Merlea Macro Matters – November

(Merlea Macro Matters)



Major global economies are rising in sync, generating strong growth and healthy labour markets. A healthy economic picture doesn’t mean it’s a good time to take on more risk. I think that central banks around the world are going to start changing their stance on monetary policy, and move away from the ultra-accommodative policies of the last 8 years; it has already started in the United States. The Federal Reserve has responded to low unemployment by raising interest rates 3 times in the past year, and I expect another rate hike in December. The European Central Bank (ECB) and the Bank of England (BOE) have already started moving away from the extraordinary monetary policies they’ve had in place in recent years. In fact, the ECB just announced that it will slow its asset purchase program beginning in 2018 and the BOE raised their target rate in November. Stock market valuations appear to be the highest since the tech bubble. That said, there is a relationship between stock valuations and the yield on the 10- year Treasury bond. When rates are low, investors put more value on future earnings, and the valuation of stocks tends to rise. Accounting for today’s low rates, valuations on stocks are about average by historical standards. If interest rates go up, stock valuations could potentially decline, contributing to greater volatility in the stock market. At the same time, rising rates depress bond prices and may be especially tough for credit sensitive bonds, because higher rates increase the cost of capital. So additional rate hikes mean it’s probably not the time to take on a lot of risk or to make big asset-allocation bets. Tighter policy increases the chances of moving into the late cycle—a period when investment performance has historically been the most mixed. Factors such as these, in the context of rising interest rates and high valuations, seem likely to result in greater volatility in the months ahead. We’re not at a point where we suggest a change in positioning, but we want to remind people the market cycle has become more mature. At this stage it becomes especially important to keep your portfolio well-diversified, with assets that can provide some protection in the event of a downturn but also in case of a rise in inflation. An example would be energy stocks, which historically have performed well in the late cycle.


Yields have remained surprisingly low but are expected to rise slowly, keeping return expectations low. While government bonds provide stability to a portfolio, returns will be small. The elephant in the room is just how long the “long end of the curve” can remain down. It must only be a matter of time before inflation accelerates to the upside, particularly with commodities and oil rallying.

Yields for investment grade credits are low but they do offer some yield pick-up over government bonds. Spreads are tight but relatively stable as corporate finances are sound.

Listed Property

The index has been dragged down by the poor performance of retail trusts, though industrial and office are in favour. The decline in the share price of retail REITs reflects a confluence of factors, the most significant being weakening investor sentiment due to slowing sales performance and a lift in the number of retailers in financial distress. There are also heightened concerns about the impact the forthcoming arrival of Amazon will have on incumbent retailers. The US online retail giant plans to open a handful of very large shopping warehouses in Australia and many analysts are speculating this could harm local shopping centres. At current pricing, the sector offers a solid 4.7 per cent yield with 3 to 4 per cent earnings growth, but I would say that A-REIT prices and asset values are looking a little overvalued relative to NTA, so further growth beyond these total return expectations of around 8 per cent in the short term may be limited.

Australian Equities

The central bank predictably left rates on hold at 1.5% for the 14th month in a row. The commentary would also suggest that the RBA is certainly not in a hurry to lift rates, with the high level of household debt and low inflation being key factors. On the positive note, and one reason to consider a lift, is an improving economy and a buoyant labour market. The RBA noted that the “labour market has continued to strengthen. Employment has been rising in all states and has been accompanied by a rise in labour force participation. The various forward-looking indicators continue to point to solid growth in employment over the period ahead. “The unemployment rate is expected to decline gradually from its current level of 5. per cent.” And for now, this is holding back overall inflation. The central bank observed that “Inflation remains low, with both CPI and underlying inflation running a little below 2 per cent. In underlying terms, inflation is likely to remain low for some time, reflecting the slow growth in labour costs and increased competitive pressures, especially in retailing. CPI inflation is being boosted by higher prices for tobacco and electricity. The Bank’s central forecast remains for inflation to pick up gradually as the economy strengthens.”

