Merlea Macro Matters – September 2019


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. and China are the world’s largest economies.  The ongoing Trade War is redrawing global supply chains, claiming casualties in the process. As persistent headwinds intersect with traditional seasonal softness, recent volatility can be expected to continue in the near term as markets await policy developments.

The trade war is taking place against a backdrop of softening economic growth. Germany’s manufacturing sector is contracting while China’s economy grew at its slowest pace in nearly three decades in the second quarter.  The U.S. bond market has also flashed a recession signal recently. The 10-year Treasury yield has dipped below its 2-year counterpart. This phenomenon is known as a yield-curve inversion. Experts fear it because it has historically preceded recessionary periods.

This economic soft patch has led central banks to ease monetary conditions, including the Federal Reserve.  Fed Chairman Jerome Powell has been quoted to say the central bank will “act as appropriate” to sustain the current U.S. economic expansion, which is the longest in history. However, Powell failed to clearly signal that another rate cut was imminent in September.

The problem facing stocks isn’t restrictive monetary policy but instead Trump’s destructive trade policy. Rates are already very low and low yields coupled with inverted curves are becoming counterproductive for stocks – as a result, central banks are doing about all they can.  Last month, the Fed cut rates by 25 basis points and market expectations for a September cut are at 100%, according to the CME Group’s FedWatch.

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.



The United States: Sharpening trade fears deepened the U.S. yield curve inversion to levels we haven’t seen since 2007. The three-month Treasury bond yielded 28 basis points more than the 10-year note on Monday, the most extreme spread since before the financial crisis.

Under normal circumstances, an issuer’s longer-term debt carries higher interest rates than shorter-term debt does. That makes sense, because the longer-term loan is riskier. Your money is tied up for a longer period, you’ve got to worry about inflation eating away the value of your principal and you also must worry that interest rates might rise, which will decrease your security’s market value. But owners of short-term IOUs don’t have to worry about that stuff. That’s why under normal circumstances, you have a rising yield curve — the longer the maturity, the higher the interest yield.

But that’s not the case these days with U.S. Treasury securities. Today, a 30-day Treasury IOU carries a higher rate (2.03 percent when last I looked) than a 10-year IOU (1.59 percent). In the past, such an inversion has sometimes meant a recession is near. Sometimes it hasn’t. It’s just an indicator, one of many. It’s not infallible by any means.

There are all sorts of strange circumstances — including the fact that longer-term government securities issued by Japan and many creditworthy European countries carry negative interest rates — that help account for the sharp drop in longer-term U.S. Treasury rates.  Getting 1.59 percent on a 10-year Treasury is better than getting less than nothing on an equivalent Japanese or German security. Although cutting the short rate to 1 percent as Trump demands would reverse the inversion, we’d be treating a symptom of possible economic disease rather than treating the disease.

Listed Property

The S&P/ASX 200 A-REIT index’s total return is 22 per cent over one year to July 2019 and several infrastructure and utility stocks and funds have rallied. Across the market, yield stocks have become expensive, falling bond yields driving the prices of bond proxies (REITs, utilities and infrastructure), and a post-Hayne royal commission rebound in the heavily weighted banking sector.

Real estate investment trusts and utility stocks typically mirror bond market movements because of their high levels of debt and relationship to interest rates.  Their revenue is somewhat resistant to downturns compared with other sectors like consumer cyclicals because of the long duration contracts or their natural monopolies over essential services.  For investors, they can offer stable earnings, safe and predictable income, and revenue streams similar to bonds. Falling interest rates have spurred investment in bond proxies offering higher yields, boosting the stock prices of some bond-like equities, and pushing valuations into overvalued territory.

