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Weekly market & economic
update
By Dr Shane Oliver, Head of Investment
Strategy & Chief Economist
WEEK ENDING FRIDAY, 22 JULY 2011
Headline developments of the past week

There was good news on the European debt front with European leaders announcing a new bailout for
Greece and enhanced support for other problem countries. The key elements are: 109 billion euros in new
official financing for Greece which covers its financing for the next 3 years; a 37 billion euro contribution from
private sector investors; an extension of loans from the current 7.5 years to at least 15 years; a cut in the
interest rate to just 3.5% for Greece, Ireland and Portugal; a Marshall type plan to mobilise European
institutions to help rebuild Greece; and an enhancement of the role of the European Financial Stability Facility
(EFSF) to enable it to act on a pre-emptive basis to support countries, banks and to buy bonds in secondary
markets. While private sector involvement will probably trigger a “selective default” rating on Greek debt from
ratings agencies, the EFSF will be used to provide a guarantee over Greek bonds so that Greek banks can still
obtain access to liquidity from the European Central Bank.

These are all excellent moves in the right direction and help underpin a relief rally in share markets and
other growth oriented assets as they help address the immediate concerns regarding Greece. However,
its doubtful they will fundamentally solve the problem. First, the changes to the EFSF will have to be
passed by the parliaments of each Euro-zone nation and this is likely to see a few hiccups. Second, while the
Greek measures will reduce the net present value of its debt by 20% it will still be equivalent to an onerous
120% or so of GDP. Third, while the EU is emphasising that Greece is a special case in involving private sector
involvement and a probable move to “selective default”, investors and ratings agencies may expect that there is
now a high risk that private investors will also be called on to share in the burden in other countries, notably
Ireland and Portugal and maybe Italy and Spain. Fourthly, fiscal austerity measures are continuing to bear
down on growth as evident in a further fall in European business conditions indicators in July, which will only
make reducing budget deficits harder and lead to further flare ups and worries about Greece, Ireland, Portugal,
Spain and Italy going forward. Finally, the fire power of the EFSF in terms of its funding potential was not
increased which is something that may be necessary (but difficult) to provide investors with confidence that
Spain and Italy will be protected. So the bottom line is: the latest European plan is a move in the right
direct and provides a bit of relief for now but the European debt problem is likely to remain a periodic
threat and source of volatility for investment markets.

Unfortunately, there is still no agreement amongst US politicians to increase the US Government’s debt
ceiling. We have always thought negotiations would go right down to the wire and our base case remains that
an agreement will be reached just in time. The political backlash from Americans not getting their welfare or
Medicare checks or public servants not getting paid would be huge if agreement is not reached – and
Republicans would probably bear much of the outrage. Given that significant areas of agreement already exist
it’s possible that an initial deal will focus on spending cuts with tax changes coming later.

In Australia the Minutes from the Reserve Bank's last Board meeting signal a further relaxation of its
tightening bias, with the removal of a reference to further monetary tightening likely being necessary at some
point. Since the last Board meeting early this month, the European debt crisis has worsened and data for
consumer and business confidence in Australia has softened further suggesting it’s now a 50/50 proposition as
to whether the next move in Australian interest rates will be up or down.
Major global economic releases and implications

US economic data was a little stronger with a large gain in housing starts, an improvement in business
conditions in the Philadelphia region, a modest rise in home builders’ conditions but surprising softness in
existing home sales and a rise in jobless claims. There was more good news on the June quarter earnings
front with street beating results from Apple and IBM. So far 76% of the 135 US S&P 500 companies to have
reported so far have exceeded expectations. This reflects a combination of cautious guidance ahead of the
results, the fall in the $US and strong emerging country growth boosting earnings for multinationals, and
continued restraint on labour costs. Strong US profit growth augurs well for business investment and
employment going forward and supports our view that the US recovery will continue.

While there good news on the European debt front, business conditions indicators fell further in July
with fiscal austerity measures starting to bite. While Germany continues to outperform even it is slowing.

