Merlea Macro Matters – October 2019

Merlea Macro Matters                                                                                                October 2019


Summary
 

Gaining power is one thing, but exercising power is another. American President Donald Trump and British Prime Minister Boris Johnson are both dealing with economic and political stress that has dominated recent headlines. How they fare on both fronts in coming months will have important implications for the current expansion.  China and the U.S. have been engaged in a trade war since last year. The economic conflict has dampened economic and corporate earnings growth expectations as investors and companies weigh its impact on the global economy.

The U.S.-China trade war are continually changing, keeping investors guessing about the future course of global commerce. We expect the U.S. tariffs against China to escalate as threatened, risking a spill-over of tensions to other arenas. October will be a telling month for Brexit, and the eurozone continues to contend with a very sluggish manufacturing sector. Japan has increased its consumption tax but has taken steps to reduce the risk of a recession. The ongoing uncertainties will continue to weigh on economic prospects throughout 2020.  To respond, major central banks have delivered accommodative policy. Corporate earnings are under pressure and wages are stagnating across the globe, the pressure is building, creating a stampede to sub-zero interest rates.

The problem is, longer-term, negative rates will undermine the banking system. Unlike the speculators who have piled into bonds to profit from the trend, banks are forced to hold government securities, and while the losses may not send them broke immediately, they will dent profits. Where this all ends is anyone’s guess, but it is not sustainable.

A perfect storm is approaching with three nasty elements – a prolonged trade war between the US and China; a disruptive and potentially damaging divorce between the EU and the UK – Brexit; and the possible implosion of the Hong Kong economy, I have never observed central banks collectively easing monetary policy while bond and equities markets are at or near record levels. This action is inviting and encouraging investors to take more risk with growth slowing.  Everything we ever knew or thought we understood about finance gradually and with little fuss has been turned on its head.

If you’re worried about another potential market collapse like the global financial crisis in 2008, you’re not alone. A recent National Seniors Australia survey found that 7 out of 10 older Australians share your concern.

Low interest rates have created problems for retirees, increasing Sequence Risk. Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall performance of the portfolio. It can have a significant impact on retirees who can no longer contribute to super to offset losses.  The below chart from global actuarial firm Milliman, shows the dangers of sequencing risk for new retirees and the dramatic effect of a market shock on savings longevity. A 65-year-old retiree who experiences a 17 per cent loss within the first year of retirement, on a $500,000 portfolio, will run out of money at 85, assuming they achieve an average annual return of 4.2 per cent plus the inflation rate.

Minimising exposure to volatility is the key to mitigating the effects of sequencing risk, as the magnitude of negative returns will be reduced, although it is not possible to completely avoid adverse market environments.

As an alternative to the traditional move to defensive assets, objective-based or ‘real return’ investing seeks to balance strong investment returns with an element of capital preservation.  Real return investing applies protection strategies and sources of portfolio diversification designed to provide investors with a higher certainty of achieving a particular return objective with a lower level of risk. Portfolios can be built to meet an investor’s risk profile, desired return and investment horizon. Through specialised asset management, dynamic asset allocation or by investing in a broader investment universe, real return investing often has greater flexibility to adjust the portfolio’s asset allocation in response to market conditions.

We believe investors should be able to choose the timing and style of their retirement. Rather than putting their assets and retirement at risk, real return funds should be considered by investors seeking a comfortable retirement, irrespective of their longevity.

 

Bonds

Long-term bond yields in major advanced economies have fallen noticeably over the past six months. In many cases, yields are close to, or have reached, historic lows, and in some cases are negative (Graph B1).

 

The most recent declines have been largely driven by cyclical factors: global growth has eased, many central banks have revised down their growth and inflation forecasts, and market participants have lowered their expectations for central bank policy rates.

