WEEKEND ECONOMIST: Storm weathered

Central bank governors in the US, Australia and New Zealand all expressed the view that the impact of the problems in Europe on their respective economies would be minor. That said – apart from New Zealand's move to raise interest rates – there is little doubt that the added uncertainty to the global outlook flowing from Europe's problems is leading to easier monetary conditions worldwide than would otherwise have been the case.

US tightening now getting pushed out into next year, the RBA is unlikely to commence raising rates again until there is greater certainty that Europe won't derail the global economic recovery and the European debt crisis, and recent market turmoil also weighed heavily on the Bank of Korea's decision to leave its policy rate on hold at 2 per cent.

The key message from Chinese economic data for May is that the Chinese economy is cooling but not collapsing and that it is continuing to rebalance towards a greater reliance on consumption. The authorities have been seeking to slow the property market and cool down growth in industrial production, fixed asset investment and bank lending, while at the same time rebalancing the economy towards a greater reliance on consumer spending. And this is exactly what we are seeing, with retail sales growth accelerating slightly in May but momentum slowing in industrial production and fixed asset investment, and the heat coming right out of the housing market.

At the same time, Chinese exports are continuing to strengthen. While inflation picked up to 3.1 per cent, this largely reflected base effects and is well below what was feared earlier this year. In any case, business surveys point to a sharp weakening in input cost pressures. The bottom line is that measures to cool the Chinese economy and property market are working and that further tightening is unlikely. As such, we remain confident in our view of a soft landing for the Chinese economy, which will see growth fall back to around 9 to 10 per cent. While much is made of the fact that 20 per cent of Chinese exports go the European Union, it is worth noting that only 3.5 per cent go to the key at risk countries of Portugal, Italy, Ireland, Greece and Spain.

Concerns about a wages boom in China are misplaced. First, the wage increases so far mostly relate to minimum wages which have been boosted by around 20 per cent in some cities; average wage increases are more likely to be around 15 per cent this year. Second, the recent resurgence in wages reflects a catch up as minimum wages were frozen last year in many cities. Third, 15 per cent wages growth is not that high when it is considered that the economy expanded 12 per cent over the year to the March quarter – in other words, it's largely being paid for by productivity growth. In fact, double-digit wages growth has been the norm in China up to 2008. Finally, on any metric Chinese wages remain very low. The hourly minimum wage is about one eighth of US minimum wages and unit labour costs in Honda's China factory are as low as 5 per cent of US and Japanese levels.

Japan now has (another) new leader and hopefully Prime Minister Kan will have more of a "can do” attitude than his predecessor. His support for a GST increase is a worry, but if it's offset by other tax cuts and a more aggressive approach to combating deflation from the Bank of Japan there may be reason for optimism.

Major global economic releases and implications

US economic data was generally favourable, with an increase in consumer credit in April, an increase in small business confidence and hiring plans and an increase in weekly chain story sales. What's more, the Fed's latest Beige Book stated that economic activity continued to improve modestly. The dampener remains the housing sector, with another big fall in weekly mortgage applications indicating that activity has really weakened after the now-expired first home buyer tax credit pulled demand forward into March and April. However, it's worth noting that the number of households receiving default notices is down 22 per cent from a year ago.

European data was better than expected, with strong rises in German industrial production and factory orders and a further rise in French factory production – the big fall in the euro is great news for German and French manufacturers. The Bank of England and the European Central Bank both left interest rates on hold. The ECB's response to the European debt crisis has been particularly disappointing. Its public sector bond purchases have been slowing over the last month but with deflation looming it should really be cutting its policy rate down to zero and buying bonds out of printed money (that is, quantitative easing).

Japanese data was generally positive, with an upwards revision to March quarter GDP growth, continued growth in machinery orders in April, a further rise in consumer confidence in May and a fall in bankruptcies.

Australian economic releases and implications

Australian economic data was generally soft, with past rate hikes, share market turmoil and the debate over the proposed resources tax resulting in sharp falls in both consumer and business confidence. Housing finance was mixed in April – down in terms of the number of new loans for owner occupiers, but investor finance continues to recover. Labour market data remained strong though, with a stronger than expected gain in employment in May, particularly in full time jobs, and the ANZ job ads series continuing to rise, pointing to more employment gains ahead. The continuing improvement in the labour market will help underpin household income and along with next month's income tax cuts should help boost consumer spending going forward.

While interest rates are likely to remain on hold for a few months as the Reserve Bank of Australia waits to assess the impact of both the European public debt crisis and the interest rate hikes we have seen to date, the strong May labour market report reminds us that more interest rate hikes likely still lie ahead.

Finally, RBA Governor Glenn Stevens provided a timely reminder that while Australia doesn't have a problem with public debt, it does have a potential issue with high household indebtedness. The RBA would prefer not to see further big increases on this front, which implies that it will be keeping a close eye on growth in housing credit – and by implication house prices as the two go hand in hand – when setting interest rates.

Major market moves

It's been another volatile week for share markets, with shares starting on a weak note in response to the worse than expected US jobs figures, but managing to rise over the week as a whole on the back of better than expected economic data including in China and Australia and a greater degree of confidence that the problems in Europe won't derail the global recovery. Share markets seem to be trying to bottom with a lot of support around the 1050-level for the US S&P500 index and around the 4300-level for the ASX200 in Australia. Asian ex Japan shares are looking particularly healthy having managed to remain well above their late May lows over the last two weeks.

The strength in share markets also translated into higher commodity prices (except for gold), a rise in the Australian dollar which was also helped by strong local jobs data and higher government bond yields.

What to watch in the week ahead?

In the US, producer and consumer price data is likely to show waning inflation and a survey of home builders and housing starts are likely to be soft in the aftermath of the expiry of the first home buyers tax credit. However, manufacturing conditions surveys are likely to remain solid.

In Australia, it will be a quite week on the data front, but the minutes from the last RBA Board meeting are likely to add to expectations that rates will remain on hold for a while. A speech by RBA Deputy Governor will also be watched closely for any update on the Bank's view regarding the problems in Europe.

Outlook for markets

It's looking increasingly likely that shares are trying to build a bottom and that the correction that commenced back in April is over. The global economic recovery is likely to continue. Shares remain very oversold and are now cheap. Investor sentiment towards shares has fallen so far that it's now positive from a contrarian perspective. The recent outbreak of uncertainty will help ensure that global monetary conditions remain easy and Chinese tightening is now on hold with the prospect of some easing in property tightening measures in the months ahead. As such, our view remains that the cyclical recovery in shares that commenced in March last year is still on track. That said, volatility will remain a key feature going forward.

Chinese shares may lead the bounce back in global markets just as they led the recovery from the GFC and the recent slump. Chinese shares are cheap – the PE has fallen to 19 times, which is well below its long term average of 34 times – and are likely to get a boost as it becomes apparent further tightening is unlikely.

The $A is likely to regain strength over the next few months as Australian interest rates remain well above global rates and as commodity prices resume their upswing.

Gold is likely to remain a long-term beneficiary of the uncertainty about major currencies.

Finally, low government bond yields are pointing to poor returns over the medium term, particularly as worries about excessive public debt continues to impact and as the latest bout of investor risk aversion abates.

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