Merlea Macro Matters – March 2018

(Merlea Investments)


Summary

February will go down as the worst month of volatility for stock markets in many years and the largest drop since early 2016. The indices had a mixed day of choppy trading, recovering from selloff into the close following Jerome Powell’s speech. While the markets may have perceived Mr Powell’s inaugural address to Congress as hawkish, he said nothing that wasn’t warranted, and the reality is that the cost of money must go up with the economic recovery. Financial markets are going to have to accept this new reality and acclimatise to a higher interest rate environment.

While the market continued to digest the Fed Chairman’s address, some relatively soft economic data may have alleviated and offset near term concerns. I still believe the Fed will hike rates four times this year (rather than the three already flagged to the market) but this view is not consensus yet with only a smaller probability priced in to the US yield curve. Global equity markets experienced a 10% correction, (last significant sell-off was the Brexit referendum in June 2016), following a bond market sell-off.

The US 10-year yields increased to levels not seen since the beginning of 2014 and rate sensitive sectors such as Telecommunications, Utilities & Real Estate took a beating.

Whilst the global economic backdrop remains favourable, we have some concerns following recent indicators which suggest global manufacturing activity has slowed in early 2018. Should this trend continue, investors need to review portfolio allocations across defensive assets versus growth assets and consider the implications of a reversion to the mean in stretched PE valuations.

 

Bonds

Upward pressure on global bond yields looks likely to persist for now given underlying growth is buoyant, credit spreads remain low and a weak US dollar supports commodity prices and capital allocation away from the US. There are few current indicators that should worry investors about the durability of this phase of the global economic cycle. Despite the persistence of below-target inflation in the US, market expectations continue to reprice the expected path of interest rates higher.

Official projections for the Fed Funds Rate to be close to 3% by end 2019, implying a further 6 interest rate hikes over that period, remain at odds with current market pricing for a further 4 hikes only. This expectations gap requires further careful communication and guidance from the Fed over the coming months.

Any prolonged rise in UST yields should be capped however, as payroll wage growth remains low and the boost to incomes from domestic tax cuts is yet unclear. Alternatively, real yields rising rapidly from here could undermine confidence in the durability of the recovery.

Whilst the US Treasury yield curve has been flattening through the cycle of increasing Fed Funds Rate, a potential steepening of the yield curve may give market participants cause for concern and undermine risk-based valuations.

The ECB will end its bond purchase programme later this year and at the same time will face the difficult task of managing market expectations for an imminent exit from negative deposit rates. Ongoing euro appreciation and bond tapering, together with persistently low core inflation and tightening financial conditions, suggest that longer-dated market-based inflation expectations above 2% should be capped and eventually fall.

Improving global growth with inflation trending higher leads us toward lower exposure to government bonds and duration.

Valuations remain expensive despite the rise in yields, highlighted by low term premiums. Normalisation of central bank

policy is also a headwind for government bonds. Low expectations for performance potential on a total return basis.

 

Australian Equities

The market in Australia ended February on a soft note, with the ASX200 closing 40 points lower at 6,016. The 6,000-mark held though, and in what was a volatile start, the index retreated just 0.4% in the month, much better than most other stock markets. This is clear evidence of the Australian stock market decoupling from the US which as a trend is set to continue this year. The ASX200 has not been nearly as overextended on the upside (and is still 1,000 points below the 2007 peak), underperforming from a long-term perspective compared to US indices in-particular. The central bank here is also much further behind other major central banks in terms of rate tightening. I think that the higher level of inflation that is coming globally will be good for Australia’s key commodity and financial sectors. The local corporate earnings season has also been strong for the most part, which is another positive indicator.

 

We see the property market slowing down – but stabilising. It is in fact thanks to the RBA and APRA for reigning in what was becoming a very excessive and speculative bubble. The clamp down and restrictions on banking sector lending to developers and investors effectively “took the punch bowl away from the party before things got out of control”. Without their intervention (led by former Governor Glenn Stevens) the property market would most probably have ended in tears. It hasn’t and now we are passed the danger point, it probably won’t – but what awaits is more than a few years of consolidation with prices doing nothing. I think the state of the consumer will also continue to weigh heavily on the RBA’s minds, and will be a key reason why the cash rate is going to stay where it is for the foreseeable future.

