WEEKEND ECONOMIST: A silver lining
Concerns about the timing and extent of interest rate hikes, particularly in the US, will translate to a more volatile ride in shares. But overall the trend is up.
Economic news has generally been positive over the last two weeks adding to confidence that the global recovery is continuing and on its way to becoming self sustaining. This in turn has seen growth assets – equities, commodities and commodity currencies such as the Australian dollar – all move higher.
Share markets have broken out to new recovery highs after a two month period of correction and consolidation and look like they are heading higher. In Australia, the key ASX200 and All Ords indexes will likely reach the 5000 level in the next week or two. The recovery to the 5000 level will be important as it is likely seen as an important psychological milestone by many investors, it will also represent a 50 per cent retracement of the November 2007 to March 2009 bear market fall and it will take us back to where the market was trading in the run-up to Lehman Brother’s collapse, which ushered in worries of a global financial meltdown and economic depression.
But is the economic recovery becoming too strong, such that monetary and fiscal tightening will start to weigh on equity markets? There is no doubt that, as the economic recovery strengthens, central banks and governments will move to wind back the stimulus pumped in to combat the global financial crisis. And the faster the economic recovery, the faster this will occur. In some countries such as Australia and China this is already happening.
However, global policy tightening overall is likely to be very gradual, as there are still pockets of weakness like US housing or European retail sales. Global economic activity is still well below normal levels, unemployment remains very high in the US and Europe, underlying inflationary pressures are low and weak bank lending in advanced countries is a significant headwind for growth. As such, while worries about the unwinding of the stimulus will result in share market corrections and increased volatility this year, the unwinding of the monetary and fiscal stimulus is unlikely to be aggressive enough to derail the continuing recovery trend in share markets and in other growth assets.
The debate over the role of monetary policy in driving asset bubbles hotted up over the last week in the US with Fed Chairman Bernanke and Vice Chairman Kohn downplaying its role in favour of regulatory policies. That said, both acknowledged that it can play a supplementary role in addressing bubbles, which is a softening from the approach of the Greenspan Fed, which was dead against using monetary policy to combat bubbles. None of this, however, has much in the way of near-term implications for US monetary policy, with US assets all being a long way away from what could be defined as a bubble at present.
Major global economic releases and implications
US economic releases have generally remained consistent with a continuation of the recovery and are becoming more self sustaining. Data for house prices, consumer confidence, car sales and the ISM business conditions surveys all rose while jobless claims and job lay-offs continued to trend down. What’s more, retail sales data suggests strong December retail sales consistent with the consumer perking up. Pending home sales were weak though (reflecting the impact of the first home buyers tax credit) and indicate that the housing recovery is still patchy. The overall picture remains favourable but the minutes from the Fed’s December meeting suggest that the Fed is in no hurry to unwind its monetary stimulus and there was even some talk that the Fed’s program of purchasing mortgage-backed securities may be extended beyond its scheduled expiry in March. With unemployment still around 10 per cent we still don’t see the Fed moving to raise interest rates before mid-year.
UK and Eurozone business conditions indicators for December rose further, consistent with a continued recovery. However, Eurozone retail sales (down 4 per cent year on year) and German factory orders were disappointingly weak. The Bank of England left interest rates on hold at 0.5 per cent, as expected.
Business conditions indicators also rose further in Japan, India, Brazil and China. In fact the Chinese manufacturing conditions index is at a level consistent with 11 per cent economic growth. Reflecting the rebound in Chinese growth and concerns about inflation, the Chinese central bank is moving to tighten monetary conditions, which partly explains a flattening in Chinese A shares over the last six months.
While December quarter GDP slipped in Singapore, this appears to reflect volatility in the manufacturing sector. Meanwhile, Korean and Taiwanese exports continued to recover in December, exports continue to recover and inflation in Taiwan remains non-existent.
Major Australian economic releases and implications
Australian economic data releases have generally been strong over the last few weeks. While new home sales were flat in November and private sector credit remains soft, reflecting weak business credit, data for house prices, car sales, building approvals and retail sales were all robust.
Against this backdrop, more interest rate hikes are on the way. I was thinking that the RBA would wait till March before moving again, but with the run of strong economic data lately, a February move is looking increasingly likely. Key indicators to watch in deciding to whether the RBA will go again next month are the December employment report, to be released in the week ahead, and December quarter inflation figures, due later this month. With underlying inflation continuing to fall, the RBA is likely to continue moving the cash rate in 0.25 per cent increments and we see the cash rate rising to 4.5 per cent by mid year and 4.75 per cent by year's end.
Australia’s trade deficit narrowed slightly in November, but is set to improve significantly from April as contract prices for iron ore and coal rebound this year by 30 to 50 per cent.
Major market moves
After a two month period of consolidation since mid-October, share markets have broken decisively higher over the last few weeks on the back of solid economic data and New Year optimism. The Santa Claus rally has happened right on cue. While trading volumes have been low, this is normal for this time of year. US shares are on track for a positive first five days of the year, which according to one version of the so-called "January barometer” (which says that, as go the first five days of January so goes the year) augurs well for a further rise in US shares for this year as a whole. Since 1950, a positive first five days in US shares has foreshadowed a positive year as a whole 84 per cent of the time.
Commodity prices have also strengthened on the back of stronger global economic data with oil and base metal prices breaking out to new recovery highs and gold recovering some of its losses in December.
With commodity prices rising sharply and expectations for a February RBA rate hike firming, the Australian dollar has rebounded back to around $US0.92.
What to watch in the week ahead?
In the US, data for the trade deficit, a survey of home builders, retail trade, industrial production, consumer sentiment, inflation and the Fed’s Beige Book of anecdotal evidence will all be released.
December retail sales is the release to watch for though as it is likely to show a decent rise, suggesting that US consumers are gaining confidence to get out and spend. The December quarter earnings reporting season will also kick off and is likely to show a pick-up in profits.
The European Central Bank will meet, but will likely leave interest rates on hold at 1 per cent.
In Australia, data for housing finance, the National Australia Bank business survey and employment will all be watched closely. Employment is expected to show another gain of around 10,000 in December but with the unemployment rate likely to have remained at 5.7 per cent.
Outlook for markets
Share markets are likely to rise further over the year ahead thanks to the combination of improving economic and profit growth, low inflation and still low interest rates at a time when there is still plenty of cash on the sidelines. However, the easy gains of the "multiple driven” phase of the equity bull market are behind us and earnings growth will be a key driver going forward. Worries about the timing and extent of interest rate hikes, particularly in the US, will result in a more volatile ride in shares than has been the case since March last year. Nevertheless, the trend will likely remain up. The Australian ASX 200 and All Ords indices are expected to rise to around 5600 by end 2010 and we see Australian shares continuing to outperform traditional global shares, reflecting higher dividend yields and stronger growth prospects.
The trend in commodity prices is likely to remain up, thanks to strengthening global demand.
Further gains in the Australian dollar are likely, with commodity prices remaining strong and more interest rate hikes are on the way from the RBA at a time when the US Fed is on hold. This is likely to take the Australian dollar above parity during the first half of the year. But expect occasional sharp corrections when the Fed moves towards interest rate hikes, from around mid year.
Government bond yields are likely to push higher over the year ahead as monetary tightening starts to be factored in. Corporate debt is far more attractive with yields of 7.5 per cent, or more.
Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.