Merlea Macro Matters – July 2019


Geopolitics is gathering momentum as a key force, and on 5th July Iran threatened the UK with a retaliatory measure to seize a British ship. On 9th July, Iran announced plans to lift uranium enrichment to 5%, above the key level that was agreed in the 2015 moratorium. This is going to pose a significant challenge to the US and destabilise the Middle East.


Comments from Larry Kudlow in the first week of July were insightful, with Trump’s economic adviser saying, “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.”  The 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. I think this confirms what we have discussed about China having seized the upper hand in negotiations and 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.


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. These 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. The chart below by Morgan Stanley illustrating how, adjusted for QE and QT by the Federal Reserve, the US bond market had been in inverted yield curve mode since November last year.



For those who are less familiar with what this means: “inverted yield curve” refers to the rather unusual situation whereby US government bonds with an expiry date in ten years from today are offering a lower yield than shorter duration bond yields, like three months for example. As everybody will understand, this instinctively doesn’t make much sense as longer dated loans (which is what a bond effectively is) should offer higher yield than a short-term loan. In financial speak this then translates into the US bond market is predicting an economic recession lies ahead, which is why all the talk is about recession this month. In practical terms it means the Federal Reserve tightened at least one time too much late last year. The bond market is now signalling to the Fed thou shalt need to be loosening monetary policy, and sooner rather than later.


When looking at the raw economic data, this can get confusing because recent data might be signalling a slowing down for the US economy, but a recession? As per always, recessions don’t show up in data until after they are in place, and financial markets are forward looking.US investors are most likely to take further guidance from proprietary downturn indicators, such as Morgan Stanley’s (above). As the asset strategists who oversee this modelling pointed out, for the first time in over a decade, the Cycle Indicator is now pointing towards a downturn taking shape for the US economy. And this downturn, on Morgan Stanley’s assessment, started before trade talks between the Trump administration and China broke down and turned nasty.


Listed Property

The idea of lower rates is to prop up 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. And because REITs provide a bit of income, we have seen this part of the market performing reasonably.


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.


Australian Equities

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, 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, starting from next week 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 ASX200 has rallied hard this year, up around 20% year to date, and outperforming most other major global indices, and the all-time highs likely could give way this week. Too far too fast? 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. This is 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.


The Cash rate is now at a record low of 1%

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.


Global markets


US employers added 224,000 jobs in June, exceeding expectations for a 165,000 increase. That represented a much stronger figure than the unexpectedly low initial figure estimating 75,000 jobs has been added, which was revised down to 72,000 in the latest report. There was a wide range in where the jobs were added, with the health-care sector particularly strong, but manufacturing adding just 17,000 jobs. Jobs growth at factories has averaged only 8,000 per month in 2019 and many indicators have been soft in the sector lately. 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. June marked a record 105 consecutive months of job gains. 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 challenge for the Fed to ease has suddenly gotten harder to justify, after the Labour Department reported nonfarm employers added 224,000 jobs last month, the most in five months and well ahead of expectations. The key question that is bound to be asked and debated going forward is whether the US economy is soft enough to justify a rate cut?


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.


Data: Factset. Graphic by The Wall Street Journal

What seems to be confounding everyone now is the underlying strength in the US stock market. Who would have thought the S&P500 would have got back to nearly challenging 3000 and breaking on through? Certainly not me. But maybe, just maybe that’s the actual truth, and the trade set up today is to be long US stocks – and global stocks – right now. That is the question confounding most money managers today.



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. Many Germans had hoped that Bundesbank boss Jens Weidmann would get the nod for the ECB President role, but it was not to be. However, Ms Lagarde has had a tremendously successful career, moving from the corporate world to be the first female Finance Minister of a G8 economy (France) and then running the IMF (also as the first female chief for that organisation.) She 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.



Household spending in Japan increased 4.0% year-on-year in May according to government data released on Friday. 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 with April 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.



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.


Experts inside China said that the unpredictability of US President Donald Trump has bamboozled the Chinese negotiating team and has been a major obstacle to a deal to end the trade war.  “There have been twists and turns on the trade war in the past year. Trump’s personality has contributed to this, but his style has also triggered the overall cautiousness in Washington towards China’s rise. At least in the short term, this status will not change,” said Yu Wanli, senior fellow at the Charhar Institute, a Beijing-based think tank.


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.  I am a buyer of 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 last week 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, and consequently we will should add significant Chinese beta to portfolios.





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.



Oil fell last week, 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.


