Merlea Macro Matters

(Merlea Macro Matters)
December 2017

 

Summary

Sentiment could well get a further kick as the Republicans’ tax code overhaul could be passed before the year-end. The bill is due to be finalised, and will likely be voted on next week. Whether the US markets can retain the same momentum next year remains a bigger question, and our view is that higher levels of inflation will see commodity centric markets such as Australia and the UK out-perform. I also expect Asia to do well as China continues to adjust to more sustainable (but still high) levels of growth. Similar powerful growth thematic are also likely to drive other markets in the region in our view.

The RBA which predictably left rates on hold for the 16th month in a row. The accompanying statement noted that “One continuing source of uncertainty is the outlook for household consumption. Household incomes are growing slowly, and debt levels are high.” Of course, one problem here as is low wage growth, but I expect that that a strong employment market will inevitably create some upward pressure. As the central bank also observed, “… wage growth remains low. This is likely to continue for a while yet, although the stronger conditions in the labour market should see some lift in wage growth over time.”

I think that once we get wage growth coming through, this will combine with rising commodity prices to push inflation much higher. This will likely catch the RBA (and other central banks) off guard, with inflation running below their target for such a long time. The first two of weeks of December are typically quiet, but I think there is enough good news for a reasonable push by the ASX200 above the 6000 mark. This is before we get the usual Santa inspired momentum running into Christmas.

 

Bonds

Central banks have been particularly slow to normalise monetary policy, though the US Federal Reserve (Fed) and the European Central Bank (ECB) communicated a more explicit path for normalisation. The Fed confirmed its balance-sheet contraction in October, and the ECB announced further tapering in November. Thanks to this, liquidity remained ample, with investors keen to find allocation opportunities. This supported the asset class, translating into spread compression across fixed income assets, as investors reduced their cash buffers against volatility or market shocks.

Recently, international financial markets have been adding to suspicions of another deterioration as the US treasury yield curve flattened at its fastest pace since the GFC. The 2-year US Treasury Yield has risen significantly to 1.77% at the start of December from 1.15% one year ago whereas the 10-year rate dropped 0.09% to 2.36% during the same horizon. This is better reflected in the spread between 10-year and 2-year yields reducing to just 0.59% from 1.30% in December 2016.

There are two main reasons behind a flattening yield curve in US. Firstly, this could potentially reflect the short-term boost the Republican Tax Reform may offer to the economy upon its approval. Another contributor is possibly the US economy recovering at a favourable pace, in which case business growth is tempered by raising interest rates and creating room to maneuverer in a future slowdown.

Short dated Australian bond yields have fallen below U.S. bond yields for the first time in 17 years, reflecting the vastly different economic cycles between Australia and the U.S., as rate hike expectations continue to build from the Federal Reserve whilst expectation for any near-term RBA move remains mute. Australian bonds continue to perform after continued weak retail sales data, weak CPI numbers. Certainly, short-term rate hikes in the largest economy are likely to spread out contagiously to the rest of the world including Australia. The biggest questions locally are how far and how soon?

I believe next year will be the biggest change for the bond markets with rising commodity prices and inflation finally pushing the bond market into bear territory and yields at the longer end of the curve – sharply higher.

 

Australian Equities

The Australian economy continues to move along at a reasonable rate, with third quarter GDP rising 0.6% in the September quarter on the previous three months. The economy though has certainly come some way in a year with 2.8% growth, although this was slightly below consensus economist expectations of 0.7% and 3% respectively. The ongoing revival in the resource sector over the past 18 months is certainly helping the economy, and this is evident in the performances (and share prices) of mining sector constituents, many of which are around multi-year highs. We have had a neutral weighting to the sector since the lows last year, which has been positive for performance. There were certainly some reasons to be positive in the numbers, with infrastructure investment and a strong employment market leading a helping hand. Business investment has also grown at the strongest rate since the peak of the mining boom in 2012, up 2% in the quarter and 7.5% through the year.

The consumer clearly remains an Achilles heel though, with household consumption, contributing just 0.1 percentage point. This does concern me, and while I think wage growth will come through the system, the prospect of rising lending rates mean that we are very cautious towards any consumer discretionary focussed sectors.

