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Licensee Economic Update – April 2013

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In Summary

April turned out to be a busy month for global financial markets. Concerns about the pace of growth in the United States and China, combined with the ongoing challenges in Europe, gave markets some pause for thought after the strong run of risk assets in the first quarter. The US Federal Reserve and the European ECB equivocated about what they would do with monetary policy, while the bank of Japan made it very clear that they would provide more stimulus than people had expected.

Here in Australia, the Federal government flagged further deterioration in the outlook for the budget deficit. However it was encouraging to see the Reserve Bank of Australia expressing optimism that the housing sector would be able to pick up the slack from the fading resource investment burden. At its meeting on 7 May, the Reserve Bank Board cut the official cash rate by 0.25% to a new all-time low of 2.75%.

Overall the trend was continued growth in world markets with a slight dip in the Australian dollar – This means diversified portfolios are showing positive returns and certainly better than the cash rate.

The chart below summarises the returns for selected major markets in April. It shows how equity markets improved to post rises for the month as a whole.

The economic news out of the United States was mixed in April. Early in the month, reports about activity in both the manufacturing and nonmanufacturing sectors, as well as the latest labour market statistics, disappointed financial market participants who had been hoping for stronger results. Although the unemployment rate in March fell to 7.6% from 7.7% the month before, the decline was due more to people leaving the workforce than new jobs being created. Consumer confidence data released around the same time also proved to be softer than had been expected and, along with the other data, prompted speculation that the sequestration measures in the US budget were starting to slow the economy.

However, later in the month and in early May, the economic news took a turn for the better. The April labour market data released in early May showed a better than expected gain in employment and a further decline in the unemployment rate to 7.5%. The manufacturing data for April released around the same time were also slightly better than expected, as were some updated consumer confidence numbers.

Figure 1 below shows how consumer sentiment in the US has gradually been improving since the GFC. Although the sentiment data (blue line) can be quite choppy from one month to the next there has been an overall upward trend since 2008. The chart also shows the path of the P/E ratio for the S&P 500. There is clearly some relationship between these two series, though it can be argued how much is coincidental and how much is causal. Nevertheless, a key part of the Federal Reserve’s policy of Quantitative Easing is to make households feel better about their balance sheets through higher asset prices while at the same time they pay down their debt. In this way, higher equity market prices (and higher house prices) are a key objective of the Federal Reserve’s policy and can help improve consumer sentiment. That in turn is a positive signal for household spending behaviour and further improvements in the labour market.

Figure 1: US consumer sentiment and the stock market – continues to improve

Where the US labour market goes from here is one of the most important questions facing the global economy today. The reason for this is that the Federal Reserve has made it clear that the future of the Quantitative Easing policy depends on what happens to unemployment and inflation. As long as inflation remains under control – which seems likely – the Fed will continue to supply liquidity until the unemployment rate is meaningfully below 7%.  However, it is likely that the Fed will want to see a more sustained and substantial fall in the unemployment rate below 7% before it starts significantly unwinding its stimulatory policies.

The closer we get to the point where the Fed starts to change its policy, the more financial markets will focus on the consequences of unwinding the liquidity stimulus the world – and risk assets in particular.  In particular, bond markets will find conditions harder and the US dollar would logically start to strengthen again. If this happens a retracement of the Australian dollar below the magic $ for $ parity should follow. This of course would help Australian exports and provide a better outlook for our own economic stability.

Last year economists all talked about the safety of investing in Gold – but the price has fallen dramatically and continued this in April – although it is hard to explain why. Reasons given include profit-taking by hedge funds, central banks selling the gold holdings (notably Cyprus) and capitulation by investors who had been expecting significant global inflation by now. Figure 2 compares the price of gold (blue line) with a measure of the money stock in America which reflects the impact of the Quantitative Easing programme. It is noticeable how the acceleration of the price of gold starts from the point at which the Fed’s easy liquidity policy kicks in. However, the latest decline in the price of gold coincides with a further expansion of the liquidity programme by the Fed. This provides an interesting perspective on the magnitude of the fall in the gold price recently, but does not necessarily tell us anything about where it goes from here. Interestingly, the fall in the gold price does coincide with a contraction in the European equivalent of this measure of money stock.

