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<strong>WEEKLY</strong> <strong>ECONOMIC</strong> <strong>BRIEF</strong> – 5 <strong>October</strong> <strong>2012</strong><br />

Key Points<br />

• Global equity markets rallied following solid US data and favourable Spanish stress test results<br />

• Spain unlikely to ask for assistance as long as 10-year government bond yields remain below 6 per cent<br />

• RBA cuts rates by 25 basis points<br />

<strong>Chief</strong> Economist’s View<br />

Overall, market sentiment was mildly positive this week, with equity markets rallying by around 1 per cent (as measured by the<br />

MSCI World Index, local currency). Positive sentiment was driven by upbeat US economic data, comments by US Federal Reserve<br />

(Fed) Chairman Bernanke that monetary policy would continue to support the US economy and the release of favourable results<br />

from the Spanish bank stress tests. In Australia, the focus was on the <strong>October</strong> Board meeting of the Reserve Bank of Australia<br />

(RBA), which saw the RBA cut the official cash rate by 25 basis points (bps).<br />

Developments in Spain are currently focusing market attention on the European debt situation. This week, markets were concerned<br />

with two key questions surrounding Spain: (i) will the €100 billion set aside to recapitalise Spanish banks be sufficient and (ii) when<br />

will the Spanish government ask for assistance in the recapitalisation of its banks? Results from bank stress tests by Spain’s<br />

independent auditors suggested that €59.3 billion would be required to recapitalise Spanish banks in the event of an adverse<br />

economic scenario; an amount significantly less than the €100 billion bailout fund to be set aside by the European Union. With 10-<br />

year yields on Spanish sovereign debt having retreated since early September, to a level below 6 per cent, the pressure on the<br />

Spanish government to apply for assistance from the EU has eased. In response to speculation over the timing of a request for<br />

assistance, Prime Minister Rajoy re-iterated that the government was not yet ready to ask for a bail out, reinforcing our view that he<br />

would hold off requesting aid as long as interest rates on Spanish debt remained at levels at-or-below 6.0 per cent.<br />

Our research, based on simulations using QIC’s proprietary version of the NiGEM global economic model show that if Spain were<br />

to increase its sovereign debt liabilities by €100 billion, the additional financing would need to be at an interest rate of 5.0 per cent<br />

or less for Spain to keep its public finances on a sustainable path. Without an increase in liabilities, our results indicate that Spanish<br />

debt could remain on a sustainable path, given its current budget targets over the coming two years, with interest rates of 6.5 per<br />

cent or less. Consequently, Prime Minister Rajoy could avoid signing away Spanish sovereignty by not seeking assistance for bank<br />

recapitalisation from the EU, but only if the market rates remain around current levels. As long as rates stay below 6.0 per cent, we<br />

expect Prime Minister Rajoy will resist applying for assistance.<br />

In his statement following the RBA <strong>October</strong> Board meeting, where the official cash rate was cut by 25bps, Governor Stevens<br />

maintained that a strong pipeline of capital expenditure by the mining sector would continue to support growth into 2013. However,<br />

he also noted that the peak of the construction phase of the mining boom was likely to be lower than previously anticipated and that<br />

other sources of demand would need to increase to offset a drop in mining investment. Rather than a seamless transition from the<br />

investment-driven construction phase of the mining boom to the export-driven operational phase of the boom, the Australian<br />

economy is now facing a potential “gap” year in 2014 as the mining companies shelve new projects and delay expansions of existing<br />

mines. If this is the case, the decline in investment expenditure will no longer be adequately compensated for by rising export<br />

volumes, with the risk that economic growth slows sharply. If the RBA is convinced of the “gap year” scenario, they would need to<br />

cut rates to (i) lower the cost of borrowing to business and households and (ii) ease pressure on the Australian exchange rate.<br />

Given lags in monetary policy, the RBA would continue with its easing cycle into 2013, even if current rate of economic growth<br />

were to prove robust.<br />

Matthew Peter<br />

<strong>Chief</strong> Economist<br />

m.peter@qic.com<br />

Drew Klease<br />

Senior Economist<br />

d.klease@qic.com<br />

Lynda Bourke...<br />

Economist<br />

l.bourke@qic.com<br />

The Weekly Economic Brief is issued by QIC Limited ACN 130 539 123 ("QIC") and is compiled by QIC's Economics & Research Team.<br />

For further information regarding QIC’s investment solutions, please contact Kate Grant (Head of Client Relationship Management) on<br />

+61 7 3360 3999 or k.grant@qic.com<br />

Page 1 of 4


Financial Market Update<br />

• The Reserve Bank of Australia surprised markets and economists by cutting the cash rate by 25 basis points on Tuesday. This<br />

helped the S&P/ASX 200 rise 1 per cent on the day, to finish up 1.6 per cent over the week to Thursday. The decision led<br />

