(Source: Merlea Macro Matters)

Summary

Due to the delayed easing by the Federal Reserve, many other economies will also see postponed rate reductions. This includes countries with currency pegs to the US dollar, like Saudi Arabia, and those managing inflation pressures and currency depreciation concerns, such as the UK. Japan, however, is an exception, with persistent yen weakness prompting an expected policy rate hike in the fourth quarter of this year. Meanwhile, the European Central Bank (ECB) cut rates by 25 basis points at its June 6 meeting, supported by stable inflation data and recent communications from the ECB.

United States

The Federal Reserve is likely to delay rate cuts due to a bumpy disinflation process, resilient labour markets, and easing financial conditions. We anticipate the Fed will cut rates by 50 basis points this year (in September and December), followed by quarterly rate cuts in 2025. Disinflation should resume as moderating wage growth and slower rent inflation weigh on service prices. Job gains will likely continue to moderate, with few signs of labour-market stress or widespread layoffs. However, risks such as inflation reacceleration and a higher neutral rate could lead to a more hawkish Fed stance in 2024 and 2025.

Euro Area

We expect an ongoing GDP recovery in 2024, with growth reaching 0.4% quarter-on-quarter by year-end. Euro area core inflation is expected to remain above target through 2024-2025, though services inflation should start to slow. We forecast 75 basis points of ECB rate cuts this year (25 basis points in June, September, and December) and an additional 25 basis points in March, June, and September 2025. The ECB began the full roll-off of its APP portfolio redemptions in July 2023, with PEPP tapering expected to start in July 2024.

United Kingdom

After a modest recession in H2 2023 and a rebound in Q1 2024, we expect a slow GDP recovery. Lower energy prices and base effects should help pull inflation down, though service prices remain sticky. Risks include past monetary tightening and belowaverage confidence. We anticipate the first rate cut in August, followed by quarterly cuts to a terminal rate of 3.5% in 2026.

China

Beijing is finally addressing the housing crisis, focusing on home delivery, though this will take time. The economy is rebalancing, with divergences between exports and domestic demand. Challenges include fading pent-up demand, property fallout, local government debt control, and investment in “green” sectors.

Asia

We expect gradual GDP growth improvement in 2024, driven by a sustained goods cycle upturn and steady domestic demand. Growth divergences exist, with Taiwan, India, and Singapore likely to outperform, while China and Thailand may disappoint. Core disinflation should continue, but headline inflation faces near-term risks from higher oil prices and weaker local currencies. We expect the Bank of Thailand to lead the easing cycle in Asia, starting in June. A hawkish Fed and higher oil prices could delay rate cuts. Korea’s resilient consumption may result in only one 25 basis point cut in October 2024.

India

Resilient growth and higher food inflation support an extended policy pause, with 100 basis points of rate cuts from August 2024.

Indonesia

Populist measures by the incoming government raise fiscal risks, with current account deficits widening.

Australia

Below-trend growth, rising unemployment, gradually easing inflation, and rate cuts are expected from November 2024.

Japan

Japan’s economy will likely remain on a recovery path, exceeding potential after contracting in Q1 2024. This year’s wage hikes are significantly higher than last year’s, increasing inflation stickiness through 2025. We expect the Bank of Japan to announce a reduction in JGB purchases in June 2024 and implement an additional rate hike in October 2024.

Bonds

Bond yields are climbing in May 2024 due to two main factors: shaky auctions and rising uncertainty about Federal Reserve rate cuts. Shaky auctions, where government bonds see weaker demand, force the government to offer higher yields to attract buyers. This increase in yields is compounded by the uncertainty surrounding the Federal Reserve’s interest rate policy.

Earlier this year, bond investors were optimistic. High yields offered attractive income, and many expected the Fed to cut rates multiple times, which would boost bond prices. However, persistent inflation and a robust economy have disrupted these expectations. The Fed has indicated that rate cuts will only occur when there is clear evidence of inflation declining. This has led to a rise in bond yields as market participants adjust their expectations.

Currently, the market does not foresee a significant bond rally like late 2023. Yet, there are still opportunities in fixed income. Short-term bonds are particularly attractive, and now may be a good time to lock in higher yields, even if rates stay steady for a while.

