Merlea Macro Matters – April 2018

(Merlea Investments)


Summary

Easing political tensions helped the markets but what really invigorated investowrs was the fact that a strong earnings season is about to start – and markets have already had a taste of what is about to come down the line. The correction that occurred earlier this year (many thought and myself included, that it would start later in the year!), is most probably over. Bearish sentiment, which has dominated and permeated the markets for the past 10 weeks, is about to give way to a more positive change.

Markets will shortly begin to focus on earnings and the underlying quality of those earnings. Valuation is about come back into the spectrum, particularly with the S&P500 with a forward estimated 15X valuation for 2019 during the recent selloff. The worries of the last few months could settle as quickly as they arrived, and I presume Wall Street will once again be focus on just how well Corporate America is doing as we roll through the reporting season. I think the “buy-the-dip” mentality is far from being dead yet with the investment community in this cycle. This could fuel what I believe will be a very strong rally lifting the S&P500 back to at least 2750/2800.

I feel that Present Trump will begin to focus on the mid term primary elections and will need to get Washington on his side, this will cause him to change direction. My view is that Trump will now begin to campaign to a broader audience and tone down much of his rhetoric. Trump will soon start pursuing a line that Wall Street wants to hear. White House noise aside, there were no new developments on the Mueller/Rosenstein issue, whereby Trump has threatened to fire the head of the Department of Justice in a bid to get at head of the FBI lead investigator Robert Mueller.

Any move by Trump to do so could instigate a constitutional crisis and invoke a response from Congress. This is perhaps the biggest near-term uncertainty overhanging the markets now, and any move by Trump could potentially be very negative. And what about the reopening of the door again on a Trans Pacific Trade partnership. Trump was very emphatic on shutting that one down, and suddenly it is back on the agenda. If Trump does not get impeached between now and November, he will become more focus on getting “re-elected”. Trump will aim to wheel out “diplomatic trophies” such as North Korea and trade relation “wins” with China with the hope of appealing to his core electorate but also the establishment in Washington. Of course, all this will be very soothing to Wall Street – and as I believe, will provide fuel for the coming rally.

We maintain the view that inflation is going to grind higher globally this year, and that equity markets also will ‘re-inflate’ post the recent correction. Commodities are part of that story, with oil at the forefront, as it is used in the manufacture of most products in some way or form, and literally oils the wheels of the global economy.

Analysts at JP Morgan say the forward curve for the one-month Overnight Index Swap rate (OIS) – a market proxy for the Fed policy rate – has flattened and “inverted” two years ahead. It is a market verdict that Fed officials have lost touch with reality in thinking that they can safely raise rates another seven times to 3.5pc by late 2019, as implied by the “dot plot” forecast. It is tantamount to a recession warning. An inversion at the front end of the US curve is a significant market development, not least because it occurs rather rarely. “It is generally perceived as a bad omen for risky markets,” said Nikolaos Panigirtzoglou, JP Morgan’s market strategist

My current focus is on the global front US rate rises are in effect being magnified, through the mechanism of LIBOR (the London Interbank Offered Rate). Three-month LIBOR – used to set the cost of borrowing on $9 trillion of US and global loans, and $200 trillion of derivatives – has surged 60 basis points since January, and the LIBOR-OIS spread (or LOIS) has widened. The last time that happened – to disastrous effect – was 2007. It is just not the last 90 days that LIBOR has surged. It was only a few years ago that LIBOR was under 0.25%. Today it is 2.3%. That is a 2% jump since the Fed’s tightening cycle began. That increase has raised rates on an enormous number of adjustable-rate mortgages and all manner of loans pegged to the LIBOR.

Greater volatility, higher inflation and the unstable stock-bond correlation are somewhat related risks that we think have heightened probability of manifesting through 2018. Even more troubling, as recent market events show, we believe most investors are ill prepared for these risks, having been lulled into complacency by their absence over the last several years.