Big Picture Crude Oil Market Factors: Bullish factors include (1) the agreement by OPEC+ to extend its production cut agreement by 9 months until March 2020, (2) the -130,000 bpd decline in OPEC June crude production to a 5-year low of 30.00 million bpd, (3) heightened Iran tensions after the recent attacks on oil tankers and the downing of a U.S. drone near the Strait of Hormuz, (4) the sharp drop in Iranian oil production from U.S. sanctions and in Venezuela oil production from U.S. sanctions and the economic crisis, and (5) the decline in active U.S. oil rigs to a 1-1/2 year low of 788 rigs in the week ended June 14. Bearish factors include (1) global trade tensions that may drag global growth and energy demand lower, (2) the recent surge in U.S. oil production to a record high of 12.4 million bpd, and (3) ample current supplies with U.S. crude oil inventories +6.0% above the 5-year average as of Jun 21, just below the recent 1-3/4 year high of 485.47 million bbl.



Sector 12 Month Forecast Economic and political predictions 2019





The Aussie dollar also has the potential to bounce off strong support and rally from here. The crowded trade (and we have been bearish for quite some time now) on the A$ has been towards shorts. The weak A$ (which could well have bottomed) has also been supportive, and to the economy generally, which may get a further boost as the property market turns around. This is also while several stimulatory initiatives have been unleashed by the government and commodity prices have continued to push higher.







A weaker dollar is also good for gold. The move back above US$1400 will be very encouraging, and recent price action would have stopped a lot of traders out. This is positive, and technically sets up for the next leg higher in my view.





Prefer Oil and Gas over bulk metals


Our view has been that the US dollar continues to lose ground, precious metals and commodities rally and we see a big “risk on” rally in Asia, led by China.





Hold – value appearing

Have removed tactical tilts away from this sector


REITs have a history of performing well during the late cycle of an economy. “Late cycle” means the tail end of a growing economy, when it has not quite become a recession yet. looking ahead for the remainder of 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



Rebalance to defensive and industrial sectors


Australia’s domestic economy continues to demonstrate the impact of softer demand and the halo effect of weaker construction activity, however we feel increasingly optimistic about the outlook for 2020+ given local interest rate cuts, pending tax cuts (and the prospect of more in 2022 and 2024), future fiscal stimulus given excellent iron ore royalty.


Australian corporate results season commences properly in early August and we have already begun to see the number of earnings pre-announcements rise for those companies failing to match analyst expectations.





Australian bonds

1.5% – 2.5%


Valuations are flashing red for bonds. Euro zone and Swiss bonds are the most expensive they’ve ever been. Indeed, apart from US investment grade credit and emerging market local currency debt, which are only just in neutral valuation territory, every other asset in the fixed income universe is overvalued.

Markets are likely to be disappointed by the scale of cuts delivered, which in turn should push up bond yields and depress prices. After an excellent half year, global bonds are looking more expensive than ever, prompting us to reduce our allocation to negative from neutral.


Cash Rates




Philip Lowe mentioned a few positive points for the economy, which suggests it will likely pause for a few months before seriously considering further interest rate moves.


Lowe noted “the outlook for the global economy remains reasonable”, which is shorthand for a broadly neutral influence from overseas to Australia in the near term. This looks a fair assessment.


Global Markets



Under weight


Our macro models now indicate that global corporate earnings will be flat to lower in the coming year, compared with a 12-month consensus forecast for a 7 per cent growth.


US equities are particularly vulnerable. Not only are they the most expensive stocks on our scorecard but our leading indicators show the US economy has been slowing for six months in a row, underperforming major developed and emerging countries. Historical evidence suggests that US corporate profits tend to fall when the economy grows by less than 3 per cent on a nominal basis.  I think that while the US indices are holding well at elevated levels, they are looking tired, and ripe for a sell-off.






Prefer exposure to Germany



The prospects for European stocks are brightening. The region’s leading indicator, while still in negative territory, has been improving for three months, outperforming the US. Consumption, which is the main engine of growth in the area, remains resilient and bank lending is improving. European stocks are cheaper than the US on a relative basis, according to our valuation model, which considers price to book, price to earnings and price to sales ratios

UK stocks remain attractive. The market offers a high dividend yield of 4.8 per cent while a weak sterling, due to Brexit-related worries, is boosting profits for many British multinational companies.







Buy on news of the US and China trade deal


Political conflicts globally and demand uncertainty continue to drive the direction of Japanese equity markets.


While Japan is set to raise its consumption tax rate in October, the Liberal Democratic Party has outlined a plan to offset the impact on lower income workers. Japanese equities trade at a discount relative to other developed markets.



China / emerging Markets



Buying on Pull back

China and Asian emerging markets


This year, MSCI is increasing the weight of Chinese A-shares in the MSCI Emerging Markets Index to 20% inclusion (up from 5% in 2018). This is an important step as we expect it to lead to continuous foreign inflows. Apart from providing evidence of China’s capital market liberalisation intentions and of the progress, this will also support the Renminbi.


The dollar fell more than 1 per cent in the month as investors priced in the prospect of easier monetary policy in the US (see chart). This, in turn, supported many emerging market assets, such as export-sensitive Asian equities and EM local debt, both of which rose over 5 per cent.




Like This