Merlea Macro Matters – June 2018

(Merlea Macro Matters)


Globally, investors are turning more cautious on the synchronised global growth story that has dominated views and asset allocations since late 2016. Throughout 2018, ‘synchronised’ has steadily turned into ‘de-synchronised’ with corporate profits and economic progress in the US looking healthy and strong, but with momentum elsewhere deflating.  With the Federal Reserve turning more hawkish, and the US dollar rediscovering its mojo, several global strategists are reviewing their exposure to Emerging Markets, traditionally viewed as beneficiaries of a weaker greenback.

This year’s weakness in Asian share markets, including in China, coincides with weakness in European markets and US markets.  Several equity strategists are now weighing up the prospect that these markets might have peaked for the time being, which then justifies reduced exposure and a more cautious/defensive portfolio composition. Australian indices have become unexpected beneficiaries from the global rotation, even with the Australian dollar losing more than US2c in two weeks. Traditionally, foreign funds tend to avoid the ASX when the Aussie is facing weakness as it erodes the value of their allocated funds when translated back in the original currency. Somehow this hasn’t been the case this time around. The Australian share market, traditionally seen as a benchmark for global growth and risk appetite, has turned into a safe haven for global investors worried the US might become the last one standing tall when all others are starting to reveal their weaknesses.

June has been a poor month for stock markets, with mounting fears on trade being the main cause of the volatility. The Trump administration is due to impose tariffs on Chinese goods worth $34 billion beginning later this week, while this has all been priced in by the markets, the concern is what is coming next down the line.


Inflation might finally be arriving if the latest updates from a couple of central banks is anything to go by. It has been something that has been widely expected for some time and even as unemployment rates reach new lows in a number of countries, a meaningful uptick in inflation has so far proved to be elusive. The recent trend in high-yield market spreads appears to relate more to concern about rising rates than the potential for credit losses. The yield spread between two-year and 10-year US notes flattened to 30 basis points, which is the flattest the yield curve has been since 2007, after softer than expected consumer spending. Investors should be aware that the impressive recent performance of short-dated high yield bonds and floating-rate leveraged loans may be reversed if credit conditions begin to deteriorate.

The inversion in US Treasury yields is concerning some economists, given that in the past this has typically been a reliable predictor of past recessions, and given the yield curve is the flattest in years. A poll of economists and bond strategists conducted by Reuters found that the consensus believed there were rising recession risks to the US economy, with growth momentum expected to slow in the second half.

While the yield on the 10-Year T Bond has struggled to hold above 3%, short-term maturities have risen and “inverted” versus longer-dated ones as more rate hikes by the Fed are priced in. Around 65% percent of 40 strategists polled expect the yield curve to invert within the next one to two years.

Listed Property


Our expectation is for a gradual rise in bond yields (to around 3.5% by end 2019 for Australian 10-year yields) and that a US recession won’t be a risk until around 2020. Against this backdrop, overall returns from unlisted commercial property are likely to remain strong for a while yet as stronger leasing conditions take over from yield compression as a key return driver. However, returns are likely slow to around 9.5% as the “search for yield” tailwind fades. Office is most attractive with retail least, as the great re-rating of retail relative to office that occurred over the last 30 years and saw retail yields fall below office yields looks at risk of some reversal as various cyclical & structural factors contain retail rental growth relative to office.

The choice between unlisted commercial property and A-REITS is now line ball with the latter having reversed their recent outperformance and now offering similar yields to unlisted.

The key threats to watch for are a sharp rise in bond yields and a deterioration in the global/Australian economic outlook.

Australian Equities

As I mentioned in recent months, the resource sector is likely to remain a powerful driver. The supply/demand equation, along with generally inflationary tailwinds (and with oil pushing into the 70’s) are likely to keep commodity pricing elevated, which should drive earnings upgrades. This is also in the context of a broader analyst fraternity that are not positioned for an event where iron ore, copper, and the like remain at robust levels.

A weaker A$ will also provide a boost to our exporters, as well as the economy generally. This is as the RBA remains very much ‘boxed in’ with respect to raising rates any time soon, and in our view at least 12 months away from doing so. On the economic data front the ABS has revealed that job vacancies have continued to rise in the most recent quarter. An official also noted that “if labour demand continues to grow at the pace we have seen today then the RBA may be hiking rates in the middle of 2019, sooner than market expectations.” I would counter that we need to see some meaningful wage inflation first.  Many institutional analysts are still very cautious on the financials, and this may be where the real upside surprise can come from for the ASX. The housing market and elevated debt levels are risks, but bank balance sheets are strong, and lending rates are ratcheting up to support margins, and soften the blow of offshore funding pressures.

From a valuation perspective the broader market also is in a good place to push on further in the second half, with a PE of around 16 times, which is higher than the historical average (15 times) but cheaper than most global peers. Our market also remains attractive from a dividend stand-point and is one of the highest yielding in the world.

