Licensee Economic Update – Feb 2013
January saw 2013 begin on a good note with strong gains on local markets. In percentage terms the Australian share market rose approximately 5%. This means the market has risen 19% since the beginning of the 2013 fiscal year – leading it to being viewed as ‘fully valued’ by many professional investors. Logically we can therefore assume some sideways drifting and market falls during the current company reporting season and the first quarter before a clearer picture of the 2013 year emerges.
The immediate threat to the US economy from the fiscal cliff was averted and further good news was reported on the economy’s recovery as well as company profits. This positive news has filtered through to world markets. One interesting fact for readers is the US equity market rallied to within reach of its all-time highs amid talk of “the great rotation” by investors out of bonds into equities.
In Japan, the new Prime Minister [Abe] started his program of economic reform, while in Australia the Prime Minister started an eight-month election campaign. “Currency wars” have become a hot topic, triggered by Japan’s moves to weaken the Yen. European economies remain soft and after a period of relative quiet, European risk issues broke out again in early February.
Here in Australia, the big news was the Prime Minister’s surprise announcement of September 14 as the date for the Federal election. Although the Prime Minister said this was designed to provide certainty for the economy and that “official” campaigning would not start until August, it seems unlikely that either of these will be achieved. The media and consensus opinion is not under any illusion that the election campaign hasn’t already begun and simply knowing the date of the election is not enough to enhance economic decision-making. Businesses and households also draw comfort knowing who will actually win the election and what policy commitments are being made along the way. If anything, the early announcement of the election date has the potential to add to uncertainty in the economy.
The latest economic figures show the Australian economy continues to slow down. The storms and flooding seen in Queensland in January, although having tragic consequences in some parts of the State, seem likely to disrupt mining and gas operations less than the floods in 2011. We are also presently in the reporting season for company earnings and early indicators suggest slowing of growth with earnings slightly below forecast. If this follows through as a theme in the top 200 companies, we will see a stagnating economy which will add to RBA pressure to continue with further rate cuts. On a brighter note, the price of iron ore rose further in January, house prices improved and domestic inflation continues to be subdued. The next slide highlights how resilient property prices have been in Australia and this provides some comfort to families in terms of personal wealth.
Figure 1: Australia – property prices
The Reserve Bank of Australia did not have a Board meeting in January and left interest rates unchanged at their meeting on 5 February. The Bank noted that some of the international pressures which have led them to cut rates last year have now eased somewhat, but that prospects for the Australian economy mean that low interest rates are still appropriate. The recent good inflation figures give the Bank room to cut interest rates further if necessary – underlying inflation rose only 2.2% in the year to the December quarter 2012. This was softer than financial markets had expected.
In the United States, the markets started January worrying about the fiscal cliff and whether politicians would be able to reach an agreement on the US budget that would avoid tipping the economy back into recession. As things turned out, agreements were reached to provide short-term solutions but without solving the longer run problems confronting US fiscal policy. Some of these issues are scheduled to be addressed in coming months so there will be further opportunities for the US political debate to unsettle financial markets. The international ratings agencies are also hovering in the background, waiting to see whether they will further downgrade the US government’s credit rating.
Nevertheless, January was a pretty good month for the US economy. Key indicators of manufacturing activity improved by more than expected and the number of workers filing for unemployment insurance fell to their lowest level since the GFC. US companies reported their latest results with the vast majority of firms recording profits above the market’s expectations. This provided a good environment for the equity market with the S&P 500 price index rising from 1,426 at the start of the month to 1,498 on 31 January. This was only about 4% below the S&P 500s all-time high of 1,565 seen in October 2007.
