Headline developments of the past week
The past week saw a distinct contrast between strong US economic data and a more optimistic Fed driving US shares and most global share markets higher, but comments from Chinese Premier Wen Jiabao dampening expectations of policy easing in China which weighed on Chinese shares, commodity prices and the Australian dollar. A further run of soft Australian economic data also weighed on the Australian dollar. The simple ‘risk on/risk off’ trade where shares, commodities and currencies like the Australian dollar all move together seems to be breaking down a bit reflecting the different stages of the economic cycle key countries are in.
Perhaps the biggest development though was the break-up in bond yields in the US on the back of stronger economic data and diminishing expectations for QE2 which in turn drove bond yields higher in Germany, Australia and elsewhere. Sovereign bonds in core countries are terrible value with yields recently plunging to multi-decade lows and in some cases record lows. At the least this points to poor returns ahead. At worst we could see a repeat of the bond crash of 1994. The latter seems unlikely though given that the economic recovery is still fragile and the Fed would intervene at some point to keep bond yields down. Either way though the outlook for returns from sovereign bonds in major countries is poor. The realisation of this could see a lot a money come out of sovereign bond funds looking for a home going forward.
The much stronger position of the US banking system compared to three years ago was highlighted by the US Federal Reserve’s latest bank stress tests. While four banks failed the test, the scenario they failed was absurdly tough involving 13 per cent unemployment, a 50 per cent share market plunge and a 21 per cent further plunge in house prices. What’s more, two of the four banks that failed would pass with a slightly different capital action plan (such as, lower dividend payments) and one is more an insurer than a bank. Bank and financial shares rose sharply, helped along on news that JP Morgan is to increase its dividend. With the stronger capital position of US banks and signs of an impending upturn in the US housing sector, the outlook for US financials is looking healthy.
Comments from Chinese Premier Wen Jiabao that house prices are still too high and that it’s premature to relax property controls contrasts with news that China was easing lending restrictions on the four biggest banks and an easing of restrictions on loans for first homebuyers. Meanwhile, the key message from the National People’s Congress was one of focusing on quality over quantity in terms of growth. Our take is that policy easing will remain selective consistent with ensuring a soft landing in the economy but avoiding any sort of unsustainable rebound leading to renewed imbalances as occurred in 2009-10. In short, policy easing is likely to remain gradual, with property controls being the last to ease.
European debt news was mostly favourablewith Italian and Spanish bond yields remaining under control despite a rise in global bond yields generally, Spain agreeing to cut back its budget deficit target for this year, the IMF committing €28 billion to Greece’s second bailout and signs that the Eurogroup would agree to increase the size of the €500 billion European Stability Mechanism rescue fund later this month.
Major global economic releases and implications
US economic data continued to surprise on the upside, with strong gains in retail sales and new mortgage applications, further gains in manufacturing business conditions in the New York and Philadelphia regions, a rise in small business optimism and a continuing fall in unemployment claims. What’s more, the Fed sounded slightly more optimistic, upgrading its description of the growth outlook from modest to moderate, but at the same time maintaining its commitment to keeping interest rates low through to late 2014 at least. It also viewed the recent increase in oil prices as having only a temporary impact on inflation.
European economic data was mixed with a smaller-than-expected rise in industrial production in January and a sharp fall in Spanish house prices, but a further sharp rise in economic expectations regarding Germany in a ZEW survey of financial analysts. Norway cut interest rates again on the grounds inflation is below target.
Japanese economic data was mixed with a rise in machine orders, but falls in consumer confidence and a tertiary activity index. What’s more, the Bank of Japan didn’t follow through with any further increase in its asset purchase (or quantitative easing) program.
The Reserve Bank of India left interest rates on hold following a higher than expected inflation reading and a surge in industrial production in January. While the RBI retained a bias towards cutting interest rates, it has become a bit more concerned about inflation risks and in any case an easing had become less likely following the surprise cut to banks’ required cash ratios the week before. With core inflation still falling, we still expect a rate cut but it may be a few months away.
Australian economic releases and implications
Economic data releases in Australia remained soft. While business conditions improved slightly in February according to the NAB business survey, business confidence actually fell as did consumer sentiment, housing finance and housing starts. Consumer sentiment has now fallen back to its lowest level since December and housing finance may go through a soft patch as first homebuyer demand in NSW falls after the ending of a stamp duty concession in January.
Major market moves
Share markets rose solidly on the back of more good news regarding the US economy, with the US share market breaking out to its highest level since June 2008. Australian shares also rose but remain constrained by the 4300-level on the ASX 200 which has proved to be stiff resistance over the last four months as a result of the higher RBA interest rates, the strong Australian dollar and concerns about a hard landing in China.
Commodity prices were mixed on good news from the US but uncertainty about China. Mixed news on commodity prices, diminishing expectations for further Fed easing & soft data in Australia all weighed on the Australian dollar.
Bond yields rose sharply on stronger US economic data and diminishing US QE expectations.
In the US, expect the NAHB housing conditions index (Monday) to show a further improvement, housing starts (Tuesday) to fall back slightly after recent gains and a further recovery in existing home sales (Wednesday) and new home sales (Friday). Data for house prices and leading indicators will also be released.
In the eurozone, business conditions indicators (PMIs) will be published (Thursday) as will data for consumer confidence, industrial orders, the current account and construction output.
In China, the flash HSBC PMI for manufacturing will be published (Thursday) and is likely to show ongoing evidence of stabilisation around the 50-level, which is consistent with GDP growth of around eight to nine per cent.
In Australia, it will be a quiet week on the data front with the main focus being on the RBA, with a speech by Governor Glen Stevens (Monday), the minutes from the last Board meeting (Tuesday) and speeches by Assistant Governors Edey and Debelle (Tuesday and Thursday respectively) all likely to be watched closely for clues regarding the interest rate outlook. The minutes are now arguably somewhat dated given recent data releases, so Governor Steven’s speech on “Economic Conditions and Prospects” is likely to be watched particularly closely to see whether the RBA has become a bit more predisposed towards a rate cut following recent soft readings for GDP and employment.
Outlook for markets
While there will be numerous pullbacks along the way the broad trend in global shares is likely to remain up. Valuations remain attractive, particularly against very low bond yields, the risk of a eurozone meltdown has faded, momentum in global economic indicators is positive, global monetary conditions are getting easier and easier and there is lots of cash on the sidelines.
Rising global share markets are likely to pull the Australian share market higher but it is likely to remain a laggard on the back of high interest rates in Australia, the strong Australian dollar and worries about a hard landing in China.
Low global bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies.
The current correction in the Australian dollar may have further to go reflecting soft data in Australia and the receding odds of more US quantitative easing. However, the Australian dollar is likely to remain strong overall as the improving global growth outlook supports commodity prices and as Australian interest rates remain above US rates.
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