Key events of the past week and implications

  • Global shares continued to move higher over the past week, but another trend that's clearly evident is the continuing slide in the Australian dollar. The past week saw it fall decisively below parity and then keep going. A negative reaction to the budget didn’t help but the big drivers of the falling Australian dollar are a downtrend in commodity prices, a resurgent US dollar and falling interest rates in Australia. The next stop is likely to be the 2011 and 2012 lows around $US0.95/0.96, and the broad trend is likely to remain down in the years ahead. This is actually good news for Australia as a rising currency was appropriate when commodity prices were surging but with that now reversing, a lower Australian dollar is needed to help boost non-mining sectors like tourism, manufacturing and retailing.
  • For some time, my view has been that the tide is going out on the Eurozone crisis. Another supportive indicator of this is Greek 10-year bond yields which have now fallen to 8.06%, way down from their crisis highs of 37%.
  • While the gold bugs have been warning of hyperinflation to come from quantitative easing there is no sign of it. Data over the past week showed that inflation is now just 1.1% in the US, 1.2% in the Eurozone and 0.4% in Canada and it’s even falling in India. This suggests that there is still room for central bank easing.
  • Something overlooked lately has been the surprising improvement in the US budget deficit. As a proportion of gross domestic product (GDP) it has almost halved from over 10% of GDP in 2010 and now the Congressional Budget Office has cut its estimate of the deficit for this year by nearly a quarter and reduced future estimates on the back of weaker outlays and stronger revenue. It still has a long way to fall and the risk is that its improvement reduces pressure for a deal to improve the structural deficit over the long term. But at least it’s going in the right direction a lot more quickly than expected. It should help reduce the chance of another ratings downgrade.
  • In Australia, the big focus was on the Federal Government’s 2013-14 Budget. The good news is that the government has found ways to fund its commendable Gonski education reforms and disability care. Superannuation was left alone, the government announced sensible long-term savings in terms of things like middle class welfare and these are likely to be supported by the Opposition. But the big disappointment was bigger budget deficits for longer. It would have been desirable to have at least some of the budget savings kick in this year to provide more confidence that a surplus will eventually be achieved. As it turns out, we are now looking at a budget deficit blowout of virtually the same size as that seen in the 1990s despite having a much stronger economy than back then. While Australia’s public finances are in good shape compared to other advanced countries, there is a danger in comparing ourselves to a bad bunch and more fundamentally having seen the biggest resources boom in our history we should have been able to put more aside for the inevitable rainy day. It now looks like New Zealand, with far tougher circumstances than Australia has faced, will get back to surplus ahead of us!

Major global economic events and implications

  • US data was mostly favourable. Industrial production and a couple of regional manufacturing conditions surveys were weaker than expected and housing starts fell sharply. However, starts are often volatile and gains in permits to build new homes, and in the NAHB survey of homebuilders conditions, point to a continued rising trend in starts. A rise in weekly jobless claims looks more like normal volatility with the four-week average at multi-year lows. Moreover, consumer sentiment rose to its highest level in almost six years, small business sentiment rose and April retail sales were far stronger than expected, suggesting the sequester spending cuts have had little impact so far. US economic growth appears to be tracking around 2 to 2.5%. Not too weak, but not so strong as to invite an immediate reduction in stimulus from the US Federal Reserve (Fed) particularly with inflation readings remaining benign.
  • The Eurozone remained in recession in the March quarter with GDP growth a little worse than expected at - 0.2%. However, it was an improvement from the 0.6% contraction seen in the December quarter and the more forward-looking indicators are a bit more favourable with industrial production up strongly in March and good recent readings for German factory orders. Growth in the Eurozone is likely to return later this year helped by easing fiscal austerity and European Central Bank (ECB) stimulus. Certainly headline inflation of just 1.2% and core inflation of just 1% provides a strong case for the ECB to do more.
  • While the Eurozone is still in recession, Japan certainly isn't, with a stronger-than-expected 0.9% gain in March quarter GDP driven by consumption, exports and housing. More strength is likely as the impact of ‘Abenomics’ kicks in. Supporting this, consumer confidence reached its highest level in six years. PM Abe also unveiled ideas including corporate tax cuts and deregulation as part of his “third arrow” to revive growth.
  • Chinese April activity indicators were a bit disappointing with retail sales picking up pace as expected but industrial production and fixed asset investment a little weaker than expected. However, growth in power consumption picked up, which is a positive sign, the activity indicators are still running at levels consistent with around 7.5% to 8% growth and strength in financing and money supply growth suggest no threat to growth.

