Merlea Macro Matters – July 2018

(Merlea Macro Matters)


G20 finance ministers and central bank governors have warned that global economic growth is becoming less harmonised and that risks are growing due to trade concerns, which weighed on investor sentiment this month. While frictions remain globally, investors responded positively to news of a break-through on trade and the consequent benefits to the US and global economies. Near-term, I am bullish on US and global equities (particularly after the hard selloff in Asia), but looking further out a more cautious approach is warranted. We see a breakout in inflation as being an inevitable obstacle that the US economy will have to face, and this could push interest rates sharply higher by the end of the year. I don’t think the US bond market will take an inflationary outcome that well, and heading into the September, it is highly probable that US and global stock markets will return to a volatile environment.

Over the next few months there is an opportunity to place portfolios on a more defensive footing. We have started this process now. History has shown us time again that the “crowded trade” no matter how appealing, always unravels at the most “unexpected of times.” Fund managers and investors alike typically head for the exits at the same time. It’s therefore not really a question of what the potential catalyst will be, but rather the event that follows. We have seen this in China recently with the CSI300 losing 25% quickly on no apparent catalysts. We have commenced placing our portfolios on a defensive footing and will further take advantage of any strength in the US and global stock markets over the coming months to make additional adjustments.


Global bonds yields have begun to rise after the Japanese central bank egged on higher yields at the long end of the curve. The result was a steepening yield curve for many markets. Here, the bond curve has flattened some more as growth and inflation prospects wane. In our view, bond and currency markets are placing too much emphasis on the influence of stronger global growth and a likely spike in inflation later this year as higher energy costs feed into consumer prices. Our view is that the RBA will look though the one-off lift in inflation due to the higher cost of electricity and will keep rates on hold to assist an orderly deleveraging of debt by Australian households and governments.

In contrast, the Federal Reserve will continue to lift rates throughout 2018 and 2019. This will be the first time for 17 years that the Fed rate has been higher than Australia’s. Although Australian bond yields may rise as global rates rise, they will rise by less than US yields, consequently, the Australian dollar will fall and we expect the Aussie to retrace to around US$0.70.

Listed Property

AREITs have posted some strong returns recently despite rising bond yields. M&A and a relief rally in global malls may explain some of the recent strength. Retail malls represent some 50% of the local AREIT index by market capitalisation. At the sector level, further reductions in vacancy rates and rental growth are expected to drive the Sydney and Melbourne office markets. Residential stocks continue to enjoy strong margins; however markets are likely to slow from here given the increase in apartment supply, prudential controls and low levels of affordability.

Capitalisation rate compression has lifted underlying property valuations, although several AREITS stated during the reporting season that they expect more limited, if any, cap rate compression going forward.  Whilst underlying property values are close to mature-cycle levels, the AREIT market is now trading at a small discount to Net Asset Value suggesting fair value. Nevertheless, the sector remains subject to moves in bond yields. We remain cautious on the long lease expiry stocks. We continue to find reasonable valuations in office markets and select small REITs.

A-REITs provide a good lead for unlisted commercial property and their weakness since 2016 signals some caution. Our expectation is for a gradual rise in bond yields (to around 3.5% by end 2019 for Australian for 10-year yields) and that a US recession won’t be a risk until around 2020.

Australian Equities

Based on historical P/E ratios, the Australian market does not look particularly expensive, with banks and resources trading at close to historical multiples. However, the industrials part of the market (the market ex resources and financials) is clearly trading at a high multiple relative to history.  The industrials component of the market is currently trading on a forward P/E of 20x, compared to a 20-year average of 17x. The last time the industrials moved higher through a 20x P/E was in February 1999. This makes the market vulnerable to a larger correction if the earnings outlook deteriorates. However, the current macroeconomic and earnings environments remain supportive, notwithstanding identifiable risks such as an escalating trade war.

I remain of the view that the RBA will lag behind many other global peers (particularly the Fed) in its tightening program. Quarterly inflation numbers came in below expectations which likely confirms that we will be in for a long wait before the RBA is compelled to lift interest rates. This will in our view ensure that downward pressure remains on the currency, which will ultimately be a positive for exporters, and some respite for an economy which (while remaining lucky) faces headwinds on a few fronts. The ABS release showed that consumer price inflation rose to 2.1% over the year to June, from 1.9% in the prior quarter. The quarterly CPI print was 0.4%, and 0.1 percentage points below consensus forecasts.

