Market Update: September 2009 Economic Commentary

The following commentary has been prepared by Lewis South, Chief Economist for Macquarie Funds Group.

Economic and market highlights for the month were:

• The data flow remained consistent with a recovery in global activity, despite a weaker employment reading in the US;
• The RBA began the process of removing their emergency monetary stimulus as downside risks to growth continued to diminish;
• Global equity markets rose further on positive sentiment regarding the global economy;
• Global bond yields were largely unchanged following the earlier fall in yields in August;
• The US$ depreciated further as the Fed continued to signal that rates will remain low for an extended period. The A$ strengthened in early October following the rate rise by the RBA.

The big news for markets in recent weeks was the decision by the Reserve Bank of Australia (RBA) to begin the process of exiting from the emergency setting of interest rates implemented earlier in the year when the global financial crisis was at its peak and concerns over a protracted contraction in Australia were high.

From a nearly 50 year low, the RBA raised rates in early October by 25bps to 3.25%. The Bank’s decision follows the continued steady improvement in global financial conditions. Combined with the significant stimulus provided by authorities (seen recently in the record level of non-residential building approvals), this has all but eliminated the near term risk of a more deleterious decline in domestic activity of the sort seen in other economies over the past year. The recent data flow also played a role here, especially the resilience in retail sales in August which saw spending remain well above its pre-stimulus level. The surprising resilience in the labour market, seen in a strong gain in employment and surprising fall in the unemployment rate in September, validates the RBAs decision to begin removing stimulus as partial indicators suggest a strengthening trend in employment in the first half of 2010.

                     Consumer spending resilient following stimulus

The RBA couched the rate rise as being part of a process of “gradually lessening the stimulus provided by monetary policy.” This suggests further rates hikes are likely over coming months, with at least one further move expected before the end of the year. That said, the market is forecasting a return to a neutral level of rates within a year. With it unlikely that rates will be pushed towards a restrictive level over this period, we believe the risks to the current market view are clearly skewed for now towards a smaller increase in rates as the global recovery proves to be slow and domestic spending softens as the impact of stimulus on households continues to fade.

Outside of Australia, the overall data flow remained consistent with a recovery in activity across the major industrial economies and many emerging economies especially in Asia. Indicators of manufacturing activity continue to point to a strengthening in industrial production over coming months as firms move to prevent an unwanted reduction in inventory levels. Also of particular note across the globe were the improvements seen in survey measures of service sector activity which suggest that the recovery is gaining some traction outside of the manufacturing sector.

In the US, a combination of underlying resilience in spending and a massive spike in auto sales due to the Government’s cash for-clunkers scheme saw consumer spending record its largest monthly gain since 2001. For the latest quarter as a whole, consumer spending is on track to grow at close to its long run average rate. In addition, a rebound in housing starts means that residential construction activity in the September quarter is poised to add to overall growth for the first time since 2005. Also of significance for the outlook was the further strengthening in the S&P Case Shiller house price index which recorded its 2nd consecutive robust monthly gain in July as all but 3 of the 20 cities in the index recorded price gains in the month. Given the role falling house prices played in the downturn, the rebound, if sustained represents a big lift for the household sector.

At the same time, the data flow has also served as a reminder that the recovery in the global economy over the course of the coming year is unlikely to be a strong one given the strains that continue to exist in many financial markets and the balance sheet repair that is likely to be undertaken by global financial institutions and US households. Consumer spending has weakened of late in the main economies in Europe as the impact of measures to boost auto sales have begun to fade, while industrial activity in the UK, rather than rising as in other economies, fell sharply to its lowest level in 22 years. Meanwhile in the US, the September payrolls report was significantly weaker than expected, with the pace of employment losses remaining substantial and average hours worked falling back to its low for the cycle. The resulting weakness in implied aggregate wages following falls in real disposable income in the past three months is consistent with the view that consumer spending is unlikely to be able to sustain its recent strength, contributing to a fairly modest recovery in overall activity.

This cautiousness was reiterated by finance ministers and central bank Governors from the world’s largest economies at the latest G20 meeting in Pittsburgh who maintained their commitment to expansionary monetary and fiscal policy settings. At the same time, however, the G20 meeting committed to developing internationally agreed rules, to be implemented by the end of 2012, to strengthen the regulatory environment in order to avoid a repeat of the financial crisis. This includes rules to increase the capital held by banks and to discourage excessive leverage, improving the operation and transparency in over the counter derivates markets and placing limits on executive compensation to remove incentives which encourage excessive risk taking. While these are all necessary steps, their implementation could be another factor serving to limit the extent of the recovery down the track. Moreover, such measures will likely ensure that the availability and cost of credit over the years ahead will be very different to that seen earlier this decade, with potentially wide ranging implications for a broad range of financial markets.
 

Commentary by Macquarie Funds Group, dated 9/10/2009

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