A healthy employment market is a positive, but it will inevitably take time for wage growth (which has come in above 1% for the third quarter in a row) to flow through to consumer pockets.

In line with an absence in wage growth, low inflation is a key feature holding the RBA back from raising rates. This is running below 2%, although the central bank expects the mark to be breached during 2018. The RBA is clearly cautious, and like other global counterparts, when inflation does get going it will likely take the central bank off guard. This may well be a 2019 story in Australia’s case though. There are also plenty of things ‘going right’ for the economy, not least of which is the revival in the resource sector.

Bond markets, which are forward-looking in their pricing, are clearly telling us that the prospects for Australia’s economy are expected to be weaker than the U.S., at least for the next few years. For the first time in 20 years, short-term bond yields in Australia are approximately equal to, and arguably going to move lower than, comparable rates in the U.S., with the 2-year government bond in both countries offering a yield of approximately 1.77% as at 21 November. Investors should not underestimate the significance of this change. In this environment of declining or negative interest rate differentials, we would expect the Australian currency to have fewer global supporters as the historical carry advantage evaporates further.

Australian companies generally are doing well, with gross operating profits up 2.2% in the fourth quarter, the second largest surge for the period on record. Australia recorded a trade surplus of $1.1 billion in January, with exports rising 4% and imports off 2%. This was a big turnaround from December’s $1.1 billion deficit, and economists had been expecting a much smaller surplus of less than $200,000. Clearly the currency remains an important part of the picture.

 

Global markets

America

United States equities suffered two blows last week. The first was Fed Chair Jerome Powell’s debut testimony to Congress, which warned about the risks of “an overheated economy.” Second, President Trump announced stricter-than-expected tariffs on US steel imports. The result was three consecutive days with declines of more than 1% for the S&P 500. But while risks have been increasing, we believe stocks can resume their upward trajectory while 10-year US Treasuries remain attractive. On monetary policy, Powell later clarified that he does not yet believe the US economy is overheating, and there is no clear evidence of wage acceleration. The Fed’s favorited inflation gauge, core PCE, held at 1.5% year-on-year in January. On trade, it remains possible that the US will water down steel tariffs, especially if there were politically-targeted retaliation from trading partners.

Pushing all of this to one side, we can make the following observations. The Trump Administration strives to deliver on what it has laid out as its mandate.   This was all flagged to the “rust belt” during the election. Rightly or wrongly – many politicians lie to get elected and fail to deliver on what they have promised. Trump has remained consistently true to what he has promised, and he is definitively pro-business. I believe US “Big Business and the corporate sector” will ultimately see Donald as having “their interest in mind” and this will further boost sentiment on Wall Street one the dust settles – even though the tariff policy is totally flawed.

A report from the Institute of Supply Management showed a slight slowing in the pace of growth in the service sector in the month of February but was still strong and above forecast. The non-manufacturing index dipped to 59.5 in February, down from 59.9 in January. The forecast was for 59.0. The modest decline was partly due to slowing job growth in the service sector. A separate services sector PMI from HIS Markit rose to 55.9 in February, up from 53.3 in January.

The unemployment rate is at its lowest level in 17 years, and still job growth continues to chug along at a solid pace. More workers are starting to voluntarily quit their jobs to take new jobs. And wages are starting to inch higher, too. For a fifth month in a row the jobless rate remained unchanged at 4.1%, a seventeen year low.

In every economic cycle, there’s a point where the good news just can’t get any better, perhaps the U.S. economy is there now? It’s true, the economy is on its healthiest footing in years, and that strength coincides with more robust growth abroad, as well. For those reasons, investors are starting to worry increasingly that inflation could pick up, which could eat into corporate profits, and as a result, pose a headwind to stocks.

 

Europe

European Central Bank’s (ECB) decision to keep rates unchanged was expected, but supplementary commentary ditched the phrase indicating the ECB was “prepared to increase the size of its asset purchase program if necessary.” This appears to be the first steps along the (long) path to a normalisation of monetary policy. Broader policy remains unchanged, the ECB said it could still “extend its 2.55 trillion euro ($3.16 trillion) bond purchase scheme beyond September if needed” but skipped a reference to “bigger purchases” – which is clear signal that the central bank remains on track to end a three-year-old stimulus scheme before the end of this year.

