Headline developments of the past week
The past week has seen a swing to ‘risk off’ with shares, commodities and growth currencies like the Australian dollar all weak on worries about Spain and China and fears of no more QE3 in the US. After a strong March quarter, some sort of consolidation or correction is inevitable and so this may be what we are starting to see.
The focus in Europe is increasingly shifting to Spain which faces an extremely difficult balancing act in implementing more austerity to reduce its budget deficit but not so aggressively that the recession deepens, only worsening the deficit. Spain’s public debt at around 70 per cent of GDP is way below the 120 per cent plus of Greece, but it has been heading in the wrong direction and its banks are at risk should the economic downturn intensify. These concerns were reflected in a poor bond auction which saw Spanish 10-year bond yields pushed above 5.5 per cent for the first time since January. This will need to be watched closely.
The minutes from the Fed's last meeting signalled there was no need for more easing unless growth slowed again and certainly didn’t help investor sentiment, given fresh memories of the falls in share markets following the ending of QE1 in 2010 and QE2 in 2011. However, the minutes are heavily dated given numerous comments by Fed Chairman Bernanke in the period since the meeting that the US recovery remains fragile with the implication that easy policy will have to remain in place and that further quantitative easing is still possible.
A week ago I thought an RBA rate cut was ‘quite likely’ at its April meeting. But no such luck, with the RBA leaving rates on hold yet again. The case to cut interest rates is overwhelming:
And now even the trade boost to the economy is showing signs of softening with two trade deficits so far this year. However, the RBA has at least moved to a strong easing bias in now acknowledging that output growth is below forecast and below trend but decided to put off a cut until it gets a look at the March inflation data due 24 April. We think it will be benign and clear the way for a May cut. The trouble though is that the RBA should have cut in February and the delay is needlessly threatening the economy. Having admitted growth is weaker than expected, it would have made more sense to get a cut out of the way rather than make it contingent on a CPI statistic that could temporarily surprise on the upside resulting in a further needless delay.
Major global economic releases and implications
US economic news was mostly good with solid ISM manufacturing and services conditions indexes, a strong rise in weekly retail sales, another rise in weekly mortgage applications and strong indications regarding jobs growth. Softer-than-expected data for auto sales and construction activity were disappointing though. Japanese data was also positive with mostly stronger readings in the Tankan survey and stronger auto sales.
European news was mixed following the decision of finance ministers to cap new bailout lending to €500 billion, rather than increase it to €740 billion as had been flagged. While the funding will be available earlier than previously indicated and €500 billion should be enough to cover any further assistance to Portugal and Spain’s funding needs over the next two-and-a-half years, it wouldn't cover Italy’s requirements. The smaller-than-hoped-for amount has made it less clear how much G20 nations will be prepared to contribute via the IMF. On the data front, March eurozone manufacturing PMIs were unchanged from earlier estimates, but services PMIs were revised up slightly. Both are consistent with a mild recession. The bad news though was that eurozone retail sales and German factory orders were both weak and the unemployment rose further to 10.8 per cent. In Italy, it is at a record high with around one-third of youth unemployed. As expected, the ECB left interest rates on hold and President Draghi made it clear that any talk of exit from easy monetary policies is premature.
The news out of China also remains mixed, but still consistent with a soft landing. Official manufacturing and non-manufacturing PMIs rose in March and while the HSBC PMI fell, it was above the flash estimate and in any case all are at levels consistent with eight per cent or so growth. Meanwhile, average residential property prices fell for the seventh month in a row. While concerns about a hard landing remain, comments by Premier Wen Jiabao over the last week have struck a more dovish tone than has been the case of late suggesting further easing may be on the way, albeit not necessarily in relation to property. Finally, China announced a further opening of its domestic asset markets by raising the QFII quota for foreign investors to $80 billion from $30 billion. Given the experience of the last few years, I can't see a huge rush in, but it is good news longer term.
India saw its manufacturing PMI fall sightly in March but remain solid.
Australian economic releases and implications
Australian economic data remained disappointingly weak with a sharp fall in building approvals, flat house prices, soft retail sales with annualised growth of just 0.9 per cent over the last three months, weak readings for business conditions in the manufacturing and services sectors and another surprise trade deficit in February. The trade turnaround from last year's surpluses to deficits so far this year is concerning. While it appears to be at least partly driven by temporary disruptions, at the very least it looks like trade will be a significant detractor from March quarter GDP growth, which coming on the back of poor readings for housing construction and retail sales points to yet another quarter of below trend growth.
Major market moves
Global shares fell on worries about a renewed intensification of the eurozone crisis centred on Spain and reduced QE3 expectations. Global weakness and the lack of an RBA rate cut also weighed on Australian shares.
Global growth worries and a stronger US dollar also weighed on commodity prices. Weak commodity prices and soft Australian economic data for retail sales, housing and trade saw the Australian dollar pushed back below 103 US cents.
What to watch over the week ahead
Chinese economic data releases for March will likely be the key focus of the week ahead. We expect inflation (Monday) to have remained around 3.2 per cent after a sharp fall in February, growth in exports and imports (Tuesday) to remain soft, March quarter GDP growth (Friday) to have slowed to 8.5 per cent, but March data for money supply and loan growth (Wednesday), industrial production, retail sales and investment (all due Friday) to have accelerated. Overall, expect the data to point to a soft landing but with plenty of scope to ease policy if need be.
In the US, expect headline inflation (Friday) to have been boosted by gains in gasoline prices but core inflation to have remained benign. The Fed's Beige book of anecdotal evidence will also be released Wednesday.
In Australia, expect more soft readings for business confidence (Tuesday) and consumer confidence (Wednesday), a one per cent fall in housing finance (Wednesday) and a further 10,000 fall in employment (Thursday) pushing unemployment up to 5.3 per cent, from 5.2 per cent in February.
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 strong rises in the March quarter, the easy gains are likely behind us: Europe is 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 yearend as valuations remain attractive and more so than was the case a year ago, particularly against very low bond yields, the risk of a eurozone banking meltdown has faded, momentum in global economic indicators is more 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, Australian shares will likely to remain a laggard. However, a rate cut from the RBA and another easing in China could change this.
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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