YOUR MONEY -- Market snapshot

Economic movements overseas have a flow-on effect for Australians and the RBA could be forced to hike rates again if the Chinese dollar continues to appreciate.

By: Brad Matthews
Chief economist
Hillross

The consistent growth in employment has been an important feature of the robustness of the Australian economy over the past two years. It has enabled the economy to avoid the cycle of declining employment - leading to declining spending and further declines in employment.The number of workers employed increased in the month of May. The 26, 900 jump in employment during the month was above expectations and brought the annual rate of growth in employment to 2.6 per cent. This allowed the unemployment rate to drop from 5.4 per cent to 5.2 per cent. Further highlighting the current strength of the labour market was the fact that all the growth in employment in May came from full time jobs.

COMMODITY PRICES MAINTAIN RECOVERY

Commodities continue to claw back much of the losses in price recorded during the GFC.

Buoyed by the increased prices achieved through recent iron ore negotiations, the Reserve Bank's Commodity Price Index is some 44 per cent above the level recorded one year ago and is only 7 per cent below the peak reached in September 2008. If maintained, current commodity prices will provide scope for healthy gains in income for Australian resource companies and the Australian economy more generally.

INFLATION - CHINA'S NEXT EXPORT?

In a potentially significant policy shift, the Chinese central bank, the People's Bank of China (PBOC) announced in June that it would be ending the fixed pegging of its currency (the Yuan) to the United States (US) dollar and reverting to a more flexible regime.

Chinese authorities fixed the exchange rate between the Yuan and the US dollar during the GFC in order to provide a source of stability. Prior to this, the Yuan was able to move within bands against the US dollar.

Despite the change in policy, Chinese authorities are still likely to play a key role in determining the value of the currency via the setting of daily trading bands. However, as market forces will now have a greater influence on the currency value.

While it is widely anticipated that the move toward having a more flexible currency regime will lead to further increases in the value of the Chinese currency, the central bank has warned that an immediate large appreciation should not be expected.

RATIONALE FOR THE POLICY CHANGE

So if bringing about a greater balance in the trade accounts isn't the primary driver of the exchange rate regime changes, why have Chinese authorities implemented the reforms?

Externally, China has been under increasing pressure to remove its fixed currency peg.

Trading partners of China, particularly the US, have made repeated calls for the currency to appreciate as it was believed the existing currency value gave China an unfair trade advantage. A low Yuan value resulted in exports from China being cheap.

The threat of retaliatory subsidies and tariffs as well as a string of anti-dumping complaints were damaging trade relations and could have ultimately impacted on China's export success.

Internally, the Chinese Government has been supporting some reorientation towards domestic consumption. Having a more balanced growth profile is not only seen as being more sustainable, but also consistent with the objective of improving living standards for the Chinese population. An exchange rate regime that allowed a rise in the value of the Yuan would make imports into China cheaper and therefore stimulate domestic consumption of imported items.

IMPLICATIONS FOR AUSTRALIAN INVESTORS?

While there may be no immediate material shift in the Chinese currency, the period from 2005 to 2008 showed that Chinese authorities did have a willingness to allow a reasonably significant appreciation (some 20 per cent) in their currency over time. A similar change in the exchange rate could have material impacts.

With over 20 per cent of imports into Australia being sourced directly from China, an appreciation in the value of the Yuan could impact Australia's inflation. This could make the RBA's efforts to manage inflation more challenging and create a case for higher interest rates. Given China's importance as a source of manufactured items globally, there may be similar implications for inflation and interest rates elsewhere as well.

In addition, the change in the exchange rate regime may reduce demand for US treasury bonds from Chinese authorities. The setting of the Yuan below its natural (or market determined) level in the past could have involved Chinese authorities selling Yuan to satisfy the quantity demanded and using the proceeds of these sales to purchase US bonds.

Market snapshot

Hillross chief economist Brad Matthews provides a tactical view for investors.

AUSTRALIAN EQUITIES: OVERWEIGHT

Even though the relatively subdued domestic economic outlook may well restrict earnings growth to modest levels over the coming short term, Australian equity valuations are attractive from a medium to longer term perspective.

Strong corporate balance sheets combined with equity valuations in the "cheap" zone, support an overweight allocation.

INTERNATIONAL EQUITIES: NEUTRAL

Uncertainties over the magnitude and length of the impact of high Government debt continue to weigh heavily on the outlook for global equity markets.

With risk and uncertainty higher than normal, the current valuation discounts on major share markets are appropriate and produce a fair value.

PROPERTY: UNDERWEIGHT

The domestic listed property sector is looking increasingly solid and is underpinned by a favourable medium term supply and demand balance. Global property however, appears slightly over valued following a period of strong growth over the past year.

FIXED INTEREST: UNDERWEIGHT

Being heavily anchored by the lack of inflation in the short term, Government bond yields are below long-term fair value levels and provide no compensation for medium term inflation risks. Opportunities remain in credit, which appears superior to sovereign debt on a risk adjusted basis.

ALTERNATIVES: NEUTRAL

Given the fine balance between inflationary and deflationary forces, a neutral exposure to inflation sensitive assets such as infrastructure and commodities is definitely warranted. With ongoing disparity in valuations, higher than normal returns may be available to absolute return managers.

AUSTRALIAN CASH: NEUTRAL

The margin between cash interest rate levels and inflation is still below historical norms, despite recent increases. Nonetheless, cash and shorter dated term deposits are attractive relative to longer-term Government bonds.