Merlea Macro Matters – January

Summary

The markets got off to a roaring start this year which has left many wondering if the rally is sustainable, and even more anticipating a decent selloff in the market. There can be no doubts that sentiment is running high. And I have to say that I am in the camp that also expects markets to correct, however, I don’t believe the “looming” correction will prove to be much beyond 5% or 10%. My argument is that pretty much everyone has the same view, and this will make it difficult for markets to “initially” correct much beyond this. One argument that has been persistent in the media is that the current bull run is long in the tooth. There is merit to that argument. This rally and indeed, economic cycle follows a once in a generation financial downturn, which remains fresh in the minds of all who lived through it. It is only human nature to expect the worst after calamity and this was exactly the pattern in the 1930s. For now, I expect markets to defy the obvious in terms of expectations. and follow the path of least resistance.

For 2018 economists are forecasting an acceleration in global GDP and leading growth indicators such as PMIs (Purchasing Managers index) indicate manufacturing, globally, is in good shape. Some steam came out of the US dollar in 2017 as well, making US products more price competitive abroad.

The global economy is expanding in a synchronised manner and this has benefitted US multinationals that source a significant percentage of their profits from abroad.

 

Bonds

We believe that global bond yields will continue to rise this year and begin a secular bear market. I think this secular bear market in bonds has now started and we are going to see a much higher yield curve in the global bond market by the end of this year. This will not be a crash by any means. Indeed, the new rising yield environment will offer investors with a long-term time horizon the opportunity to enhance portfolio returns.

The process of normalisation of interest rates in the major developed economies is, very slowly and gradually, getting under way, and interest rates look likely to rise in 2018, creating issues for bond investors. As expected, the Fed raised the Fed Funds rate to 1.25% – 1.50% in December. In its statement the Fed described the stance of monetary policy as accommodative and we do not see Jay Powell’s chairmanship of the Fed changing the overall message. That implies 3-4 interest rate increases in 2018. However, so far, the curve has flattened, and long rates have remained in well-defined ranges. We do expect to see some drift higher in yields, but market positioning remains firmly against any bond market rout. QE in Europe and Japan is also supportive of government yields remaining low. No rate changes are anticipated in Europe or Japan. The UK could see a further hike if inflation remains sticky. The upshot is that bond yields, more in the US than elsewhere, are likely to rise.

The outlook for Australian government bond yields is based on this outlook for US and Australian monetary policy, and the US 10yr Treasury yield. The forecast is for the RBA to broadly match the Fed on rate hikes over the next two years. The RBA cash rate and the fed funds rate are both expected to head towards 3%. The difference between short term interest rates in Australia and the US is a good guide to where the 10yr bond yield spread should be. History says that when US and Australian short-term interest rates are broadly the same then the 10yr ‘spread’ will be around 25-50bps.

The forecast for the Australian Government 10 year yield is based on the RBA cash rate rising to 3% over the next 12-18mths and the US 10 year rate heading to 3.5% over the same time horizon. These assumptions will result in the benchmark Australian Government 10yr bond yield rising to around 3.75% to 4% at the top of the forthcoming interest rate cycle.

 

Australian Equities

The late surge that we saw in the ASX200 in 2017, and the push through 6000, owed much to the ongoing re-rating of the resource sector. We believe this trend will gain further momentum in 2018. The Australian economy is moving beyond the mining boom; beyond the housing boom and beyond the construction boom to a broad-based expansion in the non-mining economy lead by key industries such as health and aged care, tourism and education as well as the new digital economy.

We see the ASX200 as having a robust year, driven by the resource sector. High commodity prices have supported the Australian economy over the past year and taken the consensus by surprise. Demand from China and other emerging markets was strong, and we expect this to remain the case this year. Adding to the equation is that supply is challenged across the spectrum, following in many cases a period of underinvestment. The ability of supply to respond is therefore being generally over-estimated in our view. We are positive on the Australian share market generally this year, although there are some sectors which we continue to avoid. One is retail, with competitive pressures continuing to build, and as consumers remains heavily burdened by debt. Much has been made of the ‘soft’ start by Amazon, but I don’t think Aussie retailers can breathe easily just yet. A robust resource & energy sector will be a strong tailwind for the ASX in our view. We believe that the ASX can reach 6600 during this this year, and indeed within a few years, challenge the previous all-time highs.