On a mixed note, ECB President Mario Draghi said the Eurozone “could even grow faster than now expected and the biggest risks were a global trade war and efforts to ease bank regulation, another US policy initiative. The outlook for growth confirms our confidence that inflation will converge towards our inflation aim of below, but close to, 2 percent. At the same time, measures of underlying inflation remain subdued and have yet to show convincing signs of a sustained upward trend. Our mandate is in terms of price stability. Victory cannot be declared yet.”

The Euro initially rose on the removal of the phrase, but soon fell back as ECB forecasts indicated inflation is likely to remain below the targeted 2.0% over the next few years. The forecast for 2018 inflation was reaffirmed at 1.4% and the projection for 2020 increased 20 basis points to 1.7%. The ECB projections for 2018 growth was upped from 2.3% to 2.4% while the forecasts for 2019 and 2020 were maintained at 1.9% and 1.7% respectively.

In Germany, IHS Markit data pointed to the weakest expansion in in the construction sector in 13 months in February, with the reading falling to 52.7 from a multi-year high of 59.8 in January. Both commercial and housing activity expanded, but civil engineering returned to a contraction after a brief growth spurt at the start of the year.

Japan

The Bank of Japan deputy governor nominee Masazumi Wakatabe warned against a premature exit from easy policy. Wakatabe went on to say that the BOJ “must avoid a premature exit from its ultra-easy policy and consider ramping up stimulus if needed to pull the economy out of deflation.

The merits of the BOJ’s stimulus programme “far exceeded” the costs. Central bank governor Haruhiko Kuroda unsettled Japanese markets by flagging for the first time the “prospect of an exit from accommodative policy if the inflation target is met”, which sent the yen sharply higher and pushed down interest rates.

Under the Bank of Japan’s policy framework, the focus has shifted to targeting inflation and interest rates. The BOJ now guides short-term interest rates at minus 0.1% and the 10-year government bond yield around zero percent, while allowing its bond purchases to slow significantly. This has negatively impacted profitability within the banking sector for years, but I see this era coming to an end soon.

With inflationary pressures likely to rise globally, Japan is also going to see an acceleration and this could lead to a dramatic re-rating of the Japanese banking sector which has remained depressed for decades. In economic news, Japan’s GDP for the fourth quarter of 2017 was revised upwards materially to a seasonally adjusted 0.4% from its preliminary reading last month of 0.1%.

The revision was primarily due to higher capital expenditure and inventory and implies an annualised rate of 1.6%, up from the earlier 0.5%. Japan’s economy effectively expanded more than initially estimated in the last quarter of 2017, which was due to an upward revision of capital expenditure and inventory data. This now marks the longest run of growth in 28 years.

Economists want the Japanese government to push through big reforms, such as opening the country’s labour market. That could include bringing more immigrant workers into the aging Japanese workforce and removing barriers that make it hard for Japanese women to build careers. Japan may have to wait a long time for those changes. Prime Minister Shinzo Abe, who was re-elected in October, has bigger priorities such as his desire to pursue the politically sensitive path of revamping the country’s military in response to the rise of China.

 

China

Chinese leaders began an annual planning meeting Monday and maintained the growth target at “around 6.5%” for 2018, despite surpassing that level in 2017. The country is amid a process of shifting its economy to a consumer led model, which requires a balancing act. Reigning in pollution and corporate debt are priorities. The central government intends to shrink its budget deficit to 2.6% of GDP from 3% in 2017 — the first time it has cut this ratio in more than five years. Since China plans to cut taxes this year, it will almost certainly have to achieve its budget deficit goal through reduced spending.

This is likely to weigh on the wider economy. More restrained spending by the government through heavy investment in roads, railways and other infrastructure, China appears to be trying to tread more carefully. China plans to boost its military spending by 8.1% in 2018 as it looks to further advance an ambitious modernisation drive for its armed forces. A budget document made available to the media before the opening of China’s 13th National People’s Congress (NPC) in Beijing reveals China will spend the equivalent of US$175 billion across all branches of the People’s Liberation Army. The 8.1% increase is higher than last year’s announcement, when it upped military spending by 7% over the previous year. In straight dollar terms, US military spending far outweighs China’s. The Pentagon has requested a budget of $686 billion in 2019, up $80 billion from 2017.