Since January, the yield on the 10-year Treasury note has been climbing, reflecting stalled improvement in inflation and the likelihood of sustained higher interest rates. Although recent Federal Reserve communications and positive jobs data have offered some relief, the bond market remains volatile.

Weak bond auctions and uncertainty about the Fed’s rate cuts are both contributing to rising yields in the bond market.

Fed Chair Jerome Powell has emphasised the Fed’s readiness to keep rates high to combat inflation, which significantly influences bond yields and investor strategies. Persistent inflation in early 2024 and stronger-than-expected economic data have led markets to adjust their expectations from multiple rate cuts to just one or two, or possibly none. This has resulted in higher bond yields and increased market volatility.

Despite recent losses in bond indices, we believe that the outlook for significant rate cuts is limited. High yields offer a unique opportunity for investors to earn attractive income, and bonds remain a valuable tool for diversifying portfolios and mitigating equity market risks.

By focusing on bonds with shorter durations, which are less sensitive to interest rate changes, to navigate the current high-yield environment. While longer-term bonds carry more risk due to potential rate changes and federal deficit impacts, short-term bonds offer a safer alternative with decent returns. Investors should also consider the fundamental proposition of fixed income: reliable income. High yields now present an opportunity to secure attractive returns over the next several years, even if bond prices do not appreciate significantly.

In conclusion, while the bond market faces challenges from persistent inflation and uncertain Fed policies, there are still strategic opportunities. Short-term bonds and high-quality investments can offer stable returns and help manage portfolio risk in this volatile environment.

Listed Property 

A-REITs have underperformed the broader market this year as delayed RBA rate cuts and persistent inflation weigh on property valuations. The potential for sustained higher interest rates has impacted A-REIT market performance. Despite this, Merlea remains overweight on A-REITs, believing that lower interest rates in the next 12-18 months will support property sector valuations.

Historically, A-REITs have outperformed the ASX 300 during periods of falling bond yields and RBA rate cuts. Lower rates are expected to aid A-REIT recovery, with the sector currently trading below its net tangible asset value. Positive leasing demand, low vacancy rates, and strong rental growth for high-quality assets counterbalance challenges from higher borrowing costs and valuation yield adjustments.

Near-term rental growth is anticipated to boost returns. Longer-term, falling interest rates and lower borrowing costs should generate capital gains and bolster investor confidence. Strong leasing demand is driven by surging population growth, evidenced by a record net increase of 548,000 permanent and long-term arrivals in the year to September 2023.

Higher interest rates and labour market pressures have curtailed construction activity, leading to a scarcity of high-quality commercial properties. This is especially evident in the Industrial & Logistics sector, with low vacancy rates driving 18% national rental growth over the past year. The Retail sector also saw significant rental growth due to limited new asset opportunities and high build costs.

Addressing construction challenges requires reduced costs or significant rental growth, but these may take years to resolve. Falling inflation and rising real wages, boosted by government initiatives like the Stage 3 tax cuts and increased minimum wages, support consumption and real estate demand.

The interest rate outlook, strong leasing demand, limited supply, and macroeconomic factors suggest sustained rental growth for high-quality real estate. If favourable conditions persist, A-REITs could see improved returns in the medium term, following a challenging period for the sector. Recent positive valuation trends in the Industrial & Logistics sector indicate a potential stabilisation and recovery.

Australian Equities

In the first four months of 2024, markets reached new highs but have recently eased as investors consider how central banks will manage interest rates amid persistent inflation.

The Australian economy shows modest progress and resilience, with expectations to avoid a recession in 2024 and economic growth around 1%. Domestic factors, such as low productivity and high unit labour costs, are driving inflation. Inflation is expected to fall to about 3% by the end of 2024. Business confidence has improved, and the Federal Government is running a modest fiscal deficit to fund investments in key sectors.

When combined with the personal income tax cuts, and cost-of-living measures currently being rolled out by state governments, we see a renewed threat to the core inflation.

Lifting trade restrictions by China on Australian exports could boost Australia’s economy. However, China faces headwinds, including a prolonged property downturn. As a major commodities producer, Australia could benefit significantly from a recovery in China’s domestic demand in 2024. Increased infrastructure and manufacturing investment in China may cushion the impact of its housing downturn.