The Reserve Bank of Australia (RBA) stayed on the side-lines in 2017, and we can expect ongoing caution in 2018. The benchmark interest rate of 1.5% has been unchanged since August 2016. Sluggish wage growth, apathetic inflation and concerns over the strength of the Australian dollar, will dominate the RBA’s stance, despite some stronger domestic data continuing to emerge. A key concern will remain the high level of household debt, and particularly as mortgage rates continue to ratchet up. This is likely to see a further cooling of the property market, although previous macro prudential measures, and some wage growth finally coming through given the strength of the employment market, should cap the severity of any correction in property prices. We expect one or two token rate rises at best.

Opportunities in the current environment:

  • Positive on sectors that benefit from synchronised global growth such as industrial cyclicals and energy.
  • Positive on themes that are likely to continue medium-term such as mining services, infrastructure, construction services and electric vehicle industry participants.
  • Positive on technology – Personal and business productivity is going to remain a structural theme going forward and I therefore view software, artificial intelligence, robotics, internet of things and technology leadership as critical facilitators.

 

Global markets

America

In the United States, the major leading indicators are not highlighting a strong chance of a recession in 2018, although this may change as we progress through the year and investors typically look 6-12 months ahead. As far as sentiment goes, US stocks have climbed a ‘wall of worry’ but show little signs of the exuberance that bull markets often die on.

Robust global and US economic growth, still low and only slowly climbing interest rates and a boost from tax reforms should be supportive of US corporate profit growth in 2018. The real estate market also continues to be a source of strength. US inflation is likely to pick up from low levels in 2018, as spare capacity in the economy wanes and employment remains strong.

This is likely to see more meaningful wage inflation flow through and dovetail with rising commodity prices. As the Federal Reserve responds with more rate hikes, this may cause the yield trade to wobble at times and stoke fears about the impact of a stronger greenback (US$). The successful tax reforms in the US mark a significant achievement for the Trump administration. The relatively high level of US corporation tax had previously encouraged companies to re-domicile abroad. The planned cut in US corporation tax from 35% to 21% would increase after tax profit of US companies by 21.5%.

The final corporate tax rate agreed may be over 21% but it will still have a leveraged impact on corporate America’s bottom line. The tax reforms will also mean lower levies on profits that are repatriated from overseas. While Democrats will continue to criticise the tax cuts they will increase the pace of US economic growth. A strengthening US jobs market, with improving wage growth, will help increase the standard of living for American workers.

Fed Chairman nominee Jerome Powell is likely to stick with a softly, softly approach to interest rate tightening in 2018 assuming his appointment is confirmed as expected. Mr Powell is widely considered to be likely to adhere to a similar approach to that seen during the Yellen tenure as Fed Chair. He is reported to have broadly backed Ms Yellen’s monetary policies.

As he assumes the role at a later stage in the cycle with significant strength being exhibited both globally and more specifically in the United States, we do expect a modest acceleration of the tightening process. Other factors likely to support more rate hikes than under Yellen include our expectation of greater inflationary pressure and tax reforms, which stand to further bolster corporate profits and earnings growth.

The Fed can afford to begin 2018 cautiously on the rate hikes front due to still subdued inflation. The Fed’s preferred measure of inflation has been under its 2% goal for most of the past five years. Pricing pressure has continued to be soft despite a tight labour market, growing corporate profits and a robust housing market. Commodity prices have been rising though, due to a healthy demand profile and in some cases constricted supply. Tax cuts should give economic growth another boost in 2018 and we believe the nexus of the above factors will conspire to put upward pressure on inflation. Hence, we expect at least 4 rate hikes in 2018.