It is clear the RBA’s main concern is the housing market, and the associated levels of household debt. Banks are already raising lending rates, and this process will accelerate. With elevated levels of debt, this could potentially have significant implications (unless accompanied by material wage growth) for the economy, and consumer spending (which is already fragile) in particular. A period of catch-up is well overdue. As I have been writing for some time, the fundamental foundations are falling into place, and the technical picture (and an upward break in the ASX) is starting to confirm this. While the jury may be out on the banks (investment analysts themselves have a divergent view), resource stocks continue to garner momentum. Multi-year highs in oil prices have certainly driven the energy sector. The turnaround in the resource sector over the past year is stark, and this is also looking through the financials from the big players. A KPMG report last week highlighted that the ‘Big Five’ miners (BHP, Rio, Fortescue, Newcrest, and South32) reported a combined 13% increase in annual revenues and a 426% increase in earnings as commodity prices and production rose. The other part of the story is that the producers are bearing down on production costs, while a relatively weak A$ is also offering some assistance. The currency may not always be a tailwind, but our scenario of robust commodity prices could well see a further scramble by investors for miners whose output and cost profiles are going in the right direction.

Global markets

Rising doubts over the timing of the Republicans’ plan to cut corporate taxes passing through congress weighed on US markets.

One report that surfaced in the Washington Post late said Senate Republican leaders were considering a one-year delay in implementing the corporate tax cut. The bill was never going to be smooth sailing, and it is difficult to see the Trump Administration pulling this all together before Xmas. Data on the labour sector confirmed the US economy is in great shape The ISM non-manufacturing index came in at 60.1 in October with this the highest reading since August 2005. It compares to 59.8 in September and forecasts for a modest decline to 58.5.

Job growth accelerated last month after the hurricane-related disruptions, but wages grew at their slowest annual pace in more than 18 months with non-farm payrolls increasing by 261,000 last month. Around 106,000 jobs were added to the leisure and hospitality sector as workers returned after the Hurricanes. This was the largest gain since July 2016 but below economists’ expectations for a jump of 310,000 jobs. Data for September was revised to show a gain of 18,000 jobs instead of a decline of 33,000 as previously reported.

Average hourly earnings slipped a little in October which is virtually unchanged on previous months, although wages jumped up 0.5% in September. The relatively weak wage growth will reinforce the Federal Reserve’s own view that inflation is sluggish, and that rate tightening will only be gradual next year. Jerome Powell, the new incoming Chair of the Fed, will be unlikely to change the trajectory of this approach in 2018.

I continue to think that wage growth will be an issue next year, and with the labour market near full employment. Unemployment is at a 17 year low of 4.1%, and it is only a matter of time before wages breakout on the upside.The US Indices – along with much of the world – have become overextended in recent weeks. A correction is therefore to be expected and would be a healthy outcome to what has been one of the longest consecutive rises (accompanied by low volatility). I don’t however anticipate stocks yielding to a deep correction. Whilst the delays to the planned Tax Cuts will probably be the catalyst for stocks to go lower near term, the US has just come through one of the strongest quarterly reporting seasons on record. I therefore cannot see US indices enduring a deep correction this side of Xmas.


Though many of the major political obstacles have now been overcome, events in Spain highlight that political risk continues to simmer under the surface. Elections in Austria, the Catalan situation, and recent referendums in Italy all highlight a trend towards populist, nationalist and now regionalist tendencies. – These risks are contained for the moment, helped by quantitative easing (QE), and the boost this brings for the economy and financial markets.

Across Europe, market strength has been driven by a weak euro, which softened following the recent European Central Bank (ECB) meeting and which has subsequently caused Europe-based exporters to rally. The ECB decided to extend QE by nine months, to September 2018, but at a reduced pace of €30 billion per month. Both decisions were in line with consensus expectations.

In Germany, the unemployment rate was unchanged at 5.6% in October while the number of unemployed fell by 11,000. The unemployment rate remains at the lowest rate since reunification in 1991. On the economic front the revised Eurozone Markit manufacturing PMI came in at 58.5 in October. This compares to 58.1 in the previous month and consensus forecasts for an increase to 58.6. European peripheral countries continue to improve with the Irish unemployment rate falling to 6% in October. In Portugal the yield on the 10-year bond has fallen to 2.046% while in Italy the 10 year yield declined to 1.79%.

ECB chief Mario Draghi called on the European banking sector to further reduce their non-performing loans. He stated that the problem is “not yet solved” and reforms need to be undertaken to “de-link” lenders from their sovereigns.


