Merlea Macro Matters – January 2019

(Merlea Macro Matters)

Summary

Equity markets are starting 2019 as they ended 2018, with stocks under pressure across the globe. The proximate catalyst for the selloff  was factory data from Asia and Europe, with China’s Caixin Media and IHS Markit PMI falling to 49.7, the lowest since May 2017. In Taiwan, Malaysia and South Korea readings were also below 50, indicating a contraction in activity. In Europe, while there were more signs of economic weakness in the PMI number, it seems not to be enough yet to derail further ECB tightening expected this year. U.K. manufacturing bucked the trend, with growth unexpectedly rising to a six-month high, but that came with a caveat as the boost was probably the result of preparations for a disruptive Brexit. Sentiment is not just fragile but has reached extreme levels on the spectrum in my view. This often typifies turning points. Bearish technical action has been aided by the fact that volumes and liquidity levels have fallen sharply. This is due to the fact that most investors have had a very difficult year and remain on the side-lines, looking to write off 2018 as a very poor year. This in turn has heightened downside volatility. We could see the markets stabilise from here, and this could spark a big rally in January 2019, with the “horse bolting out of the gates” so to speak. I would not be a seller into this environment and would be positioning for a “risk on rally” which could be sudden and relatively swift in January. Our argument is not just technical. Markets appear to be pricing in Armageddon – and this is typical after a sustained and consistent fall where participants become increasingly bearish the more a market goes down. Whilst there are definite risks about growth slowing down – and I wrote a lot about this during the last year including the impact the trade war would have on US and global growth – the market has excessively priced this in for now. There is no question the trade dispute is spilling over now into the broader economy, but this will provide impetus for both the US and China to negotiate an outcome on trade in January and February.

Bonds

Markets have started the year in a jittery mood. Credit spreads have widened, and stocks fallen, as concerns over a US recession have spooked investors still twitchy from last year’s volatility. But while a recession in the near term cannot be ruled out, we do not think a recession is imminent. As a result, we believe credit is still a safer investment than consensus would have you think. As recessions tend to cause higher default rates, the primary determinant of credit spreads is the economic cycle.  Wider credit spreads are themselves a traditional signal of recession. Historically, these have tended to occur in several waves: the first period of spread widening typically comes 6-9 months before a recession; the second usually arrives 3-6 months before the recession; and the third during the recession. We certainly do not want to be too long credit in the current environment – the market is not cheap and the global economy faces a number of risks. Overall, however, we take the view that the probability of a recession in the near term is less than markets believe, and therefore it makes sense to raise credit exposure while we continue to evaluate the data as it unfolds.

Listed Property

Investors turned to AREITs as a refuge from market volatility as US/China trade tensions increase and fears rise that the US economy may have reached its cyclical peak.  Currently, the earnings yield of the AREIT sector is at 6.2% which is higher than the yields of both cash and bonds. The premium to Australian 10-year government bonds is 3.6% which is higher than the average premium of 2.8%. The change over time of the spread between the AREITs earnings yield and the 10-year government bond yield is shown in chart below:

M&A continued to be a feature of the AREIT market. Starwood Capital lowered its takeover offer for Australian Unity Office Fund (AOF) from $2.95 to $2.87, reducing its offer by the value of AOF’s distribution. Dexus (DXS) announced the establishment of a new $2 billion trust with GIC, the Singapore sovereign wealth fund. It will invest in Australian logistics properties.

AREITs and property companies continued their buyback programs, acquiring $146 million of stock. Key buyers included Mirvac (MGR) which completed its $60 million buyback while Vicinity Group (VCX) completed its $45 million programme. Since early November, US 10-year bonds have fallen on growing expectations US economic growth may begin to stall as recent rises in official interest rates start to impact. It could be a signal for a pivotal turning point for the AREITs market, which over the past 12 months has been negatively impacted by concerns that rising US rates will lead to higher domestic interest rates. Based on recent news, it appears these concerns may diminish, at least in the short term.  We expect the office segment will see the strongest income growth, followed by industrial and retail.

