Concrete Evidence of NZ Expansion, Inflation. Quarterly. % change Real Retail Sales %

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1 Markets Outlook 22 August 2011 Concrete Evidence of NZ Expansion, Inflation Evidence of recent NZ momentum, inflation Concrete production up in Q2, on Christchurch bounce Retail volumes likely 0.6% higher, ex-auto stronger Seasonal deficit of $200m for July s external trade? RBNZ inflation expectations survey due Tuesday Amid signs of domestic price pressures, via PPI/CGPI % change Real Retail Sales Forecasts RWC One of the reasons for the recent correction in financial markets has been the disappointing economic data, mainly in rich-world economies. Even before the wobbly indicators of July and August came through, many of the economies concerned were slowing abruptly. The US economy, for instance, sagged to a 0.3% increment in the April-June period. UK GDP decelerated to 0.2%, Germany s to 0.1% while France s economic activity stalled altogether in Q2. By comparison, we believe New Zealand s economic output acquitted itself well in the June quarter, and with much still to sustain the gains over the second half of With this in mind, there are already a number of inflation indicators strong enough (at this early stage of recovery) to keep the RBNZ honest and as much related to purely domestic pressures as commodity price strength. While it s early days for the hard indicators on local GDP, we ve already seen enough information to hold our growth estimate up at 0.4% (following Q1 s stronger than anticipated 0.8%, and the 0.5% expansion the quarter before that). The various business survey indicators, along with confidence, have certainly been encouraging in this regard. For concrete evidence the NZ economy retained good momentum in Q2 we can take the recent example of ready-mix concrete production. It bounced a bit, on the back of a sharp lift in the Christchurch area. This is BNZ, Statistics NZ Source: interesting on a number of levels. First, that it suggests the nation s building activity is doing better, perhaps a lot better, than is indicated by the still-weak consents data. This, in turn, probably relates to the fact there s a lot of work occurring that doesn t necessarily require formal consent, particularly as it relates to the Christchurch earthquakes. Overall, the concrete figures raise the likelihood of a lift in construction as measured in the GDP accounts. As for Thursday s Q2 retail trade report, we (and the Reuters median) expect this to show a further expansion in volumes, to the tune of 0.6%. The ex-auto gain will probably be stronger still, to our mind. This will follow on from a solid Q1 performance. Moreover, there were signs in July s electronic card transactions and credit card billings that real expenditure remained on the up into Q3. Wednesday s merchandise trade figures might be more difficult to draw GDP conclusions on. However, we do anticipate ongoing reasonable growth in both exports and imports, y/y, with a seasonally-impacted deficit of $236m for the month of July enough to hold the annual balance in moderate surplus. On this we are also reasonably close to market expectations. thousand meters cubed (s.a.) 250 Ready-Mix Concrete Production 120 % 3.2 CPI Inflation Expectations (2-year ahead) 230 Auckland Christchurch Source: BNZ, Statistics NZ Supposed mid-point of RBNZ target band Source: RBNZ, BNZ research.bnz.co.nz Page 1

2 Turning to inflation, the market s big focus will be on Tuesday afternoon s RBNZ Survey of Expectations. Even we were surprised to see this survey s 2-year-ahead CPI inflation view jump as high as 3.0% last quarter. Chances are we ll see a slight dip this time. However, unless it falls below 2.5%, it will remain one of a number of inflation pointers that are uncomfortably high for an economy at the early stages of recovery and broadly set to pick up a head of steam. Also note the RBNZ survey s expectations for GDP and the labour market, which will give a feel for how the business sector and analysts expect the macro-economy to progress in the near term. For more