As the Federal Reserve responds with more rate hikes, this may cause the yield trade to wobble at times and stoke fears about the impact of a stronger greenback (US$).

After a 10-year bull market run, investors are likely to become increasingly jittery that the party in US equities will need to take a breather and as they look ahead, the steam in the US equities bull market will fade in 2018. This will see investors progressively seek out opportunities abroad and redirect more funds towards emerging markets equities. These rallied in 2017, but that was after years of underperformance and given solid long-term prospects and in some instances relatively undemanding valuations, these are likely to outperform US equities in 2018.

 

Europe / UK

While the European political tide is shifting, the economic momentum for the Eurozone will continue to be strong. The composite Eurozone PMI came in at 57.5 in December with this the highest level since February 2001. The improvement was driven by “record” manufacturing growth, according to IHS Markit. German manufacturing was particularly robust, registering a record PMI of 63.3 on the back of export demand. We expect to see particularly strong growth in Germany, Spain and France and this will support the Eurozone. Germany will continue to be driven by export demand and increased consumer confidence given the historically low unemployment rate.

France will maintain its reform agenda under Macron and this will result in growth beating forecasts. The French central bank recently increased its forecast growth for 2017 to 1.8% with this the fastest pace of expansion since 2011. Economic growth from 2018 to 2019 is expected to be 1.6-1.8% versus a previous forecast of 1.6%. The French central Bank also noted that growth in 2019 and 2020 could be faster than expected if reforms boost the economy’s potential output.

Recent commentary from the ECB points to a more aggressive stance this year with the European economy recovering strongly (growth has pushed up to 2.4% for the Eurozone which is a decade high) and this highlights a potential shift away from the large quantitative easing we have seen in recent years. A move to withdraw monetary accommodation would see interest rates move up. The upward ‘march of the euro’ has surprised many. The issue is where to from here. The ECB may adjust monetary policy but albeit this will occur at a slower rate than in US, widening US interest rate differentials. This must be supportive for the US dollar at some point.

 

UK

The UK and the completion of the first stage of Brexit talks has allowed trade talks to begin in 2018. The goodwill built up by UK Prime Minister Theresa May in the first round will help to secure access to EU markets. The strength of the EU’s negotiating position will, however, continue to encourage the UK to move away from a hard Brexit. UK politicians will accept that they cannot “have their cake and eat it” with regard to single market access without EU membership. European leaders will remain keen for the current UK government to remain in place given the tight Brexit timeline. The softer line taken by Brussels in December was prompted by fears that the UK government may collapse. With it remaining in everyone’s interests for a deal to be reached, we are likely to see cool heads eventually prevail. The UK needs a trade deal with the EU and European leaders will be keen to move on to other issues pressing the EU. 


Japan

Japan’s economy in 2017 saw tremendous improvement with it scoring its longest streak of growth in the past decades – 7 seven consecutive quarters in fact – as businesses benefitted from a surge in global demand pushing exports to highs last seen in July 2014. And it’s highly unlikely to let up anytime soon as the latest PMI data indicate continued demand with new orders and backlogs still picking up with no signs of abating. The strength of the economy has led to a steady pick-up in inflation which has been trending up for the entirety of 2017, albeit far off from the Bank of Japan’s (BoJ) 2% target but gradually getting there. After all, the annualised pace of inflation in Japan accelerated from 0.1% to 0.8% by the close of the year, signalling the effectiveness of BoJ’s policies.

The Cabinet Office’s expectations for Japan’s economy pegs annualised growth at 2.5%, one of the fastest rates of growth in years. Improving prospects for the economy may signal the end of the BoJ’s Negative Interest Rate Policy (NIRP) as the Governor, Haruhiko Kuroda, changed his tone last November stating that due to criticism from banks, which are calling for higher interest rates across the yield curve, the BoJ is now “very mindful” of their impact. In addition, he even alluded to “reversal rates” which could edge away from monetary stimulus earlier than expected.