Figure 2: USA – Equities and jobs
Figure 2 shows both the S&P 500 price index (red line) and the unemployment insurance claims (blue line inverted – as the blue line rises, so the number of claims is falling). The improvement in both series since the beginning of the Global financial Crisis is clear. The US equity market pays close attention to the unemployment claims as a key measure of the health of the economy. This is because the US Federal Reserve has clearly stated that reducing unemployment is the primary goal of their monetary policy actions. In January, the Federal Reserve released the minutes of internal meetings discussing the outlook for monetary policy, which suggested that some governors are thinking about starting to reduce monetary policy stimulus later this year. This is much earlier than had previously been indicated and financial markets had expected. However, it still seems most likely that the Reserve will have to continue providing substantial amounts of liquidity well into 2014.
In China, there was further positive news on economic growth with the latest indicators of manufacturing activity turning out better than expected by the markets. This is consistent with the view we have outlined in previous reports that the leading indicators of economic activity in China suggest improving growth through 2013. However, the latest inflation figures from China caused some concern in the markets. After having declined for several months in succession, consumer price inflation in China rose to 2.5% in the year to December 2012, largely due to increases in pork and vegetable prices caused by cold weather. However, as Figure 3 shows, world food price inflation (blue line) has been rising for several months. This has been particularly due to increases in global grain prices last year.
The red line shows China’s inflation rate which tends to follow world food price inflation with a lag. Some financial market participants worry that renewed inflation in China will lead to tighter monetary policy and thereby stall the economic recovery. These concerns may prove to be a little premature but it is a risk to watch closely.
Figure 3: China – Inflation
In Japan, the new government has been taking steps towards implementing its economic stimulus program. This includes setting a 2% inflation target, weakening the Yen in the currency markets, finding a new Governor for the Bank of Japan and enacting new fiscal policy measures. The moves on the Yen are particularly interesting and helped trigger talk of “currency wars” in which countries deliberately depreciate their currencies to gain an advantage in international trade. Australia, with its persistently high dollar, is seen as being potentially disadvantaged by this.
In Europe, the latest data confirms that economic growth is slowing across the region and the first half of 2013 will continue to be difficult as most people are aware. However, Mr Draghi from the European Central Bank made encouraging comments about how conditions are likely to improve in the second half of 2013. After several quiet weeks, which helped equity markets, European political risk re-emerged at the start of February with accusations of impropriety against Spanish Prime Minister Rajoy. Equity markets fell in response, but some of this is likely to have been simple profit-taking after January’s rally.
Investment issues to consider
Here in Australia the share market offers investors fully franked dividends, and consequently by world standards, the market is regarded as a high yield market. With the RBA on a slow grind with interest rate declines, many investors have started rotating out of cash and term deposits in pursuit of higher yielding investments from the share market. This theme generally plays itself out through larger capitalised companies such as the banks and Telstra. Since the Fiscal year start we have therefore seen growth in share prices of these types of stock as investors rotate into them and as a consequence, their yields have drifted down from 8% to 5% and increased volatility should now be anticipated.
There are differing views on this matter. For example in the banking sector some analysts argue that Bank shares are increasingly expensive, are fully priced following the rise and that a slowing economy will flow into the banking system. While others argue relative security due to the oligopoly of banking, with limited competition and security through Government and tax payer support. They also argue the banking sector could return excess capital to investors through special dividend payments or introduce buy back schemes throughout 2013.
Finally, in an interesting segue to recent thoughts about the state of global bond markets. There has been quite a discussion in the financial press both here and overseas about “the great rotation” as investors move away from defensive assets such as bonds into riskier assets such as equities. The argument goes that there is so much money sitting in defensive assets that equities will benefit from the tailwind of investors finally rebalancing their portfolios. There is merit in this argument and the rotation we have seen so far is likely to continue, in fits and starts, as long as the global economy continues to improve.
Perhaps the expression ‘ the trend is your friend’ may need to be extrapolated into the one constant view by local economists on Australia – downward pressure on interest rates, falling value in cash and upward pressure into growth assets ….but with some risk and volatility as one would expect. Diversification by asset class and increased exposure to growth seems imminent as reflected in the United States which recorded the highest single month of inflows to mutual funds (managed funds in Australia) in January, since the beginning of the Global Financial Crisis.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