Merlea Macro Matters – March 2019


For the first time since 2007, US Treasury 10-year note yields sank below three-month Treasury bill yields. In other words, the market is betting on things getting worse in the US before they get better. The Federal Reserve was noticeably far more cautious in its commentary last week, shutting the door on anymore rate rises this year and halting the program to run down its massive quantitate easing program.

Although it is difficult to be enthusiastic about developed market assets in general – we remain neutral global bonds and stocks. Defensive equities, where earnings are holding up well, and emerging markets (EM), which are growing faster than their rich world counterparts, both look promising. Our business cycle indicators show emerging economies are outpacing their developed counterparts. Historically, this has been supportive for all EM asset classes, and particularly for currencies.

While central banks have proved responsive to signs of economic weakness, we believe this could provide a temporary shift in tone. In our view, the market’s interest rate projections underestimate the likelihood of US Federal Reserve hiking interest rates once more before the year end. Fed futures are pricing in only a 2 per cent chance of such a move; in October it was 98 per cent. Virtually every asset class in our model is more expensive now than a month ago, with global equities among the priciest. This is worrying given that corporate earnings growth peaked in 2018, at 15 per cent, and that analysts have been reducing their expectations for future profits. However, we see early signs of stabilisation in earnings forecasts, which should prove positive.


So, should we be worried about the inverted yield curve? Perhaps a bit, but not enough to retreat into the foetal position just yet. Normally, short-term debt yields less than a long-term debt that requires investors to tie up their money for a prolonged period. When a short-term debt pays more than a long-term debt, the yield curve has inverted.

Government bonds decline on global growth concerns. And when the yield curve is inverted, it shows that investors are losing confidence in the economy’s prospects. Longer-term Treasury yields have been falling this year, in part on worries that economic growth is slowing around the world. When investors become nervous, they often abandon stocks and other risky assets and flock to Treasury’s, which are among the world’s safest investments. High demand for bonds will, in turn, send yields falling. Accordingly, the yield on the 10-year Treasury has sunk to 2.43 percent from more than 3.20 percent late last year.

This is clearly a concern given that past yield curve inversions have preceded US recessions. Falls in US and Eurozone shares, weak global PMIs, the risks around flattening or inverted yield curves and ongoing trade risks do highlight the significant risk of a correction in share markets after their deep ‘V’ rebound from December lows. However, it’s too early to tell whether this is indeed a harbinger of a recession or a blip. For me to feel confident to say this is a predictor of recession, I would need to see it persist for at least one to two months.

Listed Property

Given Australia’s high relative rental yields and solid domestic economy, coupled with global real estate funds that have a mandate to invest, we expect takeovers again to be a feature of the Australian listed property market in 2019. Activity is most likely in the office and industrial sectors.  At a more micro level, we expect that LPTs trading at a discount are likely to institute on-market share buybacks. Given the low level of gearing (debt relative to equity) across the listed property sector, more value can be delivered to a trust’s unitholders by buying back stock that is trading at a discount, compared to management going out and developing new assets. 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 distributions as the primary source of the returns that investors can expect.

Australian Equities

RBA cash rate has been constant for two and a half years at record-low 1.5 per cent. However, markets and economists increasingly believe this period of policy stability is coming to an end, though views diverge sharply on whether the next move will be down or up.

The Reserve Bank recently indicated that it has shifted from a bias towards increasing interest rates to a more neutral stance. Governor Philip Lowe said in a recent speech that “over the past year, the next-move-is-up scenarios were more likely than the next-move-is-down scenarios. Today, the probabilities appear to be more evenly balanced”. Despite weakening house prices, the employment rate was steady at 5.1 per cent in January, supported by strong participation in the labour force, according to the Australian Bureau of Statistics. The trend ratio of employment to population rose to a 10-year high of 62.4 per cent. The labour market is the key indicator going forward as far as interest rates are concerned.  Demand for workers has been building – about 284,000 jobs were created in 2018 and the unemployment rate has dipped to 5 per cent.  This creates pressure to gradually force wages higher and enable households to increase their spending. Eventually wages growth should reach 3.5 per cent, which would be consistent with an inflation rate of about 2.5 per cent – the mid-point of the Reserve Bank’s 2 to 3 per cent target band – (which the RBA has previously identified as a level they would like to get to before they lift interest rates). Concerns about growth, falling house prices, stagnant wages and soft household spending have been underlined by the release of figures showing underlying inflation has been below the RBA’s 2 to 3 per cent target range for most of the past four years.