Australian Equities

The Australian market clearly did not perform last year, and in the end finished down around 7.4% over the course of 2018. While early days, 2019 has started in on a more positive step, and we believe that there are reasons to be optimistic looking forward. We see the ASX200 pushing decisively back above 6000 this year, although domestic and offshore headwinds will likely prevent expansion beyond the 2018 highs. Permeating our predictions for this year is a relatively swift resolution to the current trade dispute between China and the US. This would be particularly beneficial for the key resource sector, and the economy generally, with China being Australia’s largest trading partner.

The Australian economy is in good shape – with unemployment heading below 5%, job growth strong, and the federal budget about to go into a surplus. There are headwinds, but of course we can expect the government to increasingly posture about the risks of ‘change’ (and particularly Labor’s move towards higher taxes and other key policies) as we move towards the May election. Over the last few years low quality businesses have been pushed up by the stock market on higher inflation and growth expectations. I think this is unlikely to continue in 2019 as fundamentals re-exert their dominance.

Personally, I always love these periods in investment markets as it gives me the opportunity to buy the businesses I’ve always wanted to own at much more attractive valuations. The sectors I believe to be best positioned in 2019 are consumer staples and healthcare.  Strong cash flows and greater certainty around earnings are attributes that will be in demand as the market’s higher expectations on interest rates and inflation begins to moderate. In addition, companies and sectors that can deliver growth in this environment are also likely to be chased by the market as earnings growth is proving a rare attribute in these market conditions. I firmly believe that in strong economic conditions a rising tide is likely to lift all ships, in tougher conditions you really need to back the best management teams to deliver a strong strategy and execution. The financial services sector and the banks should also start to see some light at the end of the tunnel, as the dust settles on the Royal Commission. We don’t expect the final Hayne report to deliver anything particularly earth shattering. With the skeletons all out of the closet, low valuations have effectively already priced in tighter regulation, and rising compliance costs.

We believe the market will start to focus on the upside risks as rising costs are partly passed onto borrowers, and as rising interest rates generally allow for an expansion in net interest margins. Any success against APRA’s moves for further capital increases would also be well received by the market. In 2019 I believe we’ll see a returned focus to high quality businesses with strong cash flows and high certainty of earnings.  We have maintained exposure to the banks.

Global markets

America

There are other potentially bullish near-term catalysts. The US economy certainly seems to be doing better than what many investors are currently pricing in. The US nonfarm payrolls came in for December at around 312,000 which was substantially above the Street’s estimate of c180,000, with wage growth pegged at 0.4%. This has set the market up for a better than anticipated reporting season – with expectations currently very deflated. I don’t think the earnings season is going to be that bad, and certainly not as bad as what is being priced in now.

Another big fear that dominated sentiment in late 2018 was the Trade War, but it seems that President Trump has already conducted a U-turn on the dispute and is keen to settle with the Chinese. There can be no misunderstanding by the White House of the spill-over impact the dispute has had on financial markets and the global economy, which is showing signs of slowing.  But a slowdown is different to a recession – and it is a recession that the market currently sees for the global economy, but it seems way too early.

Another near-term bullish catalyst is that we now have a much less aggressive Federal Reserve. Chair Jerome Powell “talked the market volatility down” last week when he provided soothing words on the outlook for future rate hikes, and certainly the pace at which the Fed has been shrinking its balance sheet. We could well find at the next FOMC meeting the Fed pauses all together with monetary tightening. The current reporting season is going to be pivotal and very important in terms of providing the directional catalyst for the market over the next few months. The key question for 2019 and beyond remains to what extent can the benign environment persist? Putting aside trade wars and policy missteps, whilst the US growth environment is unlikely to accelerate much from here, the combination of fiscal stimulus and the easiest US financial conditions since the Global Financial Crisis should sustain growth at current levels for longer. However, we believe the unusually favourable goldilocks combination of accelerating growth and tepid inflation experienced in 2017 will not repeat. Instead, normalisation of interest rate policy will likely upset the rhythm with more volatile and less forgiving markets.

Europe

After a sharp slowdown in 2018, euro-area growth is likely to stabilise around 1.5% in 2019, which is slightly above trend. The slowdown was exacerbated by weak global demand for euro-area exports and delays to German car production as carmakers adjust to new European Union (EU) emissions standards. In early 2019, we expect growth to modestly rebound as car production gets back on track. In addition, domestic demand in the euro area is likely to remain resilient, supported by healthy levels of business and consumer confidence and very low interest rates, which should continue to stimulate demand for credit. A stronger rebound remains unlikely in our view, given China’s ongoing slowdown and U.S.-China trade tensions, which will weigh on demand for euro-area exports.

