Merlea’s Economic Outlook – July 2017

Merlea Macro Matters
(July 2017)


The Trump “reflation rally” that drove equity markets across the developed and emerging world in the four months after the US election has continued but it is more due to the underlying expansion of the US business cycle than to any Trump effect.

The recovery in the US is now percolating out to other areas. Improved performance in Europe, Japan and non-Japan Asia owe much to the spiller effects of the US upswing. But some major central banks, most notably the European Central Bank (ECB), appear to have signalled a turning point, as indicated by yields moving back up recently. It seems central banks are peaking in terms of monetary policy accommodation and will soon begin to proceed with monetary policy normalisation, as the US already has begun. However, after such extreme policies as aggressive quantitative easing and negative interest rates, it will be difficult to normalise without potentially triggering some level of disruption. The Fed will soon begin the delicate task of balance sheet normalisation while still in the throes of a rate hike cycle. While the Fed’s plans are measured and thoughtful — intended to create the least amount of disruption possible — there are always risks. The Fed therefore needs to be cognisant that its actions could have a serious dampening impact on credit growth. The Fed may find that normalisation cannot simply happen “in the background” and may instead become “front and centre.” Adding to the risk is that three open Federal Open Market Committee (FOMC) seats may soon be filled, and there may soon be a new FOMC chair.

Stock markets may now be faced with some pressure after valuations have become very much stretched on Wall Street following a year of ultra-low volatility. The VIX is now trading near its lowest levels for 25 years and the current period of low volatility has led to a sense of complacency in the market. The honeymoon phase with Donald Trump and the markets has probably also come to an end, with the optimism over the “reflationary” trade and rollout of US infrastructure now completely overshadowed by US foreign policy and an American President that is becoming increasingly out of touch with political reality.

Rising geopolitical tensions converging with what is becoming an increasingly erratic and unpredictable Trump Administration could be a trigger. It is probably only a matter of time before markets become more sensitive to geopolitical uncertainty. Rising rates also pose a threat to markets, and there are concerns that second-half earnings in the US may not be as robust as the market is anticipating. In the past weeks, sovereign yields have risen amid a seeming sea change in thinking about global central banks and interest rate direction, which started with hawkish comments from European Central Bank President Mario Draghi. The Fed also has sounded hawkish, emphasising that it is on track to both slow down bond buying and raise interest rates before the end of the year.

Rising bond yields have started to worry investors with signs of increased volatility across a number of risk assets and emerging markets. The stock market could be at risk if there is a global economic slowdown coupled with softer earnings. We also note that “monetary tightening” could be a threat if central banks are perceived to have got ahead of the curve.”

Economic analysis (Australian Update)
The Reserve Bank of Australia is more upbeat about the economy, but the market still expects no change to the cash rate in 2017. An optimistic economic assessment in the minutes of the RBA’s July policy meeting sparked a surge in the Australian dollar, which briefly surpassed 80 US cents for the first time since May 2015. A patchy housing market and an elevated level of underemployment were among the reasons the RBA decided to leave the cash rate unchanged for an eleventh consecutive month in July. But the RBA noted a broad-based global recovery, and overseas central banks becoming more inclined to raise rates in future. It was also pleased with recent improvements in the Australian jobs market, pointing to a fall in the unemployment rate to a four year low of 5.5 per cent.

 The property market is of course the elephant in the room for many economies globally as this has been stoked by a period of ultra-low interest rates. Time will tell whether macro-prudential measures implemented by many governments have come too little too late, but we think on balance we are not going to see a GFC-style meltdown. Debt levels are elevated, and that certainly makes many economies vulnerable, but while lending rates are rising, we are not going to see this balloon overnight. A shortage of housing supply, and strong demand should also help serve to mitigate the downside.

First quarter gross domestic product growth came in at 0.3% and 1.7% over the year. The latter was better than the 1.5% expected by the market and also means Australia has continued a record of almost 26 years of headline growth. Australia now has the longest run of uninterrupted growth in the developed world. It has been 103 quarters since Australia last had a recession. The growth rate is subsiding (the weakest since 2009) and cannot just be blamed on the weather. The property market has slowed, while low wage growth highlights a slowdown in consumer spending is on the cards. Household consumption rose 0.5% in the quarter, but the savings rate fell to a 10 year low of 4.7%.