Additionally, the Japanese government plans to introduce legislation to parliament later this month that will lower the corporate tax rate to 25 per cent from about 30 per cent – but only for companies that raise wages by 3 per cent or more. The incentive will appeal to most large companies in the corporate sector. The bill (which is likely to pass into law), will also cut taxes for companies and incentivise investment in cutting-edge technology. Corporate Japan will likely respond, particularly the larger companies and manufacturing conglomerates. Japanese corporations have never been in such good shape with record profits and cash reserves held at the end of September last year of some $13.6 trillion. With Japan’s jobless rate currently at 2.7 per cent (the lowest since November 1993 and by far the lowest among G7 nations), this should lead to higher wages and inflation. An increase in disposable income would dramatically improve and change the shape of the Japanese economy. Apart from driving up consumer confidence and consumer spending (which in turn will feed into asset prices, namely real estate and equities), it will unleash optimism within the corporate sector and increase investment and get Japan back on track to a positive self-sustaining cycle.

In line with this, we see the yield curve in JGBs (Japanese government bonds) getting steeper. Note that as economic prospects improve, bonds become less attractive as investments relative to equities, which in turn would lead to a shift in allocation causing yields to go up as bond prices go down. There is economic theory that supports this, the steepening of the bond curve goes hand in hand with economic growth. Given negative deposit rates and 10-year JGB yields which were fixed at 0%, it is no surprise that banks have struggled to make lending profitable. We see the BoJ adjusting rates as the NIRP is impacting the banking industry, while the disruption is undermining their monetary policy efforts.

As such, the above factors combined mean that the BoJ will eventually end the NIRP and this will be a major boon for banks as their business model involves borrowing money in the short term (CASA) while lending money in the longer term, with positive rates and a steeper yield curve pushing bank sector profits, this will lead to a subsequent increase in earnings. Improved earnings expectations push the Nikkei well over 25,000.

 

China

China – still a global growth engine – has seemingly steadied the ship. Debt is high on an absolute basis, but the ability of corporations to service that debt has improved. The shift to a consumer-led economy continues and consumer spending was strong again in 2017. Private enterprises and “new-technology” companies are increasingly becoming drivers of growth. So Chinese growth, overall, continues to hold up well. We expect a moderate slowdown this year, as the deleveraging campaign continues, and particularly real estate activity should soften. So far, external demand has remained supportive, compensating for some moderation in fixed investment growth

The so-called hard landing many have forecast for years was again unrealised in 2017 and instead growth appears stable and set to perform robustly again in 2018. China applied the monetary brakes in 2017 and still has other levers to manipulate in 2018. Chinese authorities seem to be doing an adequate job of managing the economy and have enormous influence. Xi Jinping has emerged as one of China’s most powerful leaders in modern history.

The trade war that some worry Donald Trump may ignite with China is unlikely to eventuate, as the damage to the American economy would be significant. There will however likely be some more rhetoric from the White House. The outcome of the 19th National Congress in China suggests an aggressive deleveraging of the economy is not on the table, and instead it will likely be a gradual process.

A cyclical recovery, with improved earnings momentum in energy and material prices, along with continued strong growth in technology and internet companies is likely to support Chinese equities earnings growth in 2018. The country’s technology companies are world-leading in their ability to monetise their respective ecosystems. We expect Chinese equities to climb the ‘wall of worry’ in 2018 and the Shanghai Composite to rally 20% or more.

Commodities

Demand growth has been strong for commodities over the past few years despite rather tepid global economic expansion. With support from low prices, oil demand has been materially above trend, and as of December 2016 had witnessed the highest two-year growth period in a decade. Returns in the commodities markets have improved over the past year amid stronger macroeconomic activity and supply-side tightening, and our outlook for the next 12 months has brightened.

