Merlea Macro Matters – August 2017

(Merlea Macro Matters)
August 2017



On the economic data front US existing home sales fell 1.8% in June on a month-on-month basis to an annualized pace of 5.52 million units. This was weaker than forecasts for a 0.9% decline to 5.57 million units. The IMF has downgraded its forecast of US economic growth in 2017 and 2018 to 2.1% in both years. This compares to the 2.3% growth forecast in 2017 and 2.5% for 2018 that the IMF had forecast in April.

Turning to the global economy and the IMF has revised GDP growth upwards from 3.5% this year to 3.6% in 2018. Advanced economies are expected to grow by 2% in 2017, whilst the emerging markets and developing economies are expected to grow by 4.6% in 2017 and 4.8% in 2018. The main driver of global growth therefore remains the large emerging markets and in particular China and India. The UK was notably downgraded, mainly on the back of the higher risks associated with Brexit.

The flight to ‘safe haven assets’ was spurred by President Trump warning North Korea that it would be “met with fire and fury” if it continued to threaten America. This was in response to a Washington Post story that North Korea had produced nuclear weapons that could fit inside its missiles. North Korea retaliated by claiming that it was evaluating a missile strike on the US territory of Guam. US Secretary of State Rex Tillerson struck a more cautious tone, stating that there was no imminent threat from North Korea and flew to Guam to provide assurance.

The VIX volatility index jumped 35% higher to close at 15.7, to rise above the 15 mark for the first time since 29 June. This would seem to be a massive spike in volatility, but putting it into perspective, the VIX had hit all-time lows in late July, and as such is coming off a very low base. And while it remains to be seen, we may have reached ‘Peak Fear’ as it relates to the situation with North Korea.

I find it difficult to envision a scenario where North Korea follows through with the nuclear option. If we are right and this is peak fear for the markets, then the bullish uptrends for most stock markets should resume to the upside. A nuclear exchange would be the mutually assured “self-destruction” for the North Korean political regime. The US would settle matters relatively quickly if provoked. The wild card of course is how China would react. But even China cannot rival the US in terms of the military.

While the base case outlook is for equity, bond, and currency prices to be constrained in a tight band in the third quarter, certain factors exist that pose risks to that outlook. The Fed and the ECB are unwinding years of extraordinary, experimental intervention, global political and geopolitical uncertainties are mounting, and the intractable growth of public and private debt around the world amid a period of historically soft economic activity all heighten the risks of sudden asset re-pricing.



Demand for safe haven assets saw the yield on the 10-year US Treasury hit a six-week low at 2.226%. This downward move in US yields does not change my longer term view that rates are going to move higher, but for now and the next few months I see T Bond yields confined to a range and “not going” anywhere. I also see this as the US T Bond Market endorsing the view that the Fed is going to do very little in the way of making changes to monetary policy settings running into the end of the year. We see bond yields rising– inflation-linked debt should outperform conventional fixed income over the next five years. Low growth, rising inflation and higher real interest rates, meanwhile, will cause equity earnings multiples to contract by more than 3 per cent in aggregate worldwide over the next five years.


Listed Property

It’s hard to get excited about large Australian Real Estate Investment Trusts (A-REITs) with signs of weakening tenant demand and expectations of higher bond yields. But beneath the tough outlook are some good performances from niche A-REITs. The S&P/ASX 200 A-REIT index has a total return of 1% (including distributions) over one year. With the ASX 200 index up 10%, A-REITs have underperformed. The gap would widen as ‘bond proxies’, such as A-REITs, utilities and infrastructure stocks are sold. A pullback was overdue. The A-REIT sector strongly outperformed the broader sharemarket over three and five years and income investors flocked to listed property trusts with attractive, reliable distributions as global bond yields fell. The 12-month underperformance of A-REITs relative to the broader market might be a buying signal, especially given the rout in Australian equities this week, which almost wiped out calendar-year gains.


Australian Equities

The RBA left rates on hold, and as we expected, drew particular attention to recent strength in the A$. It remains clear that the central bank is caught between a rock and a hard place and remains hamstrung to do much at all on a number of fronts. The RBA ‘is effectively on the side-lines’ unable to pull any policy levers – which in reality has been the case for a while.

