Merlea Macro Matters – April 2019


We expect the recent weakness of global growth to persist for much longer than is commonly assumed. Previous policy tightening has yet to take its full toll on activity in the US and China’s stimulus seems too modest to prompt a sustained and significant pick-up in growth. Disappointing economic performance will leave inflation very low and cause monetary policy to be loosened almost across the board. But we do not see this prompting any meaningful recovery until 2021.

The US economy is at risk of recession in 2020 owing to the rising stock and deteriorating quality of US corporate debt. The latest Fed data shows that corporate debt had climbed to US$9.8trn by the fourth quarter of 2018, equivalent to 47% of annual GDP, returning to the pre-financial crisis peak of 2007. Worryingly, the high level of corporate debt has coincided with a sharp deterioration in the quality of that debt: more than half of investment-grade corporate bonds are rated BBB, the lowest level before “junk”. The risk, therefore, is that the slowdown in growth interacts with corporate debt concerns to tip the economy into recession. As growth inevitably slows, businesses may face higher borrowing costs or a tightening of credit availability, both of which would act as a drag on hiring and investment decisions.

The global trading system could face further shocks in 2019 from events such as a hard Brexit, which is not our current forecast, or a serious escalation in US-EU trade tensions that result in bilateral tariffs being applied. Finally, despite the likelihood of a stop-gap trade deal between the US and China, we continue to expect economic and trade tensions to remain between the two countries. The focus is likely to shift to investment and technology issues as the countries embark on a technological arms race to be the world’s dominant economy in the coming decades. These tensions will cast a long shadow over global growth and international business conditions for the foreseeable future. Share markets – globally and in Australia – have run hard and fast from their December lows and are still vulnerable to a short-term pullback. But valuations are okay, global growth looks to have bottomed and is expected to improve into the second half of the year, monetary and fiscal policy have become more supportive of markets and the trade war threat is receding, all of which should support decent gains for share markets through 2019 as a whole.


From worries over a global monetary tightening cycle driven by the US Federal Reserve, suddenly rate cuts are on the horizon for global policymakers and the fixed income market is reaping the rewards. In the bond market, 10-year government bond yields have declined to “historic lows”, including in Australia, the RBA said, with negative yields in Germany and Japan. In the US, the next move in the benchmark federal funds rate is now “expected to be down”. After US bond yields peaked last November, the first quarter of 2019 has seen “outsize gains” in fixed income markets thanks to declining interest rates and tightening credit spreads. Amid slowing US economic growth, a weak global backdrop and deteriorating financial conditions, low yields are likely to see low returns from bonds, but government bonds continue to provide an excellent portfolio diversifier. Expect Australian bonds to outperform global bonds.

Listed Property

Australian real estate investment trusts (A-REITs) are segmenting, as retail and residential are under pressure while funds management, office and industrial are now the main areas favoured by investors and fund managers. The consensus broker forecasts are for a low-return year ahead for A-REITs with the main risk to the downside, including falling shopping centre values and the risk that capitalisation rates (income divided by value or purchase price) will start to rise in office/industrial segments.

While a synchronised commercial property downturn is not in the base case, risk could arise if global and domestic economic growth risks recede and there is a resumption of upward pressure on global security yields. The increased volatility in equity markets, and the downgrade in growth expectations for both the Australian and US economies, is a positive for defensive stocks, such as A-REITs, as in times of rising volatility, historically these outperform the broader ASX. Fundamental headwinds include reduced GDP growth and consumer spending. Debt spreads have also increased. which will affect the cost of funding. I must emphasise the strong negative correlation between the relative performance of A-REITs and the 10-year Australian government bond remains intact and increased in 2018. A-REITs will still offer opportunities over the rest 2019. Therefore, exposure is warranted, and there is value, in terms of Stockland (SGP) and Lend Lease (LLC). Looking ahead for the rest 2019 we see the listed property market offering investors relatively stable returns, with some positive factors offsetting some of the negatives, to give minimal capital growth. In this environment, we see most of the returns that investors can expect coming from distributions.

Australian Equities

Australia, the Federal election campaign remains in full swing. The “Pre-election Economic and Fiscal Outlook” was released from the Federal Treasury which is meant to be an independent report that gives an assessment of the budget. Because the budget was only handed down two weeks ago there are no major changes to budget estimates or economic assumptions apart from some. Regarding the election, the polls still suggest a Labor party victory (see chart below), but the Coalition did receive a small boost in polls post Budget (because of tax cuts).