 

Global markets

America

Taxes are at the key point of focus for investors. Once source of strength for equity markets last week were hopes of tax reform being passed in the Senate with influential Senator John McCain throwing his weight behind the tax reform. The upper chamber of Congress is more challenging for Republicans with the party holding just 52 out of 100 seats. Legislation passed by the Senate now must be merged with measures passed by the House of Representatives.

A Senate committee has warned that the bill will add US$1 trillion to the US budget deficit, and this is another reason why I believe interest rates are set to rise next year. If the tax package is passed, US debt will soon begin to be priced with a higher risk premium to reflect the faster rate at which the national debt will grow. The plan will see the corporation tax rate lowered from 35% to 20% and includes modest tax cuts for individuals across income levels.

The Federal Reserve delivered the verdict from the last FOMC meeting of the year and raised interest rates by 25 basis points – as widely expected. However, what was revealing is that the Fed left its rate hike trajectory outlook for 2018 unchanged despite rising cost pressures in the economy and accelerating economic growth. In the official statement the Fed acknowledged in their latest forecasts that the economy had gained momentum this year by raising their economic growth forecasts and lowering the expected unemployment rate, but inflation continues to be projected to remain shy of the 2 percent target in 2018. This was the predominant reason the Fed saw no reason to accelerate the expected number of rate hikes. A Labour Department report showed US producer prices rose in November as gasoline prices surged and the cost of other goods increased, leading to the largest annual gain in nearly six years. This clearly points to a broader acceleration in wholesale price pressures.

 

Europe/ UK

ECB head Mario Draghi said that the euro-area economy wasn’t strong enough to justify withdrawing monetary stimulus. He said that the Governing Council’s discussion “reflected the increasing confidence that we have in the convergence of inflation towards a self-sustained path in the medium term,” However, an “ample degree” of stimulus is still needed. “Domestic price pressures remain muted overall and have yet to show convincing signs of a sustained upward trend.” Much like the Fed by the time the ECB realises that inflation is on the scene, they will likely be well behind the curve.

Alongside its interest rate decision, the ECB upgraded its growth forecasts for the Eurozone. Economic expansion is now expected to be 2.4% in 2017, 2.3% in 2018, 1.9% in 2019 and 1.7% in 2020.

The Eurozone factory sector PMI increased to 60.1 in November from 58.5 in October. This was the strongest level since April 2000 and was driven by robust new orders, output and job creation in the sector.

Pressure on the UK consumer has continued to increase with annual inflation hitting 3.1% in November. This is the highest pace of inflation since March 2012, but prices were up by 2.7% excluding volatile items. Annual price growth has been above the Bank of England’s 2% target for the last 10 months. There was a 0.3% month-on-month increase in prices versus forecasts for a 0.2% rise and the 0.1% increase in October.

 

Japan

Japanese equities should benefit from the new mandate given to Prime Minister Shinzo Abe to accelerate domestic reform. Policies encouraging women to enter the workforce have been very successful, injecting additional income into Japanese households. Japan has become destination for the Chinese tourist market and is also acting as a new catalyst for domestic demand. This, combined with near record-low valuations relative to global equities and, conservative earnings growth forecasts for the coming year, means that both expanding valuations and accelerating earnings expectations should keep equity investments attractive in 2018.

The Japanese Nikkei-Markit manufacturing PMI rose to 53.8 in November from 52.8 in October. This was the strongest reading since March 2014 and was driven by overseas demand. Japanese core consumer inflation, excluding fresh food, increased in October by 0.8% on a year ago. The reading was in line with expectations and compares to a 0.1% year-on-year increase in September.

The core CPI, excluding food and energy prices, was up 0.2% on a year ago with this unchanged from September. The headline CPI was also up 0.2% on a year ago with food prices dropping while utility prices increased.

 

China

The Hong Kong Monetary Authority and the People’s Bank of China, increased rates 0.25%. The Hong Kong dollar is pegged to the US dollar and monetary policy therefore moves in tandem with the US. China is biting the bullet on the more painful reforms, leading to a long-lasting growth slowdown, at a time when inflation in China is set to rise. High inflation would be very damaging to China’s economy. China faces high and rising leverage, particularly in the corporate and local government sectors. The

immediate consequence of higher inflation is monetary policy tightening, which would make the leveraged firms vulnerable. Tight monetary conditions and high interest rates can be damaging to the real economy. Credit growth will fall, and investment reduce. Highly indebted SOEs and leveraged small banks may face difficulties in rolling over their debt leading us believe that credit risk will be the big theme for 2018,

In the past two-and-a-half weeks, China’s equity market has fallen 5 per cent while yields on 10-year Chinese government bonds briefly jumped above the crucial 4 per cent threshold, in a sign of growing investor anxiety. This recent volatility has brought to the fore questions over the investment outlook for next year and whether economic headwinds could damp prospects for China.

