The magic ointment of stimulus

The surprise of stimulus on Friday night saw a mass risk-on event for global risk equities.

US markets
Source: Bloomberg

China broke out of a two-year malaise in interest rates to cut the one-year leading rate by 40 basis points, while also cutting the deposit rate by 25 basis points.

The PBoC hasn’t moved on interest rates since July 2012; this is the first sign in several months where the PBoC has publically shown concern about the rate of growth in the world’s second largest economy.

There have been several developments over the past six months that could be root causes for concern:

- Growth momentum has been sliding faster than expected. Industrial production and trade data has recently started to surprise to the downside more often than normally expected. Manufacturing is barely expanding and output is starting to reverse.

- Disinflation has been building, making real rates higher and heaping pressure on growth and wealth.

- Funding costs remains high, particularly in the private sector.

- Housing has begun to cool and bad and doubtful debts have been rising to uncomfortable levels.

There hasn’t been any interest rate liberalisation since last year’s third plenum, and if China is going to really create a more liberalised market is should also consider its standing on its preferential treatment in lending practices to state-owned enterprise to reduce the mounting local government debt and promote private growth.

The cuts themselves are unlikely to have a major impact on the Chinese economy, but the intent signalled will. Movement in interest rates bring possible moves to the reserve required ratio (RRR). It has been tweeted several times in the past ten months, but never by a significant amount. However, the lowering of interest rate signals that growth is still a major driver of policy in China (as it always has been), meaning all leavers are in play. Watch for increased funding allocations in support of growth in the next 12 months.

The impact of this move on the market was dramatic, considering most major industrial commodities have entered bear market territory over the past six months on China slowdown concerns. The signalled intent from the PBoC put a rocket under cyclical materials plays.

Stimulus has been the magic fix for equity markets over the past six years and the mere sign it will eventuate is enough to be championed by the markets.  We now have three of the four largest central banks in the world actively stimulating their respective domestic economies – will this see the ‘Santa rally’ starting early?

Ahead of the Australian Open

The stimulus measures will no doubt have a positive impact on the Australian market. Based on the close of the futures market on Saturday morning, we expect the ASX to jump 50 points on the open to 5354, as the materials plays find significant favour.

Be aware iron ore fell through US$70 tonne on Friday to US$69.80, which is another five year low, however this will not stop the positive reaction in BHP et. al. with its ADR suggesting it will add over 4% today after having fallen to its lowest level since June last year on Friday. The question is whether this is the event that will see the ASX finishing the year on a positive note and with some momentum heading into 2015.

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