The April Reserve Bank Board minutes had a more dovish tilt compared to recent communication with detailed discussion around impacts on the economy from lower interest rates. But a rate cut at the next Board meeting in May is unlikely. The March jobs data was solid with employment up by 25.7k over the month, with the unemployment rate higher (but remaining low) at 5.0%. Forward looking readings on job advertisements, vacancies and hiring intentions are slowing but not collapsing and we expect annual employment growth to decline to below 2% over the next six months with a tick up in the unemployment rate to 5.5%. We are seeing more economists change their views and are now expecting the RBA to cut interest rates twice this year and despite the labour market holding up. We think that the recent tick up in the unemployment rate (from 4.9% to 5.0%) will continue, home prices will fall more than the RBA expects and the RBA would be concerned about the slowing in global growth (although the global economy should be stronger in the second half of this year). The central bank could cut rates by the year end.  We currently see three-year government bond yields at 1.41% (at the time of writing) as being in our fair value range. The scope for any significant lift is limited given that the outlook for the path of the cash rate over the next couple of years is steady to lower. Further out along the yield curve, we see the yield on a 10-year government bond of 1.79% (at the time of writing) as being expensive and would need a global recession and significant downgrading of Australia’s neutral cash rate to justify current valuation.

Australian equities, our longer-term models are forecasting mid to high single digit returns. We do not think PE multiples can expand any further, so your return is likely to be the dividend yield, plus modest growth in line with GDP of 1.5- 2% pa. While 6-7% total returns hardly seem worth the effort, this is likely to be 6-7 times the Australian cash rate which we believe will be 1% within the next year.

Global markets


US data was mixed this week. Retail sales bounced back in March but the Markit manufacturing PMI slightly disappointed expectations (although is still in expansionary territory), the services PMI fell and March housing starts were lower than expected. The Fed Beige Book indicates that activity is still expanding at a “slight to moderate pace” which is consistent with the Fed on hold. The February trade deficit improved and the deficit between China and the US narrowed. The details of the Mueller report were released and while there were some calls for impeachment proceedings to start, we still see it as unlikely to progress. We believe that revenue growth for the 1st quarter will be about 5%, which normally would be supportive of good earnings growth. But profit margins have finally come under pressure beginning late in 2018 and continuing into 2019.

Capital spending has picked up, which is a positive trend for the long run. But in the short term, it puts pressure on margins. In addition, wage increases have picked up while corporate pricing power remains weak. Earnings for the full year are expected to be around 4%. Despite the dour outlook for near-term earnings, stocks have performed quite well this year, with strong gains in January and February and more muted results in March. Investors appear to be increasingly concerned with the outlook for economic growth, particularly globally. The shift in tone by the Fed reinforced (and was a reaction to) those concerns.  Some of this was evident in the performance of certain sectors in March. Large cap stocks, as measured by the S&P 500, were largely flat for the month, while the NASDAQ 100 experienced a solid advance, led by big technology companies, which are perceived to have less exposure to a slowing economy. Growth equities outperformed value, with tech shares leading the growth segment while the slumping banking sector dragged down value stock indices. Banks have come under pressure as interest rates declined, which could negatively impact their lending margins.

Major international indices largely performed in line with large cap stocks in the U.S.  Our economic research has detected some weakness in the domestic economy, but we do not have any indication at this point that we are on the cusp of serious economic decline.

First quarter earnings growth will likely be flat, U.S.-China trade negotiations are still ongoing, and structural challenges in Europe and Japan will likely persist. We believe short-term trade and political headwinds will subside as the year progresses, but there is still considerable global uncertainty weighing on economic activity. Stocks’ overbought conditions, along with slightly weaker economic and corporate profit outlooks, could hinder gains in the short term.  We recently recommended dialling back equity allocations to market weight for suitable investors because of this. 


Investor sentiment on Europe has been dampened by a range of factors. The cloud over Brexit, and its likely impact for the UK and continental Europe, is the obvious culprit. Ongoing budgetary conflict between Italy and the European Union, fears of an escalation in global trade wars and speculation on when the European Central Bank will raise rates, have also weighed heavily.  So far in 2019, it is a different story. The EURO STOXX 50 is up 9.4% year to date, tracking similarly to the S&P 500 (also up 9.4%) and relative valuations look more attractive. The euro is also approaching two-year lows, which could provide a boost to Europe’s export sector.

There are also suggestions that underlying economic conditions in the powerhouse economies of Europe are stronger than sentiment would suggest. This view is supported by the release earlier this month (March) of the Markit Eurozone Composite PMI numbers for February which were revised upwards to 51.9, the first increase (albeit slight) in private sector activity in three months. The PMI index tracks business trends across manufacturing and services based on data from over 5,000 companies. Another sign that the negative sentiment around Europe might have been overdone is the Citibank European economic surprise index. This index (which measures data surprises relative to market expectations) while still in negative territory, has been ticking upwards since the beginning of the year. Unemployment across Europe continues to fall and is at 10-year lows, wages growth has picked up and German retail sales rebounded in January, rising more than 3%. While Brexit uncertainty has been damaging for both the UK and the Eurozone, the worst case ‘no deal’ scenario is likely to hit UK companies much harder than their European counterparts. The IMF has forecast that a no deal Brexit could result in a 4% hit to the UK’s GDP BY 2030 should Britain end up adopting the default World Trade Organisation rules for its trading relationships with the EU.


Currently, the biggest holder of Japanese shares is Japan’s state-run pension fund, which is also the world’s largest, but the Bank of Japan is on course to overtake the Government Pension Investment Fund by 2020. That raises prickly questions about government authorities’ out-sized role in the capital markets, marring Japan’s free-market street credibility. The BOJ’s holdings of exchange-traded funds were $250 billion as of the end of March. That’s nearly 5% of the total market capitalization of the first section – which lists blue chips – of the Tokyo Stock Exchange. At the current pace of ETF purchases, its stockpile will head toward roughly $360 billion by November 2020. From this, two big takeaways spring to mind. One: Forget about BOJ “tapering” or even an interest rate hike. Two: Tokyo officialdom is pushing its arms deeper into the financial system, deadening the market forces any Group of Seven economy needs to thrive. Already, the BOJ is the biggest shareholder in at least 23 companies via ETFs. They include robot-maker Fanuc, motor manufacturer Nidec and electronics outfit Omron. As of the end of March, Kuroda & Co. was a top-10 investor in roughly 50% of Tokyo-listed companies. Share buyback by companies and BOJ’s ETF purchasing have been two main forces supporting the Japanese stock market.

In Japan, the outlook is equally uncertain. The downturn in nationwide purchasing manager indices (PMIs) and a general lack of inflation has led to a very weak stock market environment. Wage growth remains strong in Japan, but this has not fed through to rising consumption or improved retail sales activity. In fact, it is almost certain that demand from inbound tourists is helping to drive better performance in major retailers rather than domestic private consumption. Global monetary easing has led the rebounds of the global stock markets so far, however, improvement in real economy and corporate earnings outlook is required for the rebounds to continue. Despite stalling Chinese imports and deteriorating global economy, Japanese companies keep capital expenditure plan at high level, which is required for enhancing labour productivity or updating business software. Deteriorating outlook for the global economy is bringing global bond yields down. Japanese 10Y government bond yield became negative. In Japan, important Upper House Election is to be held in July. PM Abe’s government will take an extra care to keep Japanese economy going for avoiding any possible setback in these elections. Given that much of Japan’s corporate sector is cash rich and its facilities are underutilised, any evidence of a better-than-expected outcome is going to be very bullish for the country. The level of negative sentiment is at such an extreme level that a recovery can come very quickly.


The People’s Bank of China (PBoC) needs to be balanced in injecting liquidity—providing enough to support growth while restraining speculative activity in the financial and property sectors. Nonetheless, January’s surge in total social financing shows the PBoC, like its counterparts elsewhere, is shifting priorities from deleveraging to reversing the slowdown in growth. Expansionary fiscal policy will do more of the heavy lifting, but there are some limitations. High levels of local government debt could constrain the number of infrastructure projects that can be undertaken. Cuts in personal income tax and value-added tax will need to be combined with more upbeat sentiment to translate into more consumption and corporate spending. A GDP growth target ranging between 6.0%- and 6.5%-year over-year was set for 2019 vs. a target of around 6.5% for 2018.

The wider target range offers the government more flexibility in its policy implementation. Meanwhile, a slowdown toward the lower end of the target range, that is 6.0% growth, could prompt even stronger supportive measures. A U.S.–China trade agreement would reduce uncertainties for global businesses and Asia’s manufacturing supply chain. However, friction could still arise over long-term structural issues, such as the enforcement of a trade agreement. We believe there is still potential upside to China’s stock market rally, as monetary conditions remain accommodative and the government will increase spending to stimulate the economy.



The political instability that has enveloped the leading economies of the US and the UK is set to continue with markets responding to ongoing turmoil. The protectionist attitude of the US has encouraged inflation, with gold used by many to hedge against this. These movements have heralded a renewed interest in gold which can be seen on multiple fronts. Net positive flows into ETFs have occurred for the previous three months, though Asian markets (including Australia) have lagged Europe and America on this front.  As China and India were the greatest consumers of physical gold in 2019 (through both investment and jewellery), economic growth in these regions will likely impact the precious metal. Further economic development and particularly the increase of wealth in India and it’s growing middle class is likely to continue to drive demand. On balance key indicators that have dictated the previous performance of gold suggest that we are likely to see a continuation in the upward trend of both investment flows and price of gold.

Investors wanting to access gold may be interested in the benefits of exposure through investing in gold miners’ equities. Whilst this strategy gives the potential to receive dividends it does not offer the same exposure of a physical gold ETF such as GOLD as the price changes in gold miners can be quite different from the movement of gold price.


Since the start of the year, crude oil prices have enjoyed an almost 30 percent increase but have still not recovered from the 40 percent drop in Q4 2018. Increasing concerns about weakening global growth – especially out of powerhouse economies such as China and the US – may undercut the sentiment-linked commodity’s upside momentum if underlying demand for it is eroded.

However, crude oil prices may receive a boon from politically-based factors. The most recent OPEC+ meeting that was supposed to take place in April was cancelled, with investors now waiting for the June session. Officials are expected to be in support of deep cuts. The US is also reimposing sanctions against Iran, which may undercut supply and boost prices.



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