The combination of global growth fears and a slow-to-cut Federal Reserve briefly pushed the 10-year Treasury yield lower than its two-year counterpart, ending the quarter just 0.04% away from the much-dreaded inversion. Historically, an inverted yield curve has portended economic recession — and today, while credit markets remain well-behaved, a yield curve inversion risks creating a self-fulfilling prophecy of economic gloom. As such, the markets want more easing. The Fed has stated it will “act as appropriate to sustain the expansion.” This may require additional rate cuts (beyond the two already provided) in order to restore a positively sloped yield curve and remove that fear from the minds of executives, consumers and investors alike. Low and volatile interest rates are prompting many to question the merits of holding fixed income instruments. Fixed income certainly isn’t for the income anymore. Across the three biggest economic regions, the local stock market index is providing better yields than the local 10-year government bond – especially the case in Europe and Japan. Other, more income-oriented asset classes such as global real estate and infrastructure have even better yields. That said, fixed income still plays a role in the portfolio for diversification purposes.

Against the backdrop of declining compensation for credit risk, the risk side of the equation is increasing as the average credit quality of corporate bond issuers is getting worse, particularly in the ‘safe’ investment grade (IG) bond space.  Charts like the one below are getting more attention for good reason. Half the IG bond market is now sitting at the very low end of the IG credit rating spectrum. In fact, average IG credit quality has never been worse.

 

Corporate debt, corporate bonds, or any investment for that matter, are not inherently good or bad. Rather, it’s the balance between risk and return that matters. We’re now at a point in the cycle where the risk vs. return trade-off in corporate bonds is asymmetrically poor. Compensation for credit risk is central to the value proposition of corporate bonds as investors need to balance the trade-off between higher yields and taking more credit risk.

The attractiveness of that trade-off varies as the additional return offered by corporate bonds fluctuates and credit risk also changes with economic cycles.  Unfortunately, we’re now at a point where compensation for credit risk has collapsed to very low levels, while at the same time, the credit risk side of the equation has also deteriorated, leaving corporate bond investors facing more risk for less return.

 

Listed Property

With interest rates at record lows and continuing low inflation, there are not many options for investors seeking a healthy yield. A-REITs is one sector that investors will focus on.  The sector benefits from solid operating fundamentals, low gearing and strong interest cover, good dividend coverage and demand for institutional grade real estate. A continuation of low interest rates, reasonable consumer confidence, and corporate activity (M&A) will support the sector. The lower Australian dollar adds to the appeal for offshore investors.  A-REITs have attracted significant demand from investors seeking yield, and he feels this is likely to continue in the current low-interest environment. Additionally, the Australian dollar is at very attractive levels for offshore acquirers.

With an average return of 5.7 per cent, A-REITs compare very favourably with a Westpac five-year term deposit at 1.25 per cent, the Australian official cash rate of 0.75 per cent, the 10-year government bond yield of 0.96 per cent and the five-year government bond yield of 0.73 per cent. Australian cap rates for commercial are healthy too, especially when compared to those returns from 10-year government bonds. Since the GFC in 2008, they’ve always been significantly higher, with industrial offering a 2019 yield of 5.8 per cent, office 5.2 per cent and retail 5.1 per cent.  A-REITs continue to trade across all sectors at a robust premium to Net Tangible Assets (NTA) in comparison to their global peers.

The retail sector has been impacted by a combination of cyclical and structural issues. Cyclically, retail sales have been under pressure due to higher living expenses that have not been offset by wage growth. Structurally the market, particularly discretionary retail, is suffering from the rise of e-commerce. FY20 retail sales are expected to be boosted by the flow through of the Coalition’s tax refund plan. This will see $7.6 billion tax refunds (~0.4% of GDP) flow to consumers, with a large proportion of the refunds to be spent on retail consumption.

In perspective, the current A-REIT dividend yield is 3.5x the current 10-year bond yield and 4.5x the cash rate. The greatest risk to the sector is a rise in bond yields, which would negatively impact pricing. Right now this seems unlikely, but as the past year has shown not all A-REITs are equal, there will be winners and losers. This is a market for active stock-pickers.

 

Australian Equities

There are only two things driving global share markets now. One is central banks and their support through lower interest rates and quantitative easing, and the second is the outlook for global growth. Feeding into that is the US-China trade war and now concerns in Europe.