Global markets


The US indices have been volatile on the back of trade tensions. The narrative hasn’t really changed but investors are increasingly more nervous. Our view is that many of the threats made by Trump are not going to come to fruition, but the steady flow of “tweets” is unsettling investors, and unquestionably this is translating into higher volatility for financial markets. What is clear to the markets is that any further implementation of trade barriers “from here on in” will have serious downside repercussions for the US economy and the stock markets therefore. I therefore think the more relevant question must be whether Donald Trump’s administration has “done enough” in their own eyes to appease electorate promises? There will also be a “rising chorus” from the American corporate sector issuing warnings and tempering profit outlooks when the June quarterly earnings season gets underway.

US consumer prices accelerated in the year to May. The key personal consumption expenditures (PCE) price index rose 0.2% after a similar gain in April. In the 12 months through May, the PCE price index has surged 2.3% which is the largest rise since March 2012 and followed a 2% increase in April. The PCE Index is closely followed by the Fed, so with this measure of underlying inflation hitting the target of 2% for the first time in six years, this is going to be a focus point for the next FOMC.

This probably won’t be enough for the Fed to veer away from 4 rate hikes this year. Jerome Powell has already said that hitting the inflation objective wouldn’t warrant turning more hawkish. The Fed has highlighted that it expects inflation to temporarily overshoot the target. US President Donald Trump said he expects a second tax overhaul to be unveiled in October or a bit earlier, and he is considering cutting the corporate tax rate to 20% from 21%. In an excerpt of a Fox Business Network interview that broadcast on Sunday, Trump said: “We’re doing a phase two. We’ll be doing it probably in October, maybe a little sooner than that. One of the things we’re thinking about is bringing the 21% down to 20, and for the most part the rest of it would go right to the middle class.”

The Congressional Budget Office warned this week that more tax cuts would hasten the growth of an already rapidly rising federal debt. The debt, which equals 78% of US gross domestic product, is on track to eclipse the 106% record set just after World War Two. It will be unlikely therefore to get the additional phase two tax cuts through the Senate, unless the Republicans have a big win at the mid-term primaries in November.


Rising food and energy prices helped to push up inflation in June. Flash data showed Eurozone inflation edged up from 1.9% in May to 2.0% in June. In Germany, unemployment remained at a record low rate of 5.2% in June, while retail sales declined unexpectedly, dipping 1.6% in May. Inflation in France was also up, coming in at 2.1% in June. That compared to 2% in May and was in line with expectations. Eurozone economic confidence moderated to a 10-month low in June. The economic sentiment index dipped to 112.3 in June, down from 112.5 in May. While it was the lowest since August 2017 it was above the expected score of 112.0.

Meanwhile research group GfK said its index of German consumer confidence for July was also unchanged, with a reading of 10.7. That was marginally above the 10.6 expected. In Germany consumer price inflation eased slightly in June according to preliminary data. CPI stood at 2.1% as expected, falling from 2.2% in May. In Spain, “harmonised” consumer prices increased 2.3% year-on-year in June, accelerating from a 2.1% increase in May. In Italy prices increased 1.5% in June, up from the 1.0% pace logged in May.

The European Central Bank said loans to the private sector picked up in May. Adjusted loans to the private sector grew 3.3% year-on-year, up from the 3% increase in April. Meanwhile, in France the consumer confidence index fell to 97 in June, compared to a downwardly revised 99 in May. It was a relatively weak print, as the index was expected to come in at 100. In Italy, the measure for consumer confidence increased from 113.9 to 116.2, which was well above the forecast 113.1. The business confidence score brightened from 104.6 to 105.4.


On the economic side, according to the Office for National Statistics, gross domestic product grew 0.2% sequentially in the first quarter of 2018, compared to a preliminary estimate of 0.1%. The upward revision came on the heels of a new estimate showing the construction industry compressed less than originally thought during the period. Growth was supported by household and government spending. Inflation combined with only modest wage increases has seen British households dipping into savings. Households have reportedly been net borrowers for six straight quarters now. UK house prices increased by more than expected in June, albeit at a slower pace than in May. House prices increased 2% year-on-year in June, compared to the 2.4% pace seen in May. Expectations were for a 1.7% increase.

On the economic side, the Bank of England’s (BoE) latest survey of business conditions showed retail sales accelerating in the second quarter. Demand for consumer services though was contained by crimped incomes and Brexit uncertainty


In economic releases, Japan’s unemployment rate dropped to the lowest level in over a quarter-century. The seasonally adjusted jobless rate dropped to 2.2% in May, down from 2.5% in April, which is the level it was expected to remain at. The ratio of open positions to applicants edged up 1.6 in May from 1.59 in April. That was the highest level for that ratio since the early 1970s, when it was 1.64.

Industrial production contracted by a seasonally adjusted 0.2% month-on-month in May, contrasting to the 0.5% increase logged in April. It was the first fall in activity in four months.  The Bank of Japan (BoJ) has reportedly bought ¥70.3 billion in ETFs over the past three days, supporting the market


There are four key risks facing China. First, the policy focus could shift from maintaining solid growth to speeding up medium-term economic reforms and deleveraging (or cutting debt ratios) that could threaten short-term economic growth. Second, China’s rapid debt growth could turn sour. Since the Global Financial Crisis, China’s ratio of non-financial debt to GDP has increased from around 150% to around 260%, which is a faster rise than has occurred in all other major countries. Third, the risk of a trade war has escalated with Trump threatening tariffs on $50-150bn of imports from China and restrictions on Chinese investment in the US and China threatening to reciprocate. Finally, with the Chinese residential property market slowing again there is naturally the risk that this could turn into a slump. It’s worth keeping an eye on but absent an external shock looks doubtful.

