Merlea Macro Matters – August 2018

(Merlea Macro Matters)

Summary

September is when the next round of tariffs with China will be tabled and possibly implemented, so this is shaping up to be an important month for the markets. If agreements are not reached next month with China and Canada then this could place further upward pressure on the US dollar, which has been the chief beneficiary of the trade dispute. And in turn, I would expect this would instigate further weakness in global equities, commodities and precious metals.

The future direction of the Dollar holds the key to stock markets over the near-term. Failure to resolve the trade dispute or an escalation of tensions with China will push the greenback higher in the near term, which in turns becomes a headwind for global stock markets.

I think now is the time to adopt a much more cautious and defensive position as we move towards September and October – and the fourth quarter of the year. In doing so we have significantly raised cash balances across our portfolios and I would advise to eliminate any leverage. The trading opportunities over the next 12 months could be significant. I expect a marked pick up in volumes, liquidity – and volatility.

Bonds

I am quite concerned about rogue inflation numbers and ensuing upward pressure on bond market yields. The US ten-year yield seems to be prepping for another run through 3%, not to mention further political uncertainty later in the year. The strong consumer spending numbers have placed upward pressure on prices. The key personal consumption expenditures (PCE) price index (which is the one the Fed monitors closely) gained 0.1% in June, and the year-on-year increase has now been pegged at 1.9% for a third straight month.

We are finally seeing a recovery in wages and salaries which were up 2.8% in the 12 months through to June. This was the biggest annual gain since the third quarter of 2008. I think next year is going to be the time when markets start to price in a much higher upward adjustment, as inflationary pressures become more apparent over the next four months. It is the absence of inflation (over the past decade) that has made markets complacent and we are seeing a continuation of that today, which explains why the US yield curve is the flattest in history.

The curve’s persistent flattening has been led by increases in short-term interest rates amid rising market confidence that the Fed will carry on with policy normalisation. Markets are now pricing a high probability of the Fed raising rates another quarter percentage point at its September meeting, and we see one additional 2018 increase likely to follow. This confidence has been fuelled by strong U.S. economic momentum.

The yield on the Australian 10-year bond has slipped back to 2.69 per cent from February’s high of 2.94 per cent. US Treasuries are trading around 3 per cent and settled at 2.50 per cent after being as high as 3.11 per cent earlier this year.

Listed Property

I would expect to see continued strong performance by A-REITs. However, this will be driven by earnings increases and consolidation among certain players, which is likely to be offset by the long-awaited increase in interest rates towards the end of 2018. Earnings increases will highlight the high-quality management teams and platforms in place, but, are expected to be driven by factors such as developments, operational efficiencies and optimisation (through the increased adoption of technology).

The subsectors to watch will be the diversified, retail and industrials over the short term and office over the medium term. Notwithstanding its perception of being stable, we can expect to look forward to more interesting developments in the sector.

Going forward, we expect the distribution yield to be just under 5 per cent for the sector, with growth in distributions of more than 3 per cent per annum for the next few years, which provides the underpinning for reasonable returns.

Given that pricing is slightly above our longer-term view, we would moderate return expectations down to allow for some reversion. There is considerable valuation dispersion within the sector, providing opportunities for active managers. While we are cautious towards the major CBD office markets of Sydney and Melbourne, collectively they are less than 20 per cent of the sector and an active manager may have less exposure. Retail property represents close to 50 per cent of the sector and as the clouds start to abate we expect it to deliver good returns.

Australian Equities

In Australia, the market shrugged off the political turmoil, with Malcolm Turnbull being deposed as Prime Minister. News that Scott Morrison is the country’s new leader appeared to sit well with the markets, with the ASX200 rising. Scott Morrison certainly looks capable as (yet another) leader, and near-term investors may take some heart from this, and some degree of certainty. Australia’s economy remains ‘lucky’ but for how much longer is anyone’s guess, with rising political uncertainty set to have a significant impact on the business sector.

In Australia, the market has been trading higher mainly due to macro news events from abroad, we remain broadly cautious and have put our portfolios on a more defensive footing, reducing resource exposure and increasing our weighting in the Australian telco sector.

Economic growth is solid, underpinned by public investment, external trade and buoyant business confidence.  In my view the weaker-than-expected labour market is temporary and I would expect to see a rebound in the second half of 2018. This should support the Australian consumer, who has been cautious given high levels of debt and muted wage increases.