The bank’s overall tone remains optimistic, with it continuing to expect “the economy to grow at an annual rate of around 3 per cent” over the next couple of years. Ironically, after rattling the cages with talk of a new normal cash rate of 3.5%, the bank took extra care to highlight the risks of a rising currency.

The bank noted that the “higher exchange rate is expected to contribute to subdued price pressures in the economy. It is also weighing on the outlook for output and employment. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.”

The RBA was at least observant on one count that the increase in the A$ has been out of its control, and due to a weak US dollar. As I have been writing though, simultaneous strength in commodity pricing has very much been a key factor. In any event, for now the central bank has little in the way of options other than to remain on the side-lines and resort to jawboning the currency down.

While earnings growth expectations are firm, there are many economic variables which could cloud the outlook, and recent strength in the A$ will also be of concern to some.


Global markets


US indices have remained elevated despite the under-performance in the currency. The market’s despondency over the failure of the White House to push through any policies has effectively been cancelled out by the solid reporting season in the first quarter and the relative follow through in the current quarter. The US economy has continued to perform despite negative political fallout and the lower US dollar is providing a tailwind to US exporters and large multinationals. The US dollar has been a one way bet since Trump took office, but is now oversold and pushing against historical support. At some point there is going to be a significant counter rally.

US markets are weaker, but certainly have not lurched downward significantly. It is also worth noting that there were other drivers of weakness. Macy’s fell 10% and Kohl’s was down 5% as the department store operators reported a drop in quarterly same-store sales. Also, in a sign of market exuberance going into reverse the recent IPO of Blue Apron is now more than 40% lower than the US$10 offer price.

In addition, US producer prices declined for the first time in 11 months in July with a 0.1% month-on-month decline versus forecasts for a 0.1% increase. Producer prices were up 1.9% on a year-on-year basis versus the 2% increase in June. Weekly jobless claims also rose 3,000 last week. Although to be fair, with the US economy nearing full employment, there was always going to be limited scope for claims to keep declining. This situation should also ultimately feed through to further wage inflation.


The jobless rate in Germany was the lowest in the Eurozone, hitting a new post-reunification low at just 3.8%. Greece remains the country with the highest level of unemployment in the EU at 21.7%. I am going on the record early predicting higher rates of inflation with the catalyst likely to be a surprising upward shift in wages that will inevitably surprise the markets. Tight labour conditions are a sign of the times, and more than anything markets have become complacent about this. The euro has recently increased to its highest level in three years and is expected to impact exports going forward. The single currency is the best performing in the G10 so far this year up 7% on a trade-weighted basis. As for now, Macroeconomic data released this week also disappointed. Purchasing Managers’ Index (PMI) surveys show that eurozone economic growth slowed at the start of Q3, with the IHS Markit Eurozone PMI Composite Output Index posting a six-month low of 55.7 in July, down from 56.3 in June. Given the underwhelming performance of European companies and the continued low interest rate environment, investors may wish to be cautious, and to do so they can invest in high quality companies that offer an above-average dividend yield.


The Bank of England kept interest rates on hold at 0.25% with a 6 to 2 vote. The Bank of England has also reduced its forecast for UK economic growth in 2017 to 1.7% from 1.9% in May. The forecast for 2018 was cut to 1.6% from 1.7% and in 2019 the forecast for 1.8% growth was left unchanged. Inflation is expected to increase by 2.7% this year versus the previous forecast for a 2.6% increase, so real incomes are going backwards while the risk of recession is rising. Bank of England governor Mark Carney warned that Brexit uncertainty “weighs on the decisions of businesses and households and holds down both demand and supply.” The UK construction PMI hit its lowest level in July for 11 months at 51.9 versus 54.8 in June and forecasts for 54. The weakness was driven by a fall in the commercial construction PMI along with the residential construction PMI.