Of more relevance to the RBA is the underlying measure of inflation, which has now dropped below the lower end of the central bank’s 2-3% target range. Core CPI fell back to 1.9% on an annual basis after rising 0.5% during the quarter. While higher energy prices were a tailwind, tipping the ledger the other way was subdued pricing in the retail space, and lower rents as the property market cools.

A lower $A has also not resulted in import inflation, with a fragile consumer and strong competition meaning that retailers are finding it difficult to pass price increases on. The lack of any meaningful wage growth yet has also exacerbated matters. This further underlines our inclination to stay largely clear of the sector.

A key gauge of bank funding costs has jumped to its highest level since the euro zone sovereign debt crisis of 2011, squeezing profit margins and sparking debate over whether lenders may respond by hiking mortgage interest rates. The change, which is grabbing attention within banks, is the blowout in the gap or “spread” between the three-month bank bill swap rate (BBSW), an interbank funding market, and the overnight index swap, which reflects bets on the path of official interest rates. Some analysts believe the recent changes could be a result of US interest rates rising, which is causing investors to demand a higher rate when they lend to big corporations. There are also signs the pressure on banks to secure funds is flowing into the consumer deposit market, with new analysis from interest rate comparison website Canstar showing a trend towards higher retail term deposit rates in recent months. Deposits account for about 60 per cent of major bank funding, so experts say the trend is likely to result in banks increasing mortgage interest rates to offset some of the hit to their profitability.

Global markets


Powell underlined the current economic momentum in the US, saying that growth in the second quarter was “considerably stronger than the first.”

He went on that “Robust job gains, rising after-tax incomes, and optimism among households have lifted consumer spending in recent months. Investment by businesses has continued to grow at a healthy rate…Good economic performance in other countries has supported U.S. exports and manufacturing. And while housing construction has not increased this year, it is up noticeably from where it stood a few years ago.”

About inflation, he commented that it was running around the Fed’s 2% target for the first time in several years. However, he also inferred that while the economy was nearing full employment, and wages were growing faster than a year ago, it has not been enough to stoke inflation fears.

Ultimately, it also says to me that the Fed Chair is focussed on ‘staying the course’, with at least two more rate hikes this year.

While a strong earnings season has been expected, much has been made of whether corporate CEOs would sound the warning bells on increasing protectionism, and the prospect of an all-out trade war. To date, the ‘chimes’ have been fairly quiet in the US and on the other side of the Atlantic. The question is whether managements are ‘putting on a brave face’ or perhaps like investors are living in the ‘now.’ The dangers remain clear and present in my view. To date, around 87 of the S&P500 companies have reported, with around 85% having exceeded earnings estimates. Consensus expectations are for bottom line growth of just over 20% for the second consecutive quarter, and this highlights, for now, that the economy and business confidence are robust. I still think that the ‘over-owned’ and overbought super IT stocks represent a key risk to the market. I would also point out that there is quite a divergence on valuation amongst the FAANG stocks. Apple is trading on around 18 times earnings, while Alphabet is somewhat more expensive at around 28 times. Facebook is also on a similar multiple, but contrast these with Netflix, and Amazon which trade on 130 and 140 times earnings respectively.

Donald Trump ramped up his stance on tariffs. In an interview with CNBC he emphasized his displeasure with America’s trade imbalance with China, saying: “We’re down a tremendous amount…I’m ready to go to 500.” China imported around US$505 billion in goods to the US in 2017, leading to a trade deficit of circa US$375 billion. The implication is that Trump is prepared to put a tax on all goods coming into America from China. The latest tariff ‘plan’ marks an escalation in proceedings, but it could also be that Trump is about raising the stakes even further to achieve a ‘negotiated’ outcome. This is peculiar as he has deliberately said he is ‘prepared’ to go all in. This is all while the initial tranche of tariffs only came in a few weeks ago, the US$200 billion instalment will not come in until September.