specific CPI indications we have Thursday s Food Price Index covering the month of July. Technically we expect a further jump, of 0.8%, although there is clearly a risk it falls by the wayside after the 1.4% spike it registered in June, partly related to lagged impacts of the Queensland floods. Relative to Australia, however, there is at least comfort to be drawn from the fact NZ residents are paying peanuts for bananas. While headline CPI computations are well worth thinking through, and inflation expectations too, we continue to stress it s the fundamental drivers of inflation we are most intently monitoring. In this respect, we found it very interesting to see the early signs of domestic price pressure in the likes of last week s Q2 Producer Prices Indexes and Capital Goods Price Index (CGPI). Both displayed construction sector inflation stronger than that seen in the construction component of the CPI. For example, the PPI construction output price index spiked 1.6% in the June quarter, to be 3.0% higher than a year ago, so faster than input costs (1.1%, 3.8% y/y). And remember, the PPI numbers are all ex-gst, in effect. The clearest pressure point was in Heavy and Civil Engineering Construction, whose PPI output price jumped 3.6% in Q2, to be 6.3% up on the same period last year. We saw a similar thing in the CGPI, whose price index for Civil Construction increased 2.8%, pushing its annual inflation to 5.3%. This could well be related to the earthquakes and associated infrastructural work. The doves will dismiss this as one-off. We prefer to see it as a precursor to more generalised construction sector inflation in store. It s not as though the standard (residential/non-residential) construction sector price indices are lying low. Indeed, they are showing signs of picking up too. For example, the residential index of the CGPI expanded 0.8% in the June quarter, the fastest since the GFC swung into town. Same for the non-residential building cost index and same for the Building Construction and Construction Services subcomponents of the PPI the swiftest since mid And it wasn t just construction sector inflation beginning to poke its nose up again. Many of the services-related PPI categories were experiencing renewed perkiness too. Output prices for Legal Services, for example, enlarged 1.2% in Q2, following 0.6% in Q1, while Accounting Services saw a price increase of 2.4%, for 4.4% y/y. Commercial rents, would you believe, lifted 1.0%, according to the PPI report. Of course, the more general way forth for NZ inflation, and the economy itself, has been severely clouded by the global turmoil of recent weeks. It s potentially very serious. In this sense, the markets might well be tempted to dismiss any rearguard strength in New Zealand s data. While we can t pretend to know where this latest global process is headed we would not want to jump to the conclusion that it means we can turn a blind eye to the clear evidence of robust NZ economic momentum, and building inflation pressure. Annual % change 12 Capital Goods Building Price Index Annual % change 5 Commercial Rents Residential Civil construction Non-residential Source: Statistics NZ, BNZ Source: BNZ, Statistics NZ craig_ebert@bnz.co.nz research.bnz.co.nz Page 2

3 Domestic Interest Rates The battle between on-shore and off-shore dynamics continue. Last week, off-shore developments gained an upper hand as risk appetite deteriorated toward the end of the week. The VIX index (a proxy for risk aversion) spiked from 32 to 43 over the course of the week. NZ 2- year swap yields declined 7bps to 3.27%, while 10-year yields fell 10bps to 4.79%. However, 2-year yields remain someway above their recent lows of 3.10%, but at the lower end of their trading band since April this year. The 2s-10s spread has narrowed to 152bps. Mediumterm, we expect curve flattening pressure to continue, taking the 2s-10s spread toward 100bps in a year s time. Market expectations for RBNZ and RBA rate moves in the coming year have fallen to 40bps and -150bps respectively. We believe both are too pessimistic and will ultimately