Australia’s economic growth has moderated due to policy tightening, but inflation remains elevated. Factors like rising real household income, a resurgent housing market, and investments in key sectors are contributing to this. Despite a recent rise in the unemployment rate, strong wage growth and low productivity have slowed the disinflation process. Inward migration has also increased housing demand and rent prices.

Inflation is expected to ease to 3% by the end of 2024, at the high end of the RBA’s target, and may decrease further in 2025. The tight labour market suggests a slower path to easing rates. The unemployment rate is expected to rise to 4.6% by the end of 2024, with the RBA likely keeping its policy rate steady for some time.

Australia may be one of the last developed countries to cut rates, as its inflation peak was lower than in the US and Europe. If inflation moderates, the RBA might ease monetary policy in late 2024, potentially lowering the cash rate from 4.35% to 3.85%, eventually settling between 3%-4%. Interest rates may remain higher than the record lows during the COVID-19 pandemic. Positive real interest rates could provide a solid foundation for long-term risk-adjusted investment returns over the next decade. The spread between global equity and bond returns is expected to be 0-2 percentage points annualized over the next 10 years, suggesting more balanced returns for diversified investors.

Global markets

The markets seem to be taking a breather after a prolonged period of bullish activity. Sentiment has been optimistic since October, but it now appears overstretched due to various emerging risks, including persistent inflation, geopolitical tensions, and technical indicators reaching critical levels.

Despite this short-term pause, the overall outlook for risk assets remains positive in the medium term. Economic fundamentals are strong, with signs of improvement and a potential regression into a mid-cycle phase. While inflation remains a concern, we believe it won’t prompt overly restrictive policies, and rate cuts may still be on the horizon, albeit potentially delayed.

Additionally, supportive fiscal policies, especially in the US, and signs of stabilisation in China’s economy provide further support. European mega-cap earnings have surprised the market positively, benefiting from lower valuations compared to their US counterparts. Furthermore, the possibility of imminent rate cuts adds to the market’s tailwinds.

America

The US is set for a tumultuous year politically, with one of the most divisive elections in history drawing closer. The debt situation continues to worsen for the US with neither political party likely to change the fiscal trajectory anytime soon. Rising bond yields and expanding rate differentials favouring the US are short-term band-aids otherwise masking what are deteriorating fundamentals. International capital flows (that have favoured the US for so long) appear to be now reversing.

The latest data showed that the American economy is cooling, which weighed on loftily priced tech/growth stocks. The second estimate came in line with market expectations. However, consumer spending slowed more than initially anticipated (2% versus 2.5% in the advance estimate), due to lower consumption of goods and services.

Government spending was revised slightly upwards. Finally, pending home sales slid 7.7% monthly in April, falling by much more than the expected 0.6%. The impact of escalating interest rates throughout April clearly dampened home buying as more inventory entered the market. The key non-farm payroll data print was hot, coming in well above consensus at 272,000 new jobs, which pushed back on the September rate cut. The Fed will be hard-pressed to commence easing in September, with wage growth still very high and feeding back into inflation.

There four issues that will affect the Us markets for the rest of 2024:

• Inflation Trends and Fed Policy Headline inflation is stubbornly above 3%, with core personal consumption expenditures (PCE) at 2.8%, unchanged since December 2023. The Fed is in a tough spot, as the current rate over 5% is unsustainable, but without clear evidence of decreasing inflation, rate cuts may be delayed.
• Consumer spending has been the key driver of the economy, supported by strong wage growth. Despite a slowdown in economic growth in early 2024, consumer spending remained strong. The resilience of consumer spending is critical for the economy and markets.
• Corporate earnings have mostly met or exceeded expectations, with a positive outlook for the rest of 2024. Stock valuations are high, reflecting optimism about the future.
• External risks, such as global tensions like the Israel-Hamas conflict and upcoming elections, could affect investor sentiment.