 

Bonds

The central banks are beginning the long process of exiting the strategies that they have applied so liberally since the

Great Financial Crisis (GFC) – interest rates cut and Quantitative Easing (QE) where the central bank adds liquidity to the system by buying bonds. The US Fed is leading the charge. China is also reducing credit growth, please note this means the world’s two largest economies are in monetary tightening mode.

The European Central Bank(ECB) is widely expected to stop its bond-buying spree later this year, and the Japanese central bank has been changing the terms of reference though appears to be in no hurry to exit its program anytime soon. Central bankers believe that having inflated asset prices successfully through all this financial support and liquidity, they can create an asymmetric exit of these programs leaving asset prices and interest rates largely untouched. I remain very sceptical. In addition to a less accommodative monetary regime, US policymakers embarked on staggering fiscal expansion. Budget deficits are projected to climb from US$600 billion to well over US$1 trillion by 2019. More deficit spending means the government and the Fed will both be in the market selling bonds. Fewer buyers and more sellers creates the risk of a price boycott and rising yields

As anticipated, the spread between 10 year Australian and US government bond yields has gone negative for the first time since 2000. This shift hasn’t led to a significant fall in offshore demand for Australian bonds. Indeed, the fall in hedging costs has opened the market to a new set of investors.

Equity market volatility and a low-yielding credit environment has caused investors to re-examine opportunities with the domestic ASX-listed hybrid market. Whilst there is a link to equity markets, our view remains that fundamentally, the risk involved in the hybrid market remains, to a large extent, unchanged. Recent volatility has altered prices and changed valuation of hybrid securities, but overall the broader economic and regulatory environment including the Banking Royal Commission will, in our view, prove to be a positive in tightening and improving lending restrictions as well shoring up equity capital in the future.

 

Listed Property

AREIT sector has been weighed down by the retail AREITs. Going forward, we expect the distribution yield to be just under 5 per cent for the sector, with growth in distributions of more than 3 per cent per annum for the next few years, which provides the underpinning for reasonable returns. Given that pricing is slightly above our longer-term view, we would moderate return expectations down to allow for some reversion. There is considerable valuation dispersion within the sector, providing opportunities for active managers. While we are cautious towards the major CBD office markets of Sydney and Melbourne, collectively they are less than 20 per cent of the sector and an active manager may have less exposure. Retail property represents close to 50 per cent of the sector and as the concerns start to abate we expect it to deliver good returns.

 

Australian Market

Trade war potential remains an issue, although so does the potential for the US and China to settle their differences via negotiation. Trump’s reassessment of the TPP, however that may play out, also provides the slight chance of a positive for Australia.

I remain of the view that with more sensible lending practices in recent years (thanks to macro prudential controls), a rising population, and wage growth on the horizon, we are not going to see the property meltdown that some doomsayers are forecasting. Elevated household debt is likely to constrain future monetary tightening for the RBA. We have regularly said that the RBA will likely sit on its hands till the last quarter of 2018. Markets are currently pricing in around a 30% chance of an increase this year. Dr Lowe did say in his speech last week say that “the last increase in the cash rate was more than seven years ago, so an increase will come as a shock to some people,” He is certainly right, with many people (and markets) having been conditioned to low interest rates and almost seeing it as a new paradigm. Still I don’t see the central bank doing anything too early in 2018 to push near term rates along, even though the longer end is already telling a different storey. Australian data was rather bland over the last week.

The NAB business survey showed business conditions and confidence slipping in March but that was down from unbelievably strong levels and they remain solid. Consumer confidence fell slightly and remains below business confidence, which is likely to remain the case until wages growth picks up. The labour market’s forward-looking indicators continue to point to solid growth in employment in the period ahead. Whilst wage growth remains anaemic, there is emerging evidence that wages have troughed with some reports that some employers are finding it more difficult to hire workers with the necessary skills. The Australian market has fared better than most because it didn’t join the exuberance. Since peaking in January, the ASX 200 has fallen 5% year to date. Worst hit have been expensive tech stocks and interest rate sensitive bond proxies, the very sectors that outperformed over recent years.