In 2019, risks to the euro area are tilted slightly to the downside, given several important global risks we outlined in the global growth outlook section. Domestically, the biggest risk is a further escalation in tensions between Italy’s government and European policymakers. In 2019, Italy may break the 3% fiscal deficit ceiling imposed on all EU members, and given the recent downgrade of Italian sovereign debt by key ratings agencies and the associated rise in Italian bond yields, Italy’s debt levels are likely to remain elevated for the foreseeable future. Nervousness about Italy’s fiscal position may spill over to other Italian assets and to periphery bond markets, which on its own could dampen growth.

The record of the ECB’s December meeting was released with the main takeaway being that officials may have been more concerned with the deteriorating situation than they let on at the time. Apparently, paring near-term growth forecasts was enough of a signal that risks were increasing. This allowed Draghi to maintain the “broadly balanced” risk assessment.

Although Draghi did acknowledge that the balance of risks was moving lower, he confirmed the end of the asset purchases, which means monetary policy was becoming somewhat less accommodative. Most of the subsequent economic data has disappointed, though EMU unemployment slipped below 8% in December for the first time in a decade. Consider the erosion in consumer and business confidence. The composite PMI has fallen to four-year lows. Both German and French industrial output collapsed in December. The German economy contracted in Q3 and the recovery in Q4 looks faint, though retail sales have been stronger. Core inflation was steady in December at 1.0%, while the headline pace fell to 1.6% from 1.9% (peaked in October at 2.2%, the highest since October 2012). This tells investors what to focus on if the ECB is going to substantially change its outlook. The Euro continues to trade heavily after nearly three-month highs against the dollar earlier this month. It had been in the $1.13-$1.15 range with few exceptions since mid-October.

In Europe it is valuations that make equities interesting for investors. As soon as the situation eases about the Brexit negotiations or in the conflict with Italy, investors are likely to regain confidence and start buying again

 Japan

After a temporary soft patch earlier in the year, GDP growth is expected to remain above its estimated potential in 2018 at 1.1 percent. Inflation has gained momentum on the back of higher energy prices but—despite a very tight labour market—remains below the Bank of Japan’s (BoJ’s) 2 percent target. Financial conditions overall remain generally favourable. Japan’s parliament passed labour market legislation designed to set a legal cap on overtime work, ensure equal treatment for regular and nonregular workers, and exempt skilled professional workers from working-hour regulations, but the effectiveness of the new laws will hinge on implementation. Efforts to bring more workers into the labour force are meeting with success, with women, older workers, and inflows of foreign labour contributing to the gains. Corporate governance reforms have advanced, and the trade agenda has accelerated with two new trade agreements. While economic growth is expected to remain solid, some downside risks exist. The planned consumption tax increase in 2019 could hinder near-term growth momentum. Weaker global growth and heightened uncertainty—from trade or geopolitical tensions—could also undermine growth, trigger yen appreciation and equity market shocks, and renew deflationary risks. The target date for a return to fiscal surplus was also reset from FY2020 to FY2025.

An improvement in consumption is a key missing factor for the Bank of Japan (BOJ) to achieve its 2% inflation target. The lack of consumption growth is limiting the ability of corporations to raise prices, as they worry they will lose business from more cost-sensitive consumers. Overseas investors have continued to take a relatively fickle approach to Japanese equities. In aggregate, foreigners tend to be influenced by market momentum, appearing as sellers into market weakness and buyers into strength. The result is that we have seen no follow-through from the improved visibility on corporate profits and the recent market setback has led to further de-rating of market valuations.

Meanwhile, the Bank of Japan remains a large consistent buyer of equities via ETFs. Although this may be an effective route for its asset purchase programme, it also carries an increasing risk of distorting market prices. For 2019, however, there is no reason to expect the scale of buying to fade, and it is definitely much too early to worry about the potential impact of the central bank’s holdings being unwound.

