Merlea Macro Matters – June 2017


Over the past month we have continued to witness a synchronised global expansion which has aided in the recovery of corporate profit growth and provided a solid backdrop for riskier assets. We believe the cyclical economic and earnings growth differences are closing between the U.S. and the rest of the world. The consensus view is that there is less good news priced into the valuations of non-U.S. stocks and currencies, and this divergence is a growing theme on the growth side as an upgrade to the Eurozone is offset by a downgrade to the US and emerging markets. Looking into 2018, global growth is expected to stabilise at 3% with modest downgrades to developed markets offset by a small upgrade to Japan.

Lower political risks in Europe and the US have been replaced by some of the traditional macroeconomic risks around China, secular stagnation, inflation and the unwinding of QE by the Fed.

As the U.S. business cycle continues to mature, the upside in profit growth is likely to become more constrained, with many equity categories at full valuations. Political uncertainty around potential policy outcomes is at elevated levels. This, combined with uncharacteristically low volatility (the CBOE Volatility Index VIX has been trading well below its historic average of 20), has increased our concern that market volatility is susceptible to moving higher. Additionally, as the U.S. proceeds toward the late-cycle phase, exposure to inflation-resistant assets may become even more valuable to provide portfolio diversification. The combination of these factors warrants smaller asset allocation tilts at this point in the cycle.

There are signs that investors are finally growing tired of the Trump reflation trade, and alarmed about the prospect of impeachment proceedings. We remain of the view that the market itself was looking tired generally, and needed an excuse to pull back. The wall of cash on the sidelines, and with many investors already positioned the same way around, will also cap the downside in my view.


This week saw President Trump nominate Christopher Wray as the new FBI director. The timing is being viewed by some in the media as a way to deflect attention from James Comey’s testimony, which has the potential to be both a positive and negative catalyst for the market.

The US dollar index traded at its weakest level since November 9. The index had hit a 14-year high at the start of 2017 at 103.82 on post-election optimism for US tax cuts, deregulation and infrastructure spending. However, ongoing controversies afflicting the White House will make the agenda more difficult to carry out.

The markets have priced in a conservative outcome at the FOMC this week. Not only is the Trump reflation trade being “unwound” but markets are recalibrating the Fed’s trajectory plan to raise rates. All will be revealed at this week’s FOMC.

The ISM service sector PMI fell from 57.5 in April to 56.9 in May. This was only marginally lower than forecasts of 57, but the figures still represent robust growth.

The US housing market is a relative bright spot in the US economy and the recently released March S&P/Case-Schiller 20-city index increased 5.89% year-on-year. That marked the strongest growth rate in nearly three years, supported by robust demand and low inventory levels. Even with some interest rate bumps on the horizon, interest rates will remain low on a historical basis. Even though US consumer confidence waned for the second month in May, the job market is strong and wage inflation is flowing through.


ECB president Mario Draghi hinted in public that there is now no need for further interest rate cuts. Mr Draghi told a press conference that: “We are now confident that inflation will converge with our objectives.” This has positive implications for Europe’s banks. Inflation forecasts for the Eurozone were cut back to 1.5% in 2017, 1.3% in 2018 and 1.6% in 2019. This compares to the ECB’s previous forecasts of 1.7%, 1.6% and 1.7% respectively. The Eurozone composite PMI reading increased to 56.8 in May with this unchanged on the prior month. April’s reading was however the strongest since 2011 and the Eurozone is expected to grow by 0.7% in Q2 versus 0.5% in Q1.

The Eurozone has clearly continued to recover with the unemployment rate falling to its lowest level since 2009 at 9.3%. Inflation also remains subdued with the most recent reading at 1.4%. The ECB has also increased its forecasts for Eurozone growth by 10 basis points in each of the next three years. Growth in 2017 is now expected to come in at 1.9% followed by 1.8% growth in 2018 and 1.7% in 2019. The ECB previously described risks to growth as “tilted to the downside” but they are now calling this as “broadly balanced.”


Economic growth in the first quarter came in at 0.2% in the UK versus 0.7% in the final quarter of 2017. The main driver was a slowdown in the pace of expansion in the services sector. Looking at the composite PMI reading for May, this came in at a three-month low at 54.5. Construction was the sole sub-sector to grow last month but only accounts for around 10% of the UK economy.

The OECD has warned that UK economic growth will slow next year given the prospect of a “hard” Brexit. The OECD upgraded its growth forecast for 2017 from 1.2% to 1.6% but kept its forecast for 2018 unchanged at 1%. The OECD assumed that the UK will leave the EU without a free-trade agreement to replace single market access. This would lead to the UK defaulting to restrictive World Trade Organization rules from April 2019.