We continue to expect the ASX 200 to reach 6500 by end 2018 – it might take a bit longer to get back on the path up to there though. Low yields and capital losses from rising bond yields are likely to drive low returns from bonds. Unlisted commercial property and infrastructure are still likely to benefit from the search for yield by investors, but it is waning, and listed variants remain vulnerable to rising bond yields.

 

Global markets

America

On the economic side, consumer prices were slightly lower than expected in March. The Labour Department reported that the Consumer Price Index slipped 0.1% last month, which was the first and largest drop since May 2017 after climbing 0.2% percent in February. This places the annualised CPI through to March at 2.4% which is still the largest 12 month gain in a year and follows February’s 2.2% increase. Excluding the volatile food and energy components, the CPI climbed 0.2% which is the same increase as in February. The core CPI is now well above the 1.8% percent annual average increase over the past 10 years.

The drop in the headline monthly inflation reading will likely prove temporary however as higher producer prices (which increased sharply in March) feed through to the CPI. A tightening labour market is likely to add to inflationary pressures in the second half of 2018 and I believe the risks to US inflation is to the upside. The higher oil price is also going to soon begin having an impact. Other commodities such as the soaring price of lumber will also hit. On Wednesday the Fed released the minutes from the March FOMC meeting. The minutes revealed that the Fed was unanimously in favour of lifting interest rates by 25 basis points and wariness about future inflation. “All participants agreed that the outlook for the economy beyond the current quarter had strengthened in recent months. In addition, all participants expected inflation on a 12-month basis to move up in coming months.”

There were no surprises there and stocks, bond yields and the dollar were little changed following their release. However, the minutes did flag concerns from some Fed officials that interest rates may have to be raised faster than previously expected with some commenting that “the outlook for the economy and inflation could lead to a slightly steeper path of rate increases over the next few years”. We are on the record in calling for at least 3 more hikes this year as inflation does indeed begin to pick up.

The Fed’s monetary tightening is now biting hard. Growth of the “broad” M3 money supply in the US has slowed to a 2pc rate over the last three months (annualised) as the Fed shrinks its $4.4 trillion (£3.1 trillion) balance sheet, close to stall speed and pointing to a “growth recession” by early 2019. Narrow real M1 money has contracted slightly since November. The Fed’s bond sales have been running at a pace of $20bn a month. This rises to $30bn this month, reaching $50bn by the fourth quarter. It is estimated this will drain M3 money by roughly $300bn a year. There is no sign yet that the Fed is having second thoughts about the wisdom of charging ahead with sabres drawn. The new chairman, Jay Powell, was strikingly hawkish in a recent speech, making it clear that he has no intention of bailing out Wall Street if equities tumble or credit spreads widen. He dismissed short-term shifts in the economy as meaningless noise. The Fed view is that Donald Trump’s unwarranted fiscal stimulus – lifting the budget deficit to 5pc of GDP at the top of the cycle – is inflationary and increases the risk of over-heating.

 

Europe

In economic news, Eurostat reported industrial production in the Eurozone slipped by 0.8% month-on-month in February, with a 3.6% drop in capital goods output and 2.1% fall in durable consumer goods weighing on the reading.

Consumer price inflation in France was up more than initially estimated in March, latest figures from the statistical office Insee showed. Inflation increased to 1.6% in March from 1.2% in February. The earlier estimate for March was 1.5%.

Minutes from the latest monetary policy meeting of the European Central Bank highlight the caution policy makers have regarding rising trade protectionism and the impact from the appreciation of the Euro.

Eurozone house prices picked up in 4Q17, with Eurostat reporting they increased 4.2% year-on-year, accelerating from the 4.0% increase in 3Q17.

I believe the easy part of Europe’s post-depression recovery has largely been done and now showing signs of slowing, exposing the underlying fragilities of a banking system with €1 trillion of lingering bad debts.

