Merlea Macro Matters – October 2018

(Merlea Macro Matters)


After several months of historic calm, stocks sold off sharply this month. Rising interest rates and trade war fears were cited as the primary causes of the sell-off that caused the Dow Jones Industrial Average to drop more than 1300 points in just two days. Concerns about corporate profit margins peaking and a potentially overcrowded tech trade also likely played a role in upsetting a market that had been extraordinarily calm over the past six months. There were several contributors to this past week’s rout; not least being U.S. Treasury yields breaking out to multi-year highs, causing concern among equity investors and contributing to the sharpest two-day pullback in equities that we’ve seen in months.  I don’t believe yields will move significantly higher from here, but investors should be prepared in the event they do. We do believe we have passed a threshold of sorts about the relationship between bond yields and stock prices. During deflationary/disinflationary periods—like the one we’ve been in since the financial crisis—bond yields and stock prices tend to be positively correlated. But once disinflation gives way to higher current and expected inflation, the correlation between bond yields and stock prices tends to move from positive to inverse. This is what we are recently seeing. It’s been a regular occurrence that investor and Advisers have pushed back against our more cautious stance. But we’ve seen that the best stock returns tend to come when economic data is weaker, not stronger—remember the stock market is a forward-looking mechanism. Stocks have an uncanny ability to figure out when the data is at or near its peak and just beginning to roll over (i.e., stocks tend to discount inflection points). Stocks rarely “wait” for the data to deteriorate meaningfully.

We do not think this warrants that investors flee for the equity exits, but our more cautious stance over the past year keeps us in the camp of recommending that investors have no more than their normal long-term allocation to equities. Against a favourable fundamental backdrop, market declines present attractive buying opportunities. Eventually we will hit a recession, but in our view, economic underpinnings make that unlikely in the coming year, supporting further increases in corporate profits – a historically successful recipe for the stock market. It is certainly possible this sell-off gets worse before it gets better, our belief is that it is unlikely to develop into a bear market. The focus of markets will be on the earnings season which will be crucial in providing overall direction in the months ahead.


Global government bond yields have also been rising this year and not just among troubled countries. In fact, the 10-year bonds of countries with the highest (AAA) ratings have seen their yields rise so far this year, with Sweden’s small decline being the only exception the move has been notable for its breadth—even Japan has seen a rise in yields—but not for its magnitude. Most countries have seen a rise of less than half a percentage point. Overall, yields could be nearing a peak, but it is worth noting that some have hit new highs in October.

Global bond yields are on the rise for several logical reasons: inflation has been picking up this year around the world (even in Japan); the European Central Bank (ECB) is nearing the end of its quantitative easing (QE) bond buying program as the year draws to a close; and the U.S. Fed is shrinking its balance sheet by selling some of the bonds it had acquired through its QE. The Fed understands the need for flexibility given these crosswinds. In July, Powell emphasised that the best path of monetary policy “for now” is to continue gradually raising the federal funds rate. We expect yields to grind higher through the end of the year (led by short-term yields) with periodic bouts of volatility. Considering this, we believe fixed income continues to play an important role in a diversified portfolio. Within fixed income, we favour short-duration, high-quality bonds to provide income and liquidity, as well as a portfolio management tool during stock-market volatility. In Australia, the reaction in the bond market has been a lot more cautious with ten-year yields trading below the highs made in May 2018.

Listed Property

There is a strong negative correlation between the A-REIT sector’s share price performance and changes in the long bond yield. Note that rising global rates have led to our long bond yields rising. REITs are traditionally a defensive asset class, so rising rates have led some investors to rotate away into less defensive shares. But, the direct impact of rising interest rates on A-REITs’ profits is more gradual as many of the A-REITs have investments in commercial real estate with long term contracts in place, which are linked to inflation (so can be a hedge to rising rates). Structurally, at least, the sector is in good shape and balance sheets are generally healthy, with sector gearing of 26.8% on average. Furthermore, distribution pay-out ratios are also conservative and sustainable, at 82.2% on a weighted average basis. A-REITs with higher gearing will feel the pain more from rising rates. Macro headwinds – rising bond yields, US tax cuts and high AUD – will work against the sector in the short term, while tailwinds are not so evident. The sector is not expected to outperform the broader market in 2018 however we are finding value in individual stocks.

Australian Equities

In the Reserve Bank of Australia’s (RBA’s) most recent minutes, the central bank noted that global economic conditions continue to be positive for the Australian economy, despite outlining several risks to the global economic outlook, namely international trade policies (i.e. the US-China trade war).