Europe

The markets have reacted negatively, with the CAC and euro falling due to European election turmoil and France’s snap election call. Markets dislike uncertainty, especially with far-right parties gaining ground in Austria, Italy, and Germany. However, these reactions usually fade quickly. A rising far-right influence might lower the long-term EUR/USD forecast due to potential economic damage. The ECB cut its key rate by a quarter point to 3.75%, starting a multiyear rate-cutting cycle without a set path. With sluggish eurozone growth and easing inflation, officials aim to avoid overly restrictive monetary policy, but looser policy could increase services inflation. Policymakers emphasized a data-dependent approach, deciding on future moves on a meeting-by-meeting basis.

European shares, already near record levels, dipped briefly after the ECB’s cautious comments on inflation and its expected rate cut trajectory. The ECB had just cut rates, as expected, and traders focused on future rate cut cues for 2024. The ECB’s raised inflation forecast reduced hopes for a further cut in July, which had a low likelihood of about 10%. President Christine Lagarde did not confirm a rate-cutting trajectory for the rest of the year.

Earnings estimates for European equities have risen by 2.8% since the start of the year, and the valuation multiple (P/E) has increased from 13x to 13.8x, slightly below the historical average of 14x. Financials and telecoms, sensitive to rate cuts, and technology and industrial stocks, sensitive to economic growth outlooks, have gained the most this year.

The prospect of a more favourable macro environment should benefit equities in general, and cyclical sectors such as industrials in particular. Staples and Residential Real Estate offer the biggest upside with regards to interest rate sensitivity.

The United Kingdom

The BoE plans to cut its key interest rate four times this year, but monetary policy will remain restrictive. Despite easing economic headwinds, the labour market will stay tight post-Brexit, keeping the BoE’s rate high compared to other central banks.

The parliamentary election in late 2024 may end over 14 years of Conservative rule. Local elections in May will give early indications of voter preferences, but high public sector debt and the memory of the 2022 budget debacle limit government options. Labor is cautious, avoiding overly expansionary measures despite leading in polls.

The BoE may start cutting rates in August, though some economists predict a June cut. Inflation fell to 3.2% in March and is expected to average around the BoE’s 2% target, allowing some flexibility. However, services inflation remains high at 6.0%. A rate cut in August would align the BoE with major peers, slightly later than the ECB but ahead of the U.S. Fed.

The economy exited a short recession last quarter, growing 0.6%. While the labour market has loosened, wage growth remains strong. Economic growth is expected to slow to 0.3% per quarter until the end of 2025, with annual growth forecasts at 0.5% for 2024, accelerating to 1.2% in 2025 and 1.4% in 2026.

Japan

The BOJ is scaling back intervention in the JGB market and reducing buying deliberately to let the yield rise to arrest weakness in the yen. This should continue ahead of coming BOJ rate hikes that are likely to commence in June. Japanese banks can be opportunistically accumulated on any weakness as yields correct lower near-term. Uncertainty around the yen’s movements against the dollar has impacted the Japanese stock market. The yen recently fell to a 34-year low before rebounding due to suspected intervention by Japanese authorities.

Despite this, the trend of increasing dividends and share buybacks remains positive, reflecting efforts to maximize shareholder returns per Japanese corporate governance reforms. However, there is still room for improvement, particularly in addressing cross-shareholdings. While TSE-led reforms are helping corporate Japan become more efficient, the process is unfinished. Investor engagement will be crucial for further improvements in capital efficiency and strategic growth plans. The yen’s fall to a 34-year low has changed perceptions about the benefits of a weak currency.

While previously seen as beneficial for exporters, the weak yen is now increasing living costs for consumers. The Bank of Japan may eventually hike interest rates, potentially supporting the currency. The depreciation during the Abenomics era boosted corporate sentiment but did not address labour surplus issues.

Now, with a tight labour market, firms are raising wages, investing in capex, and increasing output driven by demand rather than currency effects. The quantity effect, as seen during Japan’s bubble era, demonstrates that strong demand can support corporate growth regardless of a strong yen. This may shift focus from exchange rates to export volumes and demand sources.

In May, Japanese equities edged up with the TOPIX rising 1.16% and the Nikkei 225 up 0.21%. Despite concerns over high valuations and cautious US Fed tones, expectations for Fed rate cuts and strong performance of high-tech stocks, especially in semiconductors, supported the market.