The pound strengthened on the back of services sector data and fourth quarter economic growth is now expected to be 0.5% versus 0.4% in Q3. The IHS Markit/CPIS UK services sector PMI index hit 55.6 in October versus 53.6 in September and forecasts for 53.3. The composite PMI – manufacturing and services – rose to 55.3 from 53.6 in September. The UK construction PMI rose to 50.8 in October from 48.1 in September and the reading was ahead of forecasts for 48. Homebuilding in the UK remains the main growth driver with civil engineering and commercial activity relatively weak. On the monetary policy front the Bank of England increased interest rates by 0.25% to 0.5%. While this has generated dramatic headlines it only takes rates back to where they were in July 2016 before the Brexit driven rate cut. The 7-2 vote resulted in the first interest rate increase in the UK since July 2007 but the outlook from the Bank of England was relatively dovish. The BoE stated that any future hikes would be “at a gradual pace and to a limited extent.” Sterling declined sharply against the greenback losing 1% – the biggest fall since June. Bank of England deputy governor Ben Broadbent called for “a couple more interest rate rises” In a media interview he sought to counter the impression that the BoE has taken a dovish stance.


The Japanese market has rallied following the re-election of Prime Minister Shinzo Abe in October with a two-third supermajority in parliament. Japanese stocks will pull back in the near term, but I see the rally resuming shortly driven by one of the strongest reporting quarters in some time. According to official data, foreign investors poured money into Japan at a record rate last month. Momentum begets momentum. The inflows from foreign investors came in at Y3.435n in October with this the highest since the data series began in 2005, but is still comparatively low given Japan is the world’s third largest economy. Bank of Japan Governor, Haruhiko Kuroda’s statement on Monday that economic growth is gathering momentum and increasing the chances of inflation hitting the 2% target. This could lead to a reversal in the central bank’s negative interest rate policy which would give Japanese Financials a boost to profitability.


Congress’s decision to enshrine Xi’s name next to his “thought” in the party constitution is representative of the fact that Xi has emerged as one of the most powerful Chinese leaders in years from an economic viewpoint, the outcome is a mixed bag. The consolidation of power around Xi will enable him to push ahead with the reform agenda, which, however, warrants a final say of the party over market forces in key areas. This is evident from the Party Congress Report, which focuses more on political achievements than on free-market reforms. However, while growth going forward may in fact become somewhat more volatile, it is unlikely to slip below 6%, as a dip below this level would call the party’s capabilities into question.

Annual consumer price inflation in China increased to 1.9% in October versus 1.6% in September and forecasts for 1.8%. It represents the highest reading since January and was driven by a jump in transportation fuel costs. China’s CSI300 Index has pushed above resistance and 4000. The recovery in the CSI300 is now much more sustainable, with China’s economy still growing at a fast rate and with the index still below the highs of 2007, there is scope for considerable upside next year.


Gold prices have been rising steadily higher as the precious commodity seems to have found some favor with the bulls over the last few days. The weakness in the dollar has also been helping prices to move higher and this is expected to continue in the short term. The dollar strength which came about due to the passage of the tax reform bills seems to be wearing off slowly and steadily. This has given an opportunity for the gold bulls to make a sort of a comeback over the last couple of days pushing prices through the 1280 region as of this writing. This weakness in the dollar is seen across the board and is likely to last for some time as doubts are now being raised about the implementation of the tax reforms.


OPEC increased its forecast for anticipated global oil demand by 2022. Consumption is expected to rise to 102.3m b/d in 2022 from the 95.4m barrels a day seen in 2016. Looking further out to 2014 and OPEC expects that demand will increase to 111.1m b/d by 2040. Oil demand in industrialised countries is expected to increase for two more years before reversing.

The main demand driver will therefore be growing demand in developing nations like India and China. Oil is expected to account for just under a third of fuel use by 2040 despite the rise of renewable energy. Supply from OPEC is expected to increase from 57m b/d in 2016 to 62m b/d in 2022 and 60.4m b/d by 2040. This will increase OPEC’s share of global oil supply from 34% in 2016 to 37% in 2040. The oil prices continue to trade in a buoyant manner as the crisis in Saudi Arabia begins to abate. Prices trade above the $57 region and may correct towards the $55 region and consolidate as it awaits the next push from somewhere. The next target of the oil bulls is likely to be the $60 region as the uptrend in the oil prices does not show any signs of abating. Traders would do well to wait for a correction in the prices before loading on their buys and looking for a move higher.

