Merlea Macro Matters – October

Summary
US equity markets keep posting modest gains with the S&P 500 setting a record closing high as did the small-cap Russell 2000 index and the closely watched Dow Jones Transport Average. What has been interesting is the breadth of the rally broadening – which is very bullish, and underpins our view that stock markets globally are going to have a very strong finish to the year.

This has wrong footed many fund managers, not to mention the bears, who have been positioned in cash waiting for a severe correction, which has defied the herd’s consensus and proven elusive. I am not an ebullient bull by any means, but I recognise a market that is climbing with pessimism overloaded on one side, and extreme optimism yet to play its hand, on the other. JPMorgan and Citi being amongst the first companies to report and beat estimates but failed to excite the market. I think this is going to be a reporting season which delivers, but fails to beat the bar of “great expectations” – which is raised so very high at present. As Sir John Templeton once said, “bull markets die on euphoria”, and we are yet to really see this dynamic play out. I therefore continue to see the stock market moving higher into November and December, with any weakness likely to be seized upon as a buying opportunity and delivering us a “Christmas rally” through to the last days of the year.

Bonds
An era of ultra-loose liquidity is coming to an end. While the yield curve is steepening, near term rates in many countries continue to be capped by the central banks, which is an aspect they can control. In short, one of the most important – if not the most important – macro drivers behind assets returns in the post-crisis years is changing direction; starting in October, the Fed’s Q/E wind down marks the beginning of the end of an era of ultra-cheap and abundant liquidity. A reduction of the Fed’s balance sheet will only accelerate the net tightening of global liquidity conditions already in place. This is even more the case if quantitative tightening results in a renewed strengthening of the US dollar, reducing the dollar value of other central banks’ balance sheets. Being the world’s number one reserve currency, it is ultimately dollar liquidity that matters.

What about interest rates? Some opposing forces are at work here. On the one hand, the Fed’ decision to stop reinvesting amounts from maturing bonds means less net demand for fixed income assets, driving yields higher. Reduced liquidity growth means monetary tightening. Tightening ultimately is deflationary, especially since it seems to be more driven by financial stability concerns rather than higher growth and inflation (still far from the Fed’s target). The Fed’s balance sheet unwind is therefore unlikely to create sustained upward pressure on core government bond yields and the yield curve may be set to flatten further. In the very short term though, increasing hopes for bold tax cuts in the US might cause a short-term spike in yields.

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 the 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
Wage inflation in Australia may continue to be muted, but the employment market keeps giving reasons why this will not remain the case for long. The number of job vacancies increased in August to 203, 700 positions according to the ABS. This was up 6% on a seasonally adjusted basis from May. The A$ weakened on the release (and after US$ strength), and clearly the RBA will continue to play it coy with rate tightening until inflation starts coming through the system in a meaningful way.

The central bank noted the improvement in the economy, which expanded by 0.8% in the June quarter. Officials also noted that ‘non-mining business investment is picking up’ while ‘capacity utilisation has risen’, and a ‘large pipeline of infrastructure investment is also supporting the outlook.’ They cautioned however, that despite strength in the employment market ‘slow growth in real wages and high levels of household debt are likely to constrain growth in household spending.’ As we enter the fourth quarter the performance of the ASX200 has certainly been disappointing this year overall, with the index below where it started in January. This is frustrating given that many other Asian markets have put in positive performances, with China being a standout. We still believe that the Australian market can break out in the final quarter, and finish the year on a more inspiring note. The financials certainly hold the key, accounting for around 40% of the index. The market hasn’t enjoyed the same rally in terms of percentage gains as overseas markets but this week’s price action confirmed the upward breakout that I have been waiting for. I might be wrong, and time will certainly tell, but I believe the ASX200 is headed for 6000+ by the end of the year.

 