China

During bad press against China it is easy to get caught in the endless stream of negative headlines. All in all, our view is that in case downward pressures on growth intensify in 2019, for instance due to US trade policies versus China, the government will add further stimulus to safeguard growth. So, what is the real effect of the implemented and forecasted tariffs. The GDP of China was $12,237.70B in 2017. The $200B tariffs represent 1.6%. The GDP is growing at an annual rate of 6.7% which is $820B per year as per China’s official forecast. The $200B tariffs represent less than 20% of the annual growth rate, it is the growth of a bit less than one quarter without touching the base GDP. Given the selloff in China’s stock market that started 8 months ago we believe the real effect of the tariffs, assuming the $200B will be implemented, is priced in. Moreover, the sentiment effect has already been largely priced in, and likely has bottomed.

The other risk factor to be considered is a possible further deterioration in China’s relationship with the US, should the unavoidable strategic competition between these two economies not be managed prudently. We could potentially see a further rise/broadening of import tariffs and more tightening of investment and export restrictions. Worst case, this could ultimately even spill-over into a broader ‘cold war’ with possible military tensions, also given regional uncertainties related to, for instance, Taiwan, North Korea and the South China Sea.

Another key risk stems from China’s (still) high debt levels, as the recent change of macroeconomic policies could jeopardise the hard-won stabilisation of macro leverage ratios.  A disorderly deleveraging would have far-reaching consequences for financial stability and could trigger a hard landing, although that is not our base case. The PBOC has already cut rates by a full 1% and is throwing other stimulatory measures at the economy to stabilise the recent slowdown. We may even see another rate cut before too long.

Emerging Markets

In 2018, fear came back to emerging market investors. In 2019, we believe the uncertainty and volatility will persist, but we also expect clarity on several issues. In our view, if these issues resolve favourably—e.g., a stable or declining US dollar, a workable trade scenario, accelerating growth outside the United States—then emerging markets will likely benefit.  At the same time, it is important to note that equity declines in 2018 have significantly lowered valuations. At the end of the year, the MSCI EM Index was down to 11.8x trailing earnings, from 15.0x times, a discount of about 35% compared to US equities. This discount is wider than the average, which has historically hovered around 20%. While many of the risks external to emerging markets have been largely priced into emerging markets assets for months, other risky asset classes, such as US high yield and equities, have only recently begun to account for these risks. Yields in emerging markets debt are near post-global financial crisis highs. This potentially provides investors with an attractive level of income and the possibility of additional upside should emerging markets outperform the market’s relatively low expectations. Accordingly, we have a constructive view on the asset class in 2019 as we head into what we believe will be a more benign environment for emerging markets.

Commodities

While the commodity markets and energy have been under pressure, resource stocks such as Rio Tinto and BHP are close to medium term highs. BHP has sustained little in the way of collateral damage from the recent rout, which can be partially explained by the fall in the Australian dollar, but also the price action in iron ore. We have not seen iron ore prices break down, and in fact the technical price action is favourable. Iron ore has not broken down during the recent financial market’s turmoil.  If iron ore demand is not collapsing, what does this point to about the global economy?

Gold

Precious metals outperformed during the recent volatility. If the Fed pulls back from tightening in the months ahead, we may well see further downside in the DXY (US Dollar Index), which will provide support for emerging markets, but also commodities and precious metals. Gold recently tested $1300, and I think our scenario of another run at the $1370/$1400 level this is year on the cards.  Gold in Australian dollars has broken out on the upside and made historic highs. Australian gold producers outperformed in December but have since corrected in recent days, however I expect further upside in the months ahead if the A$ gold price can maintain upward momentum with margins expanding to record levels for the gold producers.

WTIS

The energy markets have fallen very hard, but OPEC has cut production. We may well have seen prices bottom out already. Saudi Arabia seems intent on cutting production further, and has said that longer term, the oil price needs to be at around $70/$80 a barrel. The kingdom has already cut daily production to 7.1 million barrels and is intent on driving prices back up. The Saudis are focused on cutting back production before the 15 January deadline. This is while the US is not looking to grant more waivers for Iranian oil imports after the reimposition of sanctions. Oil’s reaction on the downside seems excessive and we anticipate a counter rally, particularly as OPEC supply cuts begin to kick in this month. A recovery in the oil price will provide a boost to energy sector, which will provide a tailwind for the US, UK and Australian indices.

