Merlea Macro Matters – September 2017

Merlea Macro Matters
(September 2017)


Concerns about a potential nuclear conflict with North Korea weighed on risk assets recently. Pyongyang has warned of retaliation if the UN Security Council approves aggressive sanctions over its recent nuclear test; however I continue to see the markets widely discounting the latest rhetoric. The VIX had its biggest decline in 3 weeks losing 11.5% to 10.7, while the rally in US stocks was broad based (and not concentrated as has been typically seen on many occasions this year). The ratio of S&P 500 shares that were rising relative to those that were falling was at the highest in three months. I think this is reflective of the markets’ dissipating concerns over NK. We still see a military conflict as a low-probability risk, and hold onto our moderate risk-on positioning. We have been bombarded in the media almost daily with fund managers getting out of the market and “cashing up”, but this has made me very nervous about the “upside risk” in stocks in the months ahead. September is not over yet, but so far so good – this could be one month that will shape up as being better than the historical average.



In fixed income markets, bond yields declined as risk aversion spread across the globe and sent investors flocking to the safety of government bonds. Consistent with the cautious mood in the marketplace, credit spreads widened and government bonds outperformed their corporate bonds during the month. In the US, investors remain sceptical of the Federal Reserve’s ability to raise interest rates again in 2017 amid ongoing uncertainties in Washington and persistently soft inflation results, both of which have seen investors reduce their expectations for fed fund rate hikes this year. Eurozone bond yields also pulled back after President Draghi failed to provide any insight on the next steps towards monetary policy normalisation in Jackson Hole, which investors interpreted as dovish in general. We still maintain a moderate short duration bias. We do not see the risk of a rapid acceleration of growth and inflation in the coming months, but we believe that the current level of government bond yields underestimate the shift in Central Bank policy in both the Eurozone and US. Inflation linkers are also attractive, as they

discount inflation forecasts that are too conservative, as are floating rate notes.


Listed Property

Australian property trusts have performed poorly over the last year, with much of the performance related to the dire performance of the retail sector. Looking ahead, and with talk of Amazon coming to local shores, the listed Australian Real Estate Investment Trust (A-REIT) sector could continue to struggle, but that may result in some bargains.

The benchmark S&P/ASX 200 A-REIT Index fell by about 10 per cent over the year to 20 July. That compares to the S&P/ASX 200, which is up by about 10 per cent. 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 that the forthcoming arrival of Amazon will have on incumbent retailers


Australian Equities

There’s no surprise at all that the RBA kept the cash rate at 1.5% for the thirteenth straight month. The associated commentary, by Governor Philip Lowe did express an upbeat picture of the economy, noting that “Our central scenario is for growth of around 3 per cent over the next couple of years and for the unemployment rate to move lower gradually.” There are clearly several reasons why now is not the right time to be tightening, just yet.

Not least of which is the level of household debt, and this was underlined by the RBA: “In striking the appropriate balance in our policy setting, we have paid close attention to trends in household borrowing, given the already high levels of debt. Over the past four years, household borrowing has increased at an average rate of 6½ per cent, while household income has increased at an average rate of just 3½ per cent. Given this, the RBA has worked closely with APRA to ensure that lending practices remain sound.”

We really need to see meaningful wage inflation before the central bank will pull the trigger on a rate rise. With full employment this is getting close, but we are not there yet. The central bank also observed that “wage growth remains low”. This is likely to continue for a while yet, although stronger conditions in the labour market should see some lift in wages growth over time. Inflation also remains low and is expected to pick up gradually as the economy strengthens. The resource sector though was once again a bright spot, led by gold stocks. The RBA is also clearly focussed on the strength of the Australian dollar versus the greenback, and noted that “The higher exchange rate is expected to contribute to the subdued price pressures in the economy. It is also weighing on the outlook for output and employment. An appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.”

The bottom line also is that “The low level of interest rates is continuing to support the Australian economy.” And with this mindset, I really can’t see the RBA touching the dial on interest rates till early 2018 at the very soonest.

Strength in resources generally is not something you would expect to see if risk was truly coming off the table, so I think these moves are also very telling. I also think we are seeing some upward reweighting by fund managers following a strong reporting season from the sector.