Global markets

America

Trump ambitiously proposed the biggest US tax overhaul in three decades, calling for the deepest tax cuts since the 1960s, but this has since prompted criticism from different corners that the plan is biased towards business and the wealthy and could add trillions of dollars to the deficit. Federal Reserve officials have questioned the tax cuts and the obvious boost to near-term economic growth. San Francisco Fed President John Williams said a tax cut could feed “unsustainable growth” that would ultimately be undone by asset price bubbles, inflation and a possible recession. He went on to say that the “Republicans’ proposed tax cuts could deliver a short-term growth surge, but also bring high inflation, burdensome government debt levels and an eventual return to sub-par economic growth.” The implications for the US dollar near term are positive, which is why I see the rally in the greenback being sustained which leads me to think the near-term lows are in for the greenback but longer term, the outlook is less clear, especially given the unknown impact on the fiscal situation. The Trump reflation trade had completely unwound and led to the US dollar being deeply oversold so a reaction was overdue. Whether the US Dollar Index can climb back to the highs of 2016 remains to be seen, but targets of 96 should be achievable in the months ahead as markets begin to price in some policy tightening from the Fed, with the next rate hike anticipated in December. US manufacturing surged amid strong gains in new orders and raw material prices, while rebounding construction spending in August bolstered the economic outlook even though Hurricanes Harvey and Irma will negatively impact third-quarter growth. The Institute for Supply Management (ISM) said its index of US factory activity rose to a reading of 60.8 last month, the highest reading since May 2004, from 58.8 in August. US third quarterly earnings reports should also be positive with the weak greenback underpinning profits for the multinationals. US corporates will begin to report earnings later this month, but I anticipate solid results and this should underwrite a rally in the US stock market that should run to at least the end of the year. The odds of a Fed rate increase in December are 80%. This compares to 42% a month ago and comes as the White House set out its plan for tax reform. Interest rate differentials are moving in favour of the US with interest rates now much higher than in Europe (including Spain), the UK and Japan.

Europe
The German election result hit sentiment. Angela Merkel’s Christian Democrat party recorded its weakest election result since 1949. Forming a coalition government is likely to be much harder with the smaller parties needing to be brought into the fold. The Social Democrats have said that they will not go into a “grand coalition” and will instead form an opposition party. It is also not clear if finance minister Wolfgang Schaeuble, will remain in place. Germany is likely to be more politically unstable going forward given that the populist AfD is now the third largest party in the Bundestag. An upcoming state election in Lower Saxony is also expected to make coalition talks time consuming.

Germany has taken a step to the left, and all eyes will be on whether Italy heads in the same direction, with elections set to take place next Spring.

UK
Brexit negotiations in Brussels have hit a deadlock. The EU’s negotiator Michael Barnier stated that the divorce bill had caused the “deadlock.” He also noted that “decisive progress” could be made in the negotiations by Christmas. I am worried about the hawkish tone from the BoE. From the BoE’s perspective growth is not a problem while inflation is. And because the labour market is tight the BoE worries that inflation could become entrenched. As a result, in the absence of a notable slowdown in the next few months the BoE will hike rates in November. We continue to be cautious on UK equities given the uncertainties surrounding the Brexit negotiations as well as the economic slowdown.

Japan
On Thursday 12th the Nikkei closed 0.35% higher at 20,954. Japan’s reporting season is also about to “get into gear”, but unlike in the US, the bar of expectations is set very low. I think Corporate Japan is about to “shoot the lights” out over coming months in terms of EPS deliverables and the outlook for 2018. Morgan Stanley highlighted in a recent report that Japan should beat all the major stock markets over the coming quarter in terms of EPS growth.

This is one catalyst that could propel the Nikkei much higher before year end. Another would be a win in the upcoming election by the Abe Administration. I expect Abe to get over the line, particularly with North Korean tensions simmering in the background; the Japanese will not want to risk a change in leadership. Economic conditions have also improved significantly and the economy has a buoyancy not seen in decades. In the mean time I expect the Nikkei to converge in on the 23,000 mark. I’m anticipating that by December, and that’s the wonderful thing about an unrivalled deflationary bear market that lasts more 30 years. No one is focused on the bigger picture.

China
China’s economy has been unexpectedly buoyant of late as the old economic model continued to perform while the new services-based model also delivered results. However, many systemic and structural problems remain to be solved and president Xi Jinping is likely to embark on a brisk reform pace at the upcoming 19th Party Congress. The focus on curbing financial risks – suggests that policymakers are more open to lower economic growth; we expect the next five years to be more turbulent than the cycle just passed. Xi will press harder on his economic reform agenda and seek to further stamp out the leverage seen as so risky to China investors. I think he will do this early and effectively by choosing to take the pain now rather than later. This will in turn slow Chinese growth more than markets anticipate and could have significant consequences for the rest of the world. More substantial signs of weaker growth will be needed to force the authorities to step in as they have in the past. I believe they will do; this will probably occur over the course of the next year.


Commodities

Gold
Gold has dropped 5% since early September as markets have more fully priced in a further Fed rate rise in 2017, which would increase the opportunity cost of holding gold. Should the slide continue into next week, we would see a buying opportunity below USD 1,250 an ounce. We expect that rumbling political risks, including uncertainty over the composition of the Fed, will support gold.

