Merlea Macro Matters – December 2018

(Merlea Macro Matters)

Summary

Over the longer term, we believe the global economy has reached a secular trend of peak globalisation. Changes to global rules may pose several market risks, including potentially higher inflation, lower productivity and profit margins, and higher political risk. Decades of disinflation have dragged down many investors’ long-term inflation expectations, and we think peak globalisation trends, plus changes in monetary and fiscal policies, could potentially cause inflation to accelerate faster than today’s subdued expectations.

We believe the global expansion has become less synchronised, and the mature business cycle warrants smaller allocation tilts. As the Fed further reduces its balance sheet and the European Central Bank (ECB) ends quantitative easing at year-end, growth in major central-bank balance sheets is expected to turn negative by Q1 2019.

In a more challenging global environment, it is increasingly clear that the room for policy mistakes is limited. Poor policymaking has already translated to crises in several emerging economies and potential for policy missteps, such as trade policy in the US and populist policies in Italy, could have global ramifications.

In the short term I believe the foundation is being laid for an ongoing rally into the end of the year, with a primary catalyst likely to be a resolution on the trade front. Now if I was President Xi, I would call Trump’s bluff and play hardball knowing that he only has 18 months and cannot afford a policy error, because there is no time left to correct a recessionary outcome. But I don’t think this will happen, rather the Chinese will hold the line on certain issues and negotiate the balance and leave everything else for another day.

It’s in everyone’s best interests at the end of the day, to let the economies and markets settle down, and focus productive effort on other initiatives. The markets have been way too negative and have priced in too much in the way of downside risk on this issue and I think we are close to an inflection point.

Bonds

Investors are worried that for once economists could be onto a good thing and be right with their forecasts. Investors are concerned that the Fed will continue to slowly hike rates at a time when prices are peaking. What we are seeing though, from an investors’ point of view, is that pressures are mounting and inflation is the primary concern. Core PCE price inflation rang in at 1.98% in September. As a result, the Fed raised its federal funds rate for the eighth time and indicated another increase may occur later in the year.

European Central Bank’s (ECB) most recent monetary policy meeting, the governing council confirmed the European economy showed signs of continued, though slightly slower, growth and inflation progressing towards its target level. The ECB’s bond buying program scheduled conclusion by the end of 2018 remained unchanged.

In the United Kingdom, real GDP is projected to grow by 1.4%. Fuelled by a tighter labour market, an increase in inflation prompted the Bank of England to raise its bank rate from 0.50% to 0.75%, the second increase in the past decade.

Japan, the world’s second largest economy, is still struggling to raise inflation to the Bank of Japan’s 2% target. As a result, the bank has continued to eschew tightening in favour of an accommodative monetary policy. Although Global Purchasing Manager’s Indices remain above the all-important level of 50 across the Eurozone, United Kingdom, Japan and China, they have dropped by 3-13% from one year prior.

Our medium-term view on interest rates is that rates will increase from their current low levels, and we expect 2018 to be the first time since November 2010 when the RBA has raised interest rates. At the shorter end of the yield curve, the yield on a three-year Australian government bond rose to a high of 2.06%, before ending the month 6 basis points (bps) lower at 1.99% as markets pushed back the timing of monetary tightening. Australian 10-year government bond yields moved in sympathy with US yields; the US 10-year government bond yield peaked at 3.23% towards the middle of the month and the domestic

yield peaked at 2.77%. As risk appetite soured, Australia’s longer end outperformed the US, ending the month 4bps lower at 2.63%, while US 10-year government bond yields ended 8bps higher at 3.14%

Listed Property

Low interest rates worldwide have driven strong demand for assets, not just property, but also infrastructure and equities. Indeed, in most markets, most of the capital growth experienced was driven by firming yields rather than any underlying income growth. Though bond rates have started to rise, and while investor demand remains strong with the prospect of some further firming of yields, rising bond rates will eventually lead to a softening of yields and prices. This will create a headwind for investment markets. Expected returns will be lower, transforming the search for yield into a search for income growth to drive future prices and returns. There have been few surprises in the property markets in the last year, the exception is the shift in sentiment against retail property. Triggered by the concern about the entry of Amazon into the Australian market, this has caused a polarisation in attitudes towards the sector. Forward earnings expectations for retail landlords have been marked down most across the listed property sector as the dust settles on the earnings season. Retail property funds – which include some of the biggest property trusts in the country such as Scentre, the owner and operator of Westfield malls, and Vicinity Centres – experienced the greatest negative earnings revisions, at 2.7 per cent. Earnings expectations for diversified property trusts were cut by 0.9 per cent. On the upside, forecasts for office property owners were revised upwards by 1.8 per cent, as they were for fund managers and diversified residential developers, which lifted 0.2 per cent. Expectations for Long WALE property trusts picked up by 0.2 per cent as well. Despite the negative revision to forward earnings, we still see the sector as being in “good shape”. Its net tangible asset growth will slow going forward but it has the lowest gearing since 1999 and trades at a 5.1 per cent distribution per share yield with 2.5-3.5 per cent annual distribution growth for the next two years.