Figure 2: Gold and US Quantitative Easing

Events in Europe continue to unfold in the fashion we have become used to. Cyprus accepted a  “haircut” on bank deposits as a precondition for its bailout package and Italy finally resolved its political stalemate with the appointment of both a President and a new Prime Minister. The stalemate to forming a new Government was broken when the Democratic Party replaced its leader, Mr Bersani, with Mr Enrico Letta. Mr Bersani’s antipathy towards Mr Berlusconi was a key factor precluding a coalition being formed. Mr Letta was able to circumvent this obstacle. At 46, Mr Letta is a good deal younger than his predecessors and has indicated a pragmatic approach to continuing the reform program for the Italian economy.

Early in April, the European Central Bank (ECB) disappointed financial markets by not cutting official interest rates further to help support the weakening Eurozone economy. However, in early May the ECB changed its tune by cutting official rates by 0.25% to a record low of 0.5%. Mr Draghi, the head of the ECB, also flagged the possibility of further interest rate cuts and even forcing banks to pay the ECB for depositing money with it. Mr Draghi also made some comments – widely interpreted as being aimed at the French – about the need to curtail government spending and not just raise taxes. The French government appears increasingly out of step with Germany about the role of fiscal management, but a recent opinion poll showed the majority of French people agree with the German approach.

In Japan, there was no doubt about the authorities’ intention to stimulate the economy. The Bank of Japan (BOJ) announced a much bigger than expected stimulus program and significantly lifted its forecasts for growth and inflation. The (BOJ) has said that it will double the monetary base in the economy in an attempt to lift inflation to 2% within two years. Financial markets received this news very favourably. However, the Bank of Japan has been expanding its money base for some years with little impact on the economy. This has led some commentators to doubt the success of the current program.

The news out of China in April was mixed as it always seems to be. The figures for Q1 2013 GDP growth came in at 7.7% compared with 7.9% the previous quarter and the 8% expected by most economists. Although there is only a fraction of a per cent between these numbers, the markets were nevertheless disappointed and materials stocks suffered further. However, the latest inflation figures showed the CPI rose 2.1% in the year to March compared with an expectation of 2.5%. Overall though, markets remain concerned about China given statements from officials about the days of high growth being over and the need for curbs on property speculation. In addition, there have been numerous reports about problems with the level of debt at local authority level and the impact this might have on the financial system.

Here in Australia, the economic data released in April pointed to a slowing economy but the health of share markets continued to improve – highlighting markets factor in activity in advance of it happening.

Job vacancies fell 1.3% in April after a 0.5% fall in March and retail sales fell 0.4% in March. The figures on job vacancies have declined for 10 months in a row which is somewhat concerning but may simply reflect the slowing of the resources boom. In March, the unemployment rate rose to 5.6% from 5.4% in the previous month.

Inflation in the March quarter was also softer than expected. The headline CPI rose 0.4% in the March quarter. In the year to March the CPI was up 2.5% implying a satisfactory level of control and within guidelines.  The figures were generally interpreted as giving the Reserve Bank room to cut interest rates further. Accordingly, at its meeting on 7 May, the Reserve Bank Board decided to cut the official cash rate by 0.25% to 2.75%. The Board specifically said the lower than expected rate of inflation was a key factor behind the decision to ease monetary policy further.  The Board also noted the resilience of the exchange rate in the face of previous rate cuts. The Federal Government announced that the budget situation is worse than previously expected because of revenue shortfalls and that deficits will be likely for some years to come.

This has been prepared by Paragem Pty Ltd [AFSL 297276] and is intended to be a general overview of the subject matter.  The document is not intended to be comprehensive and should not be relied upon as such. We have not taken into account the individual objectives or circumstances of any person.  Legal, financial and other professional advice should be sought prior to applying the information contained in this document. Advice is required before any content can be applied at personal level. No responsibility is accepted by Paragem or its officers.


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