The explicit reference to an easing bias was dropped in March. Given that QE is scheduled to end in September, we think an announcement on the exit strategy either at the 14 June or 26 July policy meetings would be appropriate. Citigroup’s economic surprise index for the region has seen the worst four-month deterioration since 2008. A reduction in the pace of QE from $80bn to $30bn a month has removed a key prop. The European Central Bank’s bond purchase programme expires altogether in September.

Germany is slowing hard despite a seriously undervalued currency (for Germany, not for France or Italy). Industrial output has contracted over the last three months and exports suffered the steepest dive for three years in February. Germany is highly leveraged to the Chinese industrial cycle.

 

UK

On the local economic front, the latest Quarterly Economic Survey from the British Chambers of Commerce (BCC) showed an economy that was “as a whole treading water, rather than powering ahead” in the first quarter of 2018. It also indicated inflation pressures are easing, reducing the prospects for aggressive BOE (Bank of England) interest rate hikes this year. The BCC director-general, Adam Marshal, stated, “What growth we see in the UK economy is due principally to strong global trading conditions, rather than domestic demand, which remains muted.”

Manufacturing company respondents to the survey reported strong growth in export sales and orders, but domestic sales were subdued. Service businesses noted steady domestic sales, but only a marginal improvement in exports.

BCC economist Suren Thiru noted, “Inflation is now on a downward trajectory,” and, “While we expect interest rates to rise next month, with UK economic conditions subdued and inflation weakening, the case for a further tightening in monetary policy continues to look limited at best.”

The Royal Institution of Chartered Surveyors said the UK house price balance remained at zero in March, which missed the expectation of a rise to 2%. Simon Rubinsohn, the chief economist of the organisation said that has the potential to soften household spending going forward.

UK construction output was down 1.6% on the month in February. That was better than the revised 3.1% drop the month before but far short of the 0.9% increase pencilled in. Annually, construction output was down 3%, compared to the 2.5% drop forecast and the previous month’s revised 2.1% slip. In economic news, weak mining and manufacturing output in February weighed on UK industrial production growth according to the Office for National Statistics.

The mining and quarrying sector saw output fall 2.7% and oil & gas extraction was down 3.2%. Overall, industrial output increased by 0.1% month-on-month increase, slowing from January’s 1.3% growth. That missed the 0.4% rise expected. Annually though, growth in industrial production came in at 2.2% in February, slower than the 2.9% expected, but up from 1.2% in January.

Manufacturing output dipped 0.2% sequentially in February, missing the 0.2% increase anticipated and marking the first fall since March 2017. Annually growth increased to 2.5%, from 2.2% in January, but again was still shy of the 3.3% forecast. The UK visible trade deficit came in at £10.2 billion in February versus the £12.2 billion deficit in January.

 

Japan

Cabinet Office said core machine orders increased a seasonally adjusted 2.1% sequentially in February, surpassing the expectation for a decline of 2.5% and pointing to a solid and lasting recovery in the Japanese economy. This followed on from the 8.2% spike in January. Even though Japan’s structural growth rate is low because of demographics, our view is that the changes to corporate governance are much more important to shareholders over the next decade.

The sell-off in early February – March has nothing to do with fundamentals such as earnings or valuations. Instead, it has more to do with fears that interest rates could rise much faster than expected. This is a key reason why stocks that are traditionally seen as bond proxies, for instance consumer staples, have underperformed globally. Every March, labour unions in Japan engage in a wage negotiation with employers in a process known as Shunto. This year’s proceedings are likely to be particularly interesting given continued tightness in the country’s labour market: the unemployment rate fell to 2.4% in January (a 24-year low) while the jobs to-applicants ratio stayed at a 34-year high. If the unions succeed in securing better wage packages for their members, it could translate into higher consumption and a tick up in inflation. A potential risk facing the economy is the leadership ballot for the incumbent governing LDP party in September. Recent scandals involving Prime Minister Shinzo Abe could take their toll. Should he fail to be re-nominated as leader, the future path of the reflationary macro policy measures being undertaken (aka Abenomics) could be under a cloud.

