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Licensee Economic Update – March 2013

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In summary

Markets have continued their upward run and now have commentators talking about a sustained growth period [so called bull market] for some time ahead. Whether this is correct or not, it is notable that sentiment and confidence has improved and these factors often drive market outcomes in advance of valuation logic. February and early March actually saw some uncertainty and despite the upward run, concerns returned to the global scene.

Background Noise

On the one hand, the economic news from the US continued in a generally positive vein, but on the other hand the markets were surprised by comments from the US Federal Reserve about when they might start to scale

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back support for the economy. Added to this were the budget negotiations in the US, the elections in Italy and fears of slower growth in China. In Australia, the Reserve Bank has kept interest rates on hold but remains cautious about the outlook for the economy.

On balance, the good news probably still outweighs the bad, but given how hard equity markets have run in the previous month or so, it is not surprising that they should be ready for a pause before moving higher again. Figure 1 shows equity indices for Australia, the US and Europe. The increased volatility in recent weeks is apparent, but readers should note that the ASX200 has breached the 5000 mark once again and the US Dow is at new all-time highs. No commentator has been able to predict this over the past 2 years – re-enforcing the need to remain in markets and be patient.

Figure 1: Selected equity markets

Australia

Here in Australia, the reporting season is completing and continues to imply the Australian economy is slowing down. Building approvals and retail sales were disappointing and although the unemployment rate is still at 5.4%, it is generally expected to rise in 2013.

The Reserve Bank’s latest announcements show that it expects the economy to be weaker than last year and to run a bit below its longer run trend rate of growth. Although the Reserve Bank did not cut interest rates at either its February or March Board meetings, citing the amount of stimulus already provided by rates cuts, nevertheless the Board noted that low inflation and a high $A give the Bank room to cut again if the economy slows enough from here. Financial markets still generally expect the Bank to cut interest rates once or twice more this year.

The Reserve Bank also made some comments about the strength of the $A which suggest they are less worried about the currency than previously thought and that they will not take action, either directly in the currency market, or indirectly through interest rates, to weaken the $A. Over the course of recent weeks, the $A has slipped back against the US$. This will result in better performance returns from overseas investments and again re-enforces portfolio diversification.

Figure 2 shows how the close relationship between the direction of the $A against the direction of the SP500 equity index has broken down lately. Previously the $A had rallied with the US equity market, but not of late. This has been attributed to some foreign selling of Australian bonds which were bought as a safety bet during the Euro crisis last year as well as renewed positive sentiment to the US dollar as the US economy improves. This second effect makes sense and although the $A is likely to remain above US$1.00 for a while longer – especially as better data on China come through – it will probably not rise as far as previously expected.

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Figure 2: The $A against the SP500 [ USA sharemarket ]

USA There was more good news on the United States economy in February. Activity in the manufacturing sector, consumer confidence and employment all continue to improve, while inflation remains under control. Although the US still has a way to go before fully recovering from the GFC there are clear signs the economy is gaining momentum. This is what has been driving the equity markets higher in recent months. However, the policy-makers can always disrupt the markets’ good mood. Statements from the US Federal Reserve [Fed] revealed that the Board of Governors has been debating how soon they should start easing up on the liquidity they have been providing to the economy. The financial markets did not like this at all and equities retreated.

Similarly, the initial reaction to US politicians’ failure to reach an agreement on the so-called “sequester” was not well received by the markets. This issue is about whether the politicians can agree to avert a set of automatic spending cuts which kick in from 1 March this year. So far no agreement has been reached and budget policy is likely to slow the US economy during the course of this year.

Where the markets go from here depends how these forces balance out. In particular, will the economy be strong enough to withstand the budget drag and will the Fed start withdrawing liquidity support this year? At this stage the answers to these questions appear to be yes and no – yes the economy will be alright and no the Fed will not act too soon. Overall, this would continue to provide a supportive environment for equities.

Europe

The same cannot really be said for Europe, where the economy remains weak and the politics remain troublesome. The Spanish Prime Minister has been embroiled in scandal and the Italian elections failed to produce a workable result. Although the markets are not pleased with the Italian result, they have taken it much better than they did the results of the first Greek election last year. Despite Mr Berlusconi and Mr Grillo espousing anti-austerity and even anti-Euro policies, the financial markets are not as worried about a possible break-up of the Euro zone as they were in June 2012. This change in sentiment is very important and reflects greater confidence that the European authorities will keep the system together. The European Central Bank stands at the forefront of those efforts.

China

The latest news from China has been on the softer side. Manufacturing activity seems to have slowed a little and inflation has moderated a bit. However, these data are distorted to some degree by the spending patterns around Lunar New Year. The economy is likely to be stronger than the latest data suggest. On the policy front, the Bank of China said it will remain vigilant about inflation and the government announced further restrictions on speculative property activity. This caused some concern that construction and demand for iron ore would slow and hurt Australian ore exporters. However, the new measures are targeted at a few key cities and limit activity in existing dwellings rather than construction of new dwellings. Overall, China still seems to be on track for a

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better year in 2013.

This document 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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