China

The last few years have been challenging for China, with critics arguing that its model is failing due to falling exports, high youth unemployment, a collapsing property market, and a weak stock market. Western critics suggested China should adopt a Western-style economic stimulus with lower interest rates, but this misses key aspects of China’s unique strategy. China has not adopted these measures, focusing instead on market forces, high interest rates, and long-term plans. Youth unemployment affects less than 6% of the workforce, unlike higher rates in countries like India.

Exports are no longer China’s primary focus. In the late 1990s and early 2000s, China needed export revenue to fund essential imports for growth. As the economy evolved, it shifted to importing raw materials for infrastructure projects, transforming its urban landscape. The property market’s-controlled deflation is part of an economic transition. Local governments sold land to developers to fund massive infrastructure projects. Despite challenges from over-indebted local governments and property developers, these issues are part of a planned transition, not a failure.

Western commentators often misunderstand China’s approach to its stock market and economic policies. Unlike the US, China’s stock market is not a major investment or savings vehicle, and its recent strong performance contradicts claims of economic distress.

China’s long-term strategy, outlined in the “Made in China 2025” initiative, aims to dominate new technologies. This ambition has driven significant industrial growth, making China the world’s largest car manufacturer and rapidly increasing exports of electric vehicles. China’s shift from earning dollars to using the yuan for international trade further illustrates its evolving strategy.

Global fund managers are returning to China, with the MSCI China Index climbing 23% from a January low. The recovery in the first quarter was driven by pent-up consumer demand, housing sector improvement, and policy support. However, growth momentum has slowed since April, indicating a fragile recovery dependent on policy support.

Sustaining growth will require improvements in the labour market, household incomes, business confidence, private investment, and a housing market turnaround. Real per capita disposable income growth remains below overall economic activity, and youth unemployment hit 20.4% in April. Private investment has been subdued since early 2022, with property market improvement concentrated in large cities driven by policy support. Addressing these vulnerabilities requires measures beyond short-term macroeconomic support.

China’s GDP growth is projected to grow at to 5% in 2024, led by a rebound in consumer spending, particularly for services. Capital spending in infrastructure and manufacturing is expected to remain resilient, but net exports may weigh on growth due to softer external demand and modest import growth reflecting improved domestic demand.

Emerging markets

Emerging markets (EMs) continue to face significant challenges in 2024, despite improving conditions. These include the lagged effects of high interest rates and a potential slowdown in U.S. growth, particularly in the second half of the year.

EM central banks, especially in Latin America, are expected to continue cutting rates, while those in EM Asia might start later this year. U.S. and domestic long-term interest rates have fallen, increasing issuance activity, mainly among investment-grade issuers. Growth paths will vary across EMs the remainer of 2024.

Among 18 major EMs, half are expected to see GDP growth accelerate, while the other half will decelerate. Countries more exposed to the U.S. are likely to outperform those tied to the eurozone or China. In 2023, EMs linked to the U.S. did better than those linked to the eurozone, and those with ties to China had mixed results.

Idiosyncratic factors such as weather events, social unrest, political uncertainty, and fiscal stimulus will continue to impact growth in 2024. Due to different stages of economic cycles, GDP growth in economies that were expanding above trend in 2023 will likely decelerate, while those growing below trend will improve but remain below trend.

Major risks to EM growth include a prolonged Middle East conflict affecting shipping and energy prices, and the risk of a U.S. recession impacting EMs with strong U.S. economic ties, like several Latin American countries. Conversely, a stronger U.S. economy could raise interest rates and the U.S. dollar, negatively impacting EM inflation. Additionally, heavy and divisive electoral agendas in several EMs could hinder investment due to policy uncertainty.

Commodities

The resource sector is poised to outperform in a soft-landing scenario, with markets underappreciating the tight commodity supply issue. The surge in AI technology will significantly increase power demand in the US and globally, likely leading to a renewed focus on nuclear energy, which is bullish for uranium. Super data centres in the US are considering small modular reactors to generate power, while in Australia, there are concerns about power supply security beyond the next 5 to 6 years.

