Shane Oliver's headlines of the past week

Headline developments of the past week ending Friday, 9 March 2007.

·         There were no surprises on the interest rate front over the past week. Reflecting its recently more relaxed stance on inflation, the Reserve Bank of Australia left interest rates on hold at 6.25%. By contrast the European Central Bank continued the process of increasing its key short term interest rate to more normal levels, taking it to 3.75%. While another increase is possible, with inflation remaining below the ECB’s 2% target and recent growth indicators for Germany looking a bit softer we think Euro-zone interest rates are at or pretty close to the top. The Reserve Bank of New Zealand also continued to raise interest rates taking them to 7.25%, but is running the risk of a hard landing at some point.

·         While Chinese Premier Wen Jiabao’s comment at the National People’s Congress that China was targeting 8% growth this year created a mini bout of nervousness on the Chinese share market the effect was temporary. 8% growth has been the Chinese Government’s growth target for the last few years and yet growth has always come in stronger – so it has proved to be a very loose target. The absence of any measures to slow the share market at the People’s Congress so far has seen the Chinese share market gradually recover from the previous week’s fall.

Major global economic releases and implications

·         US economic indicators were generally soft with a fall in pending home sales, a sharp fall in factory orders, soft weekly retail sales data and the Fed’s Beige Book of anecdotal evidence on the economy noting some slowing in conditions. The ISM survey of non-manufacturing conditions also slowed, but remains at a level consistent with reasonable growth. Bucking the soft data was weekly mortgage applications which rose solidly, possibly helped by the recent fall in mortgage rates on the back of lower bond yields. A rise in unit labour costs in the December quarter is a concern but is likely to reflect nothing more than a classic late cycle spike. It is worth noting that while former Fed Chairman Alan Greenspan has raised the possibility of a US recession he puts the probability at only 30%. Greenspan’s run of comments lately must be driving Fed Chairman Ben Bernanke crazy. We remain of the view that the US economy is on track for a soft landing – interest rates were not raised enough to cause a recession, the slowdown to date is largely contained to the housing sector, the US corporate sector is in very good shape and lower US interest rate from around mid year are likely to provide relief.

·         Euro-zone GDP rose a solid 0.9% in the December quarter or 3.3% year on year, but various indicators point to a slowdown in the March quarter with, eg, retail sales falling in January led by Germany on the back of its sales tax hike.

·         Japanese business investment rose solidly in the December quarter, but a leading index is pointing to sluggish economic growth ahead adding to evidence that the next rise in Japanese interest rates will be at least six months away. Predictions that the Yen carry trade – of borrowing in cheap Yen to invest in higher yielding currencies and investments – is now over will prove yet again to have been premature.

Australian economic releases and implications

·         In Australia, December quarter GDP data showed the economy to be in far better shape than expected. Thanks to solid growth in production and income, GDP growth was double market expectations at 1% in the quarter. More significantly though, inflation measures were subdued, productivity improved, growth in unit labour costs was below 3% and growth in profits remained solid. It’s premature to get excited about growth being too excessive though as the strong December quarter is in part just a rebound from very soft September quarter and annual growth remains sub-par at just 2.8%. Continuing the good news though inventories remain lean and the trade deficit came in better than expected in January. Housing approvals remain soft though suggesting that a recovery in housing investment beyond alterations and additions is still some time away.

Major market moves

·         After a poor start to the week which left most share markets technically oversold, global and Australian shares managed to regain some lost ground as growth fears faded to some degree and bargain hunters stepped in.

·         Bond yields were little changed after last week’s flight to safety driven declines. The $A declined a bit as Yen carry trades continued to be unwound, which is a classic outworking of recent market nervousness. Its hard to see the Yen rising too far though given the recent softness in Japanese economic indicators and the impact of a rising Yen on Japanese exports.

·         Oil prices were little changed, but base metal prices rebounded after the previous week’s falls. It is worth noting that since hitting record highs in May last year base metal prices have really just been bouncing up and down in a range. See the chart below which shows an average of prices for copper, nickel, zinc, lead, tin and aluminium. In other words the correction has been pretty mild considering the strength of the surge since lows in 2001. Chinese demand has remained strong and the supply response has been relatively constrained. Once the global growth cycle turns up again later this year and into next year the rising trend in commodity prices is likely to resume.

Source: Thomson Financial, AMP Capital Investors

What to watch in the week ahead?

·         In the US, data for retail sales, the current account, industrial production, consumer sentiment, a couple of business surveys and producer and consumer price inflation data will be released. Core inflation data is likely to show some softening in February after a stronger than expected rise in January.

·         In Australia, data for housing finance, business confidence, consumer confidence and employment will be released. After adding over 300,000 new jobs last year the labour market is now likely to have entered a softer patch and so we expect only a 5000 rebound in employment for February after the modest fall in January. Unemployment is likely to drift up to 4.6% after hitting a 32 year low of 4.5% in January.

Outlook for markets

·         While share markets have had a bounce from oversold levels over the last week, it is too early to call the all clear. Uncertainty over US and global growth may linger for a while yet, the crisis in the US sub-prime (mainly low-doc) mortgage market may have bit further to run, investor sentiment has yet to reach bearish extremes that normally signal market bottoms and the last three significant corrections in global and Australian shares (in March/April 2005, October 2005 and May/June last year) lasted about a month.

·         However, we remain of the view that recent turmoil is just another correction in a still rising bull market trend. Share market valuations both globally and in Australia are reasonable, profit growth is likely to remain robust, the current slowdown in global growth will help to sustain the low inflation/low interest rate economic expansion and there is lots of cash out there looking for a home. So notwithstanding a bit of short term volatility, global and Australian share markets are likely to provide solid gains over the remainder of the year. Our year end target for the ASX200 remains 6250 with the risk being on the upside.

·         While emerging markets have been amongst the hardest hit through the latest correction in shares (markets that go up the most generally also correct the hardest), it’s worth noting that emerging country central banks are in a good position to respond to any sustained softening by cutting interest rates. Interest rates in emerging markets are already in decline and with most running floating exchange rates there is little chance of a repeat of the late 1990’s “Asian crisis”– in fact many Asian central banks would welcome lower currencies. So while the correction in Asian/emerging share markets may have further to run in the short term, it is likely to be short lived.

·         With global growth slowing and inflation pressures receding, bond yields may fall further in the short term. More broadly, bond yields are likely to track sideways this year as growth and inflation prove benign.

·         The $A is likely to continue churning up and down around current levels with both interest rates and commodity prices providing mixed signals for the currency at present.

By Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*