The RBA left the cash rate on hold at 1.50%, it believes there is no strong case for near-term adjustment in monetary policy, whilst affirming the usual “next move is more likely up than down.” It pointed out that unemployment has declined ~20 bps to 5.3% from 5.5% in 2018, whilst job vacancies have increased gradually during Q3 2018 to remain at historically high levels (relative to the size of the labour force).

The rhetoric from the talk was that the RBA expects a strengthening of the local economy over the next year, underpinned by strong infrastructure pipelines in NSW and Victoria, solid business investment and continued export growth. This is likely to be tempered by an easing in commodity prices as China’s growth is expected to slow over the second half of the year. Risks continue to simmer as the housing market is softening and household debt levels remain at historic highs. For now, we believe the risks of a more concerted correction appear contained as interest rates remain low and employment steady. Export growth could also weaken as a result of any escalation in global protectionism. The outlook for the Australian share market is mixed. We expect robust growth in cyclical companies exposed to global trade and the domestic infrastructure boom. This will be offset by a subdued outlook for the banking sector.

While mining stocks reported strong profit growth in August, we expect their share prices to fade in line with the expected slowdown in China over the next six to twelve months. On balance, we expect this will translate to low single digit gains over the next six months

As we saw, the more traditional “blue chip” stocks can often hold together when the market is weak, particularly the areas that have already been re-priced down as a consequence of stock / sector specific issues, like the banks. While the high valuation / growth stocks that have performed for the last few years become the most vulnerable.

When we consider history, one of the standout messages for this stage of the cycle is to be extremely careful paying up for growth i.e. We want GARP (growth at reasonable price) not GAAP (growth at any price).

Global markets


A trade war between the US and China has been heating up for much of this year, and it could have huge impacts on the US economy. President Donald Trump’s administration has levied tariffs on a total of $US250 billion of imported goods from China. That represents about half of all imports from China. China has retaliated by announcing tariffs on $US110 billion of US exports. The most recent set of tariffs against Chinese imports, which went into effect at the end of September, targeted around $US200 billion of goods with a 10% tax scheduled to increase to 25% on January 1, 2019.

Unlike earlier rounds of tariffs that mostly targeted materials and intermediate goods, about a quarter of the new tariffs target consumer goods directly. As such, these tariffs could have an even more direct impact on Americans’ wallets. Some of the goods that are likely to be hardest hit by the newer tariffs include computers and computer parts, furniture, and tires. The September data seems to indicate waning momentum for private consumption growth amid growing, mostly trade-related, headwinds. Despite the welcomed rebound in September, motor vehicle sales remain a key source of concern, given their status as a major durable consumer goods staple. Indeed, on a quarter-on-quarter basis, motor vehicles and parts sales increased just 0.1% in the third quarter in seasonally-adjusted terms. Although the exceptionally tight labour market will likely continue to support consumer spending in coming months, ongoing rate hikes from the Federal Reserve should significantly dampen the momentum over time. Federal reserve officials unanimously voted to increase the federal funds rate by 0.25 percent. This will be the third such rate hike this year, lifting the benchmark rate above 2 percent for the first time since the Fed’s intervention following the credit crisis. Fed officials also hinted at one more rate hike before the year ends, while reaffirming their positive view of the U.S. economy.


The resilience of European economic indicators despite market turbulence elsewhere is evidence of European fundamental strength. Economic activity in Germany—the region’s largest economy—has improved in recent months despite the continued softening of activity in emerging markets. Meanwhile, the global economic backdrop also remains supportive, as reflected in the continued uptrend in oil prices, which we expect will be further supported by recent extreme weather events. While we consider the greatest risks to European equities to be largely external, local political developments will warrant close attention. It’s shaping up to be another difficult few weeks of politics for the euro. The highlight will be the Italian government’s submission of its budget plan and the response from Brussels. Plans for a structural deficit of 1.7% of GDP for 2019-2021 will not be greeted well by the European Commission and may presumably spark a war of words. We struggle to see Italian officials backing down anytime soon – and this could see the euro come under pressure again. And it’s not just Italy that’s providing a bit of political discomfort for EUR markets

United Kingdom

The British economy is heading for its worst year in almost a decade amid the growing risks from no-deal Brexit, according to a leading economic forecaster.

After official figures revealed zero growth in GDP in August, forecast growth of 1.3% for the whole of 2018, down from a previous estimate of 1.4%. This would be the worst annual period for growth since the financial crisis. It also downgraded the outlook for the second quarter running. Economists have said failure to reach such a deal could significantly harm the UK economy, with the International Monetary Fund warning of “dire consequences” for growth.

The government’s economic forecaster, the Office for Budget Responsibility, raised the prospect of a no-deal scenario triggering border delays, companies and consumers stockpiling food and other supplies, and aircraft being unable to fly in and out of Britain. Inflation is forecast to fall from about 2.7% to 2.3% by the end of the year, above the Bank of England’s target rate. Consumer spending growth is estimated to remain limited as a consequence, as UK households remain under pressure from weak wage growth and relatively high levels of inflation.


While the official consumer price index rose at just half of policymakers’ 2 percent target in the latest reading, less-watched gauges suggest cost pressures are building. Prices paid by services companies are climbing the most since the early 1990s, as is worker compensation. Rents are accelerating in major cities, led by Tokyo. As companies start passing those costs along, and generalised inflation takes hold, investor attention could pick up. While Japanese stocks have been caught in the global sell-off that hit equities this month, the Nikkei 225 stock average at the start of October touched its highest level since 1991. This confirms the record profits among the nation’s companies and an investment-driven rebound in growth that’s helped pull unemployment down to the lowest in more than a quarter century this year. Companies have become more focused on improving profit margins and gradually increasing shareholder returns. Consumers were less pessimistic about their confidence in income growth as well as their willingness to buy durable goods. Job prospects were unchanged, while the overall livelihood category declined in September. Regarding prices, expectations of higher prices increased slightly in September, with 81.7% of respondents expecting prices to trend higher (up 0.1 percentage points from last month’s survey). The Bank of Japan (BoJ) expects the economy will expand between 1.3% and 1.5% in the 2018 fiscal year, which ends in March 2019. In the subsequent fiscal year, the BoJ sees GDP growth at between 0.7% and 0.9%.


The performance of Shanghai Composite Index is lagging the US market by a massive 30% so far this year. This divergence is extreme when compared to the ‘economic reality’ of the trade tariffs.

What’s next in China
Increased infrastructure spending

The NDRC, the agency that oversees plans for infrastructure investment, announced plans to 1) front load some projects planned for the next couple of years; and 2) accelerate preparatory work for public projects to ensure steady flow of new projects and investment.

 Increased export tax rebate and improved trade facilitation

China announced a 2ppts increase (weighted average) in the VAT tax rebate for exports worth about $300 bn (in 2016) effective September 15. The government also plans to reduce customs fees and approval procedures to facilitate trade.

Lower import tariffs and increase market access

Premier Li stated that China is considering lowering import tariffs on imports from a wide range of economies.

More tax cuts likely

On top of the planned RMB 1.1 trillion in tax and fee cuts announced in March, which include an estimated >RMB300 bn personal income tax cut, China has also announced increases and extensions of tax waivers for micro and small businesses in the past few weeks.

 Boost domestic consumption

The State Council released on September 20 a general guidance to promote domestic consumption. The government plans to increase spending on public services, including by building related hard and soft infrastructure to facilitate consumption in health care, old age care, tourism, education and sports. It also promises to further open these sectors to private investment including by improving land access and business approvals.


Although headwinds persist in the form of an uncertain global economic outlook, we expect that global commodity prices will post solid year-on-year gains in Q4 2018. The increase will largely reflect the boost in prices observed in the first half of the year, especially for coal, nickel, oil and its derivatives, palladium and U.S. steel. Next year, global commodity prices will expand at a slower rate as a broader preference for cleaner energy and increased oil supply will lead energy prices to decline.


Just this week, we’ve seen a discount develop on the back of massive builds in US Crude Oil inventory to the tune of 6.49mln barrels. In addition to increased inventory in the US that may be showing demand is waning, traders are concerned that a tightening Fed will hurt demand while trade wars may have impacted China. Chinese GDP missed expectations when it came in at 6.5% vs. 6.6% and signs are emerging that Saudi Arabia is increasing production to more than make up for pending Iranian sanctions and depleting in Venezuela. While concerns remain about US monetary policy, global economic growth, and now crude oil supply, the historical pattern of rotational leadership in capital markets tends to see commodities lead the final charge before a recession takes place as inflationary concerns and growth see its final light of day.  JPMorgan noted that they see more than a 60% chance that the US will tip into a recession over the next 24-months based on a slew of macroeconomic data.

BASE METALS – Australia

The combined effect of a weaker exchange rate outlook and persistent strength in the price of some resource and energy commodities — particularly thermal coal and oil, which affects LNG prices — has led us to revise up our resource and energy export forecasts. We now expect Australia’s resources and energy export earnings in 2018–19 to reach a new high of more than a quarter of a trillion dollars.

Nickel is used in the production of stainless steel, but it is not only improving demand there that has driven up the price of nickel.  Nickel has become a key ingredient in the booming demand for more and better lithium-ion batteries to charge our electronic devices and now the electric vehicles (EV) of the future.

