Merlea Macro Matters – April 2017

(Merlea Macro Matters)
April 2017


The Trump government has launched 59 tomahawk missiles on a Syrian military airfield, which represents one of the most direct responses we’ve seen to the Bashar al-Assad regime. The impact of the Trump Administration’s decision will reverberate in the markets for some time. Firstly, oil prices are likely to remain elevated, especially considering the US has just deployed a carrier group near North Korea. Secondly, Putin has threatened war, but the reality is that Trump is standing up to the Russian leader who has dominated the world stage for some time. Barack Obama failed to take Putin on, despite concerted attacks on children and women in Syria by the Assad Government. I don’t think Trump will back down and as such, the markets are going to now be susceptible to elevated geopolitical risks. Thirdly, bi-partisan support in Washington from the centre left and right for Donald Trump is likely to rise sharply in the weeks ahead.


Despite the mounting fears that the Fed will move to tighten beyond what has already been signalled to the market (two more rate hikes this year), we still cannot see a significant change in direction. This is more about politics than preventing an outbreak of inflation.


A responsible Federal Reserve would have already moved to head off inflation by tightening monetary policy. As we see it, the Fed is now behind the curve. The risk of a “surprise increase in the CPI” is therefore mounting by the day. We think this is one rationale that explains why the US dollar has weakened (and the gold price has strengthened) in recent weeks.

The Fed has already deliberated on how to reduce the balance sheet, where the preferred approach is to phase out or cease reinvestments of Treasury securities and agency mortgage-backed securities, but there has been no decision as yet on the timing or method.


The second quarter is now underway, with markets seemingly balanced on the verge of a correction. The selloff that looked like it was about to begin a week ago has stalled. Ahead of the first quarter earnings season in the United States, current analyst consensus forecasts are for a 9.4% year-on-year increase. This is a rebound from the year-on-year earnings decline in the first quarter of 2016. The S&P 500 is currently priced at 17.52-times estimated earnings for the next 12 months, which is the highest level since 2004 and compares to a forward P/E of 16.53 times a year ago. US equity valuations are obviously very full with a lot of expectation priced in.



Fed is openly talking about reducing the amount of bonds on its balance sheet. Fed chairwoman Janet Yellen has said that she expects the Fed will wind down the balance sheet once the rate normalisation was well underway. There’s a little bit of uncertainty about when that will happen. My hunch is that if the economy doesn’t lose momentum and we do get some fiscal stimulus—the Fed is going to announce plans to taper their reinvestments late this year, and actually get underway sometime in 2018. We still take a bearish view on Treasuries. This is because we think that the tight US labour market and its knock-on effects on inflation will push the Fed into faster tightening than markets are currently discounting. Admittedly, we have recently lowered our forecast of the cyclical peak in the 10-year yield to 3.5% from 4.0%. But this remains significantly higher than its current level.

Inflation expectations have sprung back to life around the world. The recovery has been from a low base − particularly in Europe and Japan. This represents a move away from the obsession over weak growth that had many investors fretting about deflation and “secular stagnation” just a year ago. It is effectively a return to normal, mostly driven by a rise in the inflation risk premium, our research shows. Yet we do see risks in the near term as markets may be too hopeful about the speed at which signs of wage growth arrive. A potential slide in oil prices is another risk as the energy rebound has been a big factor in the reassessment. We still see reasons to favour inflation-protected over nominal bonds in the medium term, especially in the Eurozone. Our base case is that the ECB and BoJ will likely keep policy accommodative to ensure that inflation moves closer to target — market jitters about policy shifts notwithstanding.

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

Australia has managed to avoid a technical recession by posting positive economic growth in the last quarter of 2016. GDP rose a solid 1.1% in the fourth quarter, lifting the annual rate to 2.4%. Exports were 8.9% higher over the year, outstripping import growth of 3.3%.


Non-mining investment has failed to offset the continued decline in mining investment that peaked in 2012/13. However, this masks a big difference in state-wide activity. Non-mining investment in NSW has risen by 8%pa over the last 3 years, Victoria by 4%pa whilst WA and QLD have fallen. Mining investment is expected to continue to fall over the next 12 months but this will be offset by a gradual improvement in non-mining investment intentions, assisted by dwelling investment and infrastructure projects in NSW and Victoria.


The release of the OECD’s Economic Survey of Australia 2017 has fuelled the ongoing debate about Australia’s economic vulnerability. Our view is that it will be worse than implied by the OECD Report given the vulnerability of Australia’s banking system. Time will tell whether we see an orderly unwinding of the housing market or a more dramatic and painful collapse. One area we are watching is the cycle in residential construction activity. The approvals cycle in annual trend terms continues to ease lower, and given the amount of stock in the pipeline, we remain wary that a portion of the building applications approved to date does not evolve into actual construction. The record low wages growth in Australia has long been a concern to our theory of a weakening domestic economy, particularly when combined with high household debt levels. Wages growth remained soft in 4Q16, up only 0.5%, while in annual terms, wage growth remained at a historical low of +1.9%yoy. Wages weakness is mainly in the private sector (+0.4%qoq, +1.8%yoy), which is also where the household debt problem exists.

