Macro Matters – May 2019

(Source: Merlea Macro Matters)


Since the beginning of the year, global equity markets have staged a comeback, turning around the dismal performance of the final quarter of 2018. Year-to-date, the MSCI World is up almost 16% in US dollar terms

Notably, all major regional equity markets have kept up this pace, with the US just marginally ahead. The obvious laggard has   been Japan, where an unfavourable USD/JPY exchange rate also contributed to the underperformance. I believe that there will be more opportunities for outperformance outside of the US. This does not mean that we expect the US equity market to collapse (if it did, it would take all other markets down with it), but simply that we believe that now that President Trump’s tax cuts are over, the earnings growth differential between the US and other markets no longer warrants the wide disparity in valuations. 2019 IBES (Institutional Brokers Estimate System) consensus earnings growth figures for the MSCI US, Europe and Emerging Markets are 4.1%, 5.5% and 6.8% and price/earnings ratios for 2019 are 17.2x, 13.6x and 12.1x, respectively.

Of course, this is if earnings expectations outside of the US do not fall from the current levels and that the differential is maintained. This means that earnings revisions, which took a turn for the worse in all major markets during the last quarter of 2018, need to improve from the current levels. The rally that we saw in 1Q was nothing more than investors realising that the fourth quarter panic had caused stock prices to overshoot (on the downside) what was warranted based on fundamentals.

The global economy was weakening, but not collapsing. And the economic gloom is making the outlook appear even more ominous, namely a hawkish Fed and an escalation of the US-China trade conflict. What we need now, is for an improvement in fundamentals to follow and eventually feed through to earnings.

The two sides can still strike a deal. To get there, Beijing probably needs to drop its demand that the US removes all tariffs at once, and Washington likely needs to reduce its proposed checks on China’s technological ambitions and downsize its demands for Chinese imports of US agricultural and energy products. 

A good part of the global macro slowdown that we have witnessed in recent months has been due to the direct and indirect consequences of the trade dispute (as companies have either been directly impacted or have become more cautious with their spending plans). Moreover, the trade deal does not need to be perfect, and it most likely won’t be. It just must be good enough to scrap the tariffs that were imposed over the course of 2018. Any deal is likely to leave a lot of questions unanswered in the short term, whether they relate to the actual execution, the future of technology transfers, or any follow-through on a US-Europe trade deal. That said, none of those questions will have answers that could possibly be as bad for the global economy as the prospect of 25% tariffs on all goods traded between US and China

Global GDP Growth and Trade Volume

We need to see the world central banks to continue to remain supportive, in other words, dovish. This is particularly important given the weak global macro backdrop. The Chinese government to continue to gradually stimulate the domestic economy, managing the balancing act between stimulus injection and debt management. We expect that China’s economic growth will continue to weaken structurally, but if the government can manage the soft landing, investors will still be able to find compelling opportunities in the structural changes that are taking place in the country’s economy. Based on the above, Merlea maintains its neutral outlook on developed markets, while its outlook on emerging markets has turned positive. This is owing to the change in the monetary situation in the US and the move to constructive US-China relations. For investor sentiment to remain upbeat, markets now must show signs of improving fundamentals. If the pace of improvement is not limited to the US and other markets manage to maintain at least the same momentum, valuations in emerging markets, Japan and Europe will offer more compelling opportunities.


The rallies in G10 bond markets were spectacular, as much for their magnitude as for their incredibly low yields. While the

Japanese JGB and German Bund markets saw their 10-year yields drop through zero, the U.S. 10-year Treasury rallied down

to the Fed funds rate, completely flattening the yield curve. And the bond rally was hardly limited to the G3—its breadth also

included most developed markets and many EM rate complexes. And yet, despite the low-rate environment, economic growth in many, if not most, of these countries remains subpar and inflation generally remains solidly contained, often at below target levels. Whether it is to counter high debt levels, aging demographics, or something else, economies appear to need incredibly low rates in order to avoid the undesirable outcomes of further decelerating growth and disinflation.

Many G10 Bond Markets Are At or Near All-Time Lows.

We believe investors ‘search for yield will continue to benefit markets that stand out globally, i.e. U.S. Treasuries, while others, such as the Canadian and German markets, could experience relatively minor, short-term corrections.

Inflationary pressures in DMs remain moderate despite accommodative central bank policies. DM central banks

are departing from unconventional operational tools and, in some cases, have reduced support. Financial conditions remain easy across DMs, in our view, supporting risk assets.

Listed Property

A-REITs delivered a markedly strong quarter in March, easily outperforming the broader Australian equity market. A-REIT

pricing continued to benefit over the quarter from falling bond yields and investors moving back into defensives

on the back of a more cautious macro backdrop.

Performance in the direct property market remains robust with strong investor demand, especially for Sydney, Melbourne

office and industrial assets. This saw direct property deliver returns of +10.3% (PCA/MSCI Index, Dec-18) and unlisted

property funds return +9.1% (MSCI/Mercer Index, Mar-19) over the year. We expect returns to trend lower in the year ahead

as capital growth wanes and returns revert toward income, Returns are increasingly divergent at the sector level. The

residential and retail sectors have lagged as fundamentals have deteriorated, while Sydney/Melbourne office (robust rent

growth) and industrial (ecommerce trade) have outperformed. Retail returns are being affected by weaker income growth,

rising incentives/capex and write downs in the values of poorer assets.

Office and industrial funds continue to deliver double digit returns boosted by further cap rate compression and rising rents.

Diversified funds have been held back by their retail exposures.

AREITs tend to outperform in periods where market expectations of volatility are high. The strength of this relationship appears to have increased in recent years, suggesting the defensive characteristics of AREITs have been in demand It’s also worth appreciating the increase in correlation over the last 10 years, when AREITs have been increasingly sought after against a backdrop of expected market volatility.

Australian Equities

The big event over the past week was the Australian Federal election, with the Liberal Party coming from behind in the polls to secure an unexpected win. Not many saw this one coming, the election win by the Libs will be well received by the markets with a range of issues that had been causing consternation amongst investors, such as changes to franking credits through to negative gearing, pushed to the side-lines. Once again, we have seen that anything can happen in politics, and the pre-election polls in Australia were confounded, with the Coalition not only retaining power – but set to form a majority government. The reality is that that while consumers are facing challenges, and the property market has been going backwards, the economy overall is in reasonable shape, and the Liberals have made a reasonable case for it continuing to do so, while committing to ‘invest’ in areas which will arguably help make Australia a better place to live. Getting in a ‘punchy’ early budget also helped, and with $158 billion in tax cuts set to be soon passed through Parliament. The Australian market typically does well in the immediate period after an election as uncertainty is resolved, and the win for the Coalition, will further confound those calling for a meaningful May correction. Investors like the result, with billions of dollars of franking credits sitting on company balance sheets no longer at risk. This should bolster support for dividend heavy stocks including Telstra and the banks. Shareholders in the likes of BHP, Rio, and FMG have of course already had the windfalls from special dividend payments, I think there is plenty of scope for ‘balloon’ special dividend payments across the corporate sector. The ASX200 broke out to new medium-term record high of 6476 levels that have not been seen since 2007/2008. Markets were always going to be much happier with the ‘devil they know.’ Another big positive is that the government will be much more stable, ruling with its own majority, and with destabilising internal factions now gone.

Global markets


The US economy, while not immune to a global growth slowdown, is decelerating mostly due to fading fiscal stimulus and the effects of the previous interest rate hikes. However, its growth is resilient compared to other regions, thanks to a strong labour market and rising wages which lift consumer spending. The recent inversion of the yield curve, however, raises risks for a downturn in 2020. The Federal Reserve has put rate hikes on hold, and the fed funds futures curve is suggesting a high probability of a rate cut by year end. The US has raised tariffs on USD 200 billion of imports from China from 10% to 25%, with additional tariffs still being threatened on a wider range of imports. The costs are set to be borne by consumers, as US companies competing with China on tariff-impacted products have hiked their prices correspondingly, putting upward pressure on inflation. The direct effect on growth may be relatively limited given the size of the US economy: the USD 74 billion of tariffs announced so far amount to 0.35% of US GDP. However, there will also be potentially meaningful indirect effects, through financial conditions and business confidence. We continue to expect some form of resolution, though the timing has likely been pushed back. With some fourth-quarter headwinds, notably central bank policy, having been addressed, trade wars now appear to be the key driver of risk sentiment.


In Europe, the picture is more mixed, but here we also see signs of a turn with industrial production in Germany and across the region levelling out over the past three months while the manufacturing PMI’s have bottomed out. Provisional

Eurozone GDP came in at 0.4% in the first quarter, after just 0.1% in Q4. The one-off factors which depressed activity at the end of last year (tighter auto emissions standards, the gilets jaunes protests, low water levels in the Rhine, etc.) have faded, allowing growth to resume.  European picture is improving and allowing recession talk to fade. Alongside these positive signs, central banks have been following the Fed in moving toward an easier monetary stance.


British PM Theresa May has announced she will be stepping down as leader on June 7, sparking a leadership race currently led by former London Mayor and hair icon Boris Johnson. As a firm Brexiteer, with his views (often) predating the Brexit campaign by more than a decade, Boris has made it public that he is willing to allow a no-deal Brexit. As such, the odds of Brexit with a deal have fallen in favour of either a second referendum or a no-deal Brexit, likely because of the risk of a motion of no-confidence from pro-EU Tories triggering an election. Trailing Johnson are former Secretary of State for Exiting the European Union Dominic Raab and Environment Secretary Michael Gove; both nominally Brexiteers who have made a concerted effort to reiterate their pro-Brexit stance since May’s announcement. Despite the polarised odds, May’s resignation does provide a stronger case for a Brexit deal, with a broad willingness to accept a no-deal Brexit which would tilt the balance of power in favour of Britain.


Japanese industrial output declined unexpectedly in March, as the figures released in April showed, thereby suggesting that the economy has contracted in the first quarter. With growth sputtering, speculation is rising that Prime Minister Shinzo Abe will postpone for the third time the scheduled hike in the VAT from 8 to 10% in October this year.

In bilateral trade talks, the US is threatening to impose automobile tariffs as high as 25%. These have been postponed. A US priority is to gain a larger access to the domestic Japanese agricultural markets. The Japanese government is

unlikely to grant any concessions on agriculture ahead of Upper House elections scheduled for July. A quick, limited deal doesn’t seem likely, increasing the risk that the tensions push the Japanese economy into a technical recession.

The core-core inflation index excluding both energy and fresh food – the gauge preferred by the Bank of Japan (BoJ) – was again stable in March at 0.4% on a yearly basis, far below the ambitious target of 2.0%. For the third time, the central bank has clarified what it means by an “extended period” in which to keep interest rates low. It has now promised not to hike interest rates until at least Spring 2020. As no-one is expecting a rate hike next year, this move is unlikely to make any difference to the economy. Ironically, the BoJ has adjusted its own projections for inflation to 1.6% for the 2021/22 fiscal year, signalling it doesn’t believe it will be able to reach its target of 2.0% over the medium term.


China’s economy showed signs of stabilisation by growing at a steady rate of 6.4% in the first quarter. It defied expectations of a further slowdown, with industrial production improving markedly. Moreover, consumer demand appeared to improve. Fixed-asset investment increased as well, as new road, rail and port projects gathered steam.

Signs of stabilisation were confirmed by the Caixin General Manufacturing PMI, which pointed to continued growth in April, albeit

at a lower level. The export sector showed signs of recovery as well, illustrated by the strong rebound in new export orders.

All in all, it is probably too early to conclude that a definitive turning point has been reached. More modest stimulus by the Chinese

government is to be expected, including a further lowering of the reserve requirement ratio for Chinese banks. Earlier signs that the US administration was eager to close a trade deal with China shortly, by dropping some demands, were blown away by President Trump tweeting that he plans to increase a range of tariffs, and even wants to impose new tariffs on imports not already covered. This puts pressure on a new round of talks in May. A final trade agreement, which of course cannot be more than a temporary truce while negotiations continue on a host of subjects, will be sealed by a personal handshake between Trump and Chinese President Xi Jinping. It’s too early to say whether this is will be in the short term.



U.S. stocks were in part to blame for selling pressure in the precious metals markets this month. Still, safe-haven metals bulls are watching some elements that are not quite on the front burner of the marketplace but may be soon. August gold futures were last down $6.50 an ounce at $1,282.70. July Comex silver prices were last down $0.24 at $14.315 an ounce. There are several matters on the minds of traders and investors. The U.S.-China trade war continues with no agreement in sight and both countries appearing to dig in their heels as a trade agreement anytime soon appears unlikely. European elections produced gains in the populist parties in the U.K., while Greece’s prime minister said he will call for a general election to lower taxes. It seems that every couple of years, during the summertime, that political turmoil in the European Union moves closer to the front burner of the world marketplace. President Trump downplayed recent test missile launches from North Korea and has also been quieter on the U.S.-Iran stare down. However, these two issues could quickly heat up.


The oil price is still slightly below whereat was a year ago, hence still moderating overall year-on-year price changes.

However, it might soon start to be a positive contributor to inflation, adding one more factor to a potential inflation surprise. In any case, the consensus was not for the oil price to rise as fast and as high as it already has, and this is another factor to take into consideration.

A potential headwind to domestic demand is the rise in the oil price which has rebounded this year. This reflects a combination of the inventory building and the impact of the US ending sanctions waivers on purchases of Iranian oil.

If sustained at current levels, oil will add to inflation later in the year. The risk to activity would be that consumer spending slows in response as real incomes are squeezed. Our forecasts for global activity are likely to move in a

stag-factionary direction as a result. Long run inflation expectations have risen in the inflation market and the Fed will also be alert to any signs that inflation expectations are rising in the wider economy, potentially pushing up wages.

Sector 12 Month Forecast Economic and political predictions 2019




AUD/USD appears to be stuck in narrow range ahead of the Reserve Bank of Australia (RBA) meeting on June 4, but fresh developments coming out of the central bank is likely to shake up the near-term outlook for the Aussie Dollar exchange rate amid bets for a 25bp rate-cut




The sole exposure within commodities continues to be our position in gold which we view as complementary to the other risk mitigating assets in the portfolio, especially considering the low interest rate environment.

We use gold in portfolios both as a diversifying asset and more tactically when we are concerned that risk assets may underperform.




Prefer Oil and Gas over bulk metals

Raw materials are no longer significantly undervalued and further price increases will require data showing better demand and tighter supply, we believe that commodities have now reached a level where they are no longer significantly undervalued relative to their current fundamental.



Hold – value appearing

Have removed tactical tilts away from this sector

REITs have a history of performing well during the late cycle of an economy. “Late cycle” means the tail end of a growing economy, when it has not quite become a recession yet. looking ahead for the Remainer of 2019 we see the listed property market offering investors relatively stable returns, with some positive factors offsetting some of the negatives, to give minimal capital growth. In this environment, we see most of the returns that investors can expect coming from distributions.

Australian Equities


5500 -6600


Rebalance to defensive and industrial sectors.

Domestically, geopolitical tensions and a soft housing market was seen in recent expectations where annualised GDP growth to June 2019 was lowered to 1.75% (previously 2.5%).

Weakening household consumption as a result of sluggish wage growth was the key factor, with households finding it increasingly difficult to pay down debt and, as a result, have shifted their spending habits.

The RBA does anticipate a gradual improvement in consumer spending as growth returns to household income and the housing market stabilises.

We believe the housing market has now stabilised




Australian bonds


Our preference for higher quality, liquid opportunities translates into our preference for short duration bonds, which offer an attractive risk-return trade off in the context of a flat yield curve.

Although spreads have tightened significantly since the beginning of this year, we believe investment grade bonds will continue to earn some carry and thus outperform low yielding government bonds, specifically in Europe.

The US Federal Reserve’s accommodative stance and a weakening US dollar should continue to provide some relief to the largely dollar-denominated emerging markets (EM) debt. Following the recent rally in riskier assets, high yield bonds look quite expensive and spreads are tight by historical standards.


Cash Rates



Labour markets, widely believed to be the key indicator to the RBA’s monetary policy, softened over April with the unemployment rate gradually rising to 5.2%, with full-time employment dropping ~6k whilst part-time employment increased ~28k. This saw the participation rate tick up to 65.8%. This sent treasury yields falling with tenors compressing across the board and 3-year and 10-year government bonds reaching record lows of 1.10% and 1.53% respectively (consensus expectation is for a 50bp rate cut this year).
Global Markets



Under weight

Manufacturing output has surprised to the downside year to date and will be restrained by excess inventories and soft external demand.

• Residential investment has declined in recent quarters. Mortgage rates are down from their highs, and demand for housing should be supported by the strong labour market, limiting further downside risk.

• Core inflation, which excludes food and energy prices, has slowed recently but should trend close to the Fed’s 2% target.

• The Fed is aiming for a neutral monetary policy stance. In our view, we do not expect any rate moves until the end of 2019

• With support from fiscal and monetary policy fading, further escalation of trade disputes or another government shutdown

could pose a more serious threat to the recovery.





Prefer exposure to Germany

Activity is set to continue to stabilise, supported by increasing disposable real incomes and some fiscal stimulus measures, while trade remains the key risk. The ECB is still in a wait-and-see mode until more clarity emerges from the global trade spat. We think the central bank may start raising rates in March 2020, unless global trade tensions intensify substantially.

In Germany, the fiscal stimulus measures should help stabilise the economy. In France, President Emmanuel Macron’s reforms and fiscal stimulus should start to help stabilize GDP growth as well. Growth in Italy should continue to stabilise following the budget agreement with the European Commission and stabilising European growth. Spain is still growing strongly, but the momentum is likely to continue to normalise.




Buy on news of the US and China trade deal

Japan is set to play catch-up, having been one of the weakest equity markets so far in 2019. Since the start of the year, Japanese are up about 3%, compared to nearly 12% for global equities and almost 14% for the S&P 500.

The rising trade tensions between the US and China have had a more adverse effect so far on EM and Japan.

Uncertainty about the impact of trade negotiations on global growth is likely to weigh on sentiment in the near term. But assuming the risk scenarios we are monitoring do not materialize, we believe EM and Japanese equities offer the best upside.




Buying on Pull back

China and Asian emerging markets

Emerging markets equities should benefit from attractive valuations and increased appetite for riskier assets driven by optimism around trade tensions and better economic data out of the region

We expect fiscal and monetary easing in China to counteract a slowdown in the region and limit downside risk to earnings expectations. Trade tensions still pose a risk but will likely dissipate amid hopes for a breakthrough in trade negotiations between the US and China.



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