Risk assets, including credit, were stronger through the first half of May, before suffering a sharp pullback later in the month. The early month strength was assisted by official interest rate reductions in several countries and most notably Australia where the Reserve Bank (RBA) surprised by cutting the cash rate by 25bp to a record low 2.75%. The European Central Bank (ECB) also cut its policy rate by 25bp to 0.50% and although not a surprise helped to confirm a sense of a coordinated program of interest rate cuts around the world. Risk assets gained added impetus because the rate cuts came at a time when some indicators in the US and Australia were pointing to stronger economic activity. Key April employment readings in both the US and Australia were stronger than expected with US non-farm payrolls up by 165,000 with big upward revisions to earlier months and Australian employment rose by 50,100, nearly five times market expectations.

The strength in risk asset markets started to unravel mid-month on two main factors. The first was a degree of confusion about when the US Federal Reserve (Fed) might start to cutback liquidity support for the market through its bond buying program (QE). While the statement after the Fed’s regular policy meeting made it clear that the Fed would continue to buy $US85 billion of bonds each month, the minutes of the meeting showed some dissent among committee members. Also, a key testimony by Fed Chairman Bernanke to a Congressional standing committee appeared to be ambiguous on when QE would start to be wound back. At the same time, release of regular monthly economic readings from China confirmed a softer patch in China’s growth. While China’s Premier Li indicated that the growth pullback was a necessary part of economic reforms rebalancing towards private business investment spending and away from official investment spending – a positive change for more sustainable growth long-term – the market focused on the short term consequences for growth from less likelihood of official pump priming.

The Australian sharemarket (ASX 200) was one of the worst performing markets internationally in May, falling by 5.1%, and mostly on concern about how well Australia’s economy can perform as major resource companies postpone spending on mining investment projects because of the souring view about China’s growth prospects. The performance of the Australian sharemarket contrasts sharply with gains for the US (S&P 500), European (Euro Stoxx 50) and British (FTSE 100) sharemarkets of respectively 2.1%, 2.1% and 2.4% and a fall of 0.6% for Japan’s Nikkei.

Looking ahead, leading indicators of economic activity have strengthened in the US, are stabilizing in China and although mixed in Australia, have shown signs of considerable strengthening in housing activity, a key offset to potential weakness in resource investment spending. We see these signs as consistent with stabilization in risk asset markets, including credit, and with the RBA returning to a policy of maintaining the current low 2.75% cash rate, given that the current recovery in domestic spending is showing no signs yet of pushing up inflation.