Recently sentiment was boosted by China easing restrictions on foreign investment in the banking, automotive and agricultural sectors among others. Concerns of a trade war continue to dampen sentiment and the yuan has weakened as the central bank moved to inject liquidity into the banking sector, with the net effect being capital outflows from the stock market.

The ‘offshore’ yuan has now fallen for eleven consecutive days. Foreign investors are reportedly buying mainland Chinese equities on weakness via stock connect schemes, but local investors, who tend to be technically driven in a lot of cases are staying on the side lines.



Gold prices were testing recent lows ahead of the March FOMC meeting but have since recovered, driven primarily by USD weakness and concerns over trade protectionism and political tensions. Though we expect gold prices to trade largely range-bound, we are assigning a 25% probability that gold could trade within USD 1,350-1,400/oz, above current prices. Our view of further USD weakness and increased safe-haven asset demand could lend some support to gold prices in the near term. However, a faster-than-expected pace of rate hikes poses a key risk to our view.


Oil prices climbed through the month of June, with US crude hitting a three-and-a-half year high, bolstered by supply concerns due to US sanctions on Iran that will result in a large drop in exports. WTI crude rose 1% to the highest level since November 2014 while Brent closed just under $78. Inventories are still declining and spare capacity is very low, making the oil market susceptible to any further disruption or rising geopolitical risks

The leader of Saudi Arabia ‘promised’ President Donald Trump that he can raise oil production if needed and the country has 2 million barrels per day of spare capacity. Reuters reported, from sources familiar with Saudi Arabia’s production, that the kingdom’s intention was to increase output by only 200,000 bpd this month.

Oil prices extended gains to fresh highs on tight market conditions as US sanctions against Iran are set to remove supply from world markets.

Our call at the start of the year that oil prices would hit US$80 this year is looking on point (even with $ strength) as is the prediction that ‘oil surprises everyone with its strength and the energy sector outperforms.’ This all bodes well for the Aussie pure-play energy producers, particularly with the A$ back below 74 cents.

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


A$ the weakness in the currency this year has certainly been pronounced, with a move from around 81 cents versus the US dollar, to just under 76 cents currently (and reaching a low of US$75.05 at one point). The decline in the A$ has coincided with US dollar strength and longer-term interest rates pushing up to medium term highs. Interest rate differentials and higher growth prospects in the US are propelling the greenback up against the Aussie and other major currencies.


Some are clearly betting on further Aussie dollar weakness. The latest US Commodity Futures Trading Commission data revealed that institutions have extended their net short Australian dollar positions to a record high 47,700 contracts as of May 15. Near term this could mean that a bounce may be overdue with short position covering likely to ensue on any economic data or rhetoric that suggests the RBA could tighten earlier. I don’t think however this is really the base case, with the RBA caught between a patchy economy, rising unemployment and a weaker residential housing market.


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.




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


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





Overweight energy and materials.


We expect commodities to post modest gains amid an improved global growth outlook over the coming 12 months. Industrial metals resumed their downtrend amid rising trade tensions between the US and China. We believe slowing fixed asset investment in China will also be less supportive for the asset class moving forward.

We do expect oil prices to rise significantly from here as the supply-demand picture rebalances ($80 WTIS).


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.


Listed property markets remain weak. Rental yields are still low and prices are still high even after property trusts sold off late last year.


Australian Equities


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

5580 – 6600


I believe that Australian markets can outperform many Western global peers over the coming 6 months.




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 to a greater extent 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


The S&P500 encountered resistance at 2,670 last week. Our scenario is for the index to break through this level on the upside in April and run to 2750/2800 with a strong quarterly reporting season being the probable catalyst. However, it may take some time before new record highs are attained above 2,850.




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.



We expect economic growth to continue to consolidate but to remain at a high level.

• Inflation should start to rise firmly again, driven by base effects and higher oil prices.

• We expect the ECB to end its QE program in 2018 and to start raising rates in mid-2019.




Overweight once a correction has occurred.

Nikkei 225: 21500 – 2500

Favour Japan.


I expect Japan’s stock market to continue climbing a “wall of worry”, even though the underlying economy, labour market, along with the export and manufacturing sectors, are in the best health in decades. Japan’s stock market is in the early stage of a secular bull market. Valuations are still very compressed. Japan’s economy is only just emerging and reenergising after a multi decade deflationary slump.





Shanghai Index: 3350 -3650


GDP growth should moderate this year, but the quality of growth should be better. Monetary policy should remain prudent, with further regulatory tightening. Political, economic, and currency stability should keep investors confident on China.

Source: Merlea Investments


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