 

Sector

12 Month Forecast

Economic and political predictions 2019

AUD

70-75c

Currency management by central banks is likely to be another key theme for this year. We expect the RBA will play its part and seek to keep a lid on strength in the A$ given some of the economic risks present.

The A$ is back at US$0.72. I still think that the risks are to the downside for the A dollar this year, which will support companies with offshore earnings (including the Aussie gold producers), and likely drive further inbound M&A activity.

Gold

1240-1460

After a disappointing year, gold is looking to recover and make new gains in 2019, with the help of a dovish Federal Reserve. Economic analysts are not ruling out a pause in the rate-hike cycle next year.

The biggest obstacle for gold prices last year was the strong U.S. dollar, which has taken safe-haven attention away from the precious metals.

Commodities

Prefer Oil and Gas over bulk metals

Our view that the US dollar will weaken this year, should also lift commodity prices. This would all be positive for the likes BHP, Rio, South32, Oil Search, and Woodside.

Property

Hold – value appearing

Have removed tactical tilts away from this sector.

Australian real estate investment trust (A-REIT) industry is stable, except for the retail segment, which faces a challenging operating environment.

The growth in operating income will remain strong, and they expect aggregate comparable net operating income growth of 3% to 4% during the next 12-18 months

Australian Equities

5500 – 6100

Strength in infrastructure spending, business investment and export values will help keep the economy growing but it’s likely to be constrained to around 2.5-3% by the housing downturn and a negative wealth effect on consumer spending from falling house prices. This in turn will keep wages growth slow and inflation below target for longer.

Bonds

2.2% -3.5%

The key risk that needs to be watched and managed for fixed interest investors is interest rate risk, or more specifically, duration in a rising rate environment. In the case of Australian fixed interest, whilst we think this risk is relatively low given the Reserve Bank of Australia (RBA) is likely to be on hold over 2019 at a cash rate of 1.5%, Australian bond yields can lift in the short term on the back-rising US yields. This creates both a risk that needs to be managed, but also great opportunities to add duration to capture higher yields that may not ultimately be sustained in markets.

Cash Rates

1.5%

Also supporting the wider market this year will be the RBA likely maintaining the status quo, with one solitary rate rise later in the year at best. This is also with several other headwinds to balance. Activity in a few areas is softening, not least of which being construction (I have regularly said we are well past the peak) – the Australian Industry Group Australian Performance of Construction Index recently fell to a 5 ½ year low. Manufacturing activity has also gone backwards for the first time in more than two years, according to the Australian Industry Group.

Global Markets

America

S&P 500

Low 2480 – High 2940

Underweight

US stocks should end 2019 in the red. Not only are they among the most expensive in the world, but a likely turn in US business, consumer and investor confidence and the potential for more monetary tightening set up a challenging environment.

We expect US corporate profit growth to more than halve next year from this year’s 23 per cent, the biggest drop among major regions, also as the effect of Trump’s tax cuts wanes. More importantly, long-term corporate profit expectations for American firms are likely to be downgraded for the first time in four years from the current level of 16.5 per cent, a 20-year peak.

Europe

Neutral hold

We see limited upside for Eurozone stocks this year. We are cautious over the region’s economic prospects, not least because the Italian debt crisis has potential to escalate in the coming year at a time when the region’s economy is already slowing down. That said, investors should be able to uncover tactical opportunities in sectors such as financials and selective cyclical industries whose valuation has improved, such as energy.

Japan

Hold

Japan equities should have support thanks to its attractive valuation, political stability, low corporate leverage and the yen, which tends to appreciate when risk aversion rises. Other positives include shareholder-friendly corporate behaviour and central bank stock buying.

China and Emerging Markets

Buy

In the emerging world, our favourite market is China, which offers the best value among its peers at a 12-month price/earnings of 10 times.

For all the concerns about the trade war and an economic slowdown, investor pessimism towards the world’s second largest economy looks difficult to justify at a time when Beijing is taking various steps to support growth.

The People’s Bank of China is the only major central bank that is still firmly in easing mode, set to provide what we estimate to be a USD350 billion of monetary stimulus in 2019.

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