One fear I have is that a return of interest rates to a more neutral setting could cause a negative re-rating of all bonds and bond-like-equities, exposing investors to the risk of capital losses.  Real estate investment trusts Goodman Group (ASX: GMG), Stockland Group (ASX: SGP), GPT Group (ASX: GPT) all screen as overvalued. It’s the same case for utility companies Meridian Energy (ASX: MEZ) and APA Group (ASX: APA).  Infrastructure operations firm Transurban Group (ASX: TCL) also screens as overvalued at a 26 per cent premium to its $15 fair value estimate.


Australian Equities

Growth is in orange and value is in yellow.

In Australia, the market finished the month on a strong note, with the ASX200 rallying 1.5% on Friday to close the session at 6604. Overall, this did not however make up for a tough month for the benchmark, which lost around 3%. This was as trade concerns reignited, and as the earnings season delivered some misses, although a fair number of hits as well.

Overall I think that the reporting season confirmed our view that Australia is actually ‘not in that bad a place,’ along with the corporate sector generally. In addition to offshore risk factors, in many cases the negative reaction to some releases was more about the outlook (as it often is), than what has gone before.

Certainly, the future is not looking as bleak as some would suggest. A prime example being the results from the big diversified miners BHP and Rio, both of which delivered bumper results, with earnings, cash flows, and dividends very strong. Both managements sounded some caution going forward, which I think is prudent. While we don’t buy into the view of a global recession, I think we are likely to have seen ‘peak earnings’ for the space, at least in the near term, with iron ore unlikely to rescale the levels seen this year. That is not to say that the resource sector doesn’t still have several tailwinds, with Australia set to become increasingly in China’s good books (and if Scott Morrison doesn’t side too much with Trump), the longer the trade war drags on. A compressed A$ is also likely to remain supportive to earnings, as it is for other companies which generate a decent percentage of revenues offshore.


Global markets

Investors are grappling with the prospect of slowing economic growth and rising geopolitical risks, while trying to balance this against the need to generate returns in an ultra-low interest rate world. This environment is likely to continue with several central banks globally recently moving to cut interest rates further.

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.

The first interest rate cut by the US Federal Reserve (Fed) in more than a decade was aimed at keeping the record-long economic expansion going by insulating the economy from mounting global risks. In his press conference, Fed chairman, Jerome Powell called this interest rate cut a mid-cycle adjustment to combat current risks to the economic outlook, rather than the start of a cutting cycle. He stated three main threats to the outlook that the Fed has been monitoring since the start of the year and that they now justified a rate cut: weakening global growth, trade policy developments and inflation running below target.



The US equity market was led higher by the tech sector which saw strong gains over the month from semiconductor businesses as firms such as Teradyne and Texas Instruments announced solid company earnings results and improved outlooks. A further boost for chipmakers and tech more broadly came after it emerged that Washington officials were seeking to reignite trade talks with China.


Defensive groups of stock that are less sensitive to the business cycle, such as utilities and health care saw declines, as did energy stocks, which continued to be impacted by falling oil prices driven by concerns over global demand. US economic growth slowed in the second quarter by less than forecast as consumer spending topped estimates. Gross Domestic Product (GDP) expanded at a 2.1% annualised rate, compared to forecasts for 1.8%. Consumer sentiment was near historical highs in July. As such, consumer spending, the biggest part of the economy, increased by 4.3%, while government spending climbed 5% and offered the biggest boost in a decade.



In Europe monetary easing (central bank policies used to increase liquidity in the market) seemed all but confirmed. Following the European Central Bank (ECB) press conference, it was announced that there would be an interest rate cut in September and another wave of Quantitative Easing (printing money) in Q4 2019 looking very likely. Equity and bond markets appeared to have already priced this in.