I have written about how the US earnings season would, and is proving to, be a strong one, but reports from European companies are also tracking well. Reuters reports that second-quarter earnings growth for the STOXX600 is expected to come in at over 8% year-on-year, and stronger than the first quarter. On the economic front, the Eurozone composite output index dipped to 54.3 in July, down from 54.9 in June. That was below expectations of 54.8. In Germany the numbers were stronger, with sector activity growing at the fastest pace in five months in July. The composite output index reading increased to 55.2, while it was forecast to be around 54.8

On the economic front, Eurozone consumer confidence weakened less-than-expected in July, although it did fall to its lowest level in nine months according to a flash estimate from the European Commission. The consumer confidence index came in at minus 0.6 compared to minus 0.5 in June, while economists were expecting a score of minus 0.7. German business sentiment softened for the second straight month in July on escalating trade tensions with the US according to the closely watched Ifo business climate index, (The Ifo Business Climate Survey is based on approximately 9,000 monthly survey responses from German firms in manufacturing, construction, the service sector and trade). The reading edged down to 101.7 in July from 101.8 in June, marking the lowest reading since March 2017.

Also, in Germany, construction orders increased in May compared to April according to numbers from Destatis. The seasonally, working-day and price-adjusted orders in construction were up 4.6% month-on-month. In France, producer prices in the domestic market edged up 0.1% month-on-month in June, slowing from the 0.7% increase posted in May. Europe’s new car registrations accelerated in June according to the European Automobile Manufacturers’ Association. The passenger car market expanded 5.2% year-on-year in June, which was well above the 0.8% increase logged in May and the third straight month of growth.

According to data from the European Central Bank. The current account surplus slipped to a seasonally adjusted €22.44 billion compared to €29.55 billion in April. It was the lowest surplus since March 2015. The euro area government deficit narrowed in the first quarter, as revenues increased, and expenditure was down. The general government deficit to GDP was 0.1% in 1Q18 compared to 0.6% in the fourth quarter of 2017. Germany’s producer price increased 3% year-on-year in June, matching expectorations


British households financial outlook improved in July, with the seasonally adjusted Household Finance Index reading increasing to 44.6 from 43.6 in June. UK budget deficit narrowed in June and government net borrowing for the quarter fell to its lowest level since 2007. The public deficit came in at £5.4 billion, down from £6.2 billion a year earlier. The CBI’s quarterly survey found that 32% of respondents reported a rise in sales volumes in July versus a year ago and 12% said they were down, providing a balance of +20%. That was lower than the nine-month high of +32% in June but still better than the expected +15% reading. Retailers expect sales to flatten out in the coming month. Mortgage approvals were down in June during a quiet housing market, though re-mortgages rose with borrowers moving ahead of a potential interest rate increase. New mortgages were down 2.1% from a year earlier.


Shinzo Abe’s economic plan has clearly failed to bring the growth he promised, and more disappointment lies ahead with a slump in global demand and Japan’s continually ageing society.

Complicating matters further is that, while the BOJ policy keeps the yen at levels where Japan can compete in export markets, global demand is beginning to falter under Donald Trump’s US economic policies and the threat of trade wars. Even a weak currency cannot bolster exports and profits when no one wants to buy.

The yen has found buying support after reports over the weekend that the BOJ is mulling some potential tweaks to policy. One of these may be the winding down of purchases of exchange traded funds and that put pressure on index heavyweights. According to reports, these tweaks are to make its monetary easing campaign sustainable in the long run. Changes could also include a more flexible approach to its bond-buying to control the yield curve.

When you think employment figures cannot fall anymore, they do. Companies in the country are grappling with a deepening labour shortage as the rapidly aging population means fewer workers. In a bid to tackle the situation, Prime Minister Shinzo Abe’s Cabinet earlier this month approved a plan to accept more workers from abroad. The employment data released this month points to stronger upward pressure on wages, which so far have not responded as expected to the super tight labour market. But as companies struggle to find workers they’re hiring more staff on permanent, full-time contracts, which generally means higher pay and benefits. Our view is that a pickup in wage growth will eventually feed into faster inflation.