The housing market has certainly corrected and is now fragile with auction clearance rates down, as the APRA enforced measures make it harder for consumers and developers to borrow. The RBA will therefore want to continue proceeding with caution in the absence of inflation – although I think this could change later next year as imported consumer goods prices rise and as wage pressures build.

While the Australian economy is performing, and the jobs market is firm, there are just too many other pockets of weakness to adjust upward policy settings. The currency has fallen to 71.85 US cents which is cushioning the exporters and the resource sector, but the more domestic focused segments within the economy remain under some pressure.

Global markets

America

I think that as the US moves closer to the mid-term primaries in November – a crucial test for the Government – the Trump Administration will look to tone down rhetoric and “consolidate its narrative” before the elections.

Support for Trump is near a post electorate high, but it would make sense for them to ‘consolidate’ ahead of the elections. The US corporate sector has delivered one of the strongest quarterlies in terms of earnings, but the rhetoric from CEOs has been very cautious on trade. The US corporate sector is perhaps the one voice that is something Donald Trump will finally listen to. Killing the goose that lays the golden eggs can only have negative political consequences for the Republicans.

In other economic news, US manufacturing activity slowed in July amidst signs that a strong economy and import tariffs were “putting pressure on the supply chain,” which could undermine output over the longer term. Elsewhere other data confirmed that private employers stepped up hiring in July, which will strength in the labour market.

The Institute for Supply Management (ISM) said its index of national factory activity fell to a reading of 58.1 last month from 60.2 in June. The ISM described demand as remaining robust and noted “employment resources and supply chains continue to struggle.” The ISM also reported that “manufacturers were overwhelmingly concerned about how tariff-related activity, including reciprocal tariffs, will continue to affect their business. The market has already priced in a rate hike in September. Federal Chair Jerome Powell wrapped up the central bank meeting at Jackson Hole on Friday by commenting about policy. He said “my colleagues and I believe that this gradual process … remains appropriate. The economy is strong. Inflation is near our 2% objective, and most people who want a job are finding one … If the strong growth in income and jobs continues, further gradual increases in the target range for the federal funds rate will likely be appropriate.”

This certainly endorses our view on the two more rate hikes before year-end that have already been flagged to the markets. While the Fed has pointed to three more rate hikes for next year in recent projections, the markets see significantly less in the way of upward adjustments. Pricing on Fed funds and Eurodollar futures currently indicate only one rate hike next year, leaving rates in a range of 2.5% to 2.75% by mid-2019, up from the Fed’s current target of 1.75% to 2%.  The data on the American economy is still upbeat but becoming patchy. US consumer confidence surged to an 18-year high in August, as households remained positive on the labour market with a strong consumer. However, this was tempered by other data on Tuesday showing the goods trade deficit widened sharply in July as exports of agricultural products tumbled.

The current bull market as reflected by the S&P 500® Index is the second oldest on record, the U.S. economic expansion is one-year away from the longest ever, and the Fed is well advanced in its tightening phase. In other words, the next recession is getting closer.

The business cycle index model, which uses a range of economic and financial variables to estimate the strength of the U.S. economy, says recession risks at midyear 2018 are still relatively muted for this late stage of the expansion.

The yield-curve slope, measured as the difference between the yield on the 10-year and 2-year U.S. Treasury bonds, is a good indicator to watch. This spread narrowed to under 40 basis points in mid-June. It typically turns negative ahead of a recession, and the equity market usually peaks around six months prior to a recession. In the last 50 years, the market has never peaked more than 12 months before a recession (although the 1987 bear market was outside of a recession).

Europe

On the economic front, preliminary flash data from Eurostat showed the Euro bloc economy grew at just 0.3% in the second quarter, compared to 1Q18, which was below expectations of 0.4% growth. Inflation across the Euro zone accelerated in July to 2.1% after growing 2% in June. The inflation rate was expected to have been stable. There was a slew of other data as well, Germany’s economy grew at a faster pace in the second quarter than originally estimated. The largest European economy expanded 0.5% sequentially in 2Q18, following a 0.4% increase in the first quarter. With Germany’s retail sales picking up in June, expanding 1.2% month-on-month after logging a 1.5% contraction in May. Unemployment in Europe’s largest economy decreased by 6,000 in July, compared to an expected 10,000 decrease. On the corporate side, miners, banks and auto makers were among the strongest performing sectors. Basic materials also advanced.