Concerns about growth, falling house prices, stagnant wages and soft household spending have been underlined by the release of figures showing underlying inflation has been below the RBA’s 2 to 3 per cent target range for most of the past four years. Despite this, we don’t expect the central bank to be in a rush to cut the cash rate and will instead want to see spending measures in the April Federal Budget and the promises made by both the major parties in the lead-up to the federal election before moving. The ASX200 is facing a stern overhead barrier around 6200, and a pullback after the strong rebound in recent months would not surprise. I still think it is possible to see our market performing better than the US, for instance this year, particularly if the ‘China story’ remains intact, and with the ASX200 having significant yield appeal. Indeed, far from being out of fashion, dividend stocks are very much back in focus with interest rates globally set to remain low for some time.

The Australian dollar is assumed to gradually strengthen against the US dollar over the medium term in the absence of negative shocks to global growth US72 cents in 2018–19 and have a trade-weighted value of 62. In 2019–20 it is assumed to increase to US73 cents.

Global markets


Preliminary measures of U.S. manufacturing and services activity for March showed both sectors grew at a slower pace than in February, according to data from IHS Markit. Manufacturing grew at the slowest pace since June 2017, and both the manufacturing and services purchasing manager index readings were weaker than analysts had forecast.

The publication of the report sent the 10-year yield, which is a proxy for investor sentiment about the health of the economy, to its lowest since January 2018 at 2.418 percent. The fall in the 10-year also weighed on the spread between two- and 10-year yields, another significant measure of the yield curve, which fell to a three-month low of 9.5 basis. points. The soft data exacerbated a trend that began on Wednesday 18th after the Fed issued a statement showing policymakers at the U.S. central bank foresaw no further interest rate hikes for 2019 given the slowdown in the American economy. The market is now expecting lower rates on average over the next 10 years than we have currently. And it’s a combination both a dovish Fed and ongoing global growth concerns.  The Fed’s statement also forecast just one rate hike through 2021. In a major shift, the Fed no longer anticipates the need to guard against inflation with restrictive monetary policy. It also said it would halt the steady decline of its balance sheet in September.

Friday’s 22nd downward dynamic was a significant reaction, but then again, we have not seen the rally that began back in December checked for three months. I would not be surprised if the S&P500 paused to consolidate between 2750/2850 for the next few weeks, ahead of the next reporting season.  The market needs to believe that not only are current valuations justified, but that the corporate sector will maintain profitability, and above all avoid negative growth. The fact that the yield curve inverted on Friday was too much for some, and this triggered selling pressure which has been absent for some time now. We will know a lot more on the earnings front when US companies begin reporting around mid-April.


Europe’s economic outlook was thrown into fresh doubt after reports showed weakness across France and Germany.

Hopes that the slowdown had reached a trough have taken a beating from renewed weakness in France and the deepest slump in German manufacturing in over six years. A euro-area Purchasing Managers Index is signalling growth of 0.2 percent this quarter, matching the pace of the previous three months. The news sent Germany’s 10-year bund yield below zero percent for first time since 2016. Yields on Spanish, French and Italian debt also declined, while the euro dropped 0.6 percent. The European Central Bank has already responded to the deteriorating situation by cutting its forecasts, prolonging record-low interest rates and offering new cheap loans to banks. European policy makers may have even more reason to worry than the Fed given the region is more exposed to weaker trade and a bad Brexit than the U.S. and its financial sector is not as robust.

The UK has been given a little more time to organise its economic withdrawal from the EU. In a key development, the UE agreed to give the UK a short extension to the Brexit deadline to 22 May 2019, if a Brexit deal can get through the House of Commons this week. That assumes the Speaker of the House will even allow a third vote or that it is even held as Theresa May has come under pressure for saying she might not put it to MPs. However, if that is rejected, or a no vote held, the EU extension will only be until 12 April, giving the UK just a little more time to present alternatives.

EU Council President Donald Tusk reportedly said, “It means that until 12 April, anything is possible: a deal, a long extension if the United Kingdom decided to rethink its strategy, or revoking Article 50, which is a prerogative of the UK government.” He continued, “The fate of Brexit is in the hands of our British friends. As the EU, we are prepared for the worst, but hope for the best. As you know, hope dies last.”

Brexit really has become an intense political crisis now and has divided the population, with up to one million people (unverified, but it was certainly hundreds of thousands) marching in London over the weekend to call for another referendum.