The Bank of England, however, was looking to be out of step with central banks on interest rates. The latest Eurozone GDP figures were released and showed a quarter-on-quarter growth of 0.2% (half that of Q1 2019), in-line with market consensus and ECB forecasts. Headline inflation fell to 1.1% (down from 1.3% in June), largely driven by a fall in the Core rate to 0.9% (down from 1.1% in June). Meanwhile, the domestic picture remains resilient as the unemployment rate fell from 7.6% in May to 7.5% in June. In addition, Eurozone growth in retail sales jumped from -0.6% in May to 1.1% in June, well ahead of market consensus estimates of around 0.2%. Household consumption has remained robust and should continue to offset some of the weakness from falling exports. Nonetheless, domestic politics dominated the UK in July, with Boris Johnson confirmed as the new British Prime Minister mid-month. News of a fresh cabinet, including Chancellor of the Exchequer, Home Secretary and Foreign Secretary increased perceived likelihood of a no-deal exit from the European Union. The Prime Minister’s assertion that the United Kingdom will leave the European Union on 31 October 2019 “come what may”, saw sterling fall to a five-year low.



Key local economic releases were mixed, with retail sales contracting 2.0% year-on-year in July, dropping from a 0.5% gain in June and falling below expectations for 0.8% decline. It was a worrying signal given the consumption tax is set to be increased from 8% to 10% from the beginning of October. The steepest falls come from the machinery & equipment, general merchandise an apparel category.

More positive was a stronger than expected rebound in industrial output, up 1.3% month-on-month in July after sliding a sharp 3.3% in June. On an annual basis, industrial output was 0.7% higher, the first gain in six months. Increased production of autos and chemicals more than offset a decline in oil-related products. Tokyo’s core CPI rose 0.7% year-on-year, with inflation remaining well below the Bank of Japan’s 2.0% target.

Japan’s jobless rate fell to its lowest level in 27 years, dipping from 2.3% in June to 2.2% in July. The jobs-to-applicant ratio though edged lower to 1.59 compared to 1.61 a month earlier, suggesting the jobs market could become a little less tight in coming months.



Economic activity in China has faltered on the back of an escalation in trade tensions, and we see limited near-term upside in growth. Policy stimulus is likely to help offset any trade shocks but not deliver a meaningful growth boost. The fallout from the U.S.-China rivalry threatens a renewed downturn. Confidence in both the corporate and household sector is currently running low, the current recovery appears anaemic, even after significant stimulus in late 2018. We expect Chinese policymakers to revert to trusted tools such as infrastructure spending and another fiscal stimulus to counter the slowdown. We see significant monetary easing or a sharp currency depreciation as unlikely. This would run counter to Beijing’s prime objective to maintain financial stability and prevent a rerun of the destabilising capital outflows seen in 2015-2016.


Emerging markets

Emerging equity markets edged lower during July with consumer sentiment unsettled by concerns over global growth and uncertainties around a US-China trade deal. Asia was the weakest performing region, followed by the EMEA (Europe, Middle East and Africa) region. Equity markets in Latin America finished flat on the month. From a country perspective, Korea lost the most ground as its trade rift with Japan deepened while Turkey enjoyed the biggest gains as investors reacted positively towards a larger than expected cut in Turkish interest rates.




Heightened global tensions, currency wars, and the course of de-dollarisation have been pushing central banks to boost their gold purchases. The trend is likely to continue in the coming years.  Data from the World Gold Council shows that in the first half of this year, the banks bought a record 374 metric tons of gold worth $15.7 billion. As concerns over trade disputes and global growth boost investors’ appetite for safe-haven assets, gold remains one of the prime secure destinations In the current environment, where uncertainty in emerging-market currencies is high, we see a good reason for countries like Russia, Turkey, Kazakhstan and China to continue to diversify their portfolio



EIA expects West Texas Intermediate (WTI) crude oil prices will average $5.50/b less than Brent prices during the fourth quarter of 2019 and in 2020

 OPEC delivered a downbeat oil market outlook for the rest of 2019 as economic growth slows and highlighted challenges in 2020 as rivals pump more, building a case to keep up an OPEC-led pact to curb supply. Analysts have slashed their oil price forecasts to the lowest in more than 16 months, citing softening global demand as an economic slowdown looms and uncertainty prevails on the U.S.-China trade front. The report also said oil inventories in developed economies rose in June, suggesting a trend that could raise OPEC concern over a possible oil glut.

