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We acknowledge Perennial Investment Partners for their contribution to this month's update.
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It's official! We're no longer as tied to the US and our marriage to Asia is stronger. Research released last week confirmed the strength of our “new” marriage with Asia. It concluded that a shock to Asian economies over the last 10 years has dramatically overtaken the US as the most important external factor influencing our business cycle. It estimated that the impact of a 1% economic shock in Asia would produce a 1/3 percent change in Australia’s growth rate. Whereas a shock isolated to our old flame, the US, is now estimated to have negligible impact here.
It should be noted that the research undertaken by the International Monetary Fund (IMF) focussed on the effects of GDP rather than share market moves. So, it's likely we'll still be heavily influenced by the US lead in terms of day to day stock market movements.
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Turning Point 1 - US at the end of the "easing" cycle
It's pretty easy to flood your economy with liquidity if inflation stays under control. However, the US is now at a very important inflexion point where the "easy" game is close to being over. US Federal Reserve Chair, Ben Bernanke, now has the difficult job of managing the next stage of US policy in an environment where corporate earnings are rising; unemployment is notoriously slow to improve; and, he needs to contend with strong Republican arguments for a tougher fiscal stance.
Last week, Bernanke emphasised the fact that maintaining the current stock of quantitative easing by re-investing maturing securities was in itself stimulatory. This could be a big hint that QE3 may be off the agenda when QE2 finishes in June 2011, albeit with interest rates on hold for perhaps another 12 months or more. Markets tend to fear that higher interest rates spell the end of any rally but, as always, it will depend on where you are in the cycle. The performance of the European stock market since the European Central Bank tightening is a case in point. Tightening from extremely easy monetary conditions is not a headwind for equity markets. However, once you get past stimulatory rate levels, the headwinds typically begin. That said, the challenges facing the US appear to be far beyond a normal business cycle expansion phase tightening.
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Turning Point 2 - Little Aussie Bolter, book your overseas holiday but keep an eye on local companies' overseas earnings.
How high can the Australian dollar go? Most currency strategists are pointing to an overvalued Australian dollar. Of late, momentum has swung slightly against our dollar's favour with materials prices cooling off. Our dollar's longer term momentum has been driven by our terms of trade, portfolio flows and an incredibly weak US dollar. The weakness of the US dollar can be seen in the following chart which shows the US dollar against major world currencies since January 1973. It's interesting that markets have not yet looked through the continuing US recovery to start to set a new trading range for the US dollar based on eventual US tightening and slowly improving employment. In the meantime, as our dollar is still above parity with the US, the level of the Australian dollar is likely to continue to have a major effect on exporters, tourism and companies with overseas earnings.
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Source: Perennial
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Turning Point 3 - Aussie Inflation spikes but next rate rise is not around the corner
The March quarter CPI increase of 1.6% was well ahead of market expectations for a 1.2% gain. Floods affected food prices. However, price gains were broad based, with a range of underlying measures rising between 0.8% and 0.9%. While the December quarter CPI figure was lower than expected and gave the Reserve Bank of Australia (RBA) some breathing space before the next tightening, the latest CPI figure is expected to take much of that breathing space away.
Where to next for interest rates? Rates didn’t change at the May meeting and the RBA will probably want to look at the next couple of GDP numbers to get a better feel for the strength of the post flood rebound. Any near term moves are highly unlikely, with the March quarter GDP, due for release on 1 June, expected to range between minus 0.25% and zero. The June quarter GDP figure is due on 7 September, the day after the RBA monthly monetary policy meeting. If the story continues to unfold as expected, recent CPI data reminds us that an economy running close to full capacity will most likely need a couple of light taps on the monetary brakes. The first tap is likely to be taken at the September meeting, when the RBA should have a good feel for how the post flood/cyclone economy is travelling.
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Turning Point 4 - Australian Shares left behind again
Overall, the local share market looks a little underdone and is struggling behind the US, despite our strong economic fundamentals. As can be seen from the chart, the divergence between Australian and US shares this year really blew-out post Easter. Concerns about inflation in China; our fluctuating currency giving overseas investors an incentive to take profits; and, possible political issues, with a minority Federal Government taxing business on carbon and mining; appear to be keeping some international investors on the sidelines.
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Source: IRESS and Perennial
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In many ways there's nothing new here. Most of the market action this month is a continuation of recent trends. We're at an interesting point in the business cycle and, despite a few setbacks (the natural disaster in Japan, oil price shocks and sluggish employment growth in the US), global output is still likely to grow at around 4% to 4.5% in 2011 and much the same in 2012. I would favour unhedged international shares, local shares and would probably avoid overseas Government debt as this plays out. From a practical point of view, when I look at industry cash flows, it's disappointing to see that the local investor appears to be overly conservative at a time when equity yields and valuations are compelling.
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