While considerable uncertainties remain for all commodity sectors, we believe the worst market trends may be behind us. As we look ahead to the next 12 months, commodities will likely reclaim a diversifying role in portfolios, given growing inflation risks and shrinking correlations between commodities and other assets. In our view, the potential for another metals-intensive growth phase remains, particularly during the first year of any Chinese presidential term, where growth has often surprised to the upside. Of note, as a recent example is China’s plan to build 12,000 new electric vehicle charging stations by 2020 – 2025 a positive development for copper demand – especially if global production levels begin to roll over in 2019-2020.

At this point in the business cycle, we think investors should consider positioning commodities allocations to at least match benchmark targets, if not modestly exceed them.

 

Gold

The gold sector should also do well this year as inflationary pressures build and political instability in Asia (because of North Korea’s nuclear ambitions) and the Middle East continue to be bullish factors for precious metals. Issues in two areas of the world have the potential to come to a head in 2018 which could foster fear and uncertainty in markets across all asset classes. At the same time, the spectacular rise in digital currencies over the course of 2017 is a sign that alternative means of exchange, like precious metals, continue to attract investment demand as a safe harbor against the devaluation of fiat currencies around the world.

 

Oil

OPEC and its non-member allies including Russia extended the 32.5 million barrels of oil per day (bpd) voluntary ceiling on oil production to 31 December 2018. The decision was for once an easy one for the broader group. The issue in 2018 will again be one of compliance. The attitude of OPEC appears more reticent to the task, and we believe this will remain the case in 2018. The inclusion of Russia (a major oil producer in its own right) in the decision process may have fundamentally changed OPECs’ once chequered adherence to control measures.

Over the course of 2017, US domestic production rose from 8.6 million bpd at end-2017 to currently sit at 9.7 million bpd. The increased US production has come on the back of higher oil prices and especially a lower cost of production, as US companies cut costs. We estimate the average cost of production in the US has fallen by some US$10 per barrel and now sits in the range of US$45 to US$50 a barrel. The inventory data in the US has been on a one-way trajectory for some time with crude inventories declining 6.86 million barrels this month to the lowest level since February 2015. At the same time, US exports have risen (WTI trades at a discount to Brent) and whilst the market expected the US fracking industry to be able to quickly plug the demand/supply gap last year, doubts are now beginning to emerge. US drill rig counts are still half of what they were at the previous peak levels of production. Going into 2018 we expect to see further US domestic production coming on stream as, we believe, the oil price will be higher in 2018. We also expect a slower decline in the average US cost of production to between US$42 to US$45 a barrel. We expect to see US domestic oil production reaching 10.5 million bpd in 2018.

Oil demand is the third key factor to play a role in the direction of oil prices in 2018, and on this front the ‘experts’ are divided as to what happens in 2018. On rising confidence in the health of the global economy, with the drivers being the US, China, India and finally joining the party the European Union, albeit from a small base, will be a positive tailwind for the oil price. We estimate West Texas Intermediate price to trade by calendar year-end in the range of US$70 to US$80 per barrel. For Brent Oil we expect it to trade in the range of US$74 to US$84 per barrel by the close of 2018.

 

 

Sector 12 Month Forecast Economic and political predictions 2017
 

AUD

 

AUD/USD is also looking a little overbought. Moreover, although the Reserve Bank of Australia has yet to weigh in with any commentary about the more unwelcome effects of its strength, the pair is now firmly in the area where such warnings have come before.

72c -80c

 

A strong resource sector will likely put some upward pressure on the AUD. The Aussie has rallied recently to 0.785 (spurred by last month’s Fed meeting), but we believe that the Australian dollar will be less of a one way bet this year as the reality of US currency hikes set in.

 

Gold

 

With bond yields rising, gold could get a bid as a safe harbor asset, especially with price trend   improving.

 

Geopolitical risks, especially around North Korea, continue to cause concern, as does the potential for the major central banks to tighten liquidity conditions too early or too aggressively. We continue to hold gold to maintain ‘protection’

 

• Ultimately, however, higher real interest rates tend to be a headwind for gold.

