Download QIC Monthly Economic Brief - May 2014.docx

May 2014
Key Points
•
Global equity markets set new records in May
•
US and China leave the winter blues behind
•
ECB announces stimulus measures
•
Buoyant March quarter economic activity in Australia, but momentum wanes in June quarter
•
Federal Budget outlines a lengthy path to surplus
International economies
Global equity markets set new records in May
Global equity markets continued the positive forward momentum that has characterised the asset class since the sharp
correction in January. The MSCI World Index (in local currency) advanced by 1.9 per cent over the month to surpass its
previous high established in late June 2007. Similarly, the US S&P 500 ended the month at 1924; an all-time record and
the first time the S&P 500 has broken through 1900. The Australian market continued its trend of underperformance,
barely rising over the month. Weighing on the Australian market is the dramatic fall in bulk commodity prices, and in
particular, the price of iron ore, which fell by 13 per cent over the month, to reach a 20 month low of US$92. Unlike its
global and US counterparts, the S&P/ASX 200 remains far below its 2007 high water mark of 6568 at a current level of
5464.
Familiar themes drove the climb in equity prices over the month, including: strong earnings outlooks; post-winter
recovery in the US economy; ongoing recovery in the European and Japanese economies; the prospect of an easing of
monetary policy by the European Central Bank (ECB); and a general environment of low interest rates. Added to the list
of market-supporting factors this month were signs of stabilisation and recovery in the Chinese economy and diminished
concern over the Ukraine/Russia crisis.
Despite the general improvement in economic fundamentals, bond yields declined over the month, continuing the trend
established since the start of the year. This month, major 10-year government bond yields fell by around 15 basis points
(bps), with declines of 17 bps in the US, 11 bps in Germany and 9 bps in the UK. The Australian bond market
outperformed its peers, with yields falling by 29 basis points over the month. The ongoing fall in global bond yields is
becoming increasingly difficult to explain. This month saw an improvement in economic data, a flow of funds into
emerging market economies (for the second month in a row) and an abatement of geopolitical concerns. Placing
downward pressure on yields was the building pressure on the ECB to ease policy and commentary by current and ex
officials of the US Federal Reserve that the neutral fed funds rate will be lower over the current tightening cycle than in
past cycles. Our view is that bond yields in the US, UK and Australia are lower than levels that could be justified by
economic fundamentals and central bank monetary policy. Consequently, we expect yields in those markets to grind
higher over the remainder of 2014.
US and China leave the winter blues behind
Revisions to the US national accounts revealed the economy contracted at a 1 per cent annualised rate in the March
quarter, the first quarterly drop in output in 3 years. However, the fall in economic activity is transitory, largely reflecting
the harsh winter weather and an inventory correction after an unsustainably large run-up in stocks in late 2013. The
fundamentals of the US economy continue to improve gradually; public finances are in much better shape, the housing
market is recovering, household balance sheets are mending, unemployment is falling and external headwinds have
eased. Moreover, the underlying fundamentals continue to point towards a pickup in business investment, rather than
the 1.6 per cent annualised contraction seen in the March quarter. Corporate balance sheets are healthy, profit margins
are high, interest rates are low and credit constraints have diminished. With consumer spending showing signs of
firming, business investment should pick-up in coming quarters; a view consistent with the trend improvement in the
April durable goods orders and May ISM index. Reflecting the underlying fundamentals and recent trends in partial data,
we expect a strong rebound in US economy, with quarterly annualised growth in excess of 3 per cent over the rest of
this year and throughout 2015. A rebound in growth and a modest pick-up in inflation should see the US Federal Reserve
continue on its current course, leading asset purchases to cease in October. Policy tightening will be unlikely for some
time, with a gradual increase in the federal funds rate not expected until Q3 2015.
In China, the May releases of the Chinese manufacturing PMI showed strong improvement. The improvement in the
manufacturing sector potentially reflects the impact of recent stimulus packages and stronger foreign demand, given
the surge in the new export order index over the month. The pick-up in US economic activity, as the world’s largest
economy emerges from its winter hibernation, combined with a devaluation of the renminbi, appear to be boosting
Chinese exports. Combined with targeted easing by authorities, the lift in global demand should result in a stabilisation
of Chinese economic activity close to the target rate of 7.5 per cent over the second half of the year.