Some investors who have been following developing trends in the search for better batteries have bounced back and forth between the metals that go into li-ion battery components.  Given the current leader in the better battery battle is the lithium-ion version (and likely to remain so for the foreseeable future), investing in lithium miners seemed the obvious choice.  As often happens with booming demand, miners of all stripes rushed into the lithium space, creating oversupply conditions, real or perceived, collapsing the price.


Sector 12 Month Forecast Economic and political predictions 2018





AUD/USD as a ‘70-75 cents currency’ for a good while to come, but with risk now skewed toward spending at least some time sub-70 in the next six months or so if emerging market pressures do intensify significantly.




$1,220 – $1,350


Macro fundamentals continue to favour the upside risk. Uncertainties surrounding global trade, the Italian budget, Brexit and the upcoming mid-term elections in the U.S. have the global financial markets on edge. From a technical side, gold support sits near the $1,220 level and gold remains constructive above this level. Resistance appears at the $1,237 area and a break here would signal a quick test of the $1,250 level.




Prefer Oil and Gas over bulk metals


Global supply constraints are likely to underpin oil prices. Trade tensions add downside risk to industrial metal prices. We are neutral on the U.S. dollar. Rising global uncertainty and a widening U.S. yield differential with other economies provide support, but an elevated valuation may constrain further gains.




Hold – value appearing


Currently, the AREITs earnings yield is at 6.3% which is higher than the yields of either cash or bonds. The premium to Australian 10-year government bonds is 3.7% which is marginally above the average premium of 3.6%.


Australian Equities

ASX 300


Low 5600 – High 6600


From a risk / reward perspective, even though no clear sell signals have been generated, we believe it’s time to position portfolios to a more defensive stance.


Buy – The banks, Telcos, Wesfarmers & Woolworths and conservative hybrids i.e. good yielding ex growth stocks.


Sell – High valuation growth stocks (other examples SEK, REA and CAR), real estate and utilities i.e. expensive growth stocks and stocks that are negatively influenced by rising interest rates.


For the 2018 financial year the banking sector underperformed, driven by the Royal Commission and slowing growth in Australia. On a price to book basis the banking sector is the cheapest it’s been in many years and on a price to earnings basis it is inexpensive. We expect dividends will remain flat, providing scope for the banks to outperform the overall market.




Australian Ten-year Bonds

2.50%- 3.4%



We see rates rising moderately amid economic expansion and Fed normalisation. Longer maturities are vulnerable to yield curve steepening but should offer portfolio balance amid any growth scares. We favour shorter-duration and inflation-linked debt as buffers against rising rates and inflation. We prefer short dated mortgages over longer dated and versus short-term corporates.


Cash Rates


No change


RBA has made it increasingly clear that it is in no hurry to start raising rates. Although economic growth is now running ‘above trend’, unemployment and under-employment are still higher than the RBA wants, and inflation is lower than the RBA wants – and it expects progress on both fronts to be only ‘gradual’. The RBA seems unconcerned by recent ‘out of cycle’ movements in some lenders’ mortgage rates.

Global Markets



S&P 500

Low 2580 – High 2940

Underweight – take profit


Invest in firms that are well positioned to take advantage of Trump’s high-growth “America first” policies, because they don’t have as much exposure to foreign markets, they bypass many of the trade war pitfalls large multinationals must face. The FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) have made the S&P 500 top heavy. Today, these five stocks represent a highly concentrated 12 percent of the S&P 500, nearly double from their share just five years ago. Apple alone represents 4 percent of the large-cap index. This leaves you with too much exposure to companies that would be hardest hit in the event of a market downturn, and too little exposure to names and sectors that might rotate to the top in the next cycle.




Neutral hold


Relatively muted earnings growth, weak economic momentum and political risks are challenges. A value bias makes Europe less attractive without a clear catalyst for value outperformance.




Neutral weight hold


We see a weaker yen, solid earnings and cheap valuations as supportive, but await a clear catalyst to propel sustained outperformance. Other positives include shareholder-friendly corporate behaviour, central bank stock buying and political stability.



And Emerging markets


Start Buying


Attractive valuations, along with a backdrop of economic reforms and robust earnings growth, support the case for EM stocks. We view financial contagion risks as low. Uncertainty around trade is likely to persist, though a lot of it has been priced in. We see the greatest opportunities in EM Asia on the back of strong fundamentals.


The economic and earnings backdrop is encouraging, with near-term resilience in China despite slower credit growth. We like selected Southeast Asian markets but recognize a worse-than-expected Chinese slowdown or disruptions in global trade would pose risks to the entire region.



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