Japan has endured perhaps one of the “greatest deflationary unwinds” of the modern financial era but the policies of Abe have finally sparked a turnaround in the Japanese property sector, the broader economy, and of course the stock market. Japanese employment fell to 2.8% in June from 3.1% in May with the reading well ahead of forecasts for 3%. Wage growth inflation must be on the horizon, and I believe this will ultimately put upward pressure on longer term Japanese interest rates – which will be very positive for the banking industry. The core consumer price index rose by 0.4% year-on-year in June with this unchanged on the previous month . 10 Year Japanese Government Bond yields are once again testing resistance at 0.10%. With the unemployment rate falling to near historic lows of 2.8%, wage growth inflation must be around the corner. I believe it is only a matter of time before the 10-year JGB yield breaks above key resistance at 0.10% and challenges the longer term historic downward trend. This deeply contrarian view, if it comes to fruition, would mark a significant departure for Japan’s economy from historic trends. The good news continues to flow on the Japanese economy. Industrial production is expected to continue recovering in July and August with 0.8% and 3.6% growth respectively. Year-on-year, industrial production was 4.9% higher in June versus the 6.5% increase in May.


 Chinese exports increased by 7.2% in July on a year ago in US dollar terms. This compares to 11.3% annual growth in June and median forecasts for 10.9% growth in July. Exports to the United States increased by 8.9% in July on a year ago with exports to South Korea growing by 3.6%. Exports to EU countries grew by 10.1% on a year ago while exports to Japan increased by 6.6%. Imports increased by 11% in July on a year ago with this the ninth consecutive month of expansion. However, it was weaker than forecasts for 16.6% growth and the 17.2% in June.

Chinese exports in renminbi terms increased by 11.2% in July on a year ago versus 17.3% growth in June. Imports grew by 14.7% versus 23.1% growth in June and the trade surplus rose by nearly Rmb27bn to Rmb321.2bn.

We continue to be structurally bullish on China, as it continues to open up its domestic capital markets to greater foreign participation. Removal of restrictions to entry, together with China being included in MSCI equity benchmarks, could help to support the Chinese financial market.

Deleveraging seems inevitable. The silver lining is that government debt is relatively low, the current account is in surplus and the state can bail out corporate borrowers (after all, it owns most of them). This puts China in a much stronger position than some of the countries around the world that have succumbed to varying degrees of financial crisis over the past quarter of a century.



Iron ore prices in China traded at nearly a four-month high on Monday with a 7.3% jump to Rmb570 per tonne. The rally came after the sub-index for the Chinese construction sector hit 62.5 in July – the highest since December 2013. Goldman Sachs revised their targeted iron ore price for this year upwards from US$55 to US$70 a ton. The latest rally in iron ore, and indeed the wider commodity complex, lends supporting evidence to our view that commodities made a defining bear market bottom last year and all the “unwind” so far this year has been nothing more than “corrective price action”. We continue to see the high-quality producers as the best way to play the bull run in the resource sector which has further legs in our view.


Gold has pushed its way back up to $1270 and appears set to challenge the key $1300 level. This would establish a higher reaction low and new high for the year which is encouraging technically. For the bull market to be completely reaffirmed, gold needs to surpass the $1390 high established in the middle of last year – which I am confident it will do heading into the fourth quarter. For a diversified portfolio, an allocation to gold would therefore not just bring the diversification benefits and protection against the unexpected but also an added source of returns. For US investors, the likely weakness in their domestic currency further strengthens the metal’s appeal.


Oil prices rose slightly over the past month in which has been volatile trading as the market weighed lower U.S. crude stocks, Nigerian instability and strong global demand growth against a persistently slow rebalancing. The International Energy Agency said it had revised historic demand data for 2015-2016, meaning a lower demand base in 2017-2018 combined with unchanged high supply numbers could lead to lower stock draws than initially anticipated. Oil producers are losing their resolve to cap output just as their supply cuts are beginning to achieve their goal of rebalancing an oversupplied market. On Friday, Baker Hughes data showed U.S. drillers added oil rigs for a second time in the last three weeks. However, the pace of additions has slowed in recent months as firms cut spending plans in reaction to declining crude prices.

Sector 12 Month Forecast Economic and political predictions 2017





The currency markets are at an interesting juncture at present. On one side you could argue that this is all about US dollar weakness and the political quagmire on Capitol Hill. I would argue this is perhaps more about the likes of the euro and yen rallying from deeply oversold levels on the back of an underlying improvement in their respective economies. We could also include Australia and Canada in this basket, with the recent resurgence in the commodity markets providing a boost to economic performance.





SPT Gold 1140 – 1400


The stars appear to be aligning for several non-oil commodities.