Global markets

One can assume that the Federal Reserve will not attempt to reduce its balance sheet too aggressively and risk derailing an eight-year economic expansion (the third longest), which by the summer of 2019 will become the longest. The speed at which its balance sheet is shrunk will have an obvious impact on the pace of any planned interest rate increases and given that the Federal Reserve Chairperson, Janet Yellen, has so far failed to provide clear guidance over what the trade-off might be, there is a growing belief that both US interest rates and bond yields will stay lower for longer, rather than normalise. US Ten year treasury yields have unwound all the gains made earlier in the year and are trading at 2.15%, which is also symptomatic of the market not pricing much in the way of tightening from the Fed.


I also wonder whether the US dollar is reaching a bottom, especially considering the consensus is getting increasingly bearish. Interestingly enough, the news on debt ceiling progress and Mr Fischer’s resignation, saw the dollar rise, and I also wonder whether all the political risk here has been more than priced in. A resolution on the situation with NK could also see the bid come into the greenback with some force. Economic data in the US is also giving more reason for optimism. The US service sector (non-manufacturing) increased to 55.3 in August from 53.9 in July. The improvement was marginally below forecasts for 55.4 but the majority of respondents were optimistic on future business conditions. The consensus is calling the US dollar lower. So does that mean the bell has been rung at the bottom?


The market implied probability of a rate hike in the Eurozone has continued to decline due to ongoing euro strength, and I think ECB Chief Mario Draghi has all but given up on reducing stimulus measures anytime too soon. The strength in the euro (which is also a function of US dollar weakness) would be exacerbated by a rate hike and the Eurozone economies of Italy, Spain and France are not yet strong enough to withstand this. I think there is a good chance he will seek to avoid placing further upward pressure on the Euro now – particularly as the Federal Reserve procrastinates over whether to tighten. There is no advantage in going first. The probability of a hike in June 2018 is now 42% versus 90% six months ago and the chance of a hike in the whole of 2018 is now less than 50%. A stronger euro will keep inflation in check in the Eurozone, whilst low interest rates are going to strengthen the economic recovery. The strength of the Euro has increasingly become a concern while geopolitical fears have hit investor sentiment. The Eurozone composite PMI for August fell to 55.7 from 55.8 in July due to slower expansion in the services sector. The service sector PMI fell to 54.7 from July’s reading of 55.5.


Economic news has been broadly positive, with a synchronised global upswing being supported by a low interest rate environment and relatively subdued inflation. Unfortunately, the notable exception appears to be the United Kingdom, with Mark Carney, Governor of the BoE, recently warning that Brexit uncertainty appears to be holding back business investment and household spending, a view supported by recent economic data. Consumer confidence in July fell to a level last seen in the immediate aftermath of the Brexit vote, resulting in weak consumer spending growth, which has also been undermined by rising inflationary pressures. This has restrained economic growth over the first six months of the year to its weakest performance since 2012 and has resulted in the BoE downgrading its growth forecasts for this year from 1.9% to 1.7% and 1.6% next year.


Japanese 10 Year Government Bond yields may have found a floor recently with support coming in at 0%. If this proves to be the case and yields hold above this level, it can only be a matter of time before a “more important test” of historic downward resistance gets underway later this year with Japan’s economy showing the best recovery potential in decades. The labour market is tight and business confidence is high but efforts to lift inflation have fallen flat despite years of aggressive monetary easing by the Bank of Japan. Even so, the latest reading means the economy has had six consecutive quarters of growth — its best string of gains since the tenure of former Prime Minister Junichiro Koizumi. I continue to see the bank stocks as being one of the great contrarian opportunities in the Japanese market. In July, the core consumer price index was flat from the previous month in seasonally-adjusted terms, matching the result in the previous five months. The Bank of Japan (BoJ) expects that core inflation will be between 0.6% and 1.6% in the fiscal year ending March 2018. In the following fiscal year, the BoJ sees inflation between 0.8% and 1.9%.


China’s economic growth is expected to slow modestly in the coming years, following a robust performance in FY2017. China is expected to remain the largest incremental contributor to global industrial value-added through the 2020s even as its growth rates mature. For FY2018 specifically, we expect to see a cooling of growth rates in the housing and automobile markets in combination with a continuation of strength in infrastructure backed by expansionary fiscal policy. A positive development in the recent half year has been the improvement in Chinese manufactured exports, with the notable exception of its trade in steel.


China’s policymakers are anticipated to continue to seek a balance between the pursuit of reform and the maintenance of macroeconomic and financial stability. We expect a continuation of current efforts to address excess capacity; further encouragement for the financial system to focus on supporting the real economy; and additional measures aimed at improving the balance sheet health of over-indebted sectors, including local government.


The Caixin-Markit services PMI came in at 52.7 in August versus 51.5 in July. This is the highest reading for three months and the composite PMI – manufacturing and services – hit its highest level in six months at 52.4. China’s exports rose by 5.5% in August on a year ago versus forecasts for 6% growth and the 7.2% increase seen in July. Exports to the US were up by 8.4% on a year ago versus an 8.9% increase in July. Exports to the EU increased by 5.2% on a year ago in August from 10.1% in July and exports to Japan grew 1.1% versus 6.6% in July. And finally, exports to South Korea also had improving momentum with a 7.7% rise versus 3.6% in July. Inbound shipments rose by 13.3% in August on a year ago versus forecasts for 10% growth and the 11% increase seen in July. The trade surplus fell by around US$5bn to US$42bn when it had been forecast to increase to US$48.6bn. The renminbi hit a 21-month high against the US dollar on Friday at Rmb6.449 but pulled back to 6.431. The strength may create a headwind for Chinese exporters into the United States, but this has not been a hindrance yet for the stock market which has remained strong in recent weeks, despite a broad-based selloff in Asia in reaction to North Korea. The Shanghai Composite made a new two years high last week and demonstrates no signs of losing upward momentum.



The recovery of commodity prices has enabled large parts of the emerging world, and resource rich regions in the developed world, to stabilise. An encouraging lift in international trade has occurred in the year to date despite ongoing political uncertainty. This has helped the manufacturing export economies of Europe and North Asia return to healthier growth trajectories. Nonetheless, the importance of continued advocacy for free trade and open markets remains critical.


Financial conditions have tightened modestly, led by higher policy interest rates in the United States. Measures of financial volatility have receded to low levels. The US dollar has softened from six months ago against the currencies of both commodity and manufacturing export nations. The prospective unwinding of unconventional monetary policy in the United States is a key uncertainty.


Gold prices had a very strong month in August and it managed to close the month at its highs as global risks and uncertainties gripped the markets and this led to the migration of funds from the stock markets and other risky assets into the safe havens like gold and silver. Also, the dollar continued to be on the backfoot during the course of the month and this also helped the gold prices to continue to climb further during the month. We now find gold and the dollar at an important cross road which should lead to interesting price action in the upcoming month.

We have recommended gold as a risk overlay for some time now, albeit we do think that the current rally looks overextended. What could really rock the boat is if the Fed begins selling the bonds this year, for example in December, that move could create nervousness, and that could be a stock market negative and a gold positive.”


Hurricane Harvey slammed the US Gulf Coast on 25 August hitting US production, refining capacity and demand. The impact was initially bearish for WTI with a peak of 4.5 million b/d of refining capacity shut down. In early September, both Brent and WTI have strengthened on reports OPEC and Russia are considering an extension of the production cut agreement beyond the current period to end-Q1 2018. The OPEC rumours do not have a material impact on our 2018 forecast because we have been assuming OPEC would extend the deal through 2018 since July. If the OPEC production deal were not extended beyond Q1 2018, prices would drop much further in 2018 than in our base case view for Brent to average $50 per barrel in 2018.

Sector 12 Month Forecast Economic and political predictions 2017





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.





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.





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.





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


GDP numbers for the second quarter coming in strong, but falling short of bullish expectations. Growth came in at 0.8% for the three-month period to the end of June, and 1.8% on an annual basis, according to the ABS. The prints were slightly below economist expectations, although tracking roughly in line with RBA forecasts. There is still clearly some work to do to get up to the 3% rate of growth which the central bank is predicting over the next few years. The index has been stuck in a trading range, hugging the 5700 mark, which has clearly been frustrating, given outperformance in the likes of the US indices. The market has shied away from 6000 before, but i think that a push back above, and even through this mark is possible by the end of the year, It will require the resource sector to continue performing, but the signs have been encouraging. The sector has defied historical precedent in not selling off when risk comes off the table (the miners were higher again on Wednesday), and I think there is a lot more catch up on the way by underweight fund managers, particularly following a strong reporting season. The fact that many are way off the mark on their commodity price forecasts (iron ore is nudging $80 while many were a few months ago predicting $50 around about now) should also accelerate this process.





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


RBA Governor Philip Lowe remained optimistic about the economy, saying that the low level of interest rates continues to support the economy. It continues to appear that the RBA is quite comfortable leaving rate settings on hold for some time. The risks to the outlook suggest that rate hikes remain a way off, particularly if the AUD holds at current levels or appreciates further.


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


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.



FTSE time to take profit from this stock market stock market


Europe commodity price pressures lead to higher European inflation, generating

early signs of a 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.



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.





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.





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.



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