Sector, 12 Month Forecast and Economic and political predictions 2017


The outlook remains positive for the Australian dollar which could well see the currency stronger for longer, overall, I would not be looking for a much weaker AUD longer term. The Australian Dollar is expected to trade at 0.76c by the end of this quarter. Looking forward, we estimate it will trade at 0.74c in 12 months’ time.

SPT Gold 1140 – 1400

The tensions in the Korean region continue to simmer as Trump continues with his Asian trip and it is likely that it may spill over anytime and this possibility is also helping the gold prices to keep moving higher. But towards the end of the month, the noise over the likely rate hike from the Fed in December is likely to rise again and this should put the gold prices under pressure and this is why we believe that any bounce, like the one we are seeing now, is likely to last only for the short term.

Continued strength second half of 2017

Growth in resource exports will more than offset the diminishing drag from lower mining investment. The mining sector is therefore likely to contribute to economic growth. Chinese demand for resources for steel production has supported bulk commodity prices.

1100 – 1400

More downside as bond yields rise Listed property has undergone change and consolidation in recent years. In the lead-up to the GFC there were over 50 listed A-REITs and today that number is down to 30 in the benchmark S&P/ASX 200 A-REIT Index. But the asset base has broadened and diversification opportunities are greater. The property universe also includes assets such as childcare centres, storage facilities, petrol stations, retirement living, and even healthcare property assets, so while the number of companies has reduced, the range of assets has expanded.

Australian Equities
5200 – 6400 – Short term correction due

The resource sector was weaker on softer Chinese export numbers, although a breather was probably needed after recent strong gains, so some consolidation would be healthy. We do think that the resource sector is going higher next year but it will be the financials that will be needed to provide the real impetus to push the ASX beyond 6000. If the two sectors perform in tandem 6200/6300 on the ASX200 may not be out of the question before the year is over.

2.9% – 3.5%

Our outlook remains cautious across several dimensions. While bond yields have risen somewhat (from their lows in mid-2016) and correspondingly our return expectations have lifted, the new return expectations remain modest. We continue to run lower and better diversified interest rate risk than the benchmark, running a relative short duration position in Australian bonds. Consensus expects the 10-year bond yield will rise more sharply next year (from 2.88% expected at end of 2017 to 3.50% at end of 2018).

Cash Rates
1.5 % on hold till 2018

The RBA met and made no change. I really can’t see the central bank moving on rates for the next 6 months at a minimum, given pockets of weakness in the economy, a heavily indebted consumer, not to mention concerns over a rising exchange rate.

Global Markets

S & P 500 Overvalued. 2100-2400 risk rising of a market correction. The inflation effect of a tighter US labour market leads to a stronger Fed response and a combination of tight monetary policy and loose fiscal policy. Although economy and earnings are solid, valuation is a headwind and Washington remains a mess. Expectations have already begun to rise, meaning the end result could be a disappointment to investors. Keep underweight.


FTSE time to take profit from this stock market stock market. Europe commodity price pressures lead to higher European inflation, generating early signs of more rapid tapering of ECB quantitative easing. We expect economic growth to remain resilient, but to lose momentum during 2H17.


The outlook for Europe is still strong: growth, earnings and reasonable valuations mean it is still well-worth having a exposure. Euro strength could pose some headwinds for earnings, but they remain on track for a very good year. Eurozone – Unemployment also hit a nine-year low


14000 – 22000 hold

The macro conditions are favourable for investors in Japanese equities, with strong growth, low inflation, supportive monetary policy, and a favourable earnings backdrop. Japan is showing some positive signs. Export-driven growth is now joined by higher internal demand, and thus the link between the yen and the stock market can loosen. A surprisingly strong earnings trend and a reasonable valuation add to the outlook


Shanghai Index 3000-3600 hold. The first Sino-US Economic Dialogue by the Trump administration sputtered before the 100-day trade plan deadline, casting a shadow on bilateral trade relations. This recalls our earlier scenario, with risk of a Sino-US trade war as possible, but of limited scope. The newly (s)elected party leadership in China indicates that president Xi may stay on for longer than the two-term norm. Market implications, however, are muted in the short-term.


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