The big news of the week came from the US, where the Federal Reserve continued the process of unwinding the liquidity support it provided to financial markets by increasing its discount rate, or the rate at which banks can borrow from the Fed, from 0.5 per cent to 0.75 per cent.
While there was a knee-jerk reaction in financial markets, this move was broadly foreshadowed by the Fed a week ago and does not signal a change in monetary policy. Rather, with financial market conditions normalising, it is appropriate to start reversing the liquidity assistance the Fed provided through the financial crisis and this includes returning the gap between the discount rate and the Fed Funds rate to more normal levels.
Bank access to emergency Fed loans via the "discount window" has collapsed, so the increase in the discount rate will have virtually no impact on bank borrowing costs or on wider financial conditions. While the Fed’s unwinding of liquidity support is consistent with an eventual increase in the Fed Funds rate this is still likely to be months away with the Fed repeating that economic conditions are likely to justify an exceptionally low Fed Funds rate for an extended period. Finally, it should be noted that while we are moving into a rising interest rate environment generally this is because economic conditions are improving and so is really a good thing. The falling interest rate environment that was kicked off in the US in August 2007 was hardly associated with good times for shares because it was in reaction to terrible economic and financial news.
There was an avalanche of commentary from the Reserve Bank of Australia over the last week with the minutes from the last meeting, speeches from RBA officials Debelle and Lowe and RBA Governor Stevens’ testimony before a parliamentary economics committee. The clear message is that further interest rate hikes are likely, but given lingering uncertainties, including regarding sovereign debt levels and credit conditions, the process will be gradual. In particular Governor Stevens noted that we must now focus on managing the expansion and warned of the danger of leaving monetary policy too expansionary, given that we are starting this upturn with a relatively low level of spare capacity. While it’s a close call as to whether the next hike will be in March or April, we remain of the view that the cash rate will rise by another 1 per cent by year end.
Major global economic releases and implications.
US data releases were mostly encouraging. Surveys of manufacturing conditions in the New York and Philadelphia regions rose strongly in February, industrial production rose in January, housing starts and home builders’ conditions rose and the US leading index pushed higher in January. However, bad weather pushed down new mortgage applications and weekly retail sales data and pushed up jobless claims – snowstorms are likely to depress many economic releases for February, including for payrolls, ahead of a rebound in March.
The news on profits from abroad has also generally remained positive. The US December quarter profit reporting season is now largely over with 73 per cent of US companies beating profit expectations, 68 per cent beating revenue expectations and outlook comments generally being upbeat. Similarly, profit results in Asia have remained strong. Profit results are not so strong in Europe though, with more recent results being a bit mixed.
Japanese economic data was surprisingly upbeat with a stronger than expected 1.1 per cent rise in December quarter GDP with a strong contribution from both domestic demand and net exports.
Australian economic releases and implications
Australian economic data was mixed. According to the NAB business survey, conditions slowed in January but confidence actually rose consistent with continued economic recovery. Skilled vacancies rose solidly in February, reversing a fall in January and suggesting that the improvement in the labour market is continuing.
We are now just over half way through the December half profit reporting season in Australia. While there were a few more disappointments over the last week, the general impression remains strong. Forty of the 69 major companies to have reported so far or 58 per cent have seen their results beat expectations compared to a long term norm of 47 per cent, dividends have been increasing again and 65 per cent of companies have seen their earnings rise over the year to the December half (compared to an expectation of just 50 per cent). Outlook statements have generally been positive, consistent with a continuing recovery. As a result there has been a modest upgrade to consensus earnings estimates of around 2 per cent for each of 2009-10 and 2010-11.
Apart from the generally positive tone, key themes have been strong results for banks (with NAB being an exception), downside surprises and outlook downgrades amongst some defensive stocks (such as Telstra), cyclical stocks starting to benefit from economic recovery although at this stage it's still a bit mixed, depending on the sector. Overall the results so far provide confidence that profits will growth 20 per cent or so over the year ahead.
Major market moves
Although there were a few wobbles at the end of the week off the back of the Fed’s decision to increase its discount rate, global share markets rose as sovereign debt fears abated somewhat and as economic data and profit results were supportive. Australian shares were pushed higher over the week as a whole, by the global rebound, higher commodity prices and good earnings results.
Commodity prices were also pushed higher with share markets and this helped the $A, although its gains were limited by the US discount rate increase.
Government bond yields rose in most countries on the back of reduced risk aversion, better economic data, an upcoming record bond auction in the US and the Fed’s discount rate increase.
What to watch in the week ahead
In the US, data for house prices, home sales, consumer confidence and durable goods orders will be the key focus. Fed chairman Bernanke’s testimony before a Congressional committee will likely stress again that the discount rate increase does not signal any change in the outlook for monetary policy.
In Australia, data for business investment and construction activity will be looked at closely as both will feed into December quarter GDP data to be released in early March. Construction activity is likely to have increased by around 1.5 per cent on the back of the housing recovery and stimulus spending and December quarter capital spending is likely to show a rebound after weak September quarter data, with improving business confidence likely to have contributed to another upwards revision to business investment plans. December quarter wages growth is likely to have remained benign and data for car sales and private credit will also be released. A speech by RBA deputy governor Ric Battellino will also be watched closely, given he alluded to a possible pause in interest rate hikes in a speech late last year.
The profit reporting season in Australia will roll on with companies such as Fairfax, Aristocrat, GPT, Sun-Corp Metway, Harvey Norman, IAG and QBE due to report.
Outlook for markets
With some countries starting to unwind their stimulus measures and increase interest rates and worries about high sovereign debt likely to be a recurring theme, this year will remain a bumpy one for shares. However, the trend is likely to remain up, underpinned by improving profits, solid growth in emerging countries including China and the likelihood that interest rates are likely to remain at relatively low levels.
Monetary tightening will also ensure a bumpy ride for commodity prices and the Australian dollar, but further gains are still likely this year as global economic growth will remain commodity-intensive. The spread between Australian and US interest rates is more likely to widen than narrow over the next six months.
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.
Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.