China's unexpected move to tighten its monetary policy has focused attention on the Chinese economy and whether further moves would threaten the world status quo.

The big news over the last week was that China decisively moved to start winding back the stimulus it provided to combat the global financial crisis by raising the required level of reserves that banks must set aside by 0.5 per cent (taking it to 16 per cent for large banks). With the Chinese economy growing strongly, and worries that imbalances will build, further tightening is likely. However, while this will likely cause bouts of volatility in Chinese shares and global financial markets, China is a long way from undertaking a draconian tightening designed to crunch growth. We continue to expect Chinese GDP growth of around 10 per cent this year. As a result, Chinese tightening is unlikely to threaten the rising trend in shares this year, albeit it will, along with tightening elsewhere, result in a more volatile ride.

The dispute between Google and China is also worth keeping an eye on to the extent that it could potentially have a broader corrosive effect on bilateral relations between the US and China if it is allowed to get out of hand.

In the US, President Obama has proposed a levy on banks to recoup losses from the Troubled Asset Relief Program. While recouping TARP losses makes sense the trouble is that the proposal will likely hamper the flow of credit to the economy, and it looks to be more politically motivated than anything else.

Major global economic releases and implications

US economic data was somewhat mixed. The Fed’s Beige Book of anecdotal evidence pointed to a further modest improvement in the US economy. Retail sales unexpectedly fell in December, but this disappointment was offset by a big upwards revision to November sales suggesting solid growth in consumer spending in the December quarter as a whole. Initial jobless claims rose but the trend remains down which, along with falls in continuing claims, points to jobs growth ahead. Small business confidence declined slightly and the trade deficit widened in November. December quarter GDP still looks like coming in around 4 per cent annualised.

While the US December quarter profit reporting season got off to a mixed start with a poor result from Alcoa, far more companies have surprised on the upside so far, including Intel.

Euro-zone and UK industrial production rose in November, but German GDP growth for 2009 came in worse than expected. The European Central Bank left interest rates on hold at 1 per cent and with a sluggish recovery and lots of excess capacity rates are likely to remain there for some time.

Japanese economic data was mixed. Machinery orders fell unexpectedly in November and bank lending also fell. In positive news though, bankruptcies were down 16.6 per cent year on year in December and preliminary machine tool orders surged.

Indian industrial production continued to recover strongly in November and is now up 11.7 per cent year on year and with inflation increasing in December it’s likely that the Reserve Bank of India will soon start raising interest rates.

Australian economic releases and implications

Australian data was mostly strong. Housing finance approvals fell 5.6 per cent in November due to a sharp fall in approvals for first home buyers as the first home buyer boost phases down. Nevertheless, finance for the construction of new dwellings has nearly double from a year ago pointing to a strong rebound in housing construction activity this year. December employment data was unambiguously positive with job ads up solidly again, employment up another 35,000 (resulting in a nearly 136,000 new jobs over the last four months) and unemployment falling to 5.5 per cent, its lowest in 8 months. This all adds to confidence that unemployment has now peaked. The rebound in forward looking labour market indicators such as the ANZ job ads survey along with an expected rebound in the economy over the year ahead to 4 per cent growth all point to further employment growth and a further decline in unemployment.

The December employment figures coming on the back of strong data for retail sales, car sales and building approvals suggest that it is highly likely that the RBA will raise interest rates by another 0.25 per cent next month, which will take the cash rate to 4 per cent.

Major market moves

Share markets were somewhat mixed over the last week, with China’s monetary tightening, a disappointing profit result form Alcoa, and the US bank tax plan weighing earlier in the week. There has probably also been a bit of profit taking after strong gains over the last few weeks in most share markets. Japanese and US shares rose, but European, Asian and Australian shares were mostly down slightly.

Commodity prices were mixed with gold up, but oil and copper down slightly.

The Australian dollar rose on the back of firming expectations for another interest rate hike from the RBA next month.

What to watch in the week ahead?

Chinese economic data will likely be the highlight over the week ahead. December data for retail sales, industrial production and fixed asset investment are likely to show continued strong growth but most importantly GDP growth over the year to the December quarter is likely to come in around 11 per cent highlighting a huge turnaround from just 6.1 per cent growth in the year to the March quarter. Inflation data likely to have edged up further but to have remained low.

In a holiday shortened week in the US, data for housing starts, producer prices and leading indicators along with surveys of home builders and manufacturers in the Philadelphia region will be released. The US December quarter earnings reporting season will also hot up with 66 S&P 500 companies due to report. Profits are likely to be up strongly reflecting a bounce back from the huge asset write downs in the December quarter 2008.

It will be a relatively quiet week on the data front in Australia with the TD Securities inflation gauge, surveys of business and consumer confidence, the Westpac leading index and car sales data due for release. The consumer and business confidence surveys will be worth watching to help gauge the impact of last year’s interest rate hikes and all the talk of more to come.

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 monetary tightening in various countries this year 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.

From a very short term perspective its worth noting that after a run up in December and January, February can often be a tougher month for shares. So after recent gains and with short term investor sentiment levels having increased to relatively high levels a correction or consolidation around February is a risk even though the broader trend in shares is expected to remain up.

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 on the way from the RBA at a time when the US Fed is on hold. This is likely to take the $A 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, the supply of government bonds increases and private sector credit demand picks up. Corporate debt is far more attractive with yields of 7.5 per cent or more.

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

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