be revised higher, as current global market volatility eases. We continue to expect more than 100bps of rate hikes from the RBNZ in the coming year, starting with a 50bps hike in December. We ultimately see the OCR peaking at 5.0% in On this basis we see clear value in hedging interest rate risk on a 2-5year time horizon, though can understand participants reluctance to do so, given heightened global uncertainty. While the risk of the r word in the US has definitely increased in recent weeks, it is also important to step back from the emotive pull of daily volatility in equity markets. While the NZ economy will not be immune from downward revisions to growth forecasts in the US and Europe, it is worth remembering that these economies combined constitute just 20% of NZ s direct export markets. The NZ economy remains on a solid footing and inflationary pressures can not be ignored indefinitely. In this regard, tomorrow s RBNZ Q3 inflation expectations data will be important. While the reading may tick down from Q2 s 3.0% reading (a 20 year high), we expect it to remain uncomfortably elevated. This will keep domestic inflation risks in the RBNZ s view, even as global uncertainties prevail. Interest Rate Technicals NZD 5yr Swap Rate Outlook: Lower MT Resistance: 4.50% MT Support: 3.81% As expected we traded lower last week. Expect this to extend towards support at 3.81 Reuters pgs BNZL BNZM NZ bond yields fell 6 to 8bps along the curve last week. The yield on 21s fell 6bps to 4.42%, a new low since March Australian 10-year bond yields, however, have fallen even more sharply over the week taking them below NZ yields, to 4.23%. The AU-NZ 10-year bond spread has fallen from 6bps to almost -20bps in the past week, making NZ yields attractive on a relative basis. Last week, US 10-year yields traded from near 2.30% to 2.06%, around December 2008 lows. Intra-week they had bounced off lows of 1.97%. That is their lowest level in at least 50-years, as markets price in a muted US growth outlook, exacerbated by proposed fiscal tightening. German 10-year yields showed similar dynamics, trading from 2.35% to 2.10%, touching an all-time low of 2.03% intra-week. German Chancellor Merkel rejected calls for eurobonds to be issued, to solve the regions debt problems, saying At this time eurobonds are precisely the wrong answer. She also emphasised that policy would not be driven by market demands. Tomorrow s inflation expectations data along with Wednesday s trade and Thursday s retail sales data should confirm that the NZ economy is on a sound footing and inflation pressures remain. These factors alone suggest much higher domestic yields are warranted. However, expect markets to remain volatile, and focused on global factors, as markets move toward the meeting of global central banks at Jackson Hole on Friday. Markets will be focusing on whether Bernanke has another rabbit to pull out of the hat, at the gathering. 90 day 04/13 05/21 2yr swaps 10yr swaps 2yr/10yr bills NZGS NZGS s/a s/a swaps(bps) 12-Aug % 2.94% 4.45% 3.34% 4.89% Aug % 2.94% 4.42% 3.27% 4.79% 152 Change (bps) kymberly_martin@bnz.co.nz pete_mason@bnz.co.nz NZ 2yr-5yr Swap Spread (yield curve) Outlook: Neutral MT Resistance: +96 MT Support: +80 The market is doing some work here and await a breakout of +96/+80 near term range to enter new trade. NZD 5-yr Swap Daily NZD 2-5yr Swap Spread Daily research.bnz.co.nz Page 3

4 Foreign Exchange Market Reuters pg BNZWFWDS Ongoing concerns around global growth saw equity markets struggle and measures of risk aversion remain very elevated, over the past week. The S&P500 index and Euro Stoxx 50 index ended the week down 4.7% and 6.4% respectively. The VIX index (a proxy for risk aversion) surged from 34 to 43, just shy of its highest level since June In the US, the market focused on the Philadelphia Federal business outlook survey, which fell to its lowest level since March In Europe, the meeting between German Chancellor Merkel and French President Sarkozy disappointed as they failed to announce the issuance of eurobonds. The issuance of eurobonds could help to provide