Chinese fixed-asset investment increased 7.2% in the first nine months of 2017 versus 7.3% in the ten months to October. The reading was in line with forecasts and the slowdown was driven by weak private sector investment. Retail sales growth in November increased 10.2% on a year ago versus a 10% increase in October. Industrial production in November rose by 6.1% on a year ago versus a 6.2% increase in October.

The real estate sector was relatively weak with investment up 7.5% in the 11 months to November on a year ago. This compares to 7.8% in the 10 months to September and is the slowest pace of growth since December 2016.


Commodities

It was interesting to see Goldman Sachs make a bullish call on commodities this last quarter predicting that the asset class will bring better returns than other assets next year. Goldman’s expressed a view on Bloomberg this week that “strong global demand growth across raw materials reinforces the case for owning them, maintaining a 12-month overweight recommendation on commodities.” Goldman went on to say that it “sees returns of 10 percent in 2018. Given that equities are supported by robust views around future growth, should these views falter even as current activity remains robust, commodities should outperform equities and other asset classes, reinforcing our neutral weight view”. For the broader industrial metals index, Goldman “expect returns to be mostly flat next year. It is most bullish on copper, and most bearish on aluminium. In both cases robust and synchronous global growth will help to keep metals demand strong across the board in 2018. The difference lies in the supply dynamics. Goldman sees copper supply declining sharply post 2019. Technically, copper ended a bear market at the end of last year. We could potentially see copper hit more than $4 over the next few years with supply constrained in the face of rising demand. We agree, and continue to believe that the earnings upgrades coming through will push the resource sector much higher next year. We continue to favour the high-quality producers.

 

Gold

Should global equity euphoria weaken in 2018, gold could stand to benefit significantly. Global equity markets have now added close to $9.5 trillion in market capitalisation over the course of 2018 and valuations are very high. Against a backdrop of increasing geopolitical and financial market volatility, gold and silver’s solid track records as liquid and easily transferable tangible assets that have long been considered as a currency of last resort, may come increasingly onto investors’ radars. Despite having made solid returns in 2016 and 2017, both remain soundly unloved and under-owned.

 

Oil

Oxford Economics examined what would happen if Brent remained at $65 a barrel for two years—$10 above the firm’s baseline expectation—and then returned to the baseline. The model suggested that,” other things equal,” world gross domestic product would grow 2.6% in 2018 compared with the firm’s baseline of 2.8%, with the peak impact coming in the final quarter of 2019, knocking 0.3 percentage point off growth. It would also boost global inflation by 0.6 percentage point in the final quarter of 2018.

IEA has forecast that rising US production from shale oil companies could lead to an oil supply surplus in 2018. The Paris-based agency noted in its monthly report that US drilling and well completion rates have picked up. Opec and Russia have joined forces to curtail production and as a result the price of Brent crude has increased to over US$60 a barrel. This has encouraged US shale oil companies to step up production. The IEA expects that the oil market will be surplus to the tune of 200,000 barrels a day in the first half of 2018. In the second half the agency forecasts a deficit of 200,000 b/d with the market balanced over the whole of the year.

Prices for energy commodities – which include oil, natural gas, and coal — are forecast to climb 4 percent in 2018 after a 28 percent leap this year, the World Bank said in its October Commodity Markets Outlook.

We were bullish on oil at the start of the year and the rise in recent months has caught many off guard. I expect this could well be the case next year as well, with the IEA (and others) likely to overestimate the supply response, while underestimating the strength of demand.


Going into 2018

The macroeconomic backdrop has been steadying all year, with growth solid and synchronised and inflation confounding by its absence. Recent data points show no sign of a shift in this backdrop into year end. November’s US non-farm payrolls report validated the strong labour market, with stronger than expected job growth, though it also showed weaker-than-expected wage growth, at 0.2% month on month, as well as downward revisions to previous months. In Europe, both soft and hard data continue to suggest a strong growth environment—November’s composite PMI ticked up to 57.5—though underlying inflation remains stagnant. However, we believe that inflation is poised to pick up, particularly in the US on a cyclical basis, and average core inflation measures are beginning to show signs of this upward momentum.

