Merlea’s Economic Outlook July 2019
Geopolitics is gathering momentum as a key force. Tensions are rising between the UK and Iran with Iran vowing to retaliate over a seized oil tanker and subsequently planning to lift uranium enrichment to 5%, above the key level that was agreed in the 2015 moratorium. This will pose a significant challenge to the US and destabilise the Middle East.
Meanwhile, US-China trade talks continue with Trump’s economic adviser Larry Kudlow commenting that “We’ve been accommodative. We will not lift tariffs during the talks…We are hoping that China will toe its end of it, by purchasing a good many of American imports”. A change in tone is notable in that the US has gone from ‘demanding’ that China play ball, and with previous threats about extending tariffs, to ‘hoping’ that it will. We believe this confirms what we have discussed about China having seized the upper hand in negotiations knowing that they have more time on their side.
Trump’s tariff threats against Mexico could resurface around July 22 and again on Sept. 5, when the Mexican government is supposed to deliver to the White House its progress report on curbing illegal border crossings. Already on the edge of recession, Mexico will be careful to avoid a confrontation with the White House to steer clear of costly tariffs. After more than a quarter of a century of tariff-free trade on the U.S.-Mexico border, the economic impact of just 5 percent tariffs on Mexican imports, as Trump earlier threatened, would be tantamount to ripping up the North American Free Trade Agreement and returning to average World Trade Organization-level tariffs for most sectors.
The threat of auto tariffs will meanwhile continue to loom large as Trump waits for U.S. trading partners to come to him with a “solution” by November, in the form of voluntary export restraints and/or acceptance of U.S. quotas. While Japan has a better chance of negotiating a trade compromise with the White House that includes agriculture and autos, EU leaders, too divided and consumed with horse-trading over political positions in the European Union for most of the quarter, will resist the White House’s ultimatum on restricting auto exports to the United States. As a result, there won’t be much movement in Continental trade negotiations with the Trump administration.
Finally, Brexit chaos and Italy will weigh on Europe. The United Kingdom will get a new hard-line prime minister, who will inevitably hit a wall with Brussels when negotiating the terms of the United Kingdom’s future relationship with the European Union. The risk of a no-deal Brexit will rise through the quarter, but the likely result will be more delays and possibly a path to early elections. And even as Rome manages to dodge EU sanctions over its ballooning deficit, Italy’s fiscal policies, weakening banking sector and fragile government coalition will continue to stress the European Union.
The global collapse in bond yields reflects increasingly grave fears of slower growth and even possible recessions in Australia, US, Europe, Japan and many other countries, but share prices everywhere have been surging in anticipation of more sugar hits in the form of lower interest rates and more stimulus to try to arrest these slowdowns. The two are incompatible of course and cannot last for years.
We will no doubt have another ‘global reflation’ scare or two (like February and October 2018), and share prices are sure to correct once again as they are starting to run ahead of weakening profit growth rates.
With falling bond rates in both the US and Australia over the past 6 months, discussion around the term: “inverted yield curve” has risen dramatically. This refers to the rather unusual situation whereby government bonds with an expiry date in ten years from today are offering a lower yield than shorter duration bonds, like three months for example. This instinctively doesn’t make much sense as longer dated loans (which is what a bond effectively is) should offer higher yields than a short-term loan. In financial speak, this translates that the bond markets are predicting that an economic recession lies ahead. The bond market is now signalling to both the US and Australia ‘thou shalt need to be loosening monetary policy’, and sooner rather than later.
Economic analysis (Australian Update)
The rebound we have seen so far in 2019 comes after years of relative underperformance by the ASX200 and has been on the back of legitimate tailwinds which are fundamentally positive for the economy and stock market. The avoidance of a Labor government, stimulus initiatives from the Coalition, two cash rate cuts by the RBA down to 1.00%, and a relaxation of lending constraints by APRA, are all very much real, and will provide further impetus to the economy.
The trade situation took an important step towards resolution towards the end of June, and while ‘it isn’t over till it’s over,’ the ceasefire has at least de-risked the outlook. I would also argue (and recent data tends to support this) that the housing market in Australia has already bottomed and is in fact turning around. And then there is the small matter of the passage of a $158 billion income tax package.
To its credit, Labor got onboard with the package. As the government noted, low and middle-income earners with an income up to $126,000 will receive up to $1080, or $2160 for dual income couples, with the increased tax relief to apply from the 2018-19 income year. The top threshold of the 19 cents in the dollar tax bracket has been increased from $41,000 to $45,000, and once the plan is fully implemented, around 13.3 million taxpayers will pay lower taxes. From 2024 a 30% rate will apply to all income between $45,000 and $200,000.
The A$ held below 70 cents, and with comments from Governor Phillip Lowe that while the RBA is done for now, another rate trim (which is now favoured by the consensus as happening this year) will not be ruled out if the unemployment rate fails to head lower.
The ASX200 has rallied hard this year, up around 20% year to date, outperforming most other major global indices. I think the run in the index is based on legitimate tailwinds and needs to be put in context of a benchmark that underperformed many global peers (particularly the US) for a sustained period in previous years. The ASX200 has surpassed our target for 2019, and I think that the Australian market can go higher yet, but the pace of gains will likely be much slower than the first half of the year. In particularly as the surge in iron ore prices is unlikely to be sustained, and while supply is tight, demand on the other side is vulnerable to a reaction from consumers at some point.
There is lots of institutional demand waiting on the sidelines. Gold is reappearing on everyone’s radar, and investors are becoming more interested. Gold is in a bull market in most currencies, and overall is doing exceptionally well. We have a bullish view on gold and the gold sector, which was challenged in the face of US Dollar strength. I have to the say however, the reaction to US Dollar index strength was encouraging and did not trigger the typical 5% plus selloff in gold shares – which would typically have happened. After selling off initially, gold shares generally held up well. I still believe that the breakout above the $1350/1375 level is significant and will prove to hold. Spot gold is trading at US$1,426 per oz.
Oil traded lower with the with the worst reaction to an OPEC meeting in more than four years. This was despite the cartel agreeing to extending production cuts. I think this says more about the concerns for global growth and the prospect of a “widespread slowdown.” Certainly, a global recession would weigh on oil prices, but I don’t think we will necessarily see that scenario, particularly with the outlook for the Chinese economy remaining firm. The fact that central banks are going back to the future with lower interest rates and perhaps even QE; should also support the demand picture, while OPEC also could restrict supply further. Weakness in the US$ should also help oil to find a floor. WTI oil price is trading at US$56.60 a barrel.
Falling interest rates support economic fundamentals, especially the property market. Put simply, when interest rates are lower, owning property should become cheaper and more attractive. Property analysts expect a lift in property stocks in the immediate term, such as real estate investment trusts (REITs) – companies that own commercial property such as apartment buildings, warehouses, hotels and offices. There’s a bit of confidence that the interest rate cuts will stabilise the housing market.
Because REITs provide a bit of income, we have seen this part of the market performing reasonably given the hunt for high yielding alternatives to cash.
The strong performance of Australian property REIT stocks has seen much of the sector use the share price strength to raise capital. The likes of GPT (GPT), Cromwell (CMW), Mirvac (MGR) and Dexus (DXS) have raised over $2bn in fresh equity over the last 2 months.
Global growth momentum continued to slow, and most major economies have progressed toward more advanced stages of the business cycle. The U.S. is firmly in the late-cycle phase but with low near-term risk of recession. Policy stimulus in China has stabilised that country’s growth trajectory, but most economic indicators in Europe continue to point to lacklustre activity.
The next President of the European Central Bank (ECB) is likely to be Christine Lagarde, after she was nominated by the European Council earlier on 2nd July to succeed Mario Draghi when his tenure ends 31 October 2019. A key issue she will have to contend with is garnering support from Germany as she leads the central bank that is facing a challenge in supporting the Eurozone’s slowing economy. Lagarde is expected to maintain the dovish stance that Mr Draghi has undertaken at the ECB.
Italy will be the main source of political and financial risk in the eurozone this quarter. Rome will face external pressure — from financial markets, credit rating agencies and Brussels — to reduce its deficit. While the Italian government will be willing to introduce some cosmetic measures to reduce public spending and increase state revenue, it will not completely sacrifice its fiscal expansion plans. This will raise questions about the sustainability of Italy’s fiscal policies and the resilience of the Italian banking sector. Relations with the EU Commission will remain tense, but Brussels is unlikely to implement sanctions during the quarter.
The ongoing political crisis in the United Kingdom will escalate, but it will not lead to a disorderly Brexit in the third quarter. Several time-consuming developments will prevent the country from leaving the European Union without a deal in the next three-months. Bank of England (BoE) Governor Mark Carney said that “a global trade war and a No Deal Brexit remain growing possibilities.” The benchmark index has many heavyweight international constituents whose profits will benefit from a weaker local reporting currency. The advance in the benchmark occurred despite disappointing local economic data.
China has assumed pole position in trade negotiations with the US, and this was evident from the G20 meeting at the start of July. Donald Trump lauded China’s commitment to buying more agricultural goods, but the Chinese came away with far more in the way of concessions. The tariffs are not being extended, and Huawei has been taken out of the naughty corner to some extent, with the Chinese telco now able to buy products and services from US firms.
With China ‘seizing the upper hand,’ officials there will now be able to dictate terms more to the Trump administration, with time very much on their side .This is also why the markets have become more nervous about the timeline to resolution, and the fact that a deal may not even be done before the 2020 Presidential election. This is also why I think that the CSI300 index can gain further momentum, gaining the upper hand, and outperform the US indices (and many others) over the coming months. We are positive on Chinese stocks which are trading on 10X, and if we are right in the US dollar declining, then China’s CSI300 and Hong Kong’s Hang Seng are about to take off.
Premier Li Keqiang said that China will cease having ownership limits for foreign investors in its financial sector in 2020, a year earlier than scheduled. The manufacturing sector will be less restrictive. This is to accelerate the opening of the economy to international investors and over the medium term this should be supportive for Chinese equities.
The US will soon settle with the Chinese (in my view) and this will provide a significant amount of thrust for Asian stocks, along with a declining US dollar. I see the Hang Seng breaking out to the upside in the weeks and months ahead.
Household spending in Japan increased 4.0% year-on-year in May according to government data. That was the fastest growth since May 2015 and well above the 1.6% increase expected. The government was more upbeat on its view of household spending, saying it is “picking up.” The boost in spending was led by an increase in accommodation-linked expenses, mobile phone bills, transportation and energy bills. A recovery in household spending is viewed as critical in the central bank’s fight to lift inflation. In a low or deflationary environment, Japanese companies have been reluctant to pass on any increases in input costs as they worry customers will defect to alternative products.
On the data side, the unemployment rate was steady at 2.4% in May and the jobs to applicant’s ratio of 1.62 was little different from 1.63 in April. The Labour market continues to be very tight in Japan.
Confidence generally may be improving towards Japanese stocks. Foreigners stock investment returned to net inflows in the week ended 29 June after 6 consecutive weeks of net outflows. Japanese companies typically have strong balance sheets and are good value versus many international peers, especially as corporate profit margins are much improved versus levels of about five years ago. For exporters, the strength of the yen has been capping gains recently, so the next couple of quarters will be key to determining their direction, as traders come to a view about how much damage the trade conflict has inflicted.
For Japanese equities, the implication is mixed. Lower interest rates around the globe spur an increase in risk appetite and make equities look comparatively better value, but on the other hand, the yen is likely to remain strong, or even strengthen against the greenback (US$). The latter reduces the profits of Japanese exporters when they are translated into the yen reporting currency and that has been serving to cap gains.
Nonetheless, Japanese equities are generally good value, have strong balance sheets and are in a cycle of improved corporate stewardship in how they are looking after their shareholder’s interest. Previously, many Japanese companies (there are still some) weren’t too bothered with undertaking share buybacks, increasing dividends, or increasing transparency.
US employers added 224,000 jobs in June, exceeding expectations for a 165,000 increase. That represented a much stronger figure than the low initial forecasts of 75,000 jobs added. Despite the strong jobs figure in June, the unemployment rate edged up from the half-century low level of 3.6% to 3.7%. This occurred because the labour force participation rate increased. Average hourly earnings edged up 0.2% month-on-month which was below the 0.3% increase anticipated. On a yearly basis, they increased 3.1%, also slightly below the 3.2% increase expected. This was another indicator that inflation pressures in the economy are likely to remain muted. Year-to-date there has been solid jobs gains of 172,000 a month, approximately in line with the level of job creation in 2016 and 2017, but below the 223,000 jobs added each month on average in 2018.
The key issue now for the Fed is going to be whether softer manufacturing data (the PMIs have all drifted lower over the past few months) combined with muted inflationary pressures and slower global growth will ‘trump’ a robust labour market. Unemployment fell to 3.7% – which is near the lowest levels since 1969. Traditionally, such a tight labour market has been a precursor to wage inflation, but this has yet to really make an appearance.
The Fed is very conscious of what Donald Trump wants… a weaker US dollar. The President has made no secret of his frustration at the greenback’s strength and the US central bank’s role therein. Having potentially lost the battle over tariffs with the Chinese he may now look to at least ‘win the war’ by engineering the US dollar lower. The message here was clear in the week leading up to Independence Day, with Trump saying the US should ‘MATCH’ what trading partners are doing with respect to their currencies.
For stocks, going forward our strategy remains largely the same, buy the dips. We believe the current environment is conducive to buying dips, but also selling excessive rallies. Broadly speaking, we expect equities to trade within a volatile, slightly upward tilted range. The search for yield has returned making high dividend stocks attractive. A further compression in real rates should support high-yielding assets so we continue to look for tactical entry points into high-yielding assets.
Investors can rebalance the property component of their portfolio to their full Australian Retail Investment Trust (REIT) weighting as per the current Merlea Models. REIT’s are generally trading higher with government bonds yields at historic lows as investors buy up high yielding alternatives. Some sectors are less ‘in-vogue’ than others (such as retail), providing opportunities to enter the sector. As bond yields normalise we should be presented with further opportunities to satisfy our appetite for property and lock in higher yields.
Investments 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.
We are monitoring several risks that could destabilise the current market prosperity, as such, we still believe that the patience to find appropriate entry points to build a robust portfolio is absolutely key.
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.
Opportunities exist to accumulate specific sectors that are showing market weakness, this has given us the opportunity to focus our models back towards the top ASX200.