Australian Equities

Australia non-mining business investment remains strong and employment is steady, although the lack of wage growth has been a drag on consumer confidence. The ASX 200, does not appear as overvalued as US equities. The ASX200 has hardly risen this year and is trading on a price-earnings ratio of just below 16x which is only marginally above the long-term average of around 15x.

The RBA released its quarterly policy statement on Friday 9th of November and reaffirmed that it does not see a case for adjusting the cash rate near term. The bank continues to make the point that while Australia is lagging other central banks in policy adjustments, it did not go as ‘hard’ on the way down in lowering interest rates.

With the property market slowing, I believe that the overall construction cycle in Australia is well past its peak. Infrastructure spending has been a key driver of the economy, and I think that with the government’s current plans (and posturing ahead of the election), this should continue to provide a plank for growth.

Global markets

America

Solid economic growth and strong corporate results, particularly in the US, boosted global equities. Tax cuts continued to support corporate profits, but ongoing Federal Reserve interest rate hikes and US-China trade tension have been exacerbating late-cycle pressures. The US economy has kept to a very gradual progression through its business cycle, with mid-cycle dynamics remaining solid in the credit and inventory cycles, but with late-cycle trends growing more evident after years of tightening labour markets and gradually firming wage growth. With the unemployment rate below 4%, tightening labour markets continue to help boost consumer spending. At the same time, tighter labour markets have put upward pressure on prices, with various measures of wages and consumer inflation showing signs of modest acceleration. In September, the Fed raised rates for the eighth time this cycle, further flattening the yield curve.

The corporate sector received a significant profit boost from tax reform in 2018, which has more than offset margin pressures caused by rising wages. Lower tax rates and higher cash flows reduce the need for corporations to raise capital, lowering the supply of US corporate securities. Decreased bond issuance has provided technical support to credit markets, whereas a record amount of stock buybacks (up nearly 30% over the past 12 months) has supported equity prices. This tailwind from corporate liquidity may fade as effects from tax reform dwindle over the coming year.

Ahead of the important trade meeting at the end of the month the markets seem to be pricing in at least a truce and an announcement that both sides will work towards a solution. There is much at stake, and both political leaders will be cognisant of the growing risks to global trade and their respective economies, albeit the US has the greater ability to withstand the pressures from any trade war.

Europe

Eurozone’s gradual economic slowdown is normal and temporary to some extent, and underlying inflation is expected to rise in the coming months, making policymakers confident that the massive asset purchase program could end in December, European Central Bank President Mario Draghi said on Monday. Speaking at a hearing in the European Parliament in Brussels, Draghi said, “A gradual slowdown is normal as expansions mature and growth converges towards its long-run potential. However, risks relating to protectionism, vulnerabilities in emerging markets and financial market volatility remain prominent, The ECB expects higher wage growth, and a recovery in producer and import prices, to continue to support the acceleration in underlying inflation. Euro outlook could darken substantially once into 2019 because the single currency’s appeal to investors is hinged upon the bloc’s economy growing at a pace enough to support a sustainable return of inflation toward the target of “close to but below 2%”.

Only once that sustainable recovery of inflation is in sight will the European Central Bank (ECB) be free to begin normalising its interest rate structure, which is still calibrated to its crisis-era settings.

The ECB said in October it still intends to end its quantitative easing programme in December, through which it has kept continental bond yields pinned down at record lows in order to stimulate the economy and stoke inflation. But the bank also reiterated guidance that benchmark interest rates will remain at record lows at least “through the summer of 2019”, which markets have taken to mean that a rate rise won’t come until the end of 2019.