Sector 12 Month Forecast Economic and political predictions 2017
 

AUD

 

70c-80c

 

Rising commodity prices have been a supportive tailwind for the Aussie dollar, in our view. The Aussie has rallied 1.05% to 0.764 on the Fed meeting, but I believe that the Australian dollar will be less of a one way bet next year as the reality of currency hikes set in. Rising interest rates in the US, and with the RBA constrained, may see the interest rate differential widen and place the A$ under pressure.

 

Gold

 

SPT Gold 1140 – 1400

 

Geopolitical risks, especially around North Korea, continue to cause concern, as does the potential for the major central banks to tighten liquidity conditions too early or too aggressively. We continue to hold gold to maintain ‘protection’.

 

Commodities

 

Overweight energy and materials.

 

Improving fundamentals, stabilisation of commodity prices, global growth and higher real returns should continue to support.

 

Energy appears particularly cheap on price to book at a time

when we see improving free cash flow generation and an increasing focus on capital efficiency. We would expect to see more M&A activity in 2018

 

Property

 

1100 – 1400

 

Underweight

 

Low domestic rates remain supportive, however out-of-cycle rate increases and premium valuations makes property’s relative appeal as an asset class difficult to sustain in a global rising interest rate environment.

 

Australian Equities

 

5200 – 6200

 

Short term correction due

 

Australian equities are exhibiting amazingly low levels of volatility. Low volatility happens when the market is supplied with plenty of liquidity. We make current fair value of the ASX200 in October 2017 at 5,660 points. The market has been trading very close to that level in recent weeks. We think that improvements in earnings in the New Year will lift fair value to 6,040 points by April 2018 and that the Australian market will rise in line with those fundamentals.

 

Bonds

 

2.9% – 3.5%

 

Underweight duration and reducing credit risk

 

Improving global growth with inflation trending higher warrants lower exposure to government bonds and duration.

Valuations are looking expensive, highlighted by low term premiums. Normalisation of central bank policy also a headwind for government bonds.

 

Cash Rates

 

1.5 % on hold till 2018

 

Increase cash holding.

 

 

The expectation is for the RBA cash rate to remain steady for the remainder of CY17. Despite the low return, we maintain a higher cash weighting relative to historical levels, to protect against downside risks.

Term deposit rates continue to offer good risk adjusted returns in our view and investors can get rates of 2.60% for 12 month deposits which we view as attractive.

Global Markets
 

America

 

S & P 500

Overvalued. 2100-2400 risk rising of a market correction.

 

Underweight US

 

Signs in favour of higher inflation are building, coming from rising producer prices, commodities and pressures on wage growth in labour markets.

Despite existing uncertainties related to ongoing negotiations on US fiscal policy, corporate tax rates should decline in 2018. Fed’s new chairman J. Powell should continue the same strategy as Ms Yellen, gradually raising key rates and reducing the balance sheet regularly.

Elevated valuations, in particular in the US, may be a concern for next year, current earnings growth expectations for the next 12 months appear reasonable relative to history and to the current strength of the global economy.

 

Europe

 

Neutral

 

Although eurozone banks have seen upward earnings revisions, reported earnings proved disappointing in the latest results. Political and regulatory headwinds will be a constraint to driving earnings growth. The recent ECB policy statements, suggest a dovish bias even in the face of tapering which is set to begin in 2018.

 

Ahead of the EU summit, Brexit negotiations have made progress on the exit bill for UK.

 

Japan

 

14000 – 22000 hold

 

Favour Japan

 

Japan equities remain our best international exposure. Corporate earnings saw consistently positive revisions over the past year but, despite the rally, the Japanese market still trades near an all-time wide discount to MSCI World. Japan equities will continue to benefit from the supportive monetary policy as well as the solid trend in the real economy.

 

China

 

Shanghai Index

3000-3500

 

Take profit

 

In China, monthly indicators point towards some moderation,

due to expected rollout of reforms, a tight control on property and the financial sector. This may initially prove to be an obstacle for China economy early in the new year.

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