Australian 10-year government bond yields to fall 4 basis points to 2.98 per cent and the Australian dollar to weaken against all<br />

major currencies, falling 1.9 per cent against the US dollar.<br />

• Global equity markets edged higher over the week, with the MSCI World Index rising 0.7 per cent. European equities continued<br />

to underperform, undermined by the ongoing debt crisis. French equities fell 1.1 per cent over the week after the government<br />

unveiled its most austere budget in 30 years. Japanese equities fell 1.4 per cent, weighed down by a further deterioration in<br />

manufacturing sentiment.<br />

• Major government bond yields were little changed over the week. As expected, the Bank of England and European Central Bank<br />

left policy unchanged at their <strong>October</strong> meetings. We continue to expect the Bank of England will increase its asset purchase<br />

program by a further £25 billion next month.<br />

• In other currency markets, the Japanese yen underperformed falling 1.1 per cent against the US dollar and almost 2 per cent<br />

against the euro. Weaker economic data, combined with increasing political pressure for further policy easing after the PM<br />

reshuffled the cabinet for the third time this year, weighed on the yen. The new economy minister, Seiji Maehara, an advocate<br />

for the Bank of Japan to purchase foreign government bonds (which would have the impact of weakening the currency)<br />

announced that he would attend the BOJ meeting this week, the first minister to do so since 2003. In addition, the new finance<br />

minister, Koriki Jojima, stated that “the yen’s recent appreciation is one-sided and doesn’t reflect the state of the Japanese<br />

economy” and that they are ready to take bold action, raising expectations of further foreign exchange intervention to devalue<br />

the yen.<br />

Table 1. Financial market movements, 27 September - 4 <strong>October</strong> <strong>2012</strong><br />

Equity markets Level Change<br />

MSCI World Index (local currency) 927.1 0.7%<br />

US - S&P 500 1,461.4 1.0%<br />

Japan - Nikkei 8,824.6 -1.4%<br />

UK - FTSE 100 5,827.8 0.8%<br />

Germany - DAX 7,305.2 0.2%<br />

France - CAC 3,401.2 -1.1%<br />

Australia - S&P/ASX 200 4,452.4 1.6%<br />

Fixed interest (10 yr sovereign yields) Yield Change<br />

US 1.67% 1.9 bps<br />

Japan 0.77% -0.6 bps<br />

UK 1.70% -2.8 bps<br />

Germany 1.45% -1.1 bps<br />

Australia 2.98% -4.1 bps<br />

Foreign exchange Rate Change<br />

USD-JPY 78.480 1.1%<br />

EUR-USD 1.302 0.8%<br />

GBP-USD 1.619 -0.3%<br />

AUD-USD 1.024 -1.9%<br />

Commodity markets Level Change<br />

WTI oil price (US$/barrel) 91.71 -0.2%<br />

CRB index 310.45 1.0%<br />

Other Level Change<br />

VIX 14.55 -2.0%<br />

Source: Bloomberg<br />

Page 2 of 4


Economic Update<br />

United States<br />

• Economic indicators released over the week generally surprised to the upside,<br />

providing some evidence that the current slowdown is showing signs of<br />

stabilisation.<br />

– Key business surveys picked-up, with the ISM manufacturing survey rising<br />

from 49.6 to 51.5 in September, the first reading above the 50 threshold<br />

since May. The non-manufacturing ISM survey rose from 53.7 to 55.1, its<br />

highest level since March.<br />

– Real consumer spending rose 0.1% in August following a solid 0.4% gain in<br />

July. Light vehicle sales data rose strongly in September from 14.46 million<br />

to 14.88 million (annualised), suggesting a pick-up in consumption over the<br />

month. This places modest upside risks to our 1.6% annualised real<br />

consumption growth forecast for the September quarter.<br />

– ADP private payrolls rose 162,000 in September, suggesting a continued<br />

modest improvement in employment since the slowdown in the middle of<br />

the year. We continue to forecast the official non-farm payroll<br />

employment measure, to be released tonight, to rise by 130,000 in<br />

September.<br />

– Construction spending was one of the few indicators to disappoint, falling<br />

0.6 per cent in August. Residential spending continues to trend higher, but<br />

non-residential spending has declined due to the uncertainty facing<br />

businesses around the impending fiscal cliff.<br />

• Despite the better data over the week, the indicators continue to suggest that<br />

the US economy will expand at a below-trend pace of slightly under 2 per cent<br />

annualised in the second half of <strong>2012</strong>.<br />

Euro area<br />

• Limited new economic information emerged from Europe this week.<br />

– The composite PMI for September edged up from the flash reading of 45.9<br />

to 46.1. Nonetheless, the index remains at a four month low and is<br />

consistent with a further contraction in the euro area economy during the<br />

quarter.<br />

– Real retail sales edged up 0.1% in August for the third consecutive month.<br />