Copper is repeatedly cited as a key beneficiary of the AI technology rollout. The infrastructure needed to support AI and electrification will require a substantial number of base metals, with copper and aluminium being crucial due to their conductivity. Copper supply issues are not fully recognized, and prices could potentially increase fivefold. Copper producers offer an excellent way to gain exposure to AI-driven demand. Ai’s power consumption is approximately ten times higher than traditional usage. Data centres in the US currently consume about 4% of total power, which could rise to 12%-15% by 2030. Generative AI could increase global power consumption by 1%-2% annually.

The AI wave will necessitate a mix of energy sources, including renewables, gas, and nuclear. Nuclear energy is viewed as the most viable option due to its ability to provide consistent power supply, unlike renewables which are not available 24/7. Natural gas remains an option, but next-generation nuclear technology is increasingly seen as essential to meet future energy demands.

Gold

Gold, a non-yielding asset, historically benefits from a low-interest-rate environment. Over the past two decades, gold prices have consistently risen during periods of interest rate cuts. Typically, gold and interest rates have an inverse relationship, with gold prices rising when interest rates fall and declining when they increase. For instance, between 2000 and 2003, as interest rates fell from 6.50% to 1%, gold prices surged by nearly 53%. Similarly, from 2007 to 2008, a dovish shift by the Fed led to a 29% rise in gold prices.

From 2008 to 2011, during an “ultra-dovish” stance to combat economic slowdown, gold prices skyrocketed by 152%. While the ECB’s recent rate cut initially boosted gold prices, the People’s Bank of China (PBOC) dampened this effect by halting gold purchases in May after 18 consecutive months, citing steep prices.

Despite recent speculative volatility, long-term fundamentals still favour bullion. We expect gold prices in international markets to potentially decrease towards $2,217–$2,180, influenced by continued demand from global central banks, geopolitical tensions, and strong consumption trends.

WTIS

On June 4, OPEC+ members agreed to extend crude oil production cuts through the end of 2024. The cuts had previously been set to expire at the end of 2023. Following the June 4 meeting, Saudi Arabia also announced a new voluntary oil production cut of 1.0 million b/d for July and August 2024.

Although crude oil prices initially fell following the OPEC+ announcement, we expect the extension of all voluntary cuts through [Q324] will cause global oil inventories to continue falling through [Q125] and put upward pressure on oil prices over that period.

Global oil markets face significant challenges in the medium term as structural shifts reshape demand and trade flows, while rising oil supplies may pressure prices through the end of the decade. The pace of oil demand growth is slowing due to divergent regional economic trends and the rise of clean energy technologies. Demand growth is driven entirely by emerging Asian economies, especially China and India, while advanced economies see a sharp decline in oil demand.

Non-OPEC+ producers are expected to increase oil supplies, surpassing demand forecasts from 2025 onwards. Saudi Arabia has halted plans to increase crude oil capacity, shifting focus to natural gas liquids (NGLs) and condensates to boost domestic gas supply, reflecting a global surplus in crude oil production capacity.

The rise of non-refined products like NGLs and biofuels is expected to capture three-quarters of global demand growth from 2023-2030. Refiners must adapt their product slates to meet changing demands, especially as electric vehicles reduce the need for traditional road transport fuels. Weaker macroeconomic expectations, new government policies, and investments in efficient technologies add to market uncertainties. The industry’s adaptability, proven during crises like the Russia-Ukraine conflict and the COVID-19 pandemic, will be crucial in navigating these changes.

Growth will be dominated by China and India, though in different sectors. China’s demand is driven by petrochemicals and infrastructure investments, reducing transport fuel needs. India’s transport fuel demand will rise sharply, contrary to global trends. Demand in advanced economies continues its long-term decline, dropping from 45.7 mb/d in 2023 to 42.7 mb/d by 2030.

In summary, while the global oil market faces formidable challenges, its history of adaptability suggests it will continue to navigate these structural shifts and uncertainties.

Recent trading sessions have shown a noticeable increase in global oil prices, indicating a significant shift in energy market dynamics worldwide. Given these developments, a cautiously optimistic near-term outlook is maintained for refining margins and fuels, thereby supporting crude oil prices.