Some work will therefore be needed for growth to get to the RBA’s target of between 2.75% and 3.75% by early 2018. The resource sector will clearly need to keep on trucking for growth to get anywhere near this target. While the resources sector has a chance of excelling, we have concerns about other parts of the economy, particularly as the bank levy flows through.

Australian shares
The first six months of calendar 2017 have seen the index deliver a flat performance, but we think the story will be more positive in the second half. As far as our strategic positioning goes, we remain of the view that the market’s two biggest sectors, the resources and banks will be integral in this regard.

Commodity prices, led by iron ore, have staged a mini-revival, and we think that the underlying demand/supply equation justifies this, with a bit more in the offing. We also remain of the view that over the medium term, inflation will enter the picture, and this will also have positive implications for the banks, which are already seeking to combat various margin headwinds by raising their lending rates.

Many of the bulk commodities and base metals have bottomed out after this year’s correction and are in the process of reasserting to the upside. Separating out the noise, we are strongly of the opinion that the bear market in the resources sector and commodities generally, terminated in January last year. Whilst the correction in commodities this year has seen around half the gains of 2016 given up, we are nowhere near the lows of January 2016. And that includes oil which has been amongst the hardest hit in the shakeout over the last quarter. So, if anything the resource sector is now becoming a buy. For example Iron ore prices have reasserted to the upside in China with the commodity up 21.3% to $63 since the lows of US$53.35 a ton were set in mid-June. China’s steel mills have been replenishing inventory stock levels to take advantage of the decline in prices. Our view is that the iron ore price has found a floor around the $60 level. However, the current strength in commodity prices, and a continuing rebound in iron ore and oil is likely more than a relief rally, with the recent correction overdone given robust underlying demand (led by China), inevitable supply reactions, and (while it is not apparent as yet) the prospect of inflation on the horizon in 2018, if not later this year.

Political and geopolitical uncertainties, along with US$ weakness, and the Fed’s predicament with respect to rate tightening, are underpinning sentiment towards the precious metals sector. The US Dollar Index has lost ground and the lower Dollar Index helped the gold price surge pass $1290 and this places the key $1300 level within striking distance. Technically gold is looking very robust and a breakout through $1300 is likely. The elephant in the room is still the prospect of rising inflation later this year and into 2018. If we are right, the precious metals sector will have further to run.

The weakness of the listed energy sector has been driven by a 15.5% decline in Brent Crude oil in the first half of 2017 to US$47.92 a barrel. This is the weakest first half period for crude oil since 1998. Growth in US shale oil production has helped to offset the agreement by OPEC and its partners to curtail output. Since the OPEC agreement on 30 November the US rig count is up 345, or 60%, US crude oil production is up 7.4% and the US is now pumping 9.33 million barrels per day. Nigeria and Libya have also been increasing production but on the other hand the diplomatic rift between Qatar and its Arab neighbours has failed to impact the oil price as would have traditionally been the case.

Listed property has traditionally behaved differently from other sectors of the share market. It began life as a defensive play, and has evolved into a proxy for bond yields. When bond yields are down, money moves into listed property. When yields go up, the money moves out. Australian real estate investment trusts (AREITs) continue to provide attractive relative yields in the current low interest rate environment.

The Sydney office market remains positive given the low vacancy rates and the prospects for strong effective rental growth.  However, our view on retail is more cautious, given the relatively high valuations of trusts exposed to the sector and the threat posed by foreign entrants, including from online.

Stronger world economic growth and a recovery in short to medium term bond yields remains likely. This is expected to put downward pressure on the earnings yield potential from the AREIT sector. But current earnings yield for AREITs however remain attractive relative to bond yields. The earnings outlook for AREITs over the next twelve months remains positive albeit lower relative to previous years’ highs given higher valuation multiples and flat to lower level of earnings. Movements in bond yields will be a big driver to return expectations from the AREIT sector.

Global News
The global economy is experiencing a relatively steady, synchronised expansion. Broadly speaking, most developed economies are in more mature (mid-to-late) stages of the business cycle, with the Eurozone not as far along as the United States. Recession risks remain low globally, although less accommodative policy in several countries, including China, may constrain any upside to growth going forward.

Source: Fidelity Market Update


The Eurozone has clearly continued to recover with the unemployment rate falling to its lowest level since 2009 at 9.3%. Inflation also remains subdued with the most recent reading at 1.4%. The ECB has also increased its forecasts for Eurozone growth by 10 basis points in each of the next three years. Growth in 2017 is now expected to come in at 1.9% followed by 1.8% growth in 2018 and 1.7% in 2019.

The European Central Bank is also on track to unwind its stimulus next year but it’s likely to drag out the process. The rollback is seen starting in January and taking nine months, up from the previously predicted seven months, with future reductions announced one step at a time. The ECB has already started changing its policy language, saying at last month’s meeting that the risks to economic growth are now “broadly balanced” instead of tilted to the downside, and that officials no longer expect interest rates might be cut again. The wording on QE was left unchanged because policy makers believed altering it could be misperceived as signalling a more fundamental change.

Also while Euro-area growth has improved the hurdle of political elections has passed without threat to the Euro currency system. The German elections in September are the remaining uncertainty, but there is no serious populist threat to the established parties of centre right or centre left. – The triggering of Article 50 on March 29 for Brexit will lead to protracted negotiations between Britain and the EU over the next two years. Imported inflation from the depreciation of sterling is reducing UK consumer spending in real terms, while the overall uncertainty about the exit process will undermine foreign direct investment (FDI) in the country. – The general election called by Prime Minister Theresa May on 8 June produced a “hung parliament” with Conservatives having to ensure their survival by doing a deal with the Democratic Unionists of Northern Ireland. This outcome has greatly reduced the Prime Minister’s freedom of action across a range of policy areas. – Meantime, the Bank of England’s (BoE) credit promotion policies implemented last August risk adding domestically generated inflation to imported inflation from weak sterling. In response the BoE tightened capital requirements on 27 June.

China’s economy expanded faster-than-expected in the second quarter, setting the country on course to comfortably meet its 2017 growth target and giving policymakers room to tackle big economic challenges ahead of key leadership changes later this year. China’s gross domestic product rose 6.9 percent in the second quarter from a year earlier, the same rate as the first quarter. That was higher than analysts’ expectations of a 6.8 percent expansion. Economic data from the second quarter has prompted a number of analysts to upgrade their GDP forecasts for China for 2017, although some moderation in growth is expected later this year as policymakers’ efforts to rein in property and debt risks weigh on activity.

Chinese manufacturing beat forecasts in June with the official PMI coming in at 51.7 versus 51.2 in May and forecasts for 51. The official non-manufacturing index hit 54.9 in June versus 54.5 in May. Helping to lift China’s stock market, the government has indicated it wants to encourage commercial pension funds to invest in stocks, bonds and funds to “provide long-term stable support” for the healthy development of capital markets. This was revealed in a policy paper dated July 4 from China’s cabinet. The policy is expected to bring more long-term funds into the stock market. The mainland stock market also drew support from China’s move to hike the quota under the Renminbi Foreign Institutional Investor (RQFII) scheme for Hong Kong to 500 billion yuan ($73.58 billion) to further meet their demand for Yuan asset allocations.

For the rest of 2017 Chinese policymakers are likely to maintain a pro-growth stance before the leadership changes in late 2017 and early 2018. Monetary policy will shift back to a more neutral stance with inflation returning while fiscal policy will remain very accommodative.

The US business cycle expansion is still intact, owing much more to underlying fundamentals such as private sector deleveraging, the recovery of the banks, improved consumer finances, low inflation, and continuing low interest rates than any impact from the accession of Mr Trump to the Presidency.

The US pace of economic growth was revised to 1.4% in the first quarter versus 2.1% in the final quarter of 2016. First quarter growth has been revised up from 0.7% initially and the second estimate of 1.2%.

For some months now, the U.S. Fed has flagged its plan to “normalise” its monetary policy. The first part of its plan involved the raising of the federal funds rate and the first increase occurred in December 2015. The second part involves the disposal of its bond holdings which it plans to do by not reinvesting matured bonds. The US Federal Reserve Open Market Committee (FOMC) met on 13–14 June and, as was widely expected, raised the Fed Funds target by a further 25bp to a range of 1.0%–1.25%. This was the fourth rate rise since December 2015. The Fed made several changes to its policy statement, but its policy outlook remains unchanged. It noted that “the labour market has continued to strengthen and… economic activity has been rising moderately so far this year… household spending has picked up in recent months, and business fixed investment has continued to expand.” On inflation, the Fed acknowledged the recent lower CPI readings, but said that inflation is expected to stabilise around the committee’s 2% objective over the medium term, commenting that “near term risks to the economic outlook appear roughly balanced, but the committee is monitoring inflation developments closely.”

The main risk to growth is that the US Federal Reserve (Fed) tightens credit too sharply, not by raising interest rates but by curtailing credit growth in the private sector. This could happen as the Fed shrinks its balance sheet, even at very low interest rates. Following the 0.25% hike in the US federal funds rate in June, we expect the Fed will raise interest rates once more in 2017, by 0.25%. The Fed also released an “Addendum to the Policy Normalisation Principles and Plans”, highlighting its intention to reduce its balance sheet by decreasing reinvestments in maturing securities. This reduction is expected to be in the order of $US6bn per month initially for Treasury securities, increasing in $US6bn steps at three month internals over 12 months until it reaches $US30bn per month. For agency debt and mortgage-backed securities, the cap will initially be $US4bn per month, increase in $US4bn steps at three month intervals over 12 months until it reaches $US20bn per month.

Investment portfolios
Lower political risks in Europe and the US have been replaced by some of the traditional macroeconomic risks around China, secular stagnation, inflation and the unwinding of QE by the Fed.

Many equity categories are at full valuations with uncharacteristically low volatility. Combined with political uncertainty around potential policy outcomes this has increased our concern that market volatility is susceptible to moving higher. Low volatility can itself become a high-risk environment, because people can start overpaying for assets. This is a healthy reminder that, even in a growing climate, risk needs to be managed in portfolios, not only in terms of asset allocations but also stock selection, regional exposures, balance sheets and so on.

 With upward pressure on bond yields from both real yields and inflation expectations, we maintain our underweight positions in bonds and REITs.

The Australian market has seen quite a large rotation away from defensive and bond proxies towards the cyclicals and value end. Our view is that this correction still has some way to go, given the extent of the bubble, and should be driven by rising global inflation, and therefore earnings growth in the more economically-sensitive sectors. Going forward, our preferences include energy, capital goods, technology, transport, healthcare, financial (ex-banks offer value) and consumer discretionary. In our view, property stocks remain overvalued.

Investors should focus their attention on ensuring that their overall portfolio is suitable for their risk tolerance, their lifestyle needs and their long term return requirements. Market performance is difficult to predict, particularly over the short term but putting together an appropriate mix of Australian and international equities, fixed interest, property, cash and alternative investments is more likely to achieve an investor’s long term goals compared to reacting to market events without the benefit of a plan.

Diversified portfolios with a mix of asset classes have managed to post acceptable returns over longer time frames of 5 or 10 years despite market volatility. This reflects the short-term nature of many of the equity market declines, together with the other asset classes being influenced by different drivers, and therefore providing an offset when equities perform poorly.

Given recent volatility some stocks/sectors that have been discounted are now within buying range. There have been several new additions to the portfolio investment models as we find value in stocks that were previously unattainable. While yield is likely to remain a focus, in time, as economic activity is stimulated by low interest rates and accelerates, we expect our models to broaden to a wider range of companies that will deliver capital growth as well as income.

Merlea Investments recommended portfolios are generally designed to diversify assets across a range of asset classes to obtain low volatility given a stated return goal. The actual goal, or targeted return, from a portfolio is perhaps the most important influence in a portfolio as once a goal is stated the ability to assign asset allocations becomes a matter of maths. We will always prefer to gain as much return as possible from cash and defensive type assets and then augment this return with the higher risk/higher return possibilities from growth assets.

We aim to continue to accumulate stocks upon further weakness in the market but investors will need to be patient and wait for opportunities to arise. To find additional growth opportunities the models now have more stocks outside the Top ASX200.


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