 

China

Chinese President Xi Jinping struck a conciliatory tone, saying China would “significantly lower” tariffs on vehicle imports, allow more foreign investment in certain industries, better protect intellectual property and boost competition in a bid to further open its economy to the world. Central bank governor Yi Gang was reported to have said China will allow more foreign investment in the financial sector over the next few months. China-Hong Kong connect quotas will be increased.

Official data showed Chinese inflation eased in March as demand dipped after the Lunar New Year holidays. Consumer prices in China were up 2.1% year-on-year in March, which was below the 2.6% expected and down from 2.9% in February. Meanwhile, producer prices were up an annual 3.1%. That was also below economists’ expectation of 3.3% and the 3.7% reading in the prior month. China’s trade surplus with the United States surged almost 20% in the first quarter, which some attributed to exporters pushing shipments out early to get ahead of threatened tariffs. The surplus with the US increased 19.4% to $58.2 billion in 1Q18, while China recorded a deficit of $9.9 billion with the rest of the world during the quarter.

 

Commodities

The rebalancing of the industrial metals complex has been proceeding quickly, and prices have strengthened. However, the transition of the Chinese economy to slower, cleaner, less “dirty cyclical” growth has capped my enthusiasm for metals for now. I am looking for price stability and we believe profitability should improve. We like areas of the market that are unloved, and this is a good place to look. Commodity prices are likely to continue contributing to modest rates of inflation, even with some near-term downside pressure because of the unstable global trading environment. We do not expect the commodity complex other than oil to deliver any kind of material inflation shock over the next 12-18 months.

 

Gold

I continue to reiterate gold’s status as an insurance asset amid elevated monetary & political risks and expensive equity valuations. We also see the USD weakness persisting this year; driven by tightening monetary policies at other central banks. Furthermore, we believe that real interest in the US will remain low amid the prospects of rising inflation; keeping the overall backdrop still supportive. However, hikes in interest rates are likely to remain a headwind for gold in the short term. Gold is also heavily interconnected to our scenario of rising inflation, being a hedge against it for centuries. While many have piled into gold in recent weeks, anticipating the breakout above significant historical resistance – I think this will prove to be premature. The historical resistance is formidable, and it will require a big catalyst – which I think will be inflation – to push through it.

 

WTIS

Oil prices were supported by easing trade tensions and the heightened tension in the Middle East after the alleged chemical weapons attack in Syria. Since breaking out last year, oil has sustained a consistent rally and now appears ready to test the medium-term highs with a further upside move probable.

Bloomberg reported that conversations with OPEC delegates and oil market participants confirmed that Saudi officials had been careful to avoid pinpointing an exact price target, the “inescapable conclusion was that Riyadh is aiming for $80.” which is not surprising given the public offering of Aramco next year – the Saudis will no doubt been keen to extract a high as price as possible.

 

Sector 12 Month Forecast Economic and political predictions 2017
 

AUD

 

AUD/USD is also looking a little overbought.

72c -80c

 

The Australian dollar (‘AUD’) weakened during the quarter, depreciating by 4% on a trade-weighted basis and 1.7% against the US dollar as local ten-year government bond yields closed at 2.6%, below US levels for the first time since 2000.

$AU is likely to fall towards $US0.75 as the gap between the RBA’s cash rate and the US Fed Funds rate pushes further into negative territory. Solid commodity prices should provide a floor for the $A though – in contrast to early last decade when the interest rate gap was negative and the $A fell below $US0.50.

 

Gold

 

With bond yields rising, gold could get a bid as a safe harbor asset, especially with price trends improving.

 

President Donald Trump accused Russia and China on Monday of devaluing their currencies while the United States raises interest rates. Will “currency wars” soon join trade wars as something the markets must worry about? A confrontation on currency valuation could also prove to be one key catalyst we have been waiting for that will finally send gold up through $1350/$1370.