In France, CPI picked up more than expected in July according to preliminary numbers. Inflation climbed 2.3% year-on-year versus the forecast of a 2.1% increase. In 2Q18 Spain’s GDP grew 0.6% from the first quarter, marking its slowest expansion in four years. On an annual basis, it was up 2.7%.

The political risk regarding global trade has re-emerged. The tariffs imposed by the U.S. on steel and aluminium have kicked off a cycle of retaliation and recrimination. For now, we are hopeful cooler heads will prevail, but we are closely monitoring developments. Should the situation escalate, it will weigh on the eurozone because it is sensitive to disruptions in global trade.

 United Kingdom

A major factor weighing on sentiment and sterling is the continued risk of a ‘no-deal’ Brexit, or a deal that is punitive to UK companies. Trying to quell doubts, yesterday Brexit Secretary Dominic Raab was repeating the UK government’s message that it will be able to agree on a deal with the European Union.

Mr Raab said: “I remain confident a good deal is within our sights, and that remains our top, and overriding, priority. If the EU responds with the level of ambition and pragmatism, we will strike a strong deal that benefits both sides.”

Nonetheless, he also outlined preparations the government is making to cope with a no-deal scenario if the EU and UK couldn’t agree on terms. In the 25 documents issued covering a wide range of industries, they show that under such a scenario there are significant legal and technical hurdles (a lot of red tape!) that companies would face.

The cost of card payments increasing between the UK and the EU, new customs checks and pharmacists being told to stockpile an extra six weeks of medicine are just a few of the myriad points made. A major concern for Britons living in the EU is the potential loss of UK bank account services. We view this scenario negatively and believe all stops will be pulled out to try and make a deal, even with significant compromises.

Overall, I think the Euro bloc equity market is relatively favourable, given the continued economic recovery, combined with undemanding valuations in many instances. Europe also has largely been spared from the worst of trade tensions with the United States, despite some jawboning from President Trump. We continue to favour eurozone financial markets over U.S. markets. The push from strong fundamentals, relatively attractive valuation and supportive monetary policy will likely combine to outweigh the pull from increased political risk.

 Japan

 Bank of Japan (BOJ) policy meeting concluded and economic data was a mixed bag. The Nikkei 225 continues to consolidate above the breakout level of 21,000. What is supportive of Japanese equities apart from low valuations and an improving economy, is a changing mindset amongst the Japanese themselves, most generations have been subdued by decades of deflation.  The BOJ maintained key features of its current monetary policy framework but made some significant tweaks.

The central bank kept its interest rate targets steady but for the first time adopted a forward guidance on future policy, saying it will keep rates “very low” for an “extended period of time.” The central bank also said it would “allow yields to rise more naturally and could slow asset buying” if market conditions allowed. The move was attributed to still low levels of inflation in Japan, with the BOJ having been trying to lift inflation to 2% for some time now. Indeed, inflation forecasts were pared, and the 2% target is now not expected to be met before 2021. Inflation, excluding volatile items such as fresh food and energy, ticked up just 0.2% in June.

The negative interest rate policy (NIRP) was maintained, while the BOJ said it would introduce greater flexibility for the zero-yield target on the 10-year Japanese government bond. The BOJ will continue to buy government bonds at an annual rate of ¥80 trillion ($720 billion). The major tweak is that the BOJ will tilt the balance of its ¥6 trillion per year ETF buying programme towards the Topix index. This was widely expected, hence yesterday’s muted reaction. Going forward some ¥4.2 trillion will go to Topix-linked purchases.

On the economic data front, industrial output declined 1.2% year-on-year in June, missing expectations for an increase of 0.6% after the 4.2% increase in May. The unemployed rate was a seasonally adjusted 2.4% in June, above the forecast for 2.3% and up from 2.2% in May.

China

After the initial 25% tariff on $50 billion worth of Chinese imports, the Trump administration announced a 25% tariff on another $200 billion of Chinese imports, China responded in kind signalling an increase in tariffs on US imports. If Trump goes through with the 25% on $200b, China will ramp up easing measures to provide a bigger offset, we would still expect 2019 GDP to be > 6%. About 8% of company’s costs are at risk which will slow earnings growth. Most analysts expect less than half of the cost can be passed on, except for technology and chemicals. In aggregate, analysts expect a 2.5% cut in capex. It is less likely for industrials to cut due to the policy response from China.

