WEEKEND ECONOMIST: A longer pause

With the turmoil in Europe getting worse and clear signs interest rates are starting to bite, it's looking increasingly likely that the RBA will hold off on rate hikes until at least August.

The past week has been another bad one for shares, commodity prices and commodity currencies like the Australian dollar as worries about European economic growth and the survival of the euro intensified. This wasn’t helped by growing signs of disunity amongst European governments and some weak economic data out of the US.

Because of its commodity and high yield status the Australian dollar is usually a victim of worries about global growth and increased investor risk aversion and this has certainly been the case over the last week, with the currency down by 14 per cent at one stage from its April high as speculators have unwound long positions and "carry trades”. The plunge in the $A appears to have been magnified by growing concerns about the impact of the Resource Super Profits Tax (RSPT) on mining activity in Australia and expectations that the Reserve Bank will now leave interest rates on hold for a while. Worries about the resources tax along with the plunge in the $A have likely also magnified the fall in the Australian share market, which is now down 14 per cent from its April peak compared to a 12 per cent fall in US shares. Some sort of compromise on the resources tax looks increasingly desirable in terms of settling foreign investors’ perceptions of Australia.

Major global economic releases and implications

US data releases were mixed. Housing starts rose strongly in April and a survey of home builders rose in May, but this may have been driven by the approaching termination of a first home buyer tax credit, as permits to build new homes and mortgage applications actually fell sharply. Mortgage delinquencies continued to rise in the March quarter. Surveys of manufactures were mixed but remain at high levels. Finally, the US leading index fell 0.1 per cent in April (but this followed a 1.3 per cent gain in March) and weekly unemployment claims surprisingly rose.

Meanwhile, inflation readings were benign in April with core inflation falling to just 0.9 per cent, its lowest level since the 1960s. While the Fed slightly revised up its 2010 growth forecasts it revised down its inflation forecasts. With inflation continuing to fade, unemployment remaining high and turmoil continuing in Europe its hard to see the Fed tightening any time soon – probably not until some time next year.

Despite the ongoing sovereign debt crisis in Europe, economic data releases in the region were reasonable, with an improvement in manufacturing conditions in the UK, only a slight fall in investment analyst sentiment in Germany and a strong rise in construction activity in March. Consumer confidence dipped slightly in May though. Underlying inflation increased just 0.8 per cent over the year to April and some European countries are actually seeing deflation indicating that there is still plenty of scope to leave interest rates low or even cut them in Europe.

Japanese economic data was generally favourable, with GDP up 1.2 per cent in the March quarter or 4.6 per cent over the last year, a strong rise in core machinery orders and an increase in condominium sales in Tokyo. Taiwanese GDP growth was 13.3 per cent over the year to the March quarter and growth in Singapore over the same period was revised up to 15.5 per cent. Asia is clearly very strong.

Anecdotes out of China point to a sharp slowdown in the housing market in key cities, with reports prices in some areas of Beijing are down 25 per cent, sales of new homes in Shanghai have fallen to a five year low. This is suggesting that the authorities may soon have to ease up on the property brake.

Australian economic releases and implications

Australian economic data was pretty mixed. Wages growth came in a little bit stronger than expected in the March quarter but is still running at a benign 3 per cent year-on-year. That interest rate hikes are starting to bite big time was clearly evident in an 8 per cent fall in consumer confidence this month. Higher interest rates and house prices are also having a negative impact on housing affordability which fell again in the March quarter, according to the Commonwealth Bank and the Housing Industry Association.

While the minutes from the Reserve Bank’s last meeting implied that more interest rate increases lie ahead as growth pushes above average, its looking increasingly likely that the RBA will be on hold for the next few months. The RBA actually considered pausing at its last meeting on the basis of the turmoil in Europe, which has since worsened, and on top of this there are now clear indications that higher interest rates are starting to impact with recent weakness in consumer confidence, housing finance and retail sales. We don’t see the next hike in interest rates coming until August.

Major market moves

While the European support package has helped stabilise bond markets in Greece, Spain and Portugal, sharemarkets nevertheless fell sharply over the last week on the back of concerns about the impact form the European crisis on global growth, worries that European governments are going in different directions and what this means for the survival of the euro, some soft data in the US and ongoing concerns about Chinese tightening triggering a hard landing in China.

The same concerns also weighed on commodity prices and commodity currencies with government bonds in the US, Germany, UK and Australia benefiting from safe haven buying. After falling to a four year low the euro bounced on talk that the European Central Bank may intervene to support it.

The fall in the Australian dollar and the Australian share market was likely magnified by increasing concerns about the impact of the Resources Super Profits Tax in Australia.

What to watch in the week ahead?

In the US, April home sales data are likely to have benefited from the expiry of the first time home buyers tax credit, consumer confidence is likely to have edged up a notch and durable goods orders are likely to have increased. Key Japanese data for retail sales, employment and inflation will be released.

In Australia, the focus is likely to be on business investment data, which is expected to show continued strength in mining investment. Construction activity is also expected to have increased by around 1 per cent in the March quarter. April car sales data will also be released.

Outlook for markets

Having fallen so far so fast shares are now very oversold and due for at least a bounce. However, while it’s too early to say that the share market fall is over, we see it as part of a correction rather than the start of a new bear market. The global recovery is likely to remain on track, the profit outlook is positive, monetary conditions are very easy, China is likely getting closer to easing up on its tightening measures with respect to property and shares are now very cheap again. So we continue to see the bull market in shares resuming in the months ahead and this will ultimately take them to much higher levels by year end.

Allowing for continuing market volatility, the Australian dollar is likely to regain its strength over the next few months as Australian interest rates remain well above global rates and as commodity prices resume their upswing. By contrast, after a likely bounce from very oversold conditions the euro is likely to continue to struggle on the back of relatively weak growth prospects in the euro-zone and concerns about whether it will hang together.

Despite a dip over the last week from overbought levels, gold is likely to remain a long term beneficiary of the uncertainty about major currencies. Last year the concerns were focussed on the $US, this year it’s the euro, next year it might be the Yen’s turn.

While Government bonds have had a good run over the last few weeks on the back of safe haven buying, their low yields are pointing to poor returns over the medium term. As higher global interest rates are priced in and given the large supply of government bonds, investors will demand a higher risk premium to invest in government bonds.

Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors

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