Licensee Economic Update – July 2013
Factors driving world markets weighed heavily on July data for the US which showed the US economy to be gradually improving. The housing market data was particularly robust and the ISM manufacturing index was stronger than most economists expected. Improvement in labour market conditions is still slower than desired but nevertheless it appears to be heading in the right direction. The Federal Reserve also clarified its previous statements about easing back on the QE program and emphasised that it would be both flexible and guided by the economic data. This was comforting to investors and assisted market sentiment.
The reverse of this news was the Australian economy which has slowed further leading to the Reserve Bank cutting the cash rate to a new low of 2.5% at its 6 August Board meeting. The unemployment rate is expected to rise above 6.25% by 2014. The federal election has been called for 7 September but at this early juncture uncertainty about the outcome is now higher than a few weeks ago. The Government’s revised budget outlook highlights the size of Australia’s fiscal problem and the drag that the public sector will be on growth until this problem is fixed.
In Japan the program of reform will accelerate now that the Government has won the Upper House. The ECB reiterated that interest rates will remain low for some time and in China the latest economic figures printed stronger than expected.
The broad global economic environment at the moment favours equities over bonds. With the US Federal Reserve clarifying of its intentions, equity markets had a better month, but the $A weakened further. Figure 1 summarises the returns for selected markets in July 2013.
Figure 1: Gold bounced, volatility fell sharply & Australian equities were strong
Here in Australia the economy continues to soften – the latest news data includes:
- ANZ job ads fell by 1.1% in June to stand 18.6% below a year ago;
- Employment rose slightly by 10,000 in June, but the unemployment rate rose to 5.7%;
- The CPI rose 0.4% in the June quarter and 2.4% in the year to June;
- Total residential building approvals fell 6.9% in June and 13.0% in the year to June;
On the other hand, auction clearance rates and house prices improved as people took advantage of low interest rates to buy existing houses, rather than build new ones which is what the Reserve Bank would really like them to do. In NSW the auction clearance rate has been above 80% for more than 5 weeks – this is pushing prices up very quickly and invariably into being overpriced for some buyers.
Economists expect the unemployment rate to rise to over 6% by early 2014. Indeed, in the Government’s recently updated economic and budget outlook, Treasury forecasts the unemployment rate to reach 6.25% The combination of a slowing economy with rising unemployment and soft inflation means the Reserve Bank has room to cut the cash rate even further. The markets widely expected the 0.25% cut decided at the Bank’s 6 August Board Meeting, which brings the cash rate to a new record low of 2.5%. Further cuts are expected as long as inflation remains under control; Figure 2 shows that this is the case for the moment, with both headline and underlying inflation sitting in the lower half of the Reserve Bank’s desired range.
Figure 2: Subdued inflation gives the RBA room to cut interest rates further
In the lead-up to the Federal Election on 7 September, the Government has announced a raft of policy initiatives from modifying the carbon tax through to a proposed levy on banks to fund the deposit guarantee. While some of these may or may not see the light of day depending on what happens on 7 September, the key point to come from the revised budget statement is that the nation’s finances are in a worse state than expected – and deteriorating quickly. Fixing this will mean the government sector will be a drag on growth at a time when the export sector is also providing less support. Interest rates and the exchange rate must fall further to help offset these forces.
News in the United States is upbeat and helping world confidence. The latest data show the economy continuing to improve. In particular:
Payroll employment rose 162,000 in July and the unemployment rate fell from 7.6% to 7.4%, – although the details behind these numbers were a little softer than the market had expected;
- The ISM manufacturing index was 55.4 in July which was much higher than expected;
- Real GDP growth was reported at a 1.7% annualised pace for Q2 2013 – which was better than expected and driven by stronger consumer spending;
- The house price index rose 12.2% in the year to May 2013, which was the strongest 12-monthly increase in over seven years;
- Consumer confidence declined slightly in June but remains near its post-GFC highs;
On the negative side:
- Detroit became the largest US city to ever file for bankruptcy with more than $18bn in debt;
- Some of the regional growth remains sluggish in sections of the country.
On the policy front, President Obama has proposed a jobs package tied to tax reform in the US. In particular, the proposal includes spending on infrastructure to boost job creation. How to pay for this spending though, remains the question. Although the President’s announcement did not address comprehensive tax reform there is speculation the Democrats will embrace a version of the Republican’s proposal for taxation of un-repatriated offshore profits. The Republicans however, do not want such funds spent the way the President is suggesting. The fiscal debate in the US has taken the back seat in recent months but major issues still need to be resolved. For example, the debt ceiling will have to be raised again by October this year.
As for the Federal Reserve, Ben Bernanke emphasised that the Reserve would be flexible in its Taper program and respond as the economic data requires. He also said that even
when the unemployment rate reaches 6.5% the Federal Reserve will not rush to lift interest rates.
Overall, the economic environment in the US generally favours equities over bonds. Figure 3 shows how the 10 year bond yield in the US has tracked the path of the economy as measured by the ISM index. As the economy softened and the Federal Reserve’s monetary stimulus intensified, so bond yields fell to record low levels. But as the economy has stabilised and the Federal Reserve has begun signalling the end of Quantitive Easing, so bond yields have risen sharply. Bond yields will rise further if the US economy maintains this sort of momentum into 2014.
Figure 3: A stronger US economy will push bond yields up
The equity market, on the other hand, has benefited from the better economic conditions. Figure 4 shows the S&P500 Index at new record highs, driven partly by some good earnings reports in recent weeks. Investor surveys are showing increasing flows into equity funds and if the economy continues to improve and the Federal Reserve is able to manage the so called ‘Taper’ smoothly, then this would generally be a good scenario for equities.
Figure 4: The US equity market is at new record highs – but mangers still feel bullish
In Europe the European Central Bank (ECB) said it sees the worst of the recession as having passed, but that the risks remain on the downside. Both the ECB and the Bank of England have promised to maintain accommodative monetary policy for some time. The President of the ECB said that if markets are expecting interest rate increases any time soon from the ECB then they are seriously misreading the situation. The Greek Parliament passed further measures to cut spending and instability returned to Italian politics with Berlusconi’s conviction being upheld.
In Japan the ruling Liberal Democratic Party and its coalition partner won a majority of seats in the upper house of the Diet and thus control of both houses. This will be a significant boost to the government’s ability to implement its program of reform.
While the world watches China and it’s slowdown, it is not contracting per se’ but it is slowing from disproportionately high growth levels compared to the rest of the world. In China itself the official PMI rose to 50.3 in July from 50.1 in June. The increase caught the markets by surprise and contradicted the earlier “flash” report from HSBC which said manufacturing activity fell to an 11-month low of 47.7 in July from 48.2 in the previous month. Second quarter GDP grew 7.5% year-on-year after 7.7% in the first quarter. The authorities indicated that 7.0% is as low as they would want to see growth go. The People’s Bank of China said it will remove the floor on lending rates offered by financial institutions as part of the overhaul of the country’s financial system. All of this suggests a very nervous world watching month by month statistics in a country that is slowing- but still offers positive growth around 7%. The government is determined to maintain stability and as such the see-sawing effect from month to month should largely be ignored as it generally corrects itself en-route to the average growth rate.
The above has been prepared by Paragem Pty Ltd [AFSL 297276] and is intended to be a general overview of the subject matter. The above 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.