However, we remain optimistic that behind-the-scenes talks are ongoing, rumours that Facebook and Google are about to enter or re-enter the Chinese market provides a strong indication that China is ready to deepen its reform and further open its market to global firms.

Economic data reported this month tended to be softer partly due to the roll out of macro deleveraging policies. GDP growth for 2Q 2018 was 6.7% yoy as expected. Manufacturing FAI was slightly higher than that of May, but infrastructure and real estate FAI continued to slow. Inflation remains under control with CPI at 1.9% and PPI at 4.7%.

There are too many uncertainties in the economy, even though a lot of stocks are starting to look attractive at these prices. Several high-quality companies are currently being traded at low valuations, because investors are sceptical about their growth sustainability, Turnover is dwindling, suggesting little appetite to buy even with shares at the lowest valuations since 2014. On the economic side, the manufacturing PMI dipped from 51.5 in June to 51.2 in July, slowing a little more than expected. In Hong Kong, the non-manufacturing PMO fell from 55 to 54.

Looking past the news headlines, we see an economy that continues to be on a stable footing. Private investment is growing, and it is likely that we will see an increase in Chinese government spending to further boost activity and confidence. The inclusion of China A-shares in the MSCI indices, according to some industry analysts, will draw an estimated $20 billion of foreign capital into Chinese equities through this year.

Commodities

Gold

Strengthening in the U.S. dollar caused gold prices to fall nearly 10% over the past three months which remains at the lower end of the 18-month range. But we think the outlook for gold could be improving – particularly if President Trump’s recent remarks lamenting the strong dollar help reignite interest in owning gold. Falling gold prices in the absence of rising real yields indicate that gold has cheapened relative to other U.S.-denominated flight-to-quality assets, like TIPS and Treasuries. Correspondingly, our views on gold have shifted toward constructive. In our view, the recent price moves have been driven by investors placing too much emphasis on the value of the dollar and too little on real yields. Ultimately, we think the sell-off will prove transient and that the relationship of real yields to gold observed over the past decade will prevail.

 WTIS

Heightened geopolitical risk in the Middle East increases the likelihood of volatility in global energy markets. The rebalancing of the oil market pursued by OPEC over the past 18 months means that geopolitical developments now have a more pronounced effect on prices.

Last week we witnessed a climb in oil prices due to recent bullish data points that suggest the market is tightening. The latest EIA report revealed a surprisingly strong decline in crude oil inventories, gasoline inventories and higher gasoline demand. Oil prices popped on the news. Iran’s oil exports are set to drop sharply this month, after more modest losses in July. While China and the European Union have vowed to continue to help Iran export its oil, it’s an uphill climb for Tehran to prevent supply losses. Banks are backing away from involvement in the trade of Iranian oil, and shippers are having trouble finding insurance for cargoes. European refiners, despite political support for Tehran in Brussels, have already moved to sharply cut purchases of Iranian crude.

Base Metals

While we have pared back our overall exposure in the resource sector, we retain a preference for the diversified miners (such as BHP and Rio), which also boast higher quality when it comes to iron ore. This is a strong attribute as China looks to clamp down on pollution in its steel-making industry, a key demand driver.

Trade concerns and the impact on China (and US$ strength) have taken their toll on base metals prices. Nickel hit a seven-month low this month, with inventories on the rise, and fears emerging (contrary to the picture earlier in the year) of oversupply. Copper, zinc and iron ore have also softened.

Sector 12 Month Forecast Economic and political predictions 2017
 

AUD

 

AUD/USD

The weak A$, (which looks to be headed lower) will be positive overall for the economy, still a little overbought.

72c -80c

 

Australia’s Dollar has already been challenged in 2018 by domestic interest rates that are firmly on hold at record lows, at a time when other central banks are looking to raise rates from post-crisis lows, and now an escalating global “trade war” is threatening the currency with fresh losses given its position as a proxy for financial market risk appetite.

 

The domestic story has been one of no change to monetary policy for the foreseeable future.

 

Gold

 

Gold is expected to trade range-bound from current levels, supported by a weaker USD, but capped by rising real US interest rates.