The 3 per cent fall on the ASX200 in the first week of October — the sharpest retreat in almost a year — was a fairly abrupt and brutal change in sentiment, triggered by an outsized wobble on US and European markets.  That in turn was triggered by some worrying US manufacturing numbers (that Europe’s factories are frail is a well-established fact) and the World Trade Organisation saying it was fine for the US to whack tariffs on Europe’s wine, cheese, olives and aircraft.

The Asian and European markets were hardest hit; the benchmark US S&P500 index fell only 0.3 per cent, while the tech-centric Nasdaq, against the odds, put on 0.5 per cent.

 

A correction or something worse? Markets are experiencing their third major correction of 2019 and their fifth significant drawdown since the trade war began in early 2018. While a global recession is avoidable, market contretemps like last week’s tumble are not. This month’s market correction has delivered only about one-third the losses generated on average across episodes like February/December 2018 and May/August 2019.  The peak-to-trough declines on global equities have so far only reached 4 per cent.

Markets are now pricing in a 30% chance of a further 0.25% interest rate cut on Melbourne Cup day while the probability of a 0.25% cut next year has now risen to around an 85% chance.

Corelogic showed that house values in the country’s two biggest cities surged in value again in September. The national dwelling price increase of 0.9% for the month was largely driven by a strong rebound in the key Sydney and Melbourne markets, where values were up 1.7% over the month.  The rapid bounce-back of house values saw Sydney up a cumulative 3.3% and Melbourne up 3.2% in the last two months as lower interest rates and easier access to credit push up values. The RBA may not have been too worried about the house price rises given that the number of properties for sale has been constrained and the number of outstanding house loans are still not rising. Higher house prices and lower housing interest rates could also help to spur some economic activity as homeowners feel wealthier and the residential construction industry gets a boost.

Australia’s key leading indicators for economic activity continue to soften, reaching their lowest levels in 2 years in August. This is despite multiple interest rate cuts, the low-middle income tax offset one off, bouncing auction clearance rates, new stock-market highs and the supportive impact of a soft Australian Dollar.

Slowing construction activity is a major hinderance, including its impact on national employment. Australian job advertisement volumes are down -11% annually and signal the prospect of full-time job losses in the lead up to Christmas – something we have flagged for several months but are yet to formally witness in the data. We think Australia’s economy will bottom before the end of the year and expect a stabilisation in building activity to be a catalyst for bottoming confidence. We also think the Federal Government will be forced into upping fiscal expenditure as we move through 2020, potentially bringing forward the income tax cuts planned for 2022-23 as suggested by the Labor opposition.

Low interest rates mean that we must pay a premium for safer streams of income from the share market. Choosing dividend shares is now somewhat harder than it used to be, as you will need to weigh up the risks and rewards more carefully going forward to choose the right ones for your personal circumstances.

 

Global markets

 

The Federal Reserve has delivered its second rate cut since the financial crisis – and looks set to ease policy further. The European Central Bank (ECB) materially exceeded market expectations in early September, launching a broad package with combined impact that should potentially be greater than the sum of its parts. These actions have provided support to risk assets. Yet we do not expect a repeat, and believe markets are likely pricing in too much additional Fed easing in the year ahead. We see little near-term risk of recession, thanks to easier financial conditions and still-robust U.S. consumer spending. And it’s far from certain the Fed will try to respond to the trade war fallout with meaningfully looser monetary policy. Supply chain disruptions could hit productive capacity, fostering mildly higher inflation even as growth slows. This complicates the case for further policy easing.  Global equity markets made modest gains in July amid interest rate cuts by central banks and speculation that a trade deal between the US and China remained elusive.

What does this mean for markets? We see the monetary stimulus delivered to date operating with a lag. We are likely to see the German economy – Europe’s largest – contracting for another quarter. We still view the protectionist push as a key driver of global markets and economy. The U.S. and China appear likely to engage in trade talks again. We see some possibility of a truce, but a comprehensive trade deal as unlikely. Persistent uncertainty from protectionist policies is likely to remain a drag on corporate confidence and business spending. Robust consumer spending in the U.S. is key to our view that this long economic expansion is likely to remain intact.

Bottom line: We see moderate risk-taking likely rewarded – even as recent events reinforce our call for a greater focus on portfolio resilience.

 

America

The Federal Open Market Committee lowered the federal funds rate by 0.25% at its September meeting. The dot plot in the quarterly Summary of Economic Projections revealed a board with no interest in a prolonged cutting cycle. In the press conference following the meeting, Fed Chair Jerome Powell gave no indication of the Fed’s next step, reverting to guidance that decisions will be “data dependent.” With valid arguments both to hold and to cut, we expect the Fed to hold rates steady absent any further economic deterioration.

Sluggish business investment remains the greatest risk to U.S. economic growth. Burdened by trade battles, the manufacturing purchasing managers’ index (PMI) fell to 47.8 in September, indicating contraction (the PMI for services still shows expansion). The final estimate of second-quarter gross domestic product (GDP) showed business fixed investment falling by 1% on an annualised basis. At worst, this could signal the start of layoffs and contraction that would impair consumer spending; more optimistically, healthy consumer demand may help heavier industries bounce back.

 

Europe

Bad news continues to pile up for the region. Incoming data suggests a weak end to the third quarter, with PMIs declining further in September.  The eurozone, particularly Germany and Italy, needs a fiscal boost. However, despite growing risks of recession, German politicians are divided over whether to abandon their commitments to balanced budgets. European Central Bank President Mario Draghi solidified his legacy by announcing a host of easing measures at his penultimate meeting last month. Though the decision was in line with consensus, the pre- and post-meeting remarks from policymakers revealed a significant internal divide.  With monetary policy losing potency, expansionary fiscal policy will be essential for Europe to avoid a regional downturn.

 

United Kingdom

Chances of a no-deal Brexit on October 31 have diminished but not vanished. Parliament took control of the process in early September and did its best to take this outcome off the table. With no progress toward a new Brexit deal and elections improbable before October 31, Prime Minister Boris Johnson is expected to begrudgingly seek a Brexit extension to early next year from the European Union. The British economy is becoming increasingly fragile, leading to an increased likelihood of a technical recession in the third quarter. Despite the softer momentum, the Bank of England (BoE) stands as the odd one out among major central banks as it looks for a “gradual and limited” path of interest rate increases. A delayed Brexit will likely keep the BoE on the sidelines.

 

Japan

After a four-year delay, Japan finally raised its consumption tax from 8% to 10% on most goods and services. The tax increase carries the risk of causing a recession, but in our base case, large mitigating measures by the government will keep recession at bay. Inflation is expected to get a much needed, but temporary, boost. The central bank left its monetary policy unchanged but hinted at the possibility of easing in October. We expect it to maintain its current stance unless the yen appreciates notably.  Last week, the U.S. and Japan reached a limited bilateral trade agreement, decreasing the likelihood of the U.S. placing tariffs on Japanese autos. Though a positive development, the deal is not much of a gain to the Japanese economy but is instead the avoidance of a shock.

 

China

After a flurry of tariff escalations, it seemed the U.S. and China are looking for ways to reduce tensions ahead of negotiations this month. As a “goodwill” gesture, the U.S. delayed a tariff rate increase and China moved to increase purchases of American farm products. But amid these tentative steps toward detente, the U.S. administration is reportedly considering steps to limit financial investments between the nations.  China’s near-term economic outlook remains challenging amid weak prospects for global and domestic demand. Chinese economic growth continues to slow, dragged down by subdued investment activity and a decline in exports. Policymakers are likely to continue to deploy stimulus measures to stabilise growth. Pressure on the yuan will continue until a trade breakthrough brings economic relief.

 

Emerging markets

Buying emerging markets at a time of decelerating global growth and lingering trade frictions seems ill-timed. To be sure, both the economy and trade represent real threats to the asset class, as well as the broader market. That said, for those investors who believe that trade will simmer, not erupt, and that the global economy will continue to grow, there is one powerful argument supporting EM equities: the prospect for materially easier financial conditions. Since 2010 and the advent of quantitative easing (QE), changes in financial conditions have explained more than 75% of the variation in EM returns . And while changes in financial conditions also explain a similarly large percentage of developed market returns, historically the beta for emerging markets has been greater. In other words, when financial conditions ease, emerging markets typically get a bigger boost than developed ones.

 

Gold

Gold’s performance in the near term is heavily influenced by perceptions of risk, the direction of the dollar, and the impact of structural economic reforms. As it stands, we believe that these factors likely will continue to make gold attractive. In the longer term, gold will be supported by the development of the middle class in emerging markets, its role as an asset of last resort, and the ever-expanding use of gold in technological applications. In addition, central banks continue to buy gold to diversify their foreign reserves and counterbalance fiat currency risk, particularly as emerging market central banks tend to have high allocations of US treasuries. Central bank demand forhold in 2018 alone was the highest since 2015, as a wider set of countries added gold to their foreign reserves for diversification and safety. More generally, there are four attributes that make gold a valuable strategic asset by providing investors with:

  • a source of return
  • low correlation to major asset classes in both
  • expansionary and recessionary periods
  • a mainstream asset that is as liquid as other financial securities
  • a history of improved portfolio risk-adjusted returns

 

WTIS

Mid-September’s drone and missile attack on Saudi pipelines and crude oil processing plants at Abqaiq and Khurais knocked out half of Saudi oil production and caused a 20 percent surge in the price of Brent crude, the largest intraday percentage rise since Saddam Hussein invaded Kuwait in 1990.  Prices later fell after Saudi Arabia, which supplies more than ten percent of global crude, announced that it had restored half of the lost production and would restore the rest by the end of the month. Despite the recent attack, the impact on crude oil prices was short lived. West Texas Intermediate oil prices per barrel had receded to $55 on Sept. 25 compared with $69 following the attack. This muted reaction is due in large part to depressed global demand and strategic stockpiles around the world. But perhaps more significantly it’s because the U.S. has joined Saudi Arabia as the swing crude producer, able to rapidly increase output to compensate for problems elsewhere in the global crude oil supply chain.

Crude oil prices have fallen about 20% from 2019 highs hit in April, in part due to an escalating trade war between the United States and China, which is seen as hurting the global economy and in turn, demand for oil.

 

Sector 12 Month Forecast Economic and political predictions 2019
 

AUD

 

67c-69c

 

The Australian dollar has gone back and forth during the past weeks, but eventually settled on a 67c AUD/USD which of course is a very bullish sign. At this point, the market is likely to continue to find the consolidation area of interest attacked in both directions. The 67c level continues to be massive support, while the 69c level above is massive resistance. It’s very likely that the market will continue to see players come back into this market in a back-and-forth type of manner.

 

 

Gold

 

US$1,400/oz – US$1,500/oz

 

The precious metal may exhibit a bullish behaviour over the remainder of 2019 as market participants hedge against fiat-currencies.  The weakening outlook for global growth have pushed major central banks to shift gears this year, and the Federal Reserve may continue to alter the course for monetary policy as the US-China trade war drags on the economy.

 

 

Commodities

 

WTIS US$50 -US$61

 

Base metal complex will benefit from easy money policy.

 

 

Oil producers continue to adhere to production cuts set last year to reduce the global oil glut, although the duration of these cuts remains up for debate.  Demand for oil could slow if global growth remains subdued or U.S.-China trade tensions worsen, but supply could tighten in the event of worsening tensions between the U.S. and Iran.  Dollar weakness resulting from looser Fed policy could provide a tailwind.

 

We consider the commodity–specific fundamentals of both oil and copper markets to be sound. We estimate that their forward looking short–term fair value ranges are like six months ago, but we have a bias towards the lower half of those ranges over the coming year.

 

 

Property

 

This is a market for active stock-pickers.

 

 

 

With interest rates at record lows and continuing low inflation, there are not many options for investors seeking a healthy yield. A-REITs is one sector that investors will focus on.

 

The sector benefits from solid operating fundamentals, low gearing and strong interest cover, good dividend coverage and demand for institutional grade real estate. A continuation of low interest rates, reasonable consumer confidence, and corporate activity (M&A) will support the sector. The lower Australian dollar adds to the appeal for offshore investors.