 

WTIS
Oil prices rose as signs that Saudi Arabia and Russia will limit production through next year, overshadowing record U.S. exports and the return of production at a major Libyan oilfield. US crude oil inventories declined by 2.75m barrels to 462.2m in the week ending October 6. This was a sharper draw than the 2m barrels expected and comes as weekly exports fell to 1.27m from 1.98m in the previous week. Despite the drawdown, WTI oil declined 1.3%, albeit after a strong past couple of weeks.

Sector 12 Month Forecast Economic and political predictions 2017
 

AUD

 

70c-80c

 

Many see the dollar as a proxy for the strength of the Australian economy. Much of the dollar’s value is tied up in the demand for Australian iron ore, gas and coal. Over the past week, two events took place that pushed the dollar above 78 US cents.

The first was a speech by US Federal Reserve chair Janet Yellen, which poured cold water over the idea the US would need to brace for a series of sharp interest rate increases.

The second is better than expected economic data from China.

The Chinese economy grew at 6.9 per cent per annum in the June quarter, above forecasts of 6.8 per cent. This leads me to believe that the AUD could possibly push above 80 US cents in the coming months.

 

 

Gold

 

SPT Gold 1140 – 1400

 

Gold prices might see some more consolidation next week as the metal’s safe-haven allure continues to lose traction, according to analysts. But, the Federal Reserve meeting could offer surprising support to the yellow metal.

 

Even bullish gold analysts are admitting that the precious metal could retreat a bit further next week, especially after commodity markets chose to ignore another North Korean missile strike and a London terrorist attack on Friday.

 

“I am generally confident in gold, but I feel the metal is due for a bit of a correction next week” Jasper Lawler, head of research at London Capital Group September 2018.

 

 

Commodities

 

Continued strength second half of 2017

 

The corrections in the LME base metals prices continue for the most part, although some underlying signs suggest some dip buying. For now we would let these corrections run their course, but given a general back drop of better economic data and an image of concerted global growth, albeit slow, we would be on the lookout for bases to build and for that to provide another buying opportunity. With the dollar still attempting a rebound any rebound in base metals prices may be delayed, or laboured.

 

 

Property

 

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

 

Australian economic activity has been solid, despite a cautious consumer. Australian businesses have been reporting elevated levels of confidence for much of the year, and this has been translating into robust hiring levels and increasing capex plans. The strength in the currency (up 9% against the USD, as of September 15, and 2.5% on a trade-weighted

basis), if sustained, will prove a slight drag on trade.

 

 

Bonds

 

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
 

America

 

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

 

US economic policies, the once high-flying expectations for tax reform and/or an infrastructure investment program have fallen so low in the meantime that virtually any sort of progress would probably constitute a positive surprise for investors. The unexpected compromise on the debt ceiling between the Republican president and the minority Democrats last week seems to confirm this – as the S&P 500 has duly rallied to a new record within a few days. In any case, the US economy is performing rather well – with or without additional policy support from Washington.

 

 

Europe

 

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. Hold.

 

The European economy is undergoing a self-reinforcing recovery, even despite recent gains in the euro. While Germany and Spain were the main contributors to growth last quarter, France, Italy, and the Netherlands also posted some respectable results – providing further impetus for the ECB to scale back on its asset purchases in 2018. We maintain our overweight position on Eurozone equities against UK stocks.

 

UK

M&A activity reached £30bn in the second quarter versus £16.5bn in the first quarter of 2017. A key driver was Reckitt Benckiser’s takeover of US$17.9bn Mead Johnson but the fall in sterling has also attracted foreign takeovers. The UK service sector PMI fell to 53.2 in August from 53.8 with this a larger decline than had been expected. The service sector accounts for around 80% of the UK economy.

 

 

Japan

 

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.

 

The Japanese economy posted its sixth consecutive quarter of expansion, driven entirely by a resurgence in domestic demand. However, the Bank of Japan has pledged to press on with its unprecedented stimulus, as inflation remains far below target and as the deflationary mindset in Japan continues to place a cap on prices. Valuations remain at rock bottom and there continues to be significant operating leverage to the economic recovery in the stock market.

 

 

China

 

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.

 

Chinese stocks continue to edge up, poised for a fourth straight week of gains, amid signs investors are pumping fresh money into a market buoyed by solid economic growth and a resurgent yuan. Yuan bullishness makes yuan-denominated assets more attractive, and lures money inflows A sign investors are seizing on the more optimistic outlook and taking on risk, outstanding margin financing – money investors borrowed to buy stocks – continued to climb, hitting 960 billion yuan ($148.8 billion), the highest level this year.

 

Meanwhile, data shows Chinese individuals are opening stock trading accounts at an accelerated pace, while foreign money inflow is also on the rise.

 

Source: Merlea Macro Matters October 2017

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