 

Gold’s four-month downtrend appears to have come to a halt following what economists are describing as neutral to dovish comments from Federal Reserve Chairman Jerome Powell.

 

Powell provided little new guidance on future monetary policy. While he said that the U.S. economy has strengthened substantially, he was relatively neutral on the current pace of monetary policy.

 

We believe an allocation to gold can provide insurance in a portfolio against the risk of extreme outcomes.

 

Commodities

 

Excess demand vs. supply in all commodity sectors should prevail.

We have moved to a neutral position (from overweight) on energy and materials.

 

A source of downside risk to most commodity prices – (gold being an exception) – are the current trade tensions between the US and some of its major trading partners (particularly China, but also the EU, Canada and Mexico). An escalating cycle of tit-for-tat tariff and other trade barriers would have a negative impact on world growth, lowering demand for commodities (and commodity market expectations of future demand).

 

China remains a key player in the global commodity market and its economy is expected to slow gradually in coming years, in part driven by a slowdown in the commodity intensive construction industry.

 

Property

 

A-REITS that focus on specific market “niches”, such as properties in the education, health care, aged care, and agriculture market. These sectors not only have strong long-term tail winds behind them, they are for the most part, recession proof.

Increase weightings.

 

In a rising interest rate environment, infrastructure investments add diversity and reduce volatility in a property portfolio. And unlike bonds, where interest payments don’t increase over time, payout increases from REITS and infrastructure should underpin growth in asset values through the next cycle.

 

We believe that if rate rises are slow enough, rental increases will more than compensate any yield increases for real estate and REITs. With most observers believing the Reserve Bank will not start lifting rates until 2019 at the earliest, and then only gradually, increases at the long end of the curve should be manageable.

 

Australian Equities

 

We should begin looking at consumer staples and healthcare for equity investments. Some value emerging in the banks.

5580 – 6600

 

The Australian share market has lifted nicely over the last 12 months with a solid double-digit return. Arguably, the Australian share market is not particularly cheap at ~16 times earnings, but, within the context of a low bond yield environment, it looks reasonably priced.

 

 

Bonds

 

2.5%- 3%

 

We see rates rising moderately amid economic expansion and Fed normalisation. Longer maturities are vulnerable to yield curve steepening.

We favour shorter-duration and inflation-linked debt as buffers against rising rates and inflation.

 

Cash Rates

 

The RBA on hold.

 

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.70%.

Global Markets
 

America

 

Underweight US.

S&P 500: 2580 -3100

 

While the US economic cycle is mature, both consumer spending and corporate capital expenditure appear well supported by recent tax reform.

 

Stronger-than-expected corporate earnings growth, rising M&A and increasing capital returns to shareholders are likely to remain key supports in the coming months.

 

Europe

 

Our preferred sectors – autos, telecoms and banks – are ones that have suffered in the low-rate environment of the past few years and now look very cheap.

Overweight.

 

In Europe, the increased risk premium prompted by recent political developments in peripheral Europe will likely constrain upside potential until more clarity emerges around the fiscal intentions of the new Italian government. Despite these short-term headwinds, our longer-term base case remains positive, supported by demand growth that is still above-trend, and the

potential support to earnings from re-gearing.

 

Japan

 

Overweight once a correction has occurred.

Nikkei 225: 21500 – 2500

Favour Japan.

 

The market’s value orientation is a challenge without a clear growth catalyst. Yen appreciation is another risk.

Positives include shareholder-friendly corporate behaviour, solid company earnings and support from Bank of Japan stock buying. In Japan, core inflation remains muted despite the closing of the output gap. This supports a very gradual adjustment of current loose monetary policy. We view Japanese equities as moderately attractive.

 

China

 

Neutral weighting. Beginning to look interesting

Shanghai Index: 2860 -3250

 

We remain broadly positive on China. Any broadening of the current trade stand-off with the US. is likely to hamper Chinese growth, but a gradual economic slowdown is already priced in and the Chinese authorities have already shown themselves willing to boost liquidity to help smooth the ongoing economic transition. Chinese equities still trade at a PE discount to other markets and further market liberalisation could prompt a rerating as international capital starts to flow into Chinese assets following the inclusion of onshore Chinese equities in MSCI’s widely followed EM equity indices.

 

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