“The Australian economy looks set to continue with reasonable economic growth. In our view, the Australian equity market continues to offer patches of reasonable value. Further, on any sensible analysis it is hard to justify why some highly indebted European countries have bond yields just above those of Australia. We would suggest that the European Central Bank is a little more active than previously disclosed.”
The current fervent debate by market commentators is whether Europe and the USA economies will have a “double dip” recession. The debate suggests that the third quarter profit reports by US and major European companies will be a critical determining measure. We note that after some reasonable early profit results from Alcoa and Intel in the US , markets have bounced – yet again.
Supporting short term sentiment, the IMF increased its 2010 GDP world growth forecast to 4.6% from 4.2%. The IMF left its forecast for 2011 unchanged as stronger growth in the US is expected to offset slower growth in Europe . The developed world, taken as a whole, will grow at about 2% (with significant government support) whilst the developing world will grow at over 6%.
Our view remains that the offshore market upswings are merely short covering rallies. As we suggested last week, there continues to be significant short term positions taking by traders and hedge funds. Depending on the perceived mood swings of the market, these traders position for rallies or falls. They are constantly forced to cover and reset positions due to the volatility which they themselves are causing. The end result is mindless volatility.
This current market behaviour reinforces our opinion that market prices, in the short term, are not a good guide to value. Only over a longer period will prices gravitate towards value. This is because, over time, the market will receive more information to adjust the price towards the value.
So what of the debate about a “double dip” recession?
Given that the unemployment rate across Europe and the USA is still averaging 10% (World Cup champions Spain have 17%) then there is sufficient evidence that these regions are still in some form of recession. The economist definition of a recession is two consecutive quarters of negative economic growth. This definition is hardly relevant when you acknowledge that European and US government are running fiscal deficits of about 10% of GDP. These policies will add to GDP as it is pump priming the economic system. Growth of 2 to 3% is a really poor output of so much debt funded expenditure.
In contrast, the Australian economy looks set to continue with reasonable economic growth. In our view, the Australian equity market does continue to offer patches of reasonable value. Further, on any sensible analysis it is hard to justify why some highly indebted European countries have bond yields just above those of Australia . We would suggest that the European Central Bank is a little more active than previously disclosed.
The US – The US market and economy is back in focus as public companies release their June Quarter results over coming weeks. Realistically, the results should show a slowing of growth in the March quarter, but substantial gains from the June 2009 quarter when the US was coming out of a financial mess.
The first two major results, from Alcoa and Intel, were positive. Especially so Intel (major computer chip manufacturer), which reported quarter revenue of $10.8 billion, up 34% year on year. “Strong demand from corporate customers for our most advanced microprocessors helped Intel achieve the best quarter in the company’s 42-year history,” said Paul Otellini, Intel president and CEO.
Alcoa raised its 2010 global aluminium consumption growth forecast to 12% and cited improved end-market demand. Its sales rose 22% to $5.19 billion from the previous corresponding quarter.
The US government announced that its nine month deficit had reached $1 trillion at the end of June. The forecast is that this will reach $1.4 trillion by the end of the September 30 financial year. US government debt now exceeds $8 trillion dollars.
Despite this, the US government was able to tender 3 year government bonds at the lowest ever issued rate this week. $35 billion of 3 year bonds were cleared at a yield of just 1.05%. This is again evidence that markets think that a deflationary low growth economic period awaits the US . It also is a sobering warning to market traders who believe a strong equity price recovery is possible.
The low bond rates feed into low mortgage rates. In the US , it is possible to refinance a residential mortgage at fairly regular intervals. About 78% of new mortgage loan applications are refinance proposals. The 30 year fixed mortgage rate is currently about 4.68% and is in stark contrast to Australia ’s floating rates of above 7.25%.
The US trade deficit was announced at $43 billion for May. The result was impacted by a big jump in imports from China and this will further ignite US claims that the Chinese currency is undervalued. The Chinese currency has only been allowed to revalue by 0.8% since China announced the loosening of its peg to the US dollar.
Europe – The European sovereign debt issues wax and wane as countries undertake successful bond issues which are underwritten by the European Central Bank. The waning results are from the reviews by credit agencies that are working through a backlog of country sovereign debt downgrades.
For instance, Portugal ’s 10-year yield increased nine basis points to 5.47% after Moody’s Investors Service cut the nation’s bond ratings to A1 from AA2. The yield premium demanded by investors to own Portuguese 10-year securities instead of benchmark German bonds climbed to 283 basis points (i.e.2.83%). By way of comparison, Australian 10 year bonds are currently yielding 5.1%, or just 0.3% below Europe ’s PIGS!
The European Banking Supervisors are about to coordinate stress testing over 91 European banks in coming weeks. The tests involve scenarios surrounding a range of negative economic events (e.g. a collapse in bond markets). The aim is to see if the banks have enough capital to withstand these events. At this point, markets remain sceptical of the tests as the results must be sanitised to maintain public confidence.
In the meantime, European commercial banks have begun using their holdings of gold to raise cash with the Bank for International Settlements, in a further sign of strains in the money markets on which many rely for funding. The Bank of International Settlements (BIS), the so-called “central banks’ central bank”, took 346 tonnes of gold in exchange for foreign currency in “swap operations” in the financial year to March 31, according to a note in its latest annual report.
A raft of economic numbers last week suggested that GDP across the Euro zone is still below 1% annualised. The growth remains centred around Germany , a major beneficiary of the weak euro. The German industrial production is 12% higher than a year ago with the CPI rising a mere 0.9% over 12 months.
In the UK , inflation has surged by over 3% due to the very weak pound. The currency weakness has helped neither the UK trade account, which stood at a deficit of 3.8 billion pounds in May, nor their GDP, which was virtually zero over the last year.
Asia – The Chinese Central Bank announced last weekend that China ‘s foreign exchange reserves reached $2.45 trillion at the end of June, up 15.1% year on year. Statistics from the Central Bank show that China ‘s foreign exchange reserves increased by $7.2 billion in the second quarter, a drastic decrease compared to the first quarter when reserves grew by $126.5 billion.
In contrast, Australia ’s foreign reserves are just $43 billion dollars.
China has been reinvesting these reserves across international bond markets. For instance, last week it disclosed that it acquired four hundred million euros worth of Spanish 10 year bonds. US Treasury securities will also remain an important market for China ’s official currency reserves, but gold will not become a major component of the central bank’s portfolio. This was disclosed on an official Chinese website last week.
Chinese import data showed some recent decline in imports of some resource commodities, including copper and iron ore. Spot iron ore import prices into China have continued to decline and were at $118 or well below contract prices. This has led to some weakening in the outlook for Rio Tinto Limited (ASX: RIO ) and BHP Billiton Limited (ASX:BHP).
Chinese iron ore prices are down 36.7% from the high of $186.50 reached on 21 April this year and back to the lowest level seen since the end of last year.
In an interview last week the BHP Managing Director stated that he was not concerned by the correction to iron ore spot prices. He suggested that any purchaser who tried to claim spot prices to break contract prices would not be supplied until they honoured their contractual commitments.
As for the new Minerals Tax, he suggested that the impact of the tax (if it becomes law) will be low in the early years as it is effectively partly grandfathering existing assets by using the market value. He stated that in a generation the tax will be significant (i.e. once the grandfathering had gone).
These comments confirm our view that the new Minerals Tax will have only minor negative effect on the values of BHP and RIO. However, we note that today the Australian Government will seek to clarify the workings of the mining tax.