Despite record low wages, consumption was up 3.5%yoy in the 4Q, partly funded by savings, which has taken the savings rate down to 5.2% in 4Q16 (down from a peak of 10% in FY12).


The outlook for Australian equities remains broadly positive. Global growth is improving and domestic interest rates are likely to remain low, which should support earnings. Domestic valuations are generally reasonable.


However, it is prudent to temper expectations because geopolitical risks remain elevated and US equity valuations remain stretched and therefore more vulnerable to a correction, which would inevitably lead to weakness on global markets.


Global markets


The first round of the French presidential election is now only two weeks away on April 23rd. Polls continue to show Le Pen and Macron on around 25 per cent of the vote each. So it remains likely they will make it through to the run-off on May 7 where polls show Macron leading Le Pen by around 20 per cent.


A combination of improved demand from key trading partners (US and China) and accommodative monetary settings by the European Central Bank (ECB) have helped weaken the Euro, boost exports and aided job creation. This is particularly evident in Spain and Germany where growth is robust. The rise of anti-EU parties remains a key risk. ECB president Mario Draghi told an audience in Frankfurt that it was “too soon to declare success on inflation.” By that Mr Draghi meant there is not enough inflation in the European economic system, but this perception too will change in my opinion over the coming year.


UK economic growth was confirmed at 1.8% in 2016 with there being little impact from the Brexit vote in June. However, it remains unclear how favourable a deal with the European Union will be and whether it will have a significant negative impact.



The Japanese Tankan business conditions survey showed further improvement in the March quarter as did the March composite business conditions PMI and consumer sentiment is up all of which points to reasonable economic growth.


The big call on the Japanese economy to make over the medium-term however, is the future direction of inflation. After being absent for close to two decades, an inflationary environment is not something Japan’s economy is used to dealing with, but a welcome departure from the economy-distorting deflation that has wreaked havoc for so long. In Japan, producer prices increased by 1.4% year-on-year in March with this the fastest pace of growth since December 2014. A key driver was a 4.2% increase in export prices in March on a year ago. Japanese producer prices ended a 21-month decline in January but on a month-on-month basis producer prices were off by 0.2% in March. The month-on-month growth compares to a 0.7% increase in December. Clearly inflation is heating up, and that has to be a good thing for Japan.

Like most bond markets, Japanese Government bonds (JGBs) have been in a bull market for decades, and to date have demonstrated no sign of reaching a major inflection point. But nothing goes in one direction forever. After the Bank of Japan (misguidedly) pushed rates into negative territory last year, the JGB yields sustained another rally to the downside. However, I do believe that this year will prove important for the JGB market, and yield curves around the world will all begin to steepen if we are right in our view that inflation is going to surprise on the upside.



I remain cautious given continued credit expansion. China has demonstrated a willingness to commit to growth via continued significant credit expansion. The Chinese Premier presented the 2017 government work plan, which was not designed to be bold, but to ensure stability for the critical leadership transition year. Despite being portrayed as a pro-reform plan with a slower GDP target of around 6.5%, the fixed asset investment growth target was kept high at 9%pa (an increase from last year’s 8%). Clearly, statements promoting stronger growth and stabilisation in the RMB have resulted in positive sentiment towards China over the last quarter. Our cautious stance on China revolves around the extraordinary amount of credit growth China unleashed to ensure their economy maintains consistently high growth levels. China had to go “back to the well” of increasing credit by >30% of GDP to maintain high GDP growth. Each time with support from new and ‘interesting’ sources of credit. It’s highly possible that this excessive credit growth continues, at least until the 19th National Communist Party Congress (which is due to be held in Sep/Oct 2017). President Xi Jinping is expected to win favour for another five years. The required structural reforms needed in China have not yet been implemented, despite the strength of the Chinese economy. Perhaps after Xi consolidates power, such reforms will become of greater focus. Further ahead, the outlook for China hinges on structural reforms, but these reforms are politically difficult for the Communist Party. If policymakers move quickly to tackle the debt build-up and resulting resource misallocation by forcing SOE reform and recapitalisation, then growth could feasibly stabilise at around 4-5%pa over the forthcoming decade.

However, we suspect that a growing bad debt burden will intensify pressure on an already fragile Chinese financial system in coming years.




Is America about to join the next great race to the bottom? It is becoming readily apparent that no nation wants their currencies to be too strong. This political backdrop is going to provide a powerful tailwind for precious metal prices over the coming year. I expect the rally to continue, particularly as political risks remain elevated. Gold prices hit their highest levels since the US election at US$1,276 per ounce.