The UK general election unexpectedly resulted in a hung parliament, where no party had an overall majority. The Conservatives remain the largest single party and reports say they formed a minority government. It will rely on the support of the Northern Irish Democratic Unionist Party. On the economic side, we may well see corporates and households reduce their spending due to the uncertainty. The UK economy has already been slowing and this slowdown would likely continue.

The ratings agency Moody’s has warned that the UK election result poses a risk to Britain’s credit rating. This is because it is deemed to have “hampered” Brexit negotiations and would increase the threat to public finances. Division has sprung up within the political parties over the path to Brexit and politically the UK will be in a state of volatility for some time

On the other hand, one can read this election result as a pushback against austerity. The Conservative manifesto implied austerity for a further five years and this is unlikely to be the case now.


Japan’s estimated economic quarterly growth in the three months to March was revised down to 0.3% from an initial 0.5% estimate. Expectations had been for a modest upward adjustment to 0.6%. Year-on-year growth in the first quarter came in at 1% versus the initial estimate of 2.2% and expectations for an improvement to 2.4%. The downward revisions were driven by weak private consumption growth and residential investment. On a positive note, in Japan the services PMI hit its highest level since 2015 in May with the Nikkei-Markit index at 53. This was the 8th consecutively monthly increase and compares to a reading of 52.2 in April. This has helped pushed the Nikkei up towards five year highs around 20,100.


The Caixin-Markit services PMI index for China came in at improved to 52.8 in May versus 51.5 in April. This ended a four-month streak of weakening growth in what is becoming the main driver of China’s economy. The Caixin manufacturing PMI, however, fell into negative territory in May with a reading of 49.6. The composite Caixin index for services and manufacturing edged up to 51.5 in May from a ten-month low of 51.2 in April.

Adding to the improving tone, China’s trade growth came in very strong in May with exports up 8.7% year-on-year in US dollar terms. This compares to an 8% increase in April and forecasts for a 7% improvement last month.

Imports jumped by 14.8% on a year ago versus an 11.9% rise in April and expectations for an 8.5% increase. The trade surplus hit US$40.8bn versus US$38bn in April but this was well short of median forecasts for US$47.8bn. Still, it is encouraging to see China’s FX reserves trending higher and move back above the $3 trillion mark. China’s foreign exchange reserves increased to US$24bn in May with this being the highest level so far this year. An easing in capital outflows and a decline in the US dollar have both helped the country to build up its currency reserves. This will also serve to stabilise the yuan which has lost ground against the US dollar, and periodically was knocked around as markets fretted over China depleting its FX reserves. These reserves give China ample policy levers to keep the economy on track.

Moody’s sees the government’s direct debt burden reaching 40 percent of GDP by 2018 and nearly 45 percent by 2020. Total debt of government, households, and non-financial corporates is expected to rise from the 256 percent of GDP reached at the end of 2016, which has climbed from 160 percent of GDP in 2008. However longer-term factors are more positive for Chinese stock investors. On June 20, the MSCI is expect to announce its key decision on the inclusion of mainland shares in its emerging market indices, which if positive could see a surge in global institutional investment.


The Aussie spender is clearly under the hammer, and more so those that have overextended themselves during the property boom. This also came through in the GDP numbers which sent a mixed message on the state of the economy. First quarter gross domestic product growth came in at 0.3% and 1.7% over the year. The latter was better than the 1.5% expected by the market (with the A$ hitting a one month high), and also means Australia has continued a record of almost 26 years of headline growth. Australia now has the longest run of uninterrupted growth in the developed world. It has been 103 quarters since Australia last had a recession. The growth rate is subsiding (the weakest since 2009) and cannot just be blamed on the weather. The property market has slowed, while low wage growth highlights a slowdown in consumer spending is on the cards. Household consumption rose 0.5% in the quarter, but the savings rate fell to a 10 year low of 4.7%.

Some work will therefore be needed for growth to get to the RBA’s target of between 2.75% and 3.75% by early 2018. The resource sector will clearly need to keep on trucking for growth to get anywhere near this target. While I think the resources sector has a chance of excelling, we have concerns about other parts of the economy, particularly as the bank levy flows through. It is safe to say the RBA base rate isn’t going up anytime soon.


