past two CPI results but it will take on a smaller role in the June quarter figures. Petrol rose by 3.5 per cent in the June quarter, adding around 0.1 percentage point (pp) to the quarterly growth rate of the CPI. In the December quarter, petrol took off 0.9 pp off CPI growth and another 0.3 pp from the March quarter rate.
Overall we expect that the CPI grew by 0.6 per cent in the June quarter, resulting in the annual inflation rate easing from 2.6 per cent to 1.6 per cent. While discounting kept a lid on prices for clothing and household goods, the inflation result won’t benefit from the same fall in financial services costs that constrained the March CPI result.
Measures of “underlying” consumer prices probably rose around 0.7 per cent in the June quarter, dragging annual inflation down from around 4.25 per cent to 3.75 per cent. Underlying inflation is clearly on track to the Reserve Bank’s 2-3 per cent target band.
In terms of other data and events, minutes of the Reserve Bank Board meeting for July will be issued on Tuesday and investors will be looking for further upbeat commentary. And the car sales data will also grab attention. CommSec estimates car sales rose by 10 per cent in June, courtesy of the federal government’s tax break for businesses. Interestingly, the tax break was enhanced and extended for small business, a factor that should support sales of trucks, utes and vans. The June car sales data is released on Tuesday.
In the US, company earnings results will grab more attention than economic data. The leading index is released on Monday with existing home sales on Thursday and revised consumer sentiment figures on Friday.
In terms of economic-type events, the stand-out will be the semi-annual testimony to Congress by Federal Reserve chairman Ben Bernanke on Wednesday. While the politicians will be interested in the Fed chief’s views on the economy, they will be more interested in so-called “exit strategies” – how the central bank plans to reduce monetary stimulus without derailing the recovery.
In the coming week, earnings results are issued from 298 companies that form part of the S&P 500 index. It’s fair to say investors have been happy with the earnings results that have been published to date. So investors will have fingers and toes crossed that the good run continues over the next fortnight.
Texas Instruments is amongst companies reporting on Monday while Coca Cola, Merck, Apple and Yahoo! are slated for Tuesday. On Wednesday, Pepsi, Pfizer and Wells Fargo are expected to report with CIT Group, Microsoft, American Express, Amazon, McDonald and Ford Motor with profit results on Thursday.
Interest rate cuts are off the agenda for now, but it is too early to think about rate hikes. Currently the 90-day bank bill rate stands at 3.19 per cent, up from 3.10 per cent on 7 July and above the three per cent cash rate. The overnight indexed swap rate is hugging just under three per cent for the next nine months with a 50 per cent chance of a 25 basis point rate hike factored in by mid 2010. Interestingly, the implied yield on 90-day bank bill futures rises from 3.20 per cent in September to 4.00 per cent in June 2010.
The Aussie dollar remains comfortable in its US77-82 cent range. While the lower end of the range was tested over the week, the Aussie managed to rebound in response to firmer equity markets, and therefore an increase in risk tolerance. Remarkably, the correlation between the Australian dollar and the US Dow Jones stands at 0.83 (perfect correlation equals 1.0) for the period since March when equity markets started their recoveries.
After consistently falling for a month, a key measure of shipping costs – the Baltic Dry index – bounced four per cent higher on Tuesday. Is this index signalling the end of the correction in commodity markets? It’s worth noting that the daily correlation between the Baltic Dry index and the London Metal Exchange base metals index stands at 0.87 for the period since January 2008.
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