While retail sales have moved modestly higher in recent months, new car<br />

registrations have fallen sharply suggesting a pull-back in overall consumer<br />

spending during the quarter.<br />

– Euro area unemployment rate remained at 11.4% during August.<br />

Unemployment rose to 25.1% in Spain, but remains low at 5.5% in<br />

Germany. A modest rise in the euro area unemployment rate to 11.6% is<br />

expected over the next few months.<br />

– Inflation edged higher from 2.6% to 2.7% in September.<br />

United Kingdom<br />

• Signs of slowdown emerging at the end of the September quarter.<br />

– The manufacturing PMI fell from 49.6 to 48.4 during September, while the<br />

services PMI dropped from 53.7 to 52.2.<br />

• While we expect the UK economy to expand by 0.7% in the September<br />

quarter, this is largely due to a rebound after the Diamond Jubilee public<br />

holiday depressed activity in the June quarter and the impact of the Olympics.<br />

Underlying growth in the economy is expected to be weak excluding these<br />

temporary factors, which is supported by the PMI surveys released this week.<br />

US -ISM survey (index, sa)<br />

60<br />

Non-manufacturing<br />

55<br />

50<br />

45<br />

40<br />

Manufacturing<br />

35<br />

30<br />

2007 2008 2009 2010 2011 <strong>2012</strong> 2013<br />

US -Car and light truck auto sales (millions, annual rate)<br />

16<br />

15<br />

14<br />

13<br />

12<br />

11<br />

10<br />

9<br />

2008 2009 2010 2011 <strong>2012</strong> 2013<br />

Construction spending (% y/y)<br />

30<br />

20<br />

10<br />

0<br />

-10<br />

-20<br />

Residential<br />

-30<br />

-40<br />

Non-residential<br />

Total<br />

2003 2004 2005 2006 2007 2008 2009 2010 2011 <strong>2012</strong><br />

Euro area -Retailsales (volumes, sa, m/m%)<br />

1.5<br />

1.0<br />

0.5<br />

0.0<br />

-0.5<br />

-1.0<br />

-1.5<br />

-2.0<br />

Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12<br />

Euro area -Unemployment rate (%)<br />

11.5<br />

11.0<br />

10.5<br />

10.0<br />

9.5<br />

9.0<br />

8.5<br />

8.0<br />

7.5<br />

7.0<br />

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013<br />

UK -Manufacturing PMI (index)<br />

65<br />

60<br />

55<br />

50<br />

45<br />

40<br />

35<br />

30<br />

2007 2008 2009 2010 2011 <strong>2012</strong> 2013<br />

Page 3 of 4


China<br />

• Survey indicators suggest the weakness in the Chinese economy continued in<br />

September<br />

– The manufacturing PMI remains edged up from 49.2 to 49.8 in September,<br />

while the non-manufacturing PMI fell from 56.3 to 53.7.<br />

Japan<br />

• Japanese economy is expected to contract in the September quarter, weighed<br />

down by slowing external demand and a high exchange rate. Incoming data was<br />

consistent with this view:<br />

– Industrial production fell a further 1.3% in August, following a 1% decline<br />

in July.<br />

– Large manufacturer sentiment remains weak falling from -1 to -3.<br />

– While retail sales rebounded 1.5% in August, this simply offset the 1.5%<br />

decline in the previous month.<br />

• The slowing economy is yet to hit the labour market, with the unemployment<br />

rate edging down from 4.3% to 4.2% in August.<br />

• Japan remains in deflation, with the inflation rate remaining at -0.4% in August.<br />

Australia<br />

• Disappointing economic data during August may lead to a further rate cut by<br />

the RBA in coming months<br />

– Retail sales rose by a soft 0.2% in August.<br />

– Trade deficit widened from $1.5 billion to $2.0 billion on falling export<br />

values.<br />

– Monthly credit growth remained subdued at 0.2% in August.<br />

– Building approvals rebounded 6.4% in August, but that followed a 21%<br />

drop in the prior month.<br />

China -NBS Manufacturing PMI (index)<br />

60<br />

55<br />

50<br />

45<br />

40<br />

35<br />

2007 2008 2009 2010 2011 <strong>2012</strong> 2013<br />

Japan -Industrialproduction (sa, index, 2005 = 100)<br />

115<br />

110<br />

105<br />

100<br />

95<br />

90<br />

85<br />

80<br />

75<br />

70<br />

2007 2008 2009 2010 2011 <strong>2012</strong> 2013<br />

Japan -Consumer prices (% y/y)<br />

3<br />

2<br />

1<br />

0<br />

-1<br />

-2<br />

-3<br />

2005 2006 2007 2008 2009 2010 2011 <strong>2012</strong> 2013<br />

Australia -Retail sales (values, m/m%)<br />

1.5<br />

1.0<br />

0.5<br />

0.0<br />

-0.5<br />

-1.0<br />

Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13<br />

Sources: Thomson Reuters, ABS<br />

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