 

 

Australian Equities

 

5932 – 7105

This is a market for active stock-pickers.

 

 

 

Due to high dividends, falling interest rates and a floating currency, we believe Australian share markets can continue to outperform other equity markets. Despite reaching 10-year highs, managers agree most stocks are not overvalued.

In the current low-interest environment, we see an opportunity to increase exposure to dividends. This appears to be playing an increased role, versus traditional value and growth factors.

 

 

 

 

Bonds

 

1% – 2.5%

 

 

We see government bonds as universally expensive, with U.S. Treasuries offering the most attractive relative value. As of mid-August, around 30% of global developed government bonds on issue were trading at a negative yield. High-yield credit is slightly expensive and at risk from slowing corporate profit growth. Investment grade credit is likewise expensive, with a slightly below-average spread to government bonds and a decline in the average rating quality.

 

 

Cash Rates

 

0.25% – 0.50%

 

Local cash futures markets disagreed and the RBA Board’s October meeting remained a strong contender as the date of the next rate cut. At the end of the week, October contracts implied an 81% chance of a fourth rate cut for the year, down only a little from the previous week’s 85%. November contracts continued to completely factor in a rate cut while February contracts implied one rate cut plus an 84% chance of another cut.

 

Global Markets
 

America

 

S&P 500

2800-3000

The percentage of companies issuing negative earnings guidance is 78%, which is above the five-year average of 70%,

 

Underweight preference for U.S. equities, driven by expensive valuations and cycle concerns around the trade-war escalation, fading fiscal stimulus and the yield curve inversion. In a short easing cycle, the Fed is expected to cut rates, which could help extend the cycle into next year and support the high-beta and cyclical stocks that have recently been underperforming.

Small cap stocks could stand to benefit, as they are more levered to the U.S economy and less to global trade dynamics, and they have also lagged the performance of large caps recently.

 

 

Europe

 

Buy European Index

UK – Preferred sector

 

There are some signs of improvement. Euro-area bank loan growth is increasing which eased concerns that credit growth might be slowing. Consumers are generally in good shape. Eurozone fiscal stimulus in 2019 will be the highest since 2009.

 

In Europe and the UK, the value factor’s valuation discount relative to growth continues to widen and is now approaching historical highs last seen in 2000 and 2001.  Despite this, we remain largely cautious of the opportunity, and are waiting on the sidelines for more certainty around European Central Bank (ECB) policy and Brexit.  We have upgraded European equities to neutral. We find European risk assets modestly overpriced versus the macro backdrop, yet the dovish shift by the European Central Bank (ECB) should provide an offset. Trade disputes, a slowing China and political risks are key challenges. We believe UK equities offer good value, as demonstrated by the 5% dividend yield.

 

 

Japan

 

Accumulate

 

Japanese value stocks showed signs of life in September following a prolonged period of underperformance.

 

 

We have seen many growth managers increase their conviction in high-growth stocks, due to rising expectations toward rate cuts, which usually lead to multiple expansion. Concerns around the economy and tariffs also brings additional attention to these types of opportunities.

 

 

 

Emerging markets

 

Prefer Asian markets

Emerging markets bonds and equities attracted an estimated $37.7bn in non-resident net inflows in September after investors pulled $13.9bn during the previous month, reflecting the “pendular nature of flows during 2019”.

 

 

A dovish U.S. Federal Reserve (the Fed), continued China stimulus and trade-war normalisation have seen managers looking beyond trade-war noise. Conviction has increased to exporters and high-growth technology sectors that lagged in China and Korea.  Current valuations remain attractive and dollar weakness resulting from looser Fed policy could provide a further tailwind.

 

China

 

Hold

The first quarter offered the best opportunity for buying Chinese stocks in 2019. Stocks might give up some of their gains during the rest of the year as growth continues to slow.

 

 

The Chinese economy also continues to slow, with the manufacturing sector feeling the most pain. Employment indicators are pointing to a slowdown in hiring, which increases the imperative of the Chinese government to either negotiate some form of trade deal or introduce new measures of stimulus.

 

 

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