Japan

After a weak start to the year, the economy remains on a broad improvement trend, supported by healthy levels of corporate spending and a high demand for labour, which is leading to slightly faster wage growth, together with a generally supportive global environment. While there are reasons for remaining optimistic, in the near term several headwinds continue to face the Japanese market.

The government has unveiled an outline of fiscal measures it hopes will bolster the economy after next year’s consumption tax increase. The measures, which include tax cuts for car owners and rebates on some cashless purchases, will account for roughly ¥2 trillion of next year’s budget, officials said.

Prime Minister Shinzo Abe confirmed last month that the government will follow through on its plan to raise the consumption tax to 10 percent from 8 percent next Oct. 1, promising “extraordinary measures” to keep private consumption steady. Over the past five years, Japan’s economy has clearly improved. Corporate profits have been at record highs, and the employment situation has improved substantially. Prices have improved steadily compared to five years ago, when the economy was suffering from deflation. Japan’s economic activity and prices are no longer in a situation where decisively implementing a large-scale policy to overcome deflation was judged as the most appropriate policy conduct, as was the case before. There are several reasons why the outlook for the Japanese economy remains quite positive. Japan is making slow and gradual progress in its fight against deflation. Wages have been rising, but at a modest rate, and core inflation is still below 1 per cent. However, the Bank of Japan remains committed to lowering interest rates and increasing monetary supply through quantitative easing, a policy stance that is not expected to change in the foreseeable future and which should help keep the yen competitive relative to the US dollar.”

China

China’s industrial sector continues to signal significant weakness, and during Q3 China acknowledged the slowdown by fully shifting toward an easing stance. Policymakers there face a delicate balance of trying to ease conditions while not adding to elevated debt levels, a task made more difficult by an external sector no longer in surplus and facing rising US trade barriers. Stocks also fell in greater China as policymakers’ recent efforts to stem selling pressure through promises of stimulus, monetary measures and tax cuts was once again overcome by bearish sentiment as data continued to show the economy slowing. The best approach for China is to look for ways to quickly defuse the growing trade tensions with the US while continuing to re-orient the economy in favour of

domestic drivers of growth. This is neither an easy nor a particularly attractive option for China, especially given the difficulties of establishing trust, as well as the need to come up with measures that are subject to credible verification. There is also the issue of saving face. But the alternative, of continuing to escalate the tit-for-tat conflict with the US, would place at risk a bigger issue – that is, the continuation of the country’s impressive development process.

October economic indicators, together with the credit data, suggesting that the recent policy easing helped to stabilise economic growth. However, headwinds from the unsettled trade war with the US and domestic deleveraging still weigh on growth. As such, we expect monetary and fiscal policy to become more pro-growth in the rest of the year.

Emerging markets

The list of headwinds weighing on emerging market assets remains long. It includes global factors such as the need for the Federal Reserve to tighten US monetary policy conditions, the US-Sino trade dispute, geopolitical flashpoints in the Middle East and the Korean Peninsula, and sanctions against several emerging economies. At the same time, emerging market assets trade at a significant and still-growing discount to peers in the developed world. A lack of further negative news, or even positive surprises, can spark relief rallies. Two recent examples of the latter are the Turkish central bank’s announcement to finally tighten policy conditions in a meaningful way, and the Bank of Russia’s surprise decision to hike its policy rate. Monitoring these tailwinds is of equal relevance, and we don’t think that an overly negative positioning is a winning investment strategy at this point.

Commodities

Gold

The basic supply/demand situation continues to favour higher gold prices, or at least a floor on current levels. Demand for physical bullion from China and Russia is still strong, but they are not alone. New demand is coming from EU members Hungary and Poland, for example. In 2018, Poland became the first EU nation to buy gold in the 21st century. And Hungary’s central bank has bought gold for the first time since 1986. Asian countries are also buying gold as ways to diversify their reserves.

Overall, this year we saw central banks increase their gold purchases for the first time in five years. But the headwinds for gold prices increase as the Fed continues to raise nominal rates. In the absence of persistent inflation, that means real rates are going up also. This makes cash a more attractive safe harbour than gold because gold has no yield. Because of this, higher rates are generally seen to weigh on bullion, yet, in the two most recent US hiking cycles, gold has risen even as equities climbed because the Fed lagged inflation, which meant that cash in the bank lost purchasing power, making gold a more appealing store of value. The fundamental tailwinds and interest rate headwinds remain in a rough balance. The determining factor will come from the stock and bond markets as they continue to wrestle with political and economic uncertainty.