cheaper funding and impose tighter fiscal rules on the peripheral European economies. NZD/USD spent the first half of the week oscillating around as global risk sentiment stabilised. However, NZD/USD fell back to as global risk sentiment deteriorated on Thursday and Friday. While trading on NZD/USD remains volatile, the currency appears to have stabilised within a to range. We expect the currency meet strong resistance above so long as concerns over global growth remain in focus. In contrast, a further deterioration in global risk sentiment will be needed to sustain NZD/USD below Looking beyond the next week, we continue to forecast NZD/USD moving back towards the post-float high by the end of September. To our mind, such a move would only require risk sentiment stabilising at more normal levels. Indeed, the recent global ructions have done little to change our core view of a strong domestic recovery and need for the RBNZ to hike rates. We expect 125bps of hikes from the RBNZ over the next 12 months, in contrast to current interest rate pricing of 40bps of hikes. The risk-off sentiment weighed more heavily on the NZD relative to the AUD last week. This saw NZD/AUD fall from at the beginning of the week to currently. While the medium-term fundamentals still remain constructive for a move higher, there is a risk pricing of 150bps of RBA cuts over the next 12 months reverses. Indeed, a testimony by RBA governor Stevens and speech by RBA deputy governor Battellino during the week could provide a near-term catalyst for the interest rate market to reassess expectations of rate cuts. This would put downward pressure on the cross. However, we would v iew any move below as overdone based off mediumterm fundamentals. Despite the move lower in NZD/AUD, the implied fair value range from our NZD/AUD model has remained unchanged at to over the week. The NZ-AU 3-year interest rate differential is currently -73bps, from -77bps at the beginning of the week. This suggests some upside to the cross if global sentiment stabilises. Over the next 12 months we expect the cross to gradually appreciate to The NZD struggled against the better supported EUR and GBP. NZD/EUR started the week at , but dribbled lower on Thursday and Friday to close around The NZD lost ground against a resurgent GBP, with the cross falling from to currently. While risk sentiment is weighing on the NZD currently, should global risk sentiment stabilise we would expect NZ s relative interest rate and growth differential with the Eurozone and UK to help reverse the recent losses. The focus for the week ahead will be on Friday s meeting of central bank governors at Jackson Hole. In particular, the market will focus on Fed Chairman Bernanke s speech for any hints of further quantitative easing. Locally, the week ahead does warrant some attention when we re not staring at the offshore news wires. Tomorrow s RBNZ survey of inflation expectations will be important given the previous outturn was at the top of the central bank s target inflation band. On the activity front, we expect Thursday s Q2 retail trade report to show a further expansion in volumes of 0.6%. For Wednesday s merchandise trade figures we anticipate ongoing reasonable growth in exports and imports, y/y, with a seasonally-impacted deficit of $236m for the month of July. mike_burrowes@bnz.co.nz Foreign Exchange Technicals NZD/USD Outlook: Buy a dip ST Resistance: (ahead of ) ST Support: (ahead of ) We favour buying a dip in NZD/USD below Look for a move back to Good medium-term support around mike_burrowes@bnz.co.nz NZD/AUD Outlook: Buy ST Resistance: (ahead of ) ST Support: (ahead of ) We favour buying the cross here as it is below the recent range. Good medium-term support is seen around and then NZD/USD Daily NZD/AUD Daily research.bnz.co.nz Page 4