In Japan, the Nikkei/Markit flash manufacturing reading for March of 48.9 was unchanged on the February level. Below 50 indicates contraction and output shrank the most in nearly three years as China’s slowdown weighed. The output component reading was a preliminary 46.9, slipping from a final estimate of 47.4 in February.

Commenting on the survey, Joe Hayes, an Economist at IHS Markit stated, “Further struggles for Japanese manufacturers were apparent at the end of Q1, with latest flash PMI data showing a sustained downturn. Slack demand from domestic and international markets prompted the sharpest cutback in output volumes for almost three years. With input purchasing falling, firms appear to be anticipating further troubles in the short-term. Indeed, concern of weaker growth in China and prolonged global trade frictions kept business confidence well below its historical average in March.”


China is feeling the heat from internal imbalances and an elevated trade spat with the U.S. Economic activity in all regions will continue to be hindered by the uncertainties surrounding global commerce. We remain optimistic that these uncertainties will not extend beyond 2019. I also believe that a trade deal is coming. Both political leaderships, in the US and China, are only too aware of the risks that will follow, if an agreement is not reached.  There are reports a deal could be reached before the end of the month. At present, China’s policies mainly focus on several aspects, including expanding financial support for the real economy, as reflected in the huge increase in social financing in January after several reserve requirement ratio cuts last year.

The positive momentum of “stable monetary and relaxed credit policy” has been maintained at the beginning of this year. And proactive fiscal support policies, especially for infrastructure projects, have also been continuously implemented. At present, China’s policies mainly focus on several aspects, including expanding financial support for the real economy, as reflected in the huge increase in social financing in January after several reserve requirement ratio cuts last year.

Likewise, tax cuts, including individual income tax reform, which were fully implemented in January, and several rounds of corporate tax and fee reductions, have been intensified or are in the pipeline. Expectations run low of a thawing in the U.S.-China trade relations I’m not terribly hopeful of a breakthrough (the strategic question is: How much do you do to satisfy foreign complaints, particularly those coming from the U.S., which you can do perhaps on the cheap, versus how much do you undertake structurally to address some of these problems?).

There are good economic reasons for both sides to try to work this out. However, “brinkmanship from the Trump administration is worrisome, they have made it harder for themselves to back down and compromise. They’ve [also] made it very hard for China to compromise rather than capitulate.

Chinese stocks remained firmly in rally mode as authorities in Beijing stepped up monetary stimulus in a bid to encourage private lending. By the end of February, the Shanghai Shenzen CSI 300 index was up almost 30 per cent since the end of 2018.

Emerging markets

While we think EM currencies are at fair value, investors need to scale their exposures carefully given the persistent uncertainties around U.S. trade and fiscal policies. The MSCI Emerging Markets index is up 11% this year, following last year’s 15% loss, investors might want to take some profits if they purchased in December.



Moving forward this month and into April, geopolitical issues remain the main theme and focus of investors’ attention. As the deadlines approach, Brexit is likely to see some serious progress unless there is a delay deadline and Sino-U.S. trade talks are likely to see a new milestone. Chances are the price action in the spot market for gold is likely to remain trapped inside a range of $1275 and $1300 across the month as demand for safe-haven assets, increased demand expected from India in the physical market owing to marriage season in the month ahead of expected demand from emerging markets on low price of gold is likely to sustain price action above $1275 handle per ounce.  However, a dovish turn out in either Brexit or Sino-U.S. trade talk will immediately push the price above $1,300.

We maintain our current view on gold – which acts as a hedge against global economic uncertainty, geopolitical risks and a weaker US dollar. The World Economic Policy Uncertainty Index, which tracks global geopolitical risks has recently hit an all-time high.


Oil prices continue to rally. U.S. benchmark crude is on the cusp of $60 per barrel. A few months ago, it was trading near $43. Moves by OPEC and Russia to reduce exports have sent oil prices soaring. At the same time, drilling activity in the United States has fallen, which points to less domestic production on the horizon. Crude prices may well climb past $60 in the near term, though if they do, we expect them to then pull back a bit by September.

Monthly crude oil spot prices (shown in dollars per bbl):

Source: US EIA

The US Energy Information Administration (EIA) says in its most recent energy outlook that this may all lead to an uptick in prices for the rest of this year before the balance is disrupted and we see them walked down a few dollars per unit in 2019.




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