The other much-anticipated news from this week’s FOMC meeting is how/when the Fed intends to start reducing the massive bond portfolio it accumulated during the QE years. The initial move may be simply to stop reinvesting the proceeds when bonds mature. That is still billions of dollars each month – enough for even the very deep Treasury bond market to notice. (Then again, maybe they just let their mortgage bonds roll off and keep buying the Treasuries.

A little-discussed aspect of this situation is, ‘who will buy the Treasury bonds once the Fed backs out?’ That part is beyond the Fed’s control. The federal government won’t stop borrowing just because the Fed stops “lending.” The Treasury will have to find other buyers for its paper and will likely pay higher rates to attract them.

Listed Property

Australian real estate investment trusts (AREITs) continue to provide attractive relative yields in the current low interest rate environment. AREITs returned -1.1% over the month of May 2017, outperforming the broader Australian equities market, by 1.7%.The Retail AREIT sector (the largest constituent of the asset class) underperformed significantly over the month relative to Office and Industrial AREIT Sectors. Weaker performance of the Retail AREIT sector over the last few months is attributable to worse than expected sales values and sales volumes.

Valuation multiples of the AREIT sector are currently higher relative to long term averages. As at 31 May 2017, the yield spread for the AREIT sector above the 10-year Government bond yield was 3.3% p.a. Current yield spread is higher than the long term average spread (15 years to 31 May 2017) of 2.7% p.a.


Political and geopolitical uncertainties, along with US$ weakness, and the Fed’s predicament with respect to rate tightening, are underpinning sentiment towards the precious metals sector. The US Dollar Index lost ground and is testing the 96 support level, as the markets price in a conservative outcome at the FOMC this week. The lower Dollar Index helped the gold price surge pass $1290 and this places the key $1300 level within striking distance. Technically gold is looking very robust and a breakout through $1300 is likely. The elephant in the room is still the prospect of rising inflation later this year and into 2018. If we are right, the precious metals sector will have further to run.


There was a 3.3 million increase in US crude inventories last week when expectations had been for a 3.1m decline. Gasoline stocks rose by 3.3 million barrels versus forecasts for a 0.275 million barrels decline. Crude oil is refined into gasoline and higher inventories of gasoline may therefore weaken future crude oil demand. The US summer driving season is typically a period of heightened demand for gasoline. Oil prices fell back with West Texas Intermediate off by 4.5%, or US$2.16, to trade at US$46 a barrel. The global benchmark Brent declined by 3.7%, or US$1.88, to US$48.28 a barrel. The question now is what happens to oil and the energy sector if prices fall below key support at $45.80?


While there seems to be a lot of conjecture about where the resource sector is headed, it is undeniable that the industry is much better off than it was 18 months ago, thanks to rising commodity prices. Our outlook for commodity prices over the rest of 2017 remains neutral, with the exception of oil and grains, towards which we are more positive. Over a two-year horizon, we remain broadly constructive on commodities and expect prices to grind higher, driven by oil, non-ferrous metals, gold and agricultural commodities.


12 Month Forecast

Economic and political predictions 2017



The Australian dollar has crept a little higher against its US counterpart amid falls in oil and iron ore prices and ahead of several key political and monetary events. Investors are concerned that persistent focus on allegations surrounding Russian attempts to influence the outcome of the election will impinge on the administration’s ability to advance its pro-growth agenda. With uncertainties rising, the outlook for the USD looks less buoyant than just a few weeks ago.


SPT Gold 1140 -1400

On precious metals, we have retained our neutral stance as gold remains vulnerable to an environment of higher real rates and a stronger USD. However, gold is a diversifier in the portfolio and a hedge against the political risks this year. In addition, further US fiscal stimulus at this stage of the cycle could potentially be more inflationary than growth friendly.


Continued strength second half of 2017


We remain positive on industrial metals as the outlook on the supply side is more constructive, with most sectors likely to move into deficit next year. On the demand side, industrial metals could remain supported with the recovery in global growth and stability in the Chinese economy particularly until the 19th National Party Congress in the Autumn. However, we are aware of the downside risks particularly if there is a reversal of Chinese demand and further disappointments from Trump’s policies.

OPEC/Russia seem to have successfully capped and

reduced production but that of the US is on the rise again. The dispute with Qatar (and effectively Iran), could further complicate efforts to limit global production.


1100- 1400

More downside as bond yields rise

The 2017 earnings outlook, whilst positive, did see analysts’ consensus forecasts for 2017 and 2018 being downgraded slightly across a number of A-REITs. Value is getting difficult to identify particularly as A-REITs in the main are trading at large premiums to NTA and at record low yields. We therefore continue to focus on A-REITs with exposure to Industrial and social infrastructure sectors.


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