Japanese data provided more signs that it is recovering from the earthquake with exports coming in
stronger than expected in June, stronger than expected gains in an industry activity index in May and a strong
increase in convenience store sales.

In China HSBC’s preliminary manufacturing index fell again in July pointing to a further cooling in
growth. While this has reignited concerns about a hard landing in China our assessment is that it adds to
confidence that the tightening cycle is at or close to an end, particularly with the same survey pointing to a
further fall in input prices and food prices starting to fall again.
Australian economic releases and implications

The past week was pretty quite on the data front but what there was confirmed that the economy is
soft. New motor vehicle sales rose in June but this wrapped up a 6.7% fall in the June quarter. The WestpacMelbourne Institute Leading Index for May continued to point to economic growth running well below trend
going forward. Finally, the June quarter National Australia Bank’s business conditions survey confirmed that
outside the mining sector the economy is soft. The run of poor economic data in Australia outside the mining
sector indicates that a rate hike is not warranted any time soon and would in fact be very dangerous.
Major market moves

It was “risk on” again over the last week as Europe unveiled a new debt bailout plan. As the threat of
Lehman Brothers style catastrophe emanating out of Europe receded (at least for now), US earnings surprised
on the upside and M&A activity continued this saw strong gains in most major share markets. Australian shares
benefitted from the strong global lead with bank stocks being key beneficiaries. Chinese shares were the
exception as renewed worries about a hard landing weighed.

The risk on trade also benefitted commodity prices, but with gold being an exception as safe haven
demand receded for now. Reduced safe haven demand also saw bond yields push higher except in problem
debt countries in Europe where yields fell helped by the latest EU bailout package.

The improvement in global confidence and commodity prices also saw the $A rise sharply as the $US fell. .
What to watch in the week ahead?

In the US, data for June quarter GDP growth due Friday is likely to confirm the economy has lost
momentum with annualised growth of just 1.6% expected. We expect consumer confidence (due Tuesday)
to show a slight fall, house price data to be flat for June, new home sales to show a modest rise but pending
home sales to fall slightly and durable goods orders for June (due Wednesday) to record a further modest gain.

In Australia, June quarter inflation data due Wednesday has taken on greater than normal significance
as the Reserve Bank has indicated that it will be important in shaping views about the future path of
interest rates. We expect a benign outcome with a rise of 0.7% in the headline inflation rate which will take
the annual rate to 3.4%, but which represents a marked slowing from the 1.6% rise in consumer prices seen in
the March quarter. More importantly, we expect underling inflation to have increased by around 0.7%, down
from 0.9% in the March quarter which will leave the annual rate of underlying inflation at 2.5% which is
comfortably in the target range. The expected moderation in the quarterly pace of inflation will likely reflect a
slower increase in food prices after the boost from the floods in the March quarter, slower increases in petrol
prices, slower seasonal increases in health and education costs and ongoing discounting in consumer
discretionary items. June data for house prices and private credit will also be released on Friday.
Outlook for markets

Volatility in share markets is likely to remain high in the short term as the worry list remains significant –
European debt problems are unlikely to go away, the US debt ceiling is yet to be resolved, the soft patch in the
US is still in place and uncertainty remains as to whether China will have a hard or soft landing – and the
September quarter is normally the weakest time of the year for shares.

However, the medium term fundamentals for shares are supportive. Valuations are reasonable, monetary
conditions are easy and may even get easier and profit growth is likely to remain reasonable. This all suggests
that by the December quarter shares are likely to have regained their composure and be on the rise again.

Australian shares are likely to continue to underperform global markets thanks to relatively high interest
rates, the strong $A and uncertainty regarding the carbon tax. A less aggressive RBA may help though.

The Australian dollar is likely to remain strong on the back of high commodity prices, high interest rates in
Australia and possibly another round of monetary easing in the US. Expect a rough ride though.

Government bonds in major global countries and Australia have performed well in recent months on
the back of soft economic data and safe haven demand. However, as yields are low and as the global
economic recovery continues, government bonds are likely to deliver only modest returns in the medium term.
Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591) (AFSL 232497) makes no
representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of
future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives,
financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek
professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.