Shane Oliver's headlines developments

Headline developments of the past week ending Friday April 13, 2007.

Headline developments of the past week

·         The Australian dollar rose to its highest level since October 1990, rising above the $US0.83 level helped along by the prospect of capital inflows in response to Mexican cement maker Cemex raising its bid for Rinker along with general weakness in the $US and another week of strong Australian economic data. With commodity prices on the rise and another interest rate hike from the RBA increasingly likely the trend in the $A is likely to remain up. The next level of resistance is the August 1990 high of $US0.8405, but its probable that we are on our way to test the February 1989 high of $US0.8950. The surge in the $A is great news for Australian consumers who should expect to see lower prices for overseas holidays, cars, electronic goods and clothing. While the strong $A is a bit of a dampener for exporters and companies competing with imports, the overall impact on the economy and share market is likely to be minimal because the $A is strong only because global growth remains solid and the domestic economy is strong.

·         The minutes from the US Federal Reserve’s last interest rate setting meeting highlighted that even though the outlook for both growth and inflation has become a bit more uncertain the Fed is still more worried about inflation than growth. So while the Fed did move a step towards a more relaxed stance on interest rates at it’s last meeting, it was a relatively small step. Our view remains that slower US growth will take pressure off inflation and enable the Fed to cut interest rates, but, with the labour market still quite solid and inflationary risks remaining, a cut is now looking unlikely until some time in the September quarter.

·         The oil price fell back as Iran released the captured British sailors, but the decline has been limited by ongoing tensions over Iran’s nuclear ambitions, strong Chinese crude oil imports, an ongoing decline in US gasoline inventories and news of a sharp fall in oil inventories in OECD countries all of which is raising concern about supplies ahead of the summer driving season.

Major global economic releases and implications

·         US economic data was pretty light on and told us nothing new, remaining consistent with a slowdown as opposed to a collapse in growth. Initial jobless claims rose (but possibly due to distortions associated with the timing of Easter) and a survey showed a fall in small business optimism. Against this, weekly retail sales data remained solid and mortgage applications rose maintaining a sideways trend after last year’s fall, suggesting that the housing sector is still soft but at least it’s not taking another leg down.

·         The Bank of Japan left interest rates on hold as expected and weak machinery orders, soft leading indicators of overall growth and bank lending growth of just 2.1% year on year suggest that interest rates will remain on hold well into the second half of the year.

·         The European Central Bank also left interest rates unchanged at 3.75%, but is likely to raise them again in June.

·         China’s trade surplus narrowed sharply in March on the back of a slump in export growth. However, this is probably just a payback to very strong export growth in January and February which probably reflects distortions due to the removal of export tax rebates and the timing of the Chinese new year.

·         Revised IMF economic forecasts highlight the important role that desynchronised economic cycles are now playing in the global economy. While the IMF revised down its US growth forecast for this year to 2.2%, the growth outlook for the rest of world has been upgraded such that it still expects global growth to remain strong this year at 4.9%. The desynchronised global growth environment will help to smooth out the global economic expansion that got underway about five years ago and thereby help to extend it. This in turn will help to extend the bull market in shares, commodity prices and growth assets generally.

Australian economic releases and implications

·         Australian economic data continued its run of strong readings with the National Australia bank’s March business survey indicating that business conditions remain strong and housing finance rising solidly in February driven by investors. While employment rose by a bit less than expected in March, solid job ads suggest the labour market remains tight and the unemployment rate fell back to a 32 year low of 4.5%. The continuing run of strong economic data and the threat the tight labour market poses to wages growth and hence inflation, is only adding to the case for another interest rate hike. Given the Bank’s desire to avoid becoming entangled with the political debate after the Budget is handed down on the second Tuesday of next month and the Federal election later this year, a move following its meeting early next month is looking increasingly likely. (The RBA meets on the first Tuesday of each month.) The key will likely be what the March quarter inflation data shows when it is released on April 24^th, but at this stage an unexpectedly good outcome – defined as underlying inflation heading decisively towards 2.5% – would be required to head off another move on interest rates.

Major market moves

·         Despite a mid week scare on the Fed’s warning that it may still have to raise interest rates, global shares generally managed further gains. Japanese shares were little changed though.

·         The Australian share market had another strong week helped along by takeover news, particularly in relation to Rinker and Qantas. A bout of profit taking and concerns about the impact of the surging $A and another interest rate hike had a dampening impact at the end of the week though.

·         The surging Chinese A share market is now up 30% from its early March low.

What to watch in the week ahead?

·         In the US, the March quarter earnings reporting season will start to hot up. While Alcoa has already kicked the reporting season off with a strong result, consensus expectations for profit growth for the year to the March quarter are just 3.3% which if correct will mark the first quarter in 15 that profit growth is in single digits. That said, the ratio of negative to positive profit warnings is running above 3 to 1 which is normally a sign that there may be some upside surprise.

·         US data for retail sales, consumer prices inflation, industrial production, housing starts and permits and a couple of business surveys will also be released. Given the Fed’s ongoing concern about inflation, the March quarter CPI will be watched very closely for clues as to the outlook for interest rates. Unfortunately though, March core inflation has had a tendency to be a bit elevated in recent years so it may not provide the relief that many investors are hoping for. The good news though is that high rental property vacancy rates in the US are set to put downwards pressure on rents which represent 38%  of the US core (ie, ex food and energy) consumer price index, so this should lead to lower inflation over the remainder of the year which in turn should help relax the Fed.

·         In Australia, data for consumer confidence, car sales and import and export prices are due for release.

Outlook for markets

·       The trend in share markets is likely to remain up on the back of still reasonable valuations, okay profit growth, a gradual reduction in pressure on inflation and US interest rates and the fact that there is lots of cash out there looking for a home. So while shares will experience inevitable setbacks along the way – with worries about the US economy and profits and tensions with Iran providing potential triggers – shares are set to provide reasonable returns this year.

·       The Australian share market is set to receive a huge inflow of up to $60bn over the next six months – if the Qantas, Rinker and Coles takeovers proceed, as superannuation inflows pick up in response to policy measures last year making super more attractive and as the Future Fund commences investment. With no major capital raisings the weight of money will be a very strong force acting to push overall share prices higher. Surging commodity prices are also great news for resources stocks which are likely to see earnings upgrades and are trading at huge PE discount compared to industrial shares. Resources are trading on a forward PE of around 11 times compared to the rest of the market which is trading on around 17 times.

·       Bond yields are likely stuck in a trading range reflecting the modest slowdown in global growth and lingering inflation worries. With yields already relatively low, bond returns will be modest.

Although the $A is already overvalued at current levels, the favourable interest rate differential and strong commodity prices point to further gains ahead, probably up to the February 1989 high of $US0.8950. This would imply a similar degree of overvaluation to the undervaluation that occurred when the $A plunged to $US0.48 in 2001.