Japan’s latest data on the consumer price index, which showed a deceleration in the “core-core” CPI, which excludes the volatile prices of energy and fresh food, underscored the challenge the BOJ faces in stoking 2 percent inflation. The BOJ will release new forecasts at the end of its meeting from July 30 to 31. Lower inflation estimates would again raise questions about the effectiveness of its easing campaign and the cumulative impact of those measures on commercial banks’ profits, as well as the stock and bond markets.


Cutting debt remains an overriding priority but some fine-tuning allows Beijing to address a deceleration of investment in infrastructure. China has decided to encourage government spending at home to handle the ongoing trade dispute with the United States, reflecting Beijing’s deep concerns about its effect on growth.

China’s cabinet announced that it will pursue a more ‘vigorous’ fiscal policy, as authorities step up efforts to defend their growth targets. The State Council’s statement indicated plans to ramp up the issuance of 1.4 trillion yuan in special bonds by local governments to underwrite investment in infrastructure. The country’s central bank has also lent 502 billion yuan to financial institutions via a one-year medium-term lending facility. Although Premier Li Keqiang stressed in Monday’s statement that the adjustments are just “fine-tuning” and Beijing is not opting for all-out stimulus as it did in 2008, it sends a clear message that China is rearranging its economic priorities for the coming months by putting more focus on growth, which has stayed in a narrow range between 6.7 and 6.9 per cent for the past 12 quarters.

Banks’ reserve requirements were also lowered earlier this month, releasing 700 billion yuan in liquidity. This has seen the Chinese yuan slide to its lowest point in a year against the US dollar, and Chinese stocks have bounced in recent days. The spread between 10-year Chinese and U.S. Treasuries has also narrowed sharply, touching 19-month lows. Whether the start of a broader stimulus push or not, Chinese stock investors have certainly welcomed the news, pushing markets sharply higher for a third consecutive session, leaving them at one-month highs.


Everyone seems to be a commodities bull lately. I think those who expect commodities prices to keep rising may be disappointed. Commodities have seen a mixed start to 2018. A strong beginning to the year in markets was offset by higher risk aversion as volatility rose across February and March. More recently, several commodities markets have been affected by geopolitical tensions, with oil prices benefiting from tensions in the Middle East, and aluminium prices spiking higher as the US announced new sanctions against Russia.  The secular themes of innovation and fading resource constraints are still intact, as best exemplified by the growth in shale production that sparked a bear market in natural gas seven years ago, ultimately spreading to oil. While we see potential for higher prices for most commodities, we believe oil, the largest component in nearly every commodity index, will remain range-bound. On net, we favour a modest overweight to commodities.


The US dollar rally has knocked gold into a substantially lower trading range with funds shorting the market in record numbers. Those shorts stand a good chance of being covered in 3Q but we ultimately pin a recovery in gold prices on whether the dollar reverses in 4Q.

Gold has found support from rising geopolitical risk along with increasing concerns that the current U.S. expansion is soon nearing an end. Gold typically does well at the early stages of an inflation cycle, which does tend to come just after the peak rate of expansion. We expect geopolitical risk and growing concerns of surrounding the U.S. economy to keep macro asset allocators interested in gold.

I think that, as we move through 2018 and into 2019, we’ll see more risks come into the economy and more risks come into the financial system. I think that could drive gold much higher.


Oil prices have recovered strongly over the past 12 months, briefly touching $70 per barrel (bbl) in early 2018. Now that we are here, there is much talk about why $80 is the next stop for oil.

China accounts for around 50 per cent of global demand for many industrial metals, making the outlook for the sector closely related to the health of China’s economy, which has been resilient over the past six months given tighter credit conditions which are weighing on growth.

Although fundamentals remain supportive for commodities overall, a stronger dollar could act as a headwind. Provided the global economy ex-US continues to grow strongly, any dollar strengthening should be limited. But if the rest of the world decelerates and the US continues to grow strongly, potentially boosted by late-cycle fiscal stimulus, then the Federal Reserve could be forced to tighten monetary policy more than expected, enabling the dollar to appreciate and causing negative effects for a wider range of assets than just commodities.