A weaker dollar should provide a strong fillip for raw materials in

general, while political risks – in the shape of Brexit and an unpredictable US administration – and a pick-up in inflation are likely to boost gold. Indeed, we expect the price of gold to rise by an average of 8.5 per cent a year over the next half a decade, which would take it back up towards USD1,900 per ounce – in sight of the record highs scaled back in 2011.





Continued strength second half of 2017


This asset class has suffered significantly from over-supply, poor management of capital, and falling demand from developing economies. Valuations are however starting to look more attractive, and management appears to be committed to improving cash flows. A number of companies have consolidated their capex so if these companies can be identified then positive returns may start to materialise later in the year.





1100 – 1400

More downside as bond yields rise


A-REITs, headwinds are unlikely to abate soon as a sluggish economy compresses capitalisation rates on properties and Amazon’s expansion in Australia creates uncertainty for retail landlords.


The A-REIT sector looks like it is in an advanced stage in the property cycle; that probably means weaker returns for the next few years. Of course, there’s always opportunity at an individual A-REIT level and some niche players have excellent prospects.



Australian Equities


5200 – 6400

Short term correction due


Equities markets should be well supported if the global growth narrative plays out as expected, and as investors continue to rotate out of bonds into other asset classes. For domestic investors, too, equities may become more attractive as property investment becomes less attractive as potential price weakness and pockets of oversupply weigh on sentiment. Australian shares are likely to have solid returns as resource sector profits surge following the rebound in bulk commodity prices, overall profits rise 10 per cent and interest rates remain low. In terms of sectors favour resources, retailers and banks.





2.9% – 3.5%


10 year bonds have posted a negative performance over the past 6 months as yields have risen in the expectation of inflation picking up. We remain underweight. Corporate Bonds Neutral: The better performance of Corporate Bonds over 10yr government has narrowed the yield differential between the two asset classes, highlighting that Corporate Bonds are probably fully valued and hence a neutral weighting.



Cash Rates


1.5 % on hold till 2018


RBA Governor Philip Lowe was addressing the Standing Committee on Friday, and it’s these comments that now put a floor in the currency (AUD) and any talk of further rate cuts.


‘Reasonable assumption that the next interest rate move is likely to be up…’ then added ‘but this looks to be some time away’.


It was well known that the RBA Governor is a “hawk”, but this is a clear indication that he wants to begin normalising monetary policy – soon. That’s an Aussie dollar tailwind, and a slight growth headwind.


Global Markets



S & P 500

overvalued 2100-2200 risk rising of a market correction


Given particularly high valuations in the US, we think a cautious tactical stance on US equities is justified When it comes to investment returns, US stocks will find themselves towards the bottom of the leader board by 2020 – primarily because their lofty initial valuations should severely limit the scope for future gains.

Based on some of the most closely followed valuation metrics, such as Shiller’s cyclically adjusted price-to-earnings ratio, US stock markets look as expensive as they did in 1999, just before the Internet bubble burst. Both this and a probable decline in US corporate profit margins are the reasons we expect price-earnings multiples to contract from 18 today to 15 by 2020.





FTSE preferred stock market.

The risk of a correction will increase unless earnings can meet the lofty expectations currently factored into share prices.



Solid economic growth and a moderate rise in inflation provide a suitable background for Eurozone “value” stocks to outperform the wider market, in our view. This is because value has a cyclical sector bias, with a heavy weighting in financials. The relative performance of value tends to move in tandem with bond yields. We expect bond yields to move higher, driven by rising US interest rates and the prospect of the European Central Bank tapering its bond purchases early next year.





14000 – 22000


We maintain a positive bias for Japanese equity markets. Economic indicators are attractive relative to history, driven by OECD leading indicators, industrial production. Central bank policy is supportive; money growth is strong and attractive relative to history. Corporate fundamentals are also strong

relative to history, including revenue growth, earnings revisions, attractive ROE. Profit margins are strongest relative to DM peers. Relative valuations attractive compared to DM peers.





Shanghai Index



We expect important reforms in the quarters following the National Congress of the Communist Party of China, which will take place in October.

The Chinese economy is likely to benefit from these reforms. The government is also pressing on with reform of state-controlled companies, including reining in their borrowing, closing zombie firms and paving the way for mixed ownership reform. This in turn should stimulate more market-oriented borrowing and debt-for-equity swaps. Encouragingly, IMF research shows that private listed companies in China have reduced their leverage ratios since the global financial crisis.




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