Meanwhile China’s ruling Communist Party unveiled a proposal to allow President Xi Jinping to rule indefinitely. Now, without checks and balances on his power, Xi will command more personal authority over policy than any individual has since the chaotic reign of Mao Zedong. Xi’s personal Chinese Dream is expected to dominate every aspect of Chinese development and will have a profound impact on the business environment of foreign companies working in the country.

The worst risk is the ticking time bomb within the nation’s financial system. Banks are state-funded and owned. This means the government sets interest rates and approves loans. They pay low interest rates on deposits, so they can lend cheaply to state-owned businesses. As a result, banks have channelled government funds into an unknown number of projects that may not be profitable. Bank loans are nearly 30 percent of the economy. One-third of these may be the “off-balance sheet” loans that aren’t regulated. They are above the lending limits set by the central government. If interest rates rise, growth slows too fast, if the government cuts back on stimulus, these loans will probably default. That could set off a collapse in China like the 2008 financial crisis in the United States. China’s leaders now walk a fine line. They must reform to remove asset bubbles. On the other hand, as growth slows, the standard of living may fall.

In economic news, the services sector slowed slightly last month, with the Caixin services PMI falling to 54.2 in February from 54.7 in January. Premier Li Keqiang, indicated Chinese authorities are relatively confident of hitting the country’s growth target despite moderate fiscal and monetary tightening. China’s exports jumped 45% year-on-year in dollar terms, far outstripping the 11% increase expected. Imports rose 6.3% year-on-year, missing the 8.0% increase expected. China had a trade surplus for the month of US$33.7 billion versus the forecast deficit of US$5.7 billion.

Commodities

Inflation globally is already on the move and we are certainly seeing this in commodity pricing. Coupled with strong demand and tight supply, I see the environment as being very conducive to further strong earnings growth within the resource sector. While metals broadly have tended to be tied to China’s economy, we think a modest deceleration in China would be unlikely to derail the supportive metals outlook, given expectations for strong, synchronous global growth. In addition, years of underinvestment will limit supply growth in the next few years, outside of some brownfield expansions. In our view, the primary downside risk for base metals is a surprise downgrade in the global economic outlook, given the strong consensus that has developed. At this point in the business cycle, we think investors should consider positioning commodities allocations to at least match benchmark targets, if not modestly exceed them.

Gold

Gold pushed back above $1,330 with the retreat in the greenback. What has been highly encouraging about the price action is the succession of higher reaction lows since early 2017. Upward pressure is clearly building and our outlook for rising inflation is gaining credibility in the markets. I think it is only a matter of time this year before the significant “$1375” resistance level that extends back to 2013 – finally gives way on the upside

Oil

Crude prices have risen on supply concerns, forecasts for robust oil demand growth and fears that OPEC will not be able to increase its production capacity. Brent futures are up at $65.70 a barrel, while West Texas Intermediate jumped to $62.65. Oil ministers from OPEC and other major producers made “bullish comments” at the CERAWeek conference in Houston – which is the largest energy industry conference.

The conference discussed several issues including Venezuela’s deteriorating oil-production profile, together with prospects for strong compliance with the OPEC-led output-cut agreement. Suhail Mohamed Al Mazrouei, the United Arab Emirates oil minister and OPEC’s current president said on the weekend that the cartel had “not discussed rolling over production cuts next year. But we feel there is still market overhang.”

The International Energy Agency also advised that ‘it expects oil demand growth to average a fairly robust 1.1% a year to 2023 and noted that OPEC would fail to significantly increase its production capacity. “One thing hasn’t changed over the past year is that upstream investment shows little sign of recovering from its plunge in 2015-2016, which raises concerns about whether adequate supply will be available to offset natural field declines and meet robust demand growth after 2020.”

WTI has continued to rally after breaking out last year although the price has been checked recently in line with other commodities and stock markets since early February. I see this rally as having only paused and that WTI will increase back to $76/$80 later this year, which bodes well for the energy sector. We are positive on Asian and Australian energy producers with a strong tilt towards LNG. Demand for LNG is going to soar in Asia, particularly with China’s crackdown on pollution emissions.