Gold will face a longer period of Fed tightening before the interest rate cycle turns in 2019. US-China trade issues could also dominate the Fed’s narrative, all eyes will now be on the Federal Open Market Committee’s final gathering of this year on December 18-19 to glean further clues on what may happen. In language following that policy meeting, officials may convey “sufficient” softening of future expectations.

The other wild card is geopolitical uncertainty, as displayed recently in the Khashoggi affair and intrigue in Saudi Arabia. Safe-haven demand will also continue and gradually push gold toward the US$1,300 per ounce level in the weeks ahead. I see gold prices climbing to $1,360 in the first half and potentially hitting $1,525 in 2019, a level last seen in 2013. A gold entry point of US$1,235 per ounce is still attractive, but it may not be available much longer.

WTIS

Further weakness in oil prices weighed on sentiment, particularly in the energy sector, following a build-up in US stockpiles. Brent crude has fallen from US$85 a few months ago, to US$70 (and went below this mark recently). US waivers over Iranian sanctions have taken their toll recently. The decline in prices has primarily been as global producers have caved to political pressure and boosted output, with an almost year-long expansion.

Saudi Arabia will export 500,000 fewer barrels a day in December. While the recent meeting yielded no change in supply policy, OPEC warned it might need “new strategies,” which increases the prospect of a wider and co-ordinated cut in 2019. Stand by for

some decisive and co-ordinated action in my view, and this will further underpin our scenario of rising global inflation next year should oil prices then reassert to the upside.

Near-term prices have been under pressure from ongoing uncertainty over global economic growth and increasing supply. OPEC announced Friday 7th December that it will reduce overall production among its members by 800,000 barrels a day from October’s levels, for six months, beginning in January. The statement didn’t specify the output cut by non-members, which include Russia, but news reports have pegged the non-member cuts at 400,000 barrels a day to bring the total reduction to 1.2 million barrels a day. Now we have a situation where supply will come off the market. Would not be surprised to see oil prices move up 20+ from their lows in the next week or two.

Sector

12 Month Forecast

Economic and political predictions

AUD

70c-75c

Trump’s so-called trade war with China has destabilised markets and hurt currencies that are either sensitive to changes in the Chinese economic outlook, or developments in investor risk appetite. The Aussie is one such currency The Federal Reserve is expected to slow the pace at which it raises rates in 2019 We expect a higher Australian dollar in 2019, largely because of a rise in Australian yields, I would expect higher inflation and strong economic growth for 2019 and 2020. Therefore, it is likely that the central bank will start a tightening cycle in late 2019.

Gold

$1,220 – $1,350

Although easing trade tensions will be positive for risk assets, this won’t affect gold too much as we think dollar weakness will be the more important driver for the metal. For gold to really break out of its current range we need to see the Federal Reserve signal it will stop raising interest rates.

Commodities

Prefer Oil and Gas over bulk metals

Energy and materials were the two worst performing equities sectors during the quarter, which generally fell in line with the market dynamic in the quarter, which favoured more defensive stocks and penalised more cyclical stocks.

Property

Hold – value appearing

Though bond rates have started to rise, and while investor demand remains strong with the prospect of some further firming of yields, rising bond rates will eventually lead to a softening of yields and prices. This will create a headwind for investment markets. Expected returns will be lower.

Australian Equities

Low 5600 – High 6600

In Australia non-mining business investment remains strong and employment is steady, although we remain concerned about the lack of wage growth, which unless shows signs of improving, will be a drag on consumer confidence. Manager commentary is consistent with our tactical view that value stocks are the right place to be invested. Value-biased managers are becoming increasingly more optimistic, pointing to value stocks being cheaper than growth stocks by two times historical averages.

Bonds

Australian Ten-year Bonds

2.50%- 3.4%

We see rates rising moderately amid economic expansion and Fed normalisation. Longer maturities are vulnerable to yield curve steepening but should offer portfolio stability amid any growth scares. We favour shorter-duration and inflation-linked debt as buffers against rising rates and inflation.

Cash Rates

No change

Currently, the market is not pricing in a rate hike until the June quarter of 2020 at the earliest. Even though the experts’ growth forecasts are not that pessimistic, it is a high hurdle for the RBA to tighten policy in the face of below-trend consumer spending. But if the RBA is right, and the economy is growing above trend, with trend growth in consumer spending and the housing price correction over, expect the RBA to go by the December quarter of 2019.

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