In the US, there were no surprises from the Federal Reserve which left the key Fed Funds rate on hold at zero to 0.25 per cent and reiterated that economic conditions are likely to warrant exceptionally low rates for an "extended period”. However, the Fed did sound a bit more upbeat on the economic outlook and it wouldn’t surprise to see some relaxation of the "extended period" language in the next few months in order to give it a bit more flexibility.
That said, even if the language is softened in the next few months, we don’t see an increase in the key Fed Funds rate until late this year given that unemployment is still around 10 per cent, capacity utilisation is still very low and core inflation is still falling. However, another increase in the discount rate could come at any time as the Fed moves to restore the margin between the discount rate and the Fed Funds rate back to pre-crisis levels now that financial markets are behaving more normally. This could come at any time but, as with the first discount rate hike a few weeks ago, this shouldn’t be confused with a monetary tightening.
The split in the European Union over how to help Greece opened up again, with Germany clearly less keen to help out. With Greece doing a Basil Fawlty and bringing up the war a few weeks ago, and Germany seemingly still convinced that Greece should sell of its islands and the Acropolis, it seems these guys just can’t get it together and the IMF should be called in ASAP to help clear up the mess.
In Australia, the Treasurer poured cold water on expectations that the budget deficit is coming in much better than expected. This could just be pre-Budget posturing, and while lags may affect the timing of the flow-through from the faster-than-forecast economic recovery to the budget bottom line, we remain of the view that short of a major further easing in fiscal policy which seems most unlikely, the budget will be back in surplus by around 2013, rather than 2015-16 as currently projected by the Federal Government. This means that rather than peaking at 10 per cent of GDP in 2013-14 as currently projected by the Government, gross Federal public debt is likely to peak at half this by around 2012.
Major global economic releases and implications
Apart from housing data, which remains affected by bad weather, US economic releases were generally upbeat. Surveys of manufacturers in the New York and Philadelphia regions showed that conditions remain strong in March, industrial production managed a further gain in February despite bad weather, the US leading index rose for the 11th month in a row in February and weekly jobless claims fell, albeit less than expected. On top of all this, inflation continued to slide, with the core CPI inflation rate falling to just 1.3 per cent over the year to February. Improving growth and falling inflation is usually a pretty good combination for financial markets. It wouldn’t surprise if we start hearing talk about a return to the "Goldilocks” economy. While this would probably be taking things a bit too far given the problems with the US budget deficit, the US economy is nevertheless looking a lot better than all the "stopped clock” bears are still portraying it.
Economic data in Europe was mixed. UK house prices only rose marginally and a survey of manufacturers softened in March, but unemployment appears to have stabilised at 7.8 per cent and falling jobless claims point to a possible improvement ahead. Euro-zone construction output slumped in January and employment fell in the December quarter, albeit only marginally. As in the US inflation in Europe is falling with core prices up just 0.8 per cent over the year to the February. No need for any tightening here.
Japanese economic data was surprisingly upbeat with a rebound in a tertiary activity index in January, a rise in consumer confidence and stronger apartment sales in Tokyo. The Bank of Japan left its key interest rate on hold at 0.1 per cent and expanded a short term lending facility. However, given ongoing price deflation in Japan it would have been nice to see the Bank of Japan get more aggressive in pumping liquidity into its economy.
Meanwhile, strength in the emerging world remains clearly evident. For example Brazil’s GDP expanded at an annual rate of 8.4 per cent in the December quarter. While the Brazilian central bank left interest rates on hold at 8.65 per cent following its meeting, strong growth and accelerating inflation suggest its only a matter for time before it starts to tighten. It’s a similar story in India, where growth is strong and inflation has been rising sharply.
Australian economic releases and implications
In Australia, dwelling commencements continued to track building approvals higher in the December quarter confirming that a recovery in housing construction is well underway. Building approvals data suggest that a further rise is likely. However, dwelling commencements running at around an annual rate of 160,000 dwelling in the December quarter are still way below underlying demand which is now estimated to be around 180,000 to 200,000 dwellings per annum. So it’s hard to see the housing shortage easing up any time soon. Meanwhile, the Westpac leading indicator is continuing to point to further strength in growth ahead.
The minutes from the RBA’s last meeting added nothing new to expectations that – in the absence of any renewed shock to the global growth outlook - interest rates are likely to move higher but that the process will be gradual. Our assessment remains that the cash rate is heading up to around 4.75 per cent to 5 per cent by year end. In the absence of aggressively strong economic data, the next increase is unlikely to come until after the March quarter inflation figures are released in late April which points to either the May or June meetings.
Major market moves
Global share markets continued to rise helped along by the Fed’s continued commitment to leave interest rates on hold and generally favourable economic data. In fact, the key direction setting US share market has broken out above its January recovery highs confirming that, despite all the worries about China, Greece and the sustainability of the global economic recovery, the trend in shares is still up.
Australian shares followed global shares higher helped by takeover activity and higher commodity prices.
While the Euro was hurt by renewed uncertainty about a rescue plan for Greece, the Australian dollar made it above $US0.92 on the back of higher commodity prices and expectations that the interest rate gap in Australia’s favour will remain wide.
What to watch in the week ahead?
In the US, data for existing home sales, house prices, durable goods orders and consumer confidence will be released. Home sales data is likely to be depressed due to the February snowstorm but durable goods orders are likely to have maintained their rising trend.
In Australia, data for car sales and skilled vacancies will be released. The RBA’s Financial Stability review may be of interest, although the key themes – that US and European financial systems had improved but are from normal and that the Australian financial system remains resilient – were released in the minutes from the Bank’s last meeting. A speech by Assistant Governor Philip Lowe will also be watched closely for any new clues on the interest rate outlook – not that I think there is much that is new that can be said on this front.
Outlook for markets
In the very short term shares are a bit overbought and at risk of a undergoing a breather. However, the broad picture is positive. First, the break above January highs in US shares has come with broad based participation from most sectors and stocks suggesting there is a lot of conviction behind it. From a technical perspective the next target for the broad US S&P 500 index is around 1220 or about 5 per cent above current levels. This would likely drag other share markets higher with it, including Asian and Australian shares. A 5 per cent gain in Australian shares would take the All Ords and ASX 200 indices through the 5000 level. Secondly, shares are normally strong over the March to May period. Thirdly, sentiment towards the US/global recovery is likely to change for the better in the next few months if we are right and US employment starts to grow again and this is likely to boost investor confidence in shares. Finally, share market fundamentals are all reasonable – valuations are modestly cheap, earnings are on the rise, global interest rates are set to remain low and there is still a lot of cash sitting on the sidelines. Yes, there will be volatility along the way, but our year-end target for the Australian All Ords and ASX 200 indices remains 5600.
There is a good chance that the Australian dollar will soon break higher. Commodity prices are likely to see more upside and the spread between Australian and US interest rates is likely to widen further. A break above technical resistance at around $US0.9250 could see the Australian dollar reach parity against the $US by mid year.
Government bond yields are likely to be pushed higher over the year ahead as monetary tightening starts to be factored in, the supply of government bonds increases, and private sector credit demand picks up. Bond risk premiums are also likely to rise on the back of very high public debt levels in the US, Europe and Japan.
Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors