Merlea Macro Matters – May 2017

(Merlea Macro Matters)
May 2017



Jeremy Grantham of GMO fame, one of the world’s best asset allocators, wrote in Barron’s recently that he did not think that the lofty PE ratio on the S&P500 would come down anytime soon. “Rather than being concerned about a fall in the market and a “rush to get out,” we are more focused on the upside risk attached to a scenario of the “rush to get in.” Following an immediate correction in May, after the initial preliminary damage (which we don’t think will be significant), we will soon find out the depth and conviction of the sellers, as profits are taken off the table.

However, it will be more important to focus on the reaction of the buyers this time round. We believe that buyers will quickly overwhelm the sellers following any market rout. And this is because the overall medium-term risks to investors and institutions (many of whom are effectively sidelined with too much cash and liquidity) and are only going to mount this year as markets grind relentlessly higher.

An opportunity in volatility? With volatility back at historic lows, buying the VIX could well make sense this month. It would seem that Wall Street has been lulled into a sense of complacency following what has been a solid reporting season. However, if I am completely wrong on geopolitical tensions dissipating with North Korea, then a spike in the VIX and overall market volatility is probably on the cards. Many experts are quite negative on North Korea. One well known commentator remarked that the probability of a military confrontation over the next few weeks had escalated to north of 80%. Clearly the path that North Korea is on is not sustainable, but whether the US resorts to a full blown military engagement remains to be seen. Self-preservation is a powerful motivation, and it would seem that with North Korea’s fragile grip on power, they have significantly more to lose. Trump needs a win on foreign policy, and if he were to prevail in North Korea, this would galvanise popular support on the domestic front and potentially boost his chances of fast tracking some of his home policies through Congress. All of this would be well received by the markets.


While 10 Year T Bond rates have crept up following the drop earlier in the year, they still remain range bound between 2.3% and 2.6%. For 2 Year T Bond yields it is a completely different story, and yields are pushing up against overhead resistance at the highest level in 5 years. The most probable scenario that I see playing out later this year and certainly in 2018, is for 10 Year T Bond yields to “close the gap” and rise, and in doing so, steepening the US yield curve. We were right in calling a rally in US bond yields earlier this year. The consensus at the time were pricing in more frequent rate hikes from the Fed, stronger economic data, and this was reflected in the Dollar Index hitting 105 and 10-year T Bond yields rising north to 2.7% earlier in the year. This will have implications for the stock market, but as I have mentioned in previous notes, 10 Year T Bond yields may take some time yet to stage an important inflection base, as higher levels of inflation work through the system.

Another Wall Street legend, renowned bond investor Bill Gross. Bill warned of a major secular bear market in bonds if ten year interest rates crossed the Rubicon at 2.7.

Listed Property

Australian Real Estate Investment Trusts (AREITs) continue to provide attractive yields in this current low interest rate environment.

AREITs returned 0.6% over the month of March 2017, underperforming the broader Australian equities market, by 2.7%. The Retail AREIT sector (the largest constituent of the asset class) posted a negative return over the month, consequently dragging down the overall performance of the asset class. Poor performance of the Retail AREIT sector was attributable to subdued market sentiment and slowing retail sales amidst the possible entry of Amazon as a competitor.

Valuation multiples of the AREIT sector are still high relative to long term averages. As at 31 March 2017, the yield spread for the AREIT sector above the 10-year Government bond yield was 2.03% p.a. The yield spread has fallen by close to 50bps since November 2016 attributable partly to a rise of approximately 30bps in the 10-year Government bond yield and a lower AREIT earnings yield over the same period. Yield expectations across the Office, Industrial and Diversified sectors fell during

the month of March 2017 attributable to flat earnings expectations and an increase in overall pricing of those AREIT sectors as prices are bid up on expectations of stronger longer term fundamentals and the weight of money into the sector.

As at 31 March 2017, the sector was trading at around a 23.3% premium to NTA compared to 40% premium to NTA as at 31 July 2016.

A recovery in short to medium term bond yields remains likely and will consequently impact the earnings yield potential from the AREIT sector. Current earnings yields for AREITs remain attractive relative to bond yields. The return outlook for AREITs over the next twelve months still remains positive albeit lower relative to recent years’ highs.

Australian Equities

The 6000 mark is getting closer by the day but the market will face a stern test surmounting this level, which has historically been repelled during several attempts. Our view is that 6000 will eventually give way this year with the ASX200 running through to higher levels. I remain of the view that it will be surpassed, but this may not be till June/July as we enter a seasonally weak period.

Helping the nation stay ‘lucky’ is the commodity story of course, and while the sector was softer last week, I think we are just seeing a mild correction in prices after a stellar run. We have not been in the camp which has seen commodity prices going back to their lows – with tight supply set against robust demand, and inflation also coming into the mix. Iron ore prices rebounded 4% to US$68.80 a tonne on Friday, and the appetite of Chinese steel mills clearly remains very robust.

The budget is generally pro-growth, and the commitment to spend $75 billion on infrastructure projects will certainly provide an economic boost (if somewhat overdue) in my view. Australia is finally ramping up much needed infrastructure spending that has badly lagged strong population growth. This will go a long way to helping the “lucky” country remain as such.

As investors digest the implications of the Bank levy, the political jockeying has already started. Ultimately everyone (even Scott Morrison) knows that the banks will pass the bank levy onto customers. The big banks are effectively a quasi-monopoly (albeit with some competition from the regionals) and will not simply suck up the new tax.

There is a wall of liquidity waiting for the “right opportunity” and given markets habitually disappoint, I think this will prove key to containing any downside should a correction finally occur this month. The corporate sector also generally remains very liquid, and this may be the precursor to increasing M&A as we get into the second half of the year.

Global markets


US jobs report, non-farm payrolls came in at a solid 211,000 in April. This compares to consensus estimates for 193,000 and is a

strong rebound from the 79,000 jobs created in March. The rate of unemployment fell to 4.4% from 4.5% but wage growth was

weaker than expected at 2.5% on a year ago in April.

Analysts had expected annual wage growth to come in at 2.7% last month. Nevertheless, the strong jobs result has bolstered Wall

Street expectations for a June rate rise (which would bring the tally to two rate hikes for the year). While wage growth moderated,

the unemployment rate is now at its lowest level in almost a decade. The ‘Trump’ rally though has already faded with the market quite confused now about the political direction and what will “get passed through Congress” and what will not. However what has mitigated and staved off a corrective selloff in US indices so far this year has been the rise in corporate profits amidst the better than expected reporting season. How long the market defies gravity remains to be seen, but any disappointment could well prove to be the catalyst and see the market give way on the downside. May is a notorious month for doing so.


Macron defeated Le Pen to become the youngest leader of France since Napoleon. Does this mean France is finally ready for significant reform? Being at the centre of French politics with considerable bipartisan support from both left and right, Macron is a staunch supporter of the euro and the EU. He is also a staunch advocate of reforming France and the economy.

The UK service sector PMI in April hit a four-month high at 55.8 versus 55 in March. A sustained increase in business activity and strong job creation have both underpinned the improved pace of growth.

The backdrop points to UK GDP growth increasing to a pace of 0.6% in the second quarter. UK mortgage approvals in March did fall for a second month in a row to come in at 66,837.

The French election result will galvanise support for the EU and this in turn could see the euro survive for much longer than a year or two. Timing is everything and pushing the euro sceptics back has been a resurgence in the Eurozone economy, which is becoming broader based and lifting some of the more maligned economies such as Spain, Italy and Portugal.


Japanese economic activity is accelerating. A tight labour market has been supporting wage growth. At its heart,

Japan’s growth story centers on increased inflation. While Japan has struggled with deflation for nearly 25 years, tight labour markets are poised to defeat it: March’s jobs report pegged unemployment at 2.8%, a 22-year low. The implication is that average hourly earnings could reach a 3% annualised pace by 2018 .The latest Tankan Survey is at its highest level since 2007, while real GDP growth for 2017 could hit 2%. Even though the yen has been a headwind this year, real goods exports managed to increase by 12.4% at a quarter-over-quarter annualised rate. That’s the second consecutive quarter of double-digit growth and the highest volume in nine years. Japanese manufacturing success has been driven by companies leveraging the surge in global trade throughout Asia and the emerging markets; manufactured exports to China are up 16% for the year to date.

Domestically, infrastructure and construction spending—part of a fiscal stimulus plan and the buildout for the 2020

Olympics—have also added to growth. All of this should be positive for equities


On the economic front, producer prices in China jumped by 6.4% in April on a year ago, which was below the peak 7.8% seen in February and is the weakest increase since December. But this level of inflation is obviously still very high by Western standards. Overall, consumer price inflation increased to 1.2% in April on a year ago versus forecasts of a 1.1% increase. Higher healthcare and housing costs offset a year-on-year decline in food prices.

The Chinese services gauge was also weak with the Caixin-Markit PMI falling to 51.5 in April versus 52.2 in March. It is the lowest level since May 2016 and is the fourth month of slowing growth. The Caixin composite PMI, manufacturing and services, for China in April fell to 51.2 versus 52.1 in March. This is the lowest reading for ten months with the manufacturing PMI in April also weak at 50.3.

An apparent tightening of credit conditions in China continued to put pressure on global commodity prices.


Commodity prices have been hit by a liquidity squeeze with short-term lending rates at close to a two-year high. It is something of a predictable story with the Chinese, and a ‘virtuous circle’ of destocking inventories when prices are high and restocking when low. After correcting sharply this year, I think iron prices will find support around current levels.

Iron ore prices were weaker and breached $65 on the downside. Despite the weekend press running a lot of bearish commentary, the latest price action looks climactic, and I expect some important lows to be reached this week in not just iron ore, but also the diversified resource stocks. While we may see the usual seasonal correction, and risk come off the table, we remain bullish on the commodity sector.


Technically the overall structure of gold’s breakout remains intact. The advance in the gold price last year (which marked the termination of a 5 year bear market) still holds integrity. Financial institutions and investors are very underweight so another push to the upside would likely trigger a significant rally in precious metal producers. Time will tell. Gold prices were 3.2% lower over the week, closing at US$1,227, as geopolitical risks declining. While risk is currently back “on” and geopolitics are taking a back seat for now, gold prices have come under pressure. I still see this as being corrective and that higher inflation levels over the medium term will become “tomorrow’s story”.


Commodities were mixed with the energy sector leading the rally after WTI crude rebounded from seven-month lows. Bolstered by speculation that members of the Organization of the Petroleum Exporting Countries (OPEC) are planning to extend production cuts for longer than initially planned.

Members of OPEC’s monitoring committee voiced support for continued production cuts beyond the initial six-month period pledged in November. Iran’s Bijan Zanganeh said both OPEC and non-OPEC members are planning to extend the agreement, pending further face-to-face discussions. Analysts at Goldman Sachs have warned that an extension of the OPEC deal is not required since the market is already adjusting. A further reduction in output would do nothing but encourage U.S. companies to ramp up activity at an even faster rate. Some analysts expect the price rally to wane in the coming days on profit-taking and technical re-positioning. The threat of rising U.S. shale production could also weigh on market sentiment.


12 Month Forecast

Economic and political predictions 2017



The A$ has also dipped below US$0.75. I think the reality though is that investors appreciate that we are not about to see WWIII, although as I have noted, escalations of tensions within the region will only put upward pressure on the oil price, and inflationary pressures in general. This would ultimately be positive for our commodity led market.


SPT Gold 1140 -1400

The prospect of rising geopolitical conflict in the Middle East will also be positive for the gold price. Our scenario of inflation ratcheting up later in the year also boosts the case for precious metals exposure.


Continued strength second half of 2017

Despite a strengthening global economy, we expect the recent rally in commodity prices to fade as China pares back on the stimulus measures enacted in 2016. However, due to the recent retracement in share prices, valuations now appear reasonable.

The larger, more-diversified miners in the resources sector have benefitted from the sale of lower quality, non-core assets as well as cost-cutting and productivity improvements in 2016, delivering simplified portfolios.

As a result, many resource companies now possess strong balance sheets. Furthermore, dividends have generally been pared back in efforts to preserve credit ratings. The health of companies within this sector is no longer as precarious as it was a mere eighteen months ago.


1100- 1400

More downside as bond yield rise

Gearing across the sector is around 30%, well down from levels seen prior to the GFC. However, it must be noted that the moderate gearing levels of AREITs is due, in large part, to the upward revaluations of property prices. In addition, valuations of commercial property prices remain expensive on a through-the-cycle basis and have been supported by strong offshore demand and the artificially low interest rate environment, which could both reverse over the medium term, posing a downside risk to property values and hence valuations of companies within the sector. This is especially true for AREITs exposed to residential developments.

Australian Equities

5200- 6400

Short term correction due

Companies exposed to a highly indebted Australian household sector (e.g. property developers, discretionary retailers, retail-focused REITs, commercial banks, etc.) will begin to confront a much more challenging and hostile earnings environment in the next few years. The strong historical tailwinds of easy monetary policy which has boosted household cash flows will continue to slow significantly and turn into strong headwinds as we experience more upward pressures on interest rates.


2.9 %-3.5%

The persistent rise in government bond yields came to a halt in mid-March, even amid ongoing signs of a synchronised global acceleration. Instead, bond yields declined as investors scaled back their expectations for rate hikes in the aftermath of the March FOMC monetary policy meeting, where the Fed raised rates but failed to accelerate the future pace of normalisation – which investors interpreted as dovish in general. Meanwhile, both corporate and high yield spreads widened in the environment of heightened political uncertainty and declining oil prices during the month.


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