Australian economic events and implications

  • Australian economic data was mixed with falls in business confidence and conditions according to the NAB's latest survey, but a broad-based pick-up in housing finance, including for the construction of dwellings, suggested the housing recovery is gathering some pace. Low wages growth in the March quarter of just 3.2% along with weak selling price readings in the NAB survey suggest inflation is no barrier to further rate cuts from the RBA.

Major market moves

  • Global share markets continued to rise over the past week helped by reasonable economic news and expectations that monetary conditions would remain supportive. US shares rose 2.1%, Eurozone shares gained 1.2%, Japanese shares rose 3.6% and Chinese shares rose 1.6%. Australian shares were the exception though, falling 0.5% as gains slowed in financials and resources shares slipped a bit.
  • The US dollar continued to rise on optimism about the US and this contributed to further falls in commodity prices. This, combined with a negative reaction to the budget, put more downward pressure on the Australian dollar.
  • Bond yields were mixed, falling in Europe and Australia but rising in the US and Japan, with the latter providing another sign that the Bank of Japan's massive reflation efforts are working.

What to watch over the next week?

  • Expect the US housing recovery to be confirmed by ongoing rising trends in existing home sales (Wednesday), new home sales and house prices (both Thursday). The housing recovery is expected to add 1 percentage point to US GDP growth this year, providing an offset to the drag from falling government spending. Durable goods orders (Friday) are expected to rebound after a fall in March and the preliminary Markit business conditions PMI (Thursday) will be watched closely to see whether recent softness has continued into May. The minutes from the Fed's last meeting and Congressional testimony by Fed Chairman Bernanke (both Wednesday) will be watched closely in terms of the debate regarding when to start tapering the pace of quantitative easing.
  • Business conditions PMI's will also be released in Europe on Thursday and are likely to show signs of improvement after recent softness.
  • China's flash HSBC business conditions PMI (Thursday) is likely to be little changed after the fall seen last month.
  • The Bank of Japan meets Wednesday but it’s too early to expect any further monetary stimulus given the big easing announced in March and the positive response seen to date.
  • In Australia, the minutes from the Reserve Bank of Australia’s (RBA) latest board meeting will be looked at closely as a guide to how strong the RBA's easing bias remains, after having used up some of its ‘scope’ to ease with this month's rate cut. Our view remains that further easing is likely this year to provide confidence that a pick-up in non-mining activity will provide an offset to slowing mining investment.
  • On the data front, it will be a quiet week in Australia, but consumer confidence data to be released on Wednesday will be watched closely as a guide to how Australians have responded to the rate cut two weeks ago and the budget. Expect the skilled vacancy index (also due Wednesday) to have remained weak.

Outlook for markets

  • After a period of very strong gains, shares are vulnerable to a bit of a correction, particularly as we come into the seasonally weaker period of the year. Maybe more debate about when the Fed will start to ease up on quantitative easing could be a trigger. However, we remain of the view that any setbacks will be mild. Shares are still far from expensive, monetary conditions are very easy, the gradually strengthening growth outlook points to stronger profits ahead and the chase for yield and better returns in the face of low bank deposit rates is seeing the return of ‘buy on the dips’ demand from investors. Increased mergers, buybacks and dividends will also help. So by year-end we see further upside in global and Australian shares.
  • Sovereign bonds remain fundamentally vulnerable as an improving global and Australian growth outlook will likely see bond yields move higher over the year ahead resulting in capital losses for investors.
  • The downtrend in commodity prices along with ongoing rate cuts in Australia are acting as an increasing drag on the Australian dollar, offsetting the impact of monetary printing in the US and Japan. Having broken down below parity against the US dollar, the Australian dollar looks to be heading lower.

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