Precious metal prices consolidated after Friday’s rally following the US missile attacks on Syria. I note that the A$ gold price is elevated and near all-time record highs with the Aussie dollar under some pressure due to the tepid unemployment numbers and softer iron ore price. This places Australian gold producers in a “sweet spot”, particularly those that have low cash costs



 US crude oil stocks declined by 2.2m barrels in the week ending April 7 taking total oil stocks to 533.4m barrels. This was the largest decline so far this year and comes at a time when refinery demand typically starts to pick up. WTI has remained firm above $52. WTI has pushed back above $50 with OPEC stressing that members adhere to production targets. The Cartel has a well-documented history of cheating. OPEC and the other major oil producing nations probably have a finite amount of time to sell their oil in commercial quantities and for reasonable prices. They are on borrowed time, and the only question now is just how long will it take for the world to wean itself off a hundred-year old thirst for oil? The challenge now for OPEC is to achieve a “not too hot, not to cold” oil price that maximizes profits, but does not encourage the ‘frackers’ and particularly those in the US after shale gas. However I would argue much of this has already been priced in. What the markets are not prepared for over the next few years is an OPEC that actually co-operates and functions as a cartel, and where there is actually no cheating, and supply is constricted. My view is that OPEC will succeed in adhering to production quotas, cheating is going to fall off the agenda – at least over the short term – and that oil will move into a “sustainable” range between $60 and $80 a barrel. This would fuel inflation. And that is my call for 2017. Whilst the rear view economists will tell you that inflation is “peaking”, we see a very different scenario for this year. Commodity prices and inflation are also very reflexive, and feed off each other as we have seen in the past Inflation will rear its head again this year. The problem is the Central bankers struggling to catch up.


Sector 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- 1400More 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- 6400Short 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.Yet depressed volatility across asset classes’ points to market complacency. Any signs of a more hawkish Fed — or signals that the ECB is getting ready to tighten policy or the BoJ is shifting its yield target — could lead to turbulence.Global yields are rising on improved growth. This is fuelling expectations of an eventual pullback in global monetary policy accommodation. We see medium-term opportunities in inflation-linked bonds, but some risk of disappointment in the near term as wage growth remains elusive.

Cash Rates

1.5 % on hold till 2018

The RBA has little appetite to further ease monetary settings. Looking forward, it would appear GDP growth is likely to be robust throughout 2017. There has been a sharp improvement in the terms of trade due to stronger export prices and volumes than was the case twelve months ago.
Global Markets


S & P 500overvalued 2100-2200 risk rising of a market correction

The US continues to have the preconditions, including a USFederal Reserve slightly behind the curve, to benefit from policies that promote internal investment, favour domestic consumption and seek to rebuild infrastructure. The Trump rally to date is symptomatic of a global system refocusing towards nominal growth – a great outcome for equities in the medium term. U.S. equities do not look cheap, and gains since the presidential election have been powered mostly by multiple expansion, prospects of tax reform and deregulation are supportive. Timing and implementation are uncertain, however, and valuations have risen. We like value, financials, selected health care, dividend growers and shale oil companies.


FTSE preferred stock marketThe risk of a correction will increase unless earnings can meet the lofty expectations currently factored into share prices.

With our view that higher inflation and political uncertainty are likely to affect real household spending less than we had previously anticipated. But with no pick-up in core inflation or wage pressures, even in Germany where the unemployment rate has reached a record low, we have not changed our forecasts for the ECB. We expect it to move very slowly in scaling back its asset purchases next year and to leave rates unchanged until 2019.
UK While the latest data shows some loss of momentum in Q1, the impact of Brexit on the economy should continue to be quite limited, particularly as there is likely to be a long transitional period after the UK formally leaves the EU. Exports should benefit from the improved global environment and more competitive exchange rate. Against this backdrop, the Bank of England is likely to begin raising interest rates by mid-2018.We see global reflation and an improving earnings outlook supporting cyclicals and exporters, particularly industrials andMultinationals with EM exposures. We believe the risk of populist outcomes in upcoming elections is overstated in the near term.


Hold -21000

A steady pickup in global growth and a weaker yen continue to be supportive of the Japanese economy, as demand for its goods underpins activity in the manufacturing sector. Export growth has been strong and this trend should continue. A free trade deal between Japan and the European Union is currently being negotiated, which will provide a further boost to Japanese exporter.The outlook for Japan has not changed. Consumption growth has recovered after a long period of stagnation, and the unemployment rate has reached its lowest level in over two decades. But wage and price inflation remain very subdued. Monetary policy will stay very loose for the foreseeable future.Positives are improving global growth, more shareholder-friendly corporate behaviour and earnings upgrades amid a stable yen outlook. We see BoJ policy and domestic investor buying as supportive.Risks are yen strength and rising wages.


Hold 3600

In summary, we remain cautious towards China due to the major imbalances resulting from an excessive reliance on credit creation to generate investment-led economic growth. While major supply side reforms are necessary, the Chinese Government has the levers to prevent a hard landing in the next few years. China will continue its transition to a “new normal” growth trajectory, which implies weaker but more sustainable economic growth. However, downside risks in the form of a trade war with the United States and a sharp correction in the property market loom on the horizon. (While we do not anticipate a “hard landing”, in the short term) the acceleration in China’s growth rate is likely to run out of steam in the ‘coming months as the authorities scale back their policy support. Financial sector reform and rising current account surpluses are encouraging. China’s economic growth momentum and corporate earnings outlook look strong in the near term.

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