 

Sector 12 Month Forecast Economic and political predictions 2017
AUD AUD/USD is also looking a little overbought.

72c -80c

Part of the strength in AUD reflects a weak USD, improving Australian and global economies, higher commodity prices and a structural improvement in Australia’s current account deficit.

The Australian Dollar is facing increasing headwinds in the months ahead now the short-term interest rate outlook has deteriorated.

Gold With bond yields rising, gold could get a bid as a safe harbor asset, especially with price trends   improving. Geopolitical risks, and the potential for the major central banks to tighten liquidity conditions too early or too aggressively. We continue to hold gold to maintain ‘protection’

Ultimately, however, higher real interest rates tend to be a headwind for gold.

Commodities Overweight energy and materials. Improving global growth, a tailwind, especially as higher profits and improved business confidence should lead to higher capital expenditures and benefit commodities. China also continues to exhibit steady growth, highlighted by rising PMIs.

Supply-demand balance in oil has improved as well, with a trending decline in US crude oil inventories a factor.

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.

Underweight

XJP: 1300 – 1340

REITs, like many other high-dividend investments, tend to move in the opposite direction of interest rates. Higher interest rates make dividend investments less appealing to investors, causing negative pressure on their prices. In contrast, lower rates make the relatively high dividends paid by most REITs seem attractive.
Australian Equities We should begin looking at consumer staples and healthcare for equity investments.

5580 – 6600

 

The Australian market remains well supported, helped by a reporting season that saw more companies exceed expectations than miss expectations. The fall in aggregate FY18 earnings growth expectations has partially been offset by the upgrade to FY19 earnings growth expectations of 6%. Capital management continued to be highlighted with buybacks coming from leading ASX 50 companies LLC, QAN, and RIO. International businesses, RMD, CSL & TWE posted strong results, largely due to exposure to faster growing markets.

We see opportunities in energy and materials, and – on the defensive side – in healthcare. Conversely, we are cautious on consumer discretionary and industrials, the two most expensive sectors in our universe. We are also underweighting two defensive sectors (utilities and consumer staples) that are not cheap enough and have poor earnings prospects due to falling margins. Such stocks also tend to suffer more than others when bond yields rise.

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

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Ten-year Treasury yields held just below 2.9% – which is elevated compared to the beginning of the year and the highest since 2014. The ten-year yield also successfully tested a corrective spike lower to 2.7% so we are adhering to a view that yields are going higher, and sooner or later, the 3% level is going to give way on the upside.
Cash Rates The RBA cash rate rises to 3% over 12-18mth period.  

 

Global Markets
America Underweight US.

S&P 500: 2580 -3100

February helped blow some of the froth from equity valuations. Following the sell-off, the P/E ratio for US stocks has dropped to 17 times from 18.8 times at the end of January. However, just because the market is cheaper, it does not mean it is cheap or even good value. Even more worrying, this comes at a time when analyst forecasts for corporate profits appear overly optimistic. Consensus estimates show earnings rising by 19 per cent this year – a pace which our research shows has only ever occurred when the economy is growing at a nominal 5.9 per cent per year
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.

Europe’s leading indicators – while robust – are starting to plateau. We believe this is at least partly a temporary trend, prompted by the fact that European business and consumer sentiment surveys have traditionally been more sensitive to spikes in market volatility, such as the one we saw at the start of this year. Nonetheless, we think there are sufficient grounds to trim our overweight in Europe.
Japan Overweight once a correction has occurred.

Nikkei 225: 21500 – 2500

Favour Japan.

Japanese stocks look more attractive – not only compared to their US counterparts but also their European peers – in terms of both valuations and short-term growth prospects. The Japanese economy continues to pick up pace, boosted in part by overseas demand for its exports.
China Take profit. Do not sell out. Underweight.

Shanghai Index: 3350 -3650

Emerging from the latest Congress, it appears Chinese growth will slow as policymakers focus on quality growth, less pollution and avoiding economic crises. Even so, the sheer size of this economic giant in the region creates a positive ripple effect. 2018 growth likely to remain solid in China; the economy is moving very slowly toward services and the consumer.

We maintain our preference for consumer/service sectors including internet, tourism and education on the back of our positive long-term outlook for consumption demand in China.

 

Source: Merlea

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