 

Commodities

 

Overweight energy and materials.

 

Improving fundamentals, stabilisation of commodity prices, global growth and higher real returns should continue to support.

 

Energy appears particularly cheap on price to book at a time

when we see improving free cash flow generation and an

increasing focus on capital efficiency. We would expect to see more M&A activity in 2018.

 

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.

 

Underweight

XJP 1300 – 1340

 

Low domestic rates remain supportive, however out-of-cycle rate increases, and premium valuations make property’s

relative appeal as an asset class difficult to sustain in a global rising interest rate environment.

REITs, like many other high-dividend investments, tend to move in the opposite direction to interest rates. Higher interest rates make dividend investments less appealing to investors, causing negative pressure on their prices. In contrast, lower rates make the relatively high dividends paid by most REITs seem attractive.

 

Australian Equities

 

5580 – 6600

 

Currently, the positive bullish drivers of the market are winning over the more cautious bearish drivers. Points for the bull are well supported by data and sentiment including a synchronised global recovery, a continued boom in infrastructure spending and a rise in capex across a range of industries. In addition, inflation is negligible, stock correlations are low and commodity prices are generally rising. Points for the bear include high asset valuations across many markets, low top line world growth and record global debt levels.

Sector 12 Month Forecast Economic and political predictions 2017
 

Bonds

 

Underweight long duration and reducing credit risk.

Over the next 12-18mths US 10yr rates heading to 3.5%. Over the same time horizon, the 10yr spread is expected to be around 25-50bps.

 

These assumptions will result in the benchmark Australian Government 10yr bond yield rising to around 3.75% to 4% at the top of the forthcoming interest rate cycle.

 

The era of central bank distortions appears to be ending. Ultralow yields like those on European High Yield and negative government bond rates are at risk. Bond owners beware. Improving global growth with inflation trending higher warrants lower exposure to government bonds and duration.

 

 

 

 

 

 

 

 

Cash Rates

 

The RBA cash rate rises to 3% over 12-18mth period.

 

 

 

Global Markets
 

America

 

Underweight US

 

S&P 500

2580 -3100

 

The US deficit is likely to blow out over the next eighteen months (with a drop in taxation revenue) and markets are pricing up the cost of US debt and the increased risk profile. I also believe that inflation pressures are building. We have seen this with rising commodity prices, and the cost of oil,. At some point the very low unemployment levels and corresponding tightness in the labour market is going to feed into wage inflation. I think this is the other major driver behind the rising US bond yield.

 

Europe

Overweight

 

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

 

From what we can see, there is a lot of economic, earnings and price momentum in Europe right now. Emerging from the various banking, export, and employment malaise of the past five years, the European recovery is broadening well past Germany and the industrial North. Italy and France have joined the party.

Eurozone growth is robust, political risks are abating, and ECB policy remains easy; supports EUR and eurozone stocks.

 

Japan

 

Overweight once a correction has occurred.

 

 

Nikkei 225

21500 – 2500

 

Favour Japan

 

There is a lot to like short-term about Japanese equities. Equity valuations are modest, return on equity measures continue to improve, and both corporate earnings and general economic conditions have strong momentum. Japanese companies are leveraged to a global economic cycle. In the short-term, both earnings and economic growth should remain above trend.

Japanese earnings are picking up strongly as corporate governance improves; JPY stable, Japanese equity supported.

 

China

 

Take profit. Do not sell out. Underweight

 

Shanghai index

3350 -3650

 

Emerging from the latest Congress, it appears Chinese growth will slow as policymakers focus on quality growth, less pollution and avoiding economic crises. Even so, the sheer size of this economic giant in the region creates a positive ripple effect. 2018 growth likely to remain solid in China; the economy is moving very slowly toward services and the consumer.

We maintain our preference for consumer/service sectors including internet, tourism and education on the back of our positive long-term outlook for consumption demand in China.

 

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