Headline developments of the past week
Eurozone finance ministers look likely to agree to increase Europe’s debt firewall to around €940 billion by combining the €500 billion in the European Stability Mechanism that will commence from mid year with the €440 billion in the existing European Financial Stability Facility (EFSF) bailout fund. Given that €200 billion of EFSF funding has already been committed, this would leave a total of €740 billion in new funds that would potentially be available until mid-2013 at which point the EFSF will wind down.
While risks remain huge in Europe – with upcoming elections in Greece and France, referendums and backsliding on the fiscal compact and economic reforms, worries about Spain and the reality of a recession this year – the expansion of the firewall coming on the back of the ECB’s actions to support eurozone banks suggest that it is gradually (fingers crossed) getting on top of its problems.
In the US, Fed Chairman Ben Bernanke reiterated his concerns that the US recovery remains fragile with the clear implication that accommodative monetary policy will need to remain in place for an extended period and that further quantitative easing is still possible. The extended run of dovish comments from Bernanke along with recent softish economic data has seen the global bond sell-off stop dead in its tracks.
In Australia, it’s coming up to Budget time and as always the Treasurer is warning it will be tough. The Government’s surplus projection for 2012-13 from late last year was wafer thin at $1.5 billion and unfortunately the mining investment boom has cut into the tax revenue normally generated out of the mining sector and at the same time the tough economic backdrop has seen weaker-than-expected company tax receipts from elsewhere in the economy.
While the Government remains committed to delivering a surplus for 2012-13, our view is that in order to avoid worsening the economic outlook, spending cuts should be kept to a minimum and that the Government should rely more on revenue raising from things such as telecom spectrum sales and creative accounting with the timing of spending measures. More spending cuts or not, the huge fiscal drag (equal to around 2.4 per cent of GDP next financial year) coming down the line adds to the case for lower interest rates.
Major global economic releases and implications
US economic data continued the softer-than-expected run seen over the last couple of weeks with an unexpected fall in pending home sales, a slight fall in consumer confidence, falls in regional manufacturing conditions surveys and a smaller than expected rebound in durable goods orders. Against this though, unemployment claims continue to trend down, durable goods orders still point to reasonable growth in capital spending, house prices are basically and new mortgage applications continue to trend higher.
European economic data was mixed with a better-than-expected German IFO business climate survey, a rise in Italian business confidence and gains in consumer confidence in France and Italy along with stronger than expected money supply growth in February but a slight fall in eurozone economic sentiment. We still expect a mild recession in the eurozone this year with a GDP contraction of negative one per cent.
Japanese data was mixed with a rise in small business confidence, solid gains in household spending and a fall in unemployment but with deflation continuing. Chinese industrial profits fell 5.2 per cent over the year to February, the first fall since 2009, adding to worries about a hard landing in China.
Australian economic releases and implications
In Australia, it was a quiet week on the data front with a marginal pick up in credit growth with the trend remaining weak, a modest rise in job vacancies over the three months to February after a fall over the past year and three per cent gain in new home sales which left them at still very weak levels.
Major market moves
Global share markets started the past week on a strong note on the back of indications from the Fed that monetary accommodation will still remain in place and signs the European debt firewall will be expanded. Gains were gradually reversed though on the back of softer-than-expected US data and worries about China and Europe.
It was a very good week for Australian shares though with the ASX 200 finally breaking above the 4300-resistance level that has been in place all year, partly boosted by increasing expectations that the RBA will soon cut interest rates.
Commodity prices were soft on global growth concerns. The oil price fell sharply on talk of a release of global oil reserves. China worries, softer commodity prices and increasing talk of an RBA rate cut are all weighing on the Australian dollar.
Bond yields fell in major countries and Australia on softer data releases and lowered interest rate expectations.
What to watch over the week ahead?
In the US, both the ISM manufacturing conditions index (due Monday) and the non-manufacturing conditions index (Wednesday) are expected to show continued growth in March, and payroll employment (Friday) is expected to have expanded by another 210,000 jobs.
Both the ECB (Wednesday) and the Bank of England (Thursday) are expected to leave monetary policy unchanged. Final eurozone PMIs for March and retail sales for February will be released on Wednesday.
In China, both the official and the HSBC manufacturing PMIs for March will be released on Sunday and are likely to show some softening after the fall in the flash estimate. Reflecting the run of softer Chinese data lately another policy easing is likely soon, and could come in the next few days.
In Australia, the main focus will be on the Reserve Bank’s meeting on Tuesday where a 0.25 per cent interest rate cut is quite likely. We think there is an overwhelming case to cut rates again as recent indicators for GDP growth, retail sales, construction, housing and employment have been weaker than is consistent with trend growth and the inflation outlook is benign. While the last two post meeting statements from the RBA implied a high hurdle for future rate cuts in terms of a “material” slowing in domestic demand, a recent speech by Governor Stevens acknowledging below trend growth and indicating that monetary policy can provide a role in supporting demand suggests the RBA has been softening its stance. While the RBA may prefer to wait till after the release of the March quarter CPI data on 24 April, which we expect to show benign inflation, my assessment is that there is actually a good chance of a rate cut this Tuesday. Rates need to come down so why wait. But whether it’s in the week ahead or May we think that interest rates should and will come down. If rates do come down on Tuesday expect banks to pass on at least 0.15 per cent to their customers.
On the data front in Australia, expect soft readings for building approvals and house prices (Monday) and retail sales (Tuesday) but a return to a trade surplus for February (Wednesday).
Outlook for markets
While I don’t see a rerun of the last two years where shares peaked around April only to fall 15 to 20 per cent, it does seem that the ride ahead will become a bit rougher. After a 10 per cent or so gain in global shares and seven per cent in Australian shares so far this year the easy gains have been seen: while Europe is looking less scary it's still a potential source of mishaps given upcoming elections in Greece and France, budget problems in Spain, austerity fatigue and recession; next year’s fiscal drag equal to 3.5 per cent of GDP in the US may worry investors as could a soft patch in economic data after the strong patch of late; and China hard landing fears remain.
However, any correction should be mild and we still see share markets higher by year end as 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 there is lots of cash on the sidelines. Chinese and emerging country share markets should pick up as China starts to more aggressively ease economic policy.
If the RBA continues to hold fast on interest rates and hard landing fears remain in China, the Australian share market is likely to remain a laggard. However, a rate cut from the RBA on Tuesday and another easing in China could change this though.
Low bond yields in major countries suggest low returns unless Europe’s debt crisis intensifies. Don’t expect a bond yield melt up though as higher inflation and US monetary tightening are still a long way off.
The current correction in the Australian dollar may have further to go reflecting soft data in Australia and worries about China. 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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