 

Commodities

 

Overweight energy and materials.

 

In metals and mining, while the primary risk remains a slowdown in the Chinese economy, we expect any modest softness in the first half of 2018 to be offset by continued infrastructure spending, supporting demand for bulk commodities and metals as the year unfolds.

 

Property

 

A-REITS that focus on specific market “niches”, such as properties in the education, health care, aged care, and agriculture market. These sectors not only have strong long-term tail winds behind them, they are for the most part, recession proof.

Increase weightings

 

Real estate valuations are still reasonable offering the potential for positive return along with inflation hedging we see real estate investment trust valuations as attractive given their recent underperformance.

 

Low interest rates continue to be a key driver for the real estate sector, and with no indication that this will change soon, we expect investor demand for assets with relatively higher yields, whilst retaining secure income streams.

 

“Gearing is also down to its lowest level in a very long time.”

 

Australian Equities

 

We should begin looking at consumer staples and healthcare for equity investments. Value in the banks.

5580 – 6600

 

The resource sector is leading the way on higher commodity pricing and easing fears over a trade war between the US and China. BHP and Rio Tinto were well bid. Broker upgrades have begun to come through as commodity prices remain robust, and Morgan’s has been the latest to upgrade Rio to a buy. Amongst the drivers cited are higher aluminium price forecasts following US sanctions against Russian mega producer Rusal. I think that the upgrades will continue to flow, with supply tightness across the commodity spectrum, and as inflation comes to the fore. The ASX200, like many other indices has held an important region of support in the recent correction, and in this case around 5750/5800. If we are right that the correction has now passed, this lays a solid foundation for an advance back towards 6000 and beyond in the medium term.

 

Bonds

 

A rising rate environment means we should shorten our duration for bonds.

 

For the bond curve, we expect a modest steepening over the remainder of 2018. Yields on 3 year bonds will be anchored near current levels until markets start pricing in rate hikes from the RBA more aggressively. The 10 year leg will be influenced to a greater extent by US Treasuries and so should rise.

 

Cash Rates

 

The RBA cash rate rises to 3% over 12-18mth period

 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

Global Markets
 

America

 

Underweight US.

S&P 500: 2580 – 3100

 

The S&P500 encountered resistance at 2,670 last week. Our scenario is for the index to break through this level on the upside in April and run to 2750/2800 with a strong quarterly reporting season being the probable catalyst. However, it may take some time before new record highs are attained above 2,850.

 

Europe

 

Our preferred sectors – autos, telecoms and banks – are ones that have suffered in the low-rate environment of the past few years and now look very cheap.

Overweight.

 

I continue to believe that the European recovery is three years behind the US, so we are getting a second chance to participate in much of the long-term equity run. The short-term outlook for European equities remains relatively solid except that the news flow has been so good the risks are to the downside – could it really get any better? Certainly, there is a lot of economic and corporate earnings growth built into Europe economies

and equity markets right now.

 

Japan

 

Overweight once a correction has occurred.

Nikkei 225: 21500 – 2500

Favour Japan.

 

Japan’s Nikkei has successfully held above key support at 20,000/21,000 which is very encouraging. The correction in the Nikkei rolled back around 3,000 points of the 8,000 point advance that has occurred since 2016. This reaction was typical, despite many fearing that Japan would once again succumb to another bear market. While it may take some time before the Nikkei makes new medium term highs above 24,000 – the fundamental backdrop is the best in years. Foreign deleveraging (See March 2018 Discussion Document) is also positive for the Japanese stock market with overbought conditions of last year having now corrected.

 

China

 

Underweight.

Shanghai Index: 3350 -3650

 

Markets rebounded in the second half of the month, supported by strong corporate earnings and solid economic fundamentals. In addition, the Chinese equity market also responded positively to further initiatives from the central government to drive financial deleveraging. It appears investors think structural adjustments will be positive in the long run.

 

Source: Merlea Investments

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