5 Key Upcoming Events Forecast Median Last Forecast Median Last Monday 22 August US, Chicago Fed Nat Activity Index, July Tuesday 23 August NZ, RBNZ Survey of Expectations, Aug (2-yr ahead) +3.0% Aus, RBA's Battellino Speaks China, PMI (HSBC), August (flash) 48.9 Euro, PMI Manufacturing, August 1st est Euro, PMI Services, August 1st est Germ, ZEW Sentiment, August UK, CBI Industrial Trends, August US, New Home Sales, July 312k 312k Wednesday 24 August NZ, English Speaks, HK/NZ Business Assoc NZ, Merchandise Trade, July -$236m -$150m +$230m Aus, Building Work Done, Q2 flat +1.0% +0.7% Euro, Industrial Orders, June +0.4% +3.6% Germ, IFO Index, August US, Durables Orders, July +2.1% -1.9% Thursday 25 August NZ, Retail Trade, Q2 vol s.a. +0.6% +0.6% +0.9% NZ, Food Price Index, July +0.8% +1.4% UK, CBI Dist Trade Survey, August US, Jobless Claims, week ended 20/08 405k 408k Friday 26 August Aus, Stevens Testifies Jpn, CPI, July y/y flat -0.4% Euro, M3, June y/y +2.2% +2.1% Germ, (circa) Retail Sales - vol, July +6.3% UK, GDP, Q2 2nd est +0.2% +0.2%P US, Bernanke Speaks, Jackson Hole US, GDP, Q2 2nd est +1.1% +1.3%P US, Mich Cons Confidence, Aug 2nd est P Monday 29 August Aus, HIA New Home Sales, July -8.7% US, Personal Spending, July +0.5% -0.2% US, Pending Home Sales, July -0.8% +2.4% Historical Data Today Week Ago Month Ago Year Ago Today Week Ago Month Ago Year Ago CASH & BANK BILLS Call mth mth mth mth GOVERNMENT STOCK 11/ / / / / CORPORATE BONDS BNZ 05/ BNZ 09/ FON 04/ FON 03/ GEN 03/ GEN 03/ TRP 06/ SWAP RATES 2 years years years years FOREIGN EXCHANGE NZD/USD NZD/AUD NZD/JPY NZD/EUR NZD/GBP NZD/CAD TWI NZD Outlook TWI New Zealand Dollar NZD TWI NZD/USD (rhs) Source: BNZ, RBNZ Monthly F/C NZD/USD research.bnz.co.nz Page 5

6 Contact Details Stephen Toplis Head of Research +(64 4) Craig Ebert Senior Economist +(64 4) Doug Steel Economist +(64 4) Mike Burrowes Strategist +(64 4) Kymberly Martin Strategist +(64 4) Main Offices Wellington 60 Waterloo Quay Private Bag Wellington Mail Centre Lower Hutt 5045 New Zealand Phone: +(64 4) FI: Fax: +(64 4) Auckland 80 Queen Street Private Bag Auckland 1142 New Zealand Phone: +(64 9) Toll Free: Christchurch 81 Riccarton Road PO Box 1461 Christchurch 8022 New Zealand Phone: +(64 3) Toll Free: National Australia Bank Peter Jolly Head of Research +(61 2) Alan Oster Group Chief Economist +(61 3) Rob Henderson Chief Economist, Markets +(61 2) John Kyriakopoulos Currency Strategist +(61 2) Wellington Foreign Exchange Fixed Income/Derivatives Sydney Foreign Exchange Fixed Income/Derivatives +(61 2) London Foreign Exchange Fixed Income/Derivatives +(44 20) New York Foreign Exchange Fixed Income/Derivatives Hong Kong Foreign Exchange +(85 2) Fixed Income/Derivatives +(85 2) HOUR FOREIGN EXCHANGE SERVICE Phone Toll Free 6am to 10pm NZT Wellington Office pm to 6am NZT London Office Sam Hehir ANALYST DISCLAIMER: The person or persons named as the author(s) of this report hereby certify that the views expressed in the research report accurately reflect their personal views about the subject securities and issuers and other subject matters discussed. No part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in the research report. Research analysts responsible for this report receive compensation based upon, among other factors, the overall profitability of the Markets Division of National Australia Bank Limited, a member of the National Australia Bank Group ( NAB ). The views of the author(s) do not necessarily reflect the views of NAB and are subject to change without notice. NAB may receive fees for banking services provided to an issuer of securities mentioned in this report. 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Any U.S. person receiving this information wishes further information or desires to effect transactions in the securities described herein should call or write to nabsecurities, LLC, 28th Floor, 245 Park Avenue, New York, NY (or call (877) ). The information contained herein has been obtained from, and any opinions herein are based upon, sources believed to be reliable and no guarantees, representations or warranties are made as to its accuracy, completeness or suitability for any purpose. Any opinions or estimates expressed in this information is our current opinion as of the date of this report and is subject to change without notice. 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