Oliver's Insights

THE WEEK'S HEADLINE DEVELOPMENTS

• In Australia, benign inflation readings provided confirmation that interest rates are on hold for the foreseeable future.
• After last week’s surge the oil price fell back to about $US66 a barrel thanks to a combination of Saudi Arabia promising to make up any shortfall resulting from problems in Nigeria, the hope that a diplomatic solution to the Iran nuclear stand-off is still possible, indications that OPEC won’t cut production targets at next week’s meeting and warmer weather in North America. While the situation with Iran is likely to wax and wane, a retest of the August 2005 high of nearly $US71 a barrel is looking nearer and it is looking increasingly likely that we may see $US80 a barrel by mid year. Oil inventories are at reasonable levels, but despite high oil prices, global demand remains strong and excess production capacity remains low, meaning that any real or perceived threat to oil supply will see prices spike higher. The oil price will remain a drag on consumer spending and a source of volatility for share markets this year.

GLOBAL ECONOMIC RELEASES AND IMPLICATIONS

• In the US, evidence continues to mount that the housing sector is rolling over; home sales are slowing as are house price gains. However, a strongly rising trend in durable goods orders suggests that business investment remains strong and very low jobless claims (the lowest since April 2000) indicate that the labour market remains robust.
• US December quarter earnings reports were a lot more positive than last week with better than expected results and/or good outlook statements from companies such as Caterpillar, Honeywell, McDonald's and Lockheed Martin. Of the 226 S&P 500 companies to have reported results so far, 62% have been better than expected, which is above the long-term average of 59%. But its still not as strong as has been the case over the last couple of years consistent with the view that positive earnings surprise is unlikely to be as supportive for the US sharemarket this year as has been the case since 2003.
• In Europe, economic conditions are continuing to improve. The German Ifo business conditions index rose to its highest level in more than five years and Euro-zone industrial orders rose strongly in November. With the economy on the mend, the European Central Bank is expected to further move interest rates (currently just 2.25%) up this year.
• The Chinese economy is continuing to surge, with growth coming in at 9.9% in 2005. December data shows that while growth in fixed asset investment has moderated, it still remains very strong as are retail sales and industrial production. Meanwhile in December, inflation remained low at just 1.6%. Continued strong growth in China this year is expected to underpin further gains in commodity prices and resource shares.

AUSTRALIAN ECONOMIC RELEASES AND IMPLICATIONS

• In Australia, inflation remains benign. The December quarter consumer price index came in below market expectations and underlying inflation is running at 2 –2.5% year on year. Although prices for petrol, education, health and housing rose solidly in 2005, this is being offset by price weakness or deflation in areas such as clothing, cars and goods prices generally. Thanks to intense competitive pressures, the rise in production costs is not generally being passed on to consumers. The December quarter producer price index also showed that production cost pressures are moderating.
• The combination of benign inflation along with the weak housing market and soft consumer spending indicate that there is absolutely no reason for the Reserve Bank to move on interest rates. Our view is unchanged; interest rates are on hold for the foreseeable future.

MAJOR MARKET MOVES

• After a nervous start to the week, sharemarkets rose strongly helped by favourable economic data, better US profit reports and the fall back in the oil price. Thanks to a positive lead from global sharemarkets and further strength in commodity prices, the Australian sharemarket has pushed further into record territory, with resources stocks leading the charge. With the benchmark ASX 200 index surging through the 4900 level, our year-end forecast of 5000 is looking too conservative already!
• The $A edged back up against the $US as the euro moved higher on firming expectations of further interest rate increases from the European Central Bank. Global bond yields moved sharply higher on solid economic data and a poor Treasury bond auction in the US. This also flowed through to Australian bonds despite better than expected December quarter inflation readings.

THE WEEK AHEAD

• In the US, the main event will be the Federal Reserve’s interest rate setting meeting on Tuesday, which will be Fed chairman Alan Greenspan’s last before he hands over to Ben Bernanke on Wednesday. We expect another 0.25% move in the Fed Funds rate to 4.5%, to most likely mark the end of the tightening cycle. Interest rates have been returned to neutral, inflation remains benign and there are increasing signs that the housing and consumer sectors are starting to slow. As a result, the Fed is expected to offer less guidance regarding future interest rate moves in the post meeting statement, possibly softening or removing altogether the reference to “measured” further tightening that has been in recent statements.
• The key US ISM business conditions surveys will be released along with data for employment, labour costs and consumer confidence. December quarter profit results will remain a focus of attention.
• The OPEC meeting is expected to leave oil production quotas unchanged.
• In Australia, it will be a big week with data for retail sales, the trade balance, building approvals, private sector credit and the National Australia Bank’s business conditions survey down for release.
• The December-half profit reporting season also kicks off locally with a handful of companies due to report, including Alumina Ltd, Sims and West Australian Newspapers, along with mining giant Rio Tinto. We expect December-half profit growth of about 18% year on year (down from about 30% in the June half), but yet again results are likely to be polarised between the very strong conditions in the resources sector, where profit growth is likely to be about 50%, and tougher conditions for domestically exposed cyclicals, such as retail stocks, where revenue growth has slowed and costs have picked up. A key focus will be company guidance regarding the outlook going forward. It is worth noting that the last two profit reporting seasons (February and August last year) were associated with very mild corrections in the Australian sharemarket after a strong prior run-up, so we might see something similar this time around in February.

MARKET OUTLOOK

• Global shares remain on track for further gains this year thanks to reasonable valuations, solid economic growth, benign inflation and still easy monetary conditions. However, as evidenced over the last couple of weeks, investors should anticipate a more volatile ride thanks to periodic oil, inflation and interest rate scares along with slowing profit growth. Gains are also likely to be more subdued than last year.
• The Australian sharemarket continues to offer solid gains on the back of attractive valuations, a relatively high yield compared to other investment alternatives, reasonable profit growth and resource sector strength. Our 5000-point year end target is already looking too conservative. However, with profit growth slowing towards more sustainable levels and periodic oil, inflation and interest scares likely to impact global financial markets, investors should expect a more constrained and volatile ride than has been the case over the last few years.
• Bonds offer poor returns of about 5%, reflecting their low running yields. But with inflation likely to remain relatively low and Asia and Europe still awash in savings, it’s hard to be bearish about the outlook for bonds.
• Listed property securities offer better prospects than bonds thanks to their high yields, solid underlying property fundamentals and their potential to benefit as US interest rates top out.
• The $A seems to be going nowhere fast with the positive influence from strong commodity prices being offset by Australia’s declining interest rate advantage. Overall, we continue to see the $A being stuck in a range of US68–80¢ this year. But rising interest rates in Europe and later on in Japan may see the $A drift a bit lower against the yen and euro.