ECB announces stimulus measures
A raft of new policy measures were announced by the European Central Bank (ECB) designed to alleviate growing
deflationary fears. The ECB decided to lower modestly its main interest rates, cutting the refinancing rate by 10 basis
points to 0.15 per cent and the deposit rate by 10 basis points to -0.10 per cent. The ECB is the first major central bank
to take deposit rates into negative territory, resulting in banks being charged to park funds at the central bank in an
attempt to encourage them to boost lending. While the impact of the rate cuts is likely to be minor, the ECB also
decided to provide banks with around €400 billion of funds for 4 years at a negligible interest rate and provide further
funds in March 2015 and June 2016. The additional funds available will be three times the bank’s net lending to the
private non-financial sector (excluding loans for house purchase). This policy is clearly aimed at encouraging banks to
lend to the real economy to stimulate activity; a policy that is desperately needed considering that loans to non-financial
corporations have fallen 2.7 per cent over the past year (or by around €120 billion) as banks have restrained lending and
focussed on improving their balance sheets, particularly ahead of the forthcoming asset quality review. Finally, the ECB
has also announced policies to inject further liquidity into the system by extending its fixed-rate full allotment process
for as long as necessary (at least until the end of 2016) and by suspending the sterilisation of its prior government bond
purchases, which will inject about 170 billion euros.
While these policies should help stimulate activity, they fall short of the ‘big-bang’ quantitative easing programs
announced previously by US and Japanese authorities. The ECB did signal that it will continue its preparatory work on
developing a scheme that would purchase asset-backed securities, but outright large-scale bond purchases seem away
off, unless conditions deteriorate further. One reason for this is that the ECB sees the monetary policy transmission
process as quite different from the US, with the main channel via the banking sector rather than bond markets. And of
course, the institutional framework in the 18 country region results in many more challenges for the ECB. Although we
think these policies should be sufficient for the European economy to continue its gradual recovery and for inflation to
slowly move higher, we would not rule out the need for further unconventional actions by the ECB; especially if the euro
fails to depreciate.
Interest rate forecast (%)
Level at
6-Jun-14
Sep-14
QIC Forecast
Dec-14
Mar-15
2.50
2.50
2.50
2.75
0.00 - 0.25
0.00 - 0.25
0.00 - 0.25
0.00 - 0.25
Canada
1.00
1.00
1.00
1.25
Europe
0.15
0.15
0.15
0.15
UK
0.50
0.50
0.50
0.50
0.00 - 0.10
0.00 - 0.10
0.00 - 0.10
Australia
US
Japan
0.00 - 0.10
Source: Central Banks, QIC.
Australian economy
Buoyant March quarter economic activity in Australia, but momentum wanes in June quarter
The Australian economy expanded at an above-trend pace in the March quarter, with real GDP growth of 1.1 per cent,
the best quarterly outturn in two years, and above market expectations for a 0.9 per cent gain. The strong growth was
largely due to higher exports, as additional capacity in the resource sector came on line. While it is clear that the
external sector has accounted for a large part of the growth in the Australian economy, with net exports contributing 2.7
percentage points of the 3.5 per cent real GDP growth over the past year, promising signs of a gradual rebalancing in
demand are evident. Domestic final demand has started to firm despite falling business investment (reflecting the dropoff in mining investment) and ongoing fiscal restraint, with the record low interest rates underpinning a solid pick-up in
dwelling investment and consumer spending over the past year.
However, more timely data suggests the momentum in the Australian economy has eased early in the June quarter. The
trade balance has returned to deficit, growth in retail sales have slowed in the three months to April and a sharp drop in
consumer confidence following the Budget suggest little improvement is likely in May. Momentum in the housing
market is also starting to cool, with dwelling approvals falling to their lowest level since last August and house prices
retracing some of their gains in May. For the rebalancing underway in the Australian economy to continue over the rest
of 2014, the Reserve Bank of Australia (RBA) will need to keep rates at record lows.
Federal Budget outlines a lengthy path to surplus
The context for a ‘tough’ budget was set in December’s Mid-year Economic and Fiscal Outlook and the recent
Commission of Audit report, which both warned of ongoing deficits in the absence of budgetary reform. The Budget
implies fiscal tightening of 1.0 percentage point of GDP in 2014-15, with a further tightening of 0.8 percentage points of
GDP on average per annum in 2015-16 and 2016-17 and a return to surplus not expected until 2019-20.
The direct impact of sharper fiscal tightening, along with potential effects on consumer confidence in the near term,
adds weight to our view that the RBA will leave interest rates on hold for the rest of 2014, before beginning a gradual
tightening cycle in 2015. The fall in mining investment will accelerate in the second half of this year around the time
fiscal austerity starts to bite. Combined with a subdued recovery in non-mining investment, economic growth will be
driven to below trend rates in the second half of 2014, despite a housing recovery and ramp-up in exports.
It should also be kept in mind that this Budget is only the start of the reform process. Opposition parties have
announced they intend to block many measures in the Senate (particularly in education, health and welfare). Further,
with the largest saving the result of asking states to take on greater responsibility for hospitals and schools, the Budget
has set the scene for broader debate on the tax system (including the rate and scope of GST) as part of next year’s tax
review.
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