According to the Short-term Energy Outlook by the U.S. Energy Information Administration, worldwide crude oil prices will average $64 a barrel in the second half of 2019 and $65/b in 2020.


Sector 12 Month Forecast Economic and political predictions 2019



68c – 65c



Previous forecasts suggested Australia’s Dollar was due to catch a break in the final quarter of 2019 as the Federal Reserve (Fed) began to cut its interest rate in earnest, enabling other currencies to draw capital away from the mighty and still-dominant greenback, but all of that changed with the August escalation of the U.S-China trade war.





Gold’s latest price surge is raising support for the precious metal, with many analysts saying they now expect gold prices to trade between support at $1,500 and $1,540 an ounce.


The gold markets have been very bullish for some time, but right now it appears that we are on the sidelines trying to take advantage of a little bit of consolidation. The $1550 level continues to be important, so pay attention to that level. It is an area that is a large, round, psychologically significant figure, but I do also believe that it’s only a matter of time before we see money running back into Gold markets for safety.







On the demand side, we continue to see emerging Asia as an opportunity rich region. China, India, ASEAN and the global impact of China’s Belt and Road initiative are all expected to provide additional demand for our products. We anticipate average benchmark prices for steel making raw materials are likely to remain above long run marginal cost.








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



Prefer Value Stocks


Much has been written about the divergent valuation of so-called ‘growth’ and ‘value’ stocks into this market rally, and we don’t pretend to have a strong view to its appropriateness or not. However, it is worth interesting to note as it likely provides some context for investors as to why increasingly we are finding more interesting opportunity amongst the so-called ‘value’ set, as we think there are many good quality companies facing only short term earning headwinds that do not justify the significantly depressed valuations on which the market is currently pricing them. We like value stocks such as IOOF, Reliance Worldwide, Webjet, Challenger, BWX and Woodside to name just a few.





1% – 2.5%







Australian government bond yields have reached a new historical low. The investment outlook in Australia more generally is broadly positive. Non-mining business investment continues to expand at a moderate pace, supported by a solid pipeline of non-residential building work and infrastructure projects (particularly transport and renewable energy). Infrastructure projects have also been an important element of public demand’s ongoing support to growth.



Cash Rates


0.75% – 1.5%



I don’t see the central bankers in a rush to take the cash rate below 1%. There will be plenty of talk about trade frictions, but the RBA will be cognisant that these could soon be resolved, or equally the saga could drag on into next year – in that event the central bank would be wise to keep something in the chamber (other than going into negative territory or rolling out QE).


Global Markets





A supportive policy mix and the prospect of an extended cycle underpin our positive view. Valuations still appear reasonable against this backdrop.  From a factor perspective we like momentum and min-vol, but have turned neutral on quality due to elevated valuations.







We have reduced 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 have downgraded Japanese equities to underweight. We believe they are particularly vulnerable to a Chinese slowdown with a Bank of Japan that is still accommodative, but policy constrained. Other challenges include slowing global growth and an upcoming consumption tax increase.



Emerging markets




We have downgraded EM equities to neutral amid what we see as overly optimistic market expectations for Chinese stimulus. We see the greatest opportunities in Latin America, such as in Mexico and Brazil, where valuations are attractive, and the macro backdrop is stable. An accommodative Fed offers support across the board, particularly for EM countries with large external debt loads.





Neutral – Buying on Pullback


The uncertain macro outlook keeps us broadly neutral Chinese and China related assets in the short run. Yet we see the gradual opening up of China’s onshore markets — and their increasing weight in global bond and equity indexes — as important sources of diverse returns for investors in the medium term. Consumer-oriented services such as advertising, healthcare, or insurance have room to grow and are now more accessible to foreign investors.




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