Sector 12 Month Forecast Economic and political predictions 2018



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

72c -80c


Our base case scenario is that a significant escalation of the trade conflict is averted. In the near-term, tough, rhetoric will continue to weigh on EM FX and cyclical FX (such as the Australian dollar), but once the situation calms down somewhat, a considerable recovery of the Australian dollar is on the cards,


We forecast the Australian Dollar will fall to 0.72 against the US Dollar before the end of September, which is down from an earlier forecast of 0.75. However, the exchange rate is expected to recover to 0.74 by year-end and to 0.80 before close on the 2019 year.


In my view the Fed will remain some way ahead of the RBA in its rate tightening program. We are on record for calling for four rate hikes by the Fed this year, while a tick-up in the unemployment rate and benign inflation have likely pushed a move by the RBA well into 2019.




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


There is some belief among investors that this could be as good as it gets for the rest of the year. Many things have happened since the end of the second quarter.


Although the US GDP report showed robust growth, the market was already expecting a substantial number. We see fewer factors in place that will continue to drive the U.S. dollar high and gold prices lower in the medium term. I believe the market is pretty much as bearish as it can get.


We continue to see limited downside risk for gold going forward.




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

We have move 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.




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


After years of being a global underachiever, Australia’s stock market has been a standout performer this year.


The benchmark ASX 200 has rallied 8.5% since the start of April, a somewhat remarkable performance given mounting concerns surrounding the outlook for the Chinese economy.  A sharply lower Australian dollar, especially against the greenback, has undoubtedly been a factor, proving a tailwind for companies with a large share of offshore earnings.


Australian stocks remain a defensive destination for capital flows in Asia.




A rising rate environment means we should shorten our duration for bonds.


For the bond curve, we expect a modest steepening over the remainder of 2018. Yields on 3-year bonds will be anchored near current levels until markets start pricing in a rate hike from the RBA more aggressively. The 10-year leg will be influenced by US Treasuries and so should rise.


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



Underweight US.

S&P 500: 2580 -3100


For the last 4 1/2 months, the S&P 500 Index has been stuck in the 2,581 to 2,872 range. A trading range is healthy in my view as it allows market participants to digest the topic of the month. The yield curve, inflation and talk of tariffs — are likely to lead to more volatility in the month ahead, right now, one of the most watched charts on Wall Street is commanding the attention of investors of all varieties. Yield curve, which plots the difference between interest rates on short-term U.S. government bonds versus long-term bonds, is flashing warning signals to investors, with the difference between two-year Treasury yields and 10-year Treasury yields narrowing lately.




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.



Political uncertainty has returned to the fore in Europe, but we believe the euro zone economy remains strong enough to withstand these turbulences. Economic momentum in the region is positive, supported by an accommodative central bank.  In June, the ECB announced that it would wind down its bond-buying programme by the end of December 2018, subject to incoming data. ECB president Mario Draghi added that the central bank expects key interest rates to remain at their present levels at least through to mid-2019, possibly longer.




Overweight once a correction has occurred.

Nikkei 225: 21500 – 2500

Favour Japan.


While Japan is vulnerable to a tariff-based disruption to demand, the country appears to be in a fortunate position as it may be able to avoid or even profit from the ongoing trade war between China and the United States. No short-term rate hikes are expected by the market in the near-term, but the target rate for the longer-term 10-year bond may be increased to 0.1% from zero.


The Japanese stock market remains attractive for three reasons: 1) valuation multiples have barely risen

and remain very reasonable; 2) stimulative monetary and fiscal policies; and 3) corporate governance reform should

result in a market re-rating over time up to higher multiples




Neutral weighting. Beginning to look interesting

Shanghai Index: 2860 -3250


Chinese shares are now in bear territory, down more than 20 per cent since the recent peak in late January. The yuan slipped against the US dollar and is down about 3 per cent over the past weeks. This might all be part of the Chinese central planners’ defensive strategy. A weaker Chinese currency would soften the blows of higher US tariffs. Chinese authorities would be unlikely to let it slip too far for fear it might inspire an unseemly and destabilising flood of capital offshore.


A statement from the PBOC pledging [unspecified] support for the economy was a further step and it may have helped the yuan and Shanghai equities recover a little and this should keep investors confident on China.




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