investment matters - june 2019 · in forecasting where economic growth is heading it is useful to...

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Investment Matters

Waiting for the cavalry to arrive

June 2019

macquarie.com

Waiting for the cavalry to arrive

When the pulse from economic growth is weak, easy liquidity (plenty of cheap credit) is the oxygen for financial markets and is usually enough to offset political and other more traditional concerns. When the pulse from economic growth is weak, liquidity conditions

are contracting and political concerns are rising, financial markets become volatile, at best treading water, but more often than not, trading lower.

This had been the situation from the end of April through to the end of May where rising trade concerns undermined confidence in an economic recovery on top of the belief that central banks were providing insufficient monetary policy support to stem emerging growth weakness and provide enough oxygen for financial markets.

Global PMI’s have been deteriorating

Source: Macquarie Research, MWM Research, June 2019.

Once again, we find ourselves back in familiar territory. Despite more than a decade of unprecedented monetary policy support, the world does not look like it has reached a prolonged period of self-sustaining economic growth. In turn, the emergence of downside “risk” events like rising trade war fears (it was the European crisis in 2011/12, falling commodity prices/a slowing China in 2015 and weakening global growth in 2018), has been enough to shift the centre of gravity for economic growth from positive to negative.

One might believe that the solution is all too simple. Just keep monetary policy settings at very accommodative levels in order to provide insurance against downside risks, wherever they may emerge. We don’t doubt this strategy has been/is being largely employed. Policy makers do not pull back from easy settings until they also believe the outlook is improving, but such is the fragility of the backdrop that even small bumps are becoming difficult to offset if all supports are not available at the same time.

Unfortunately, this is the world we live in. After repeated bouts of optimism, followed by requisite periods of pessimism, one might begin to think that the medicine for the problem might actually be worse than the ills of the disease that is being treated (in other words, if too much debt was the problem, is the solution of adding more cheap debt actually worse?). Only time will tell, but for financial markets that are now addicted to cheap money, we once again find ourselves waiting for the cavalry to arrive in the form of rate cuts that will deliver more free money and another dose of oxygen. The alternative is weaker growth and/or lower asset prices, but neither are tolerable outcomes for central banks or politicians.

If it feels like ground hog day (rinse, repeat, repeat) then you would be correct, but that is the world we live in. So where does this leave us? It leaves us tracking a broadening economic slowdown and one which has been recently accentuated by trade war uncertainty. These growth concerns have seen a strong bid for defensive assets (sovereign bonds) and a broadening deterioration in risks assets (commodities, emerging markets, externally exposed currencies, small cap stocks) and in stocks that are highly exposed to political machinations (i.e. technology and exporters).

However, once again bonds and equities have assessed the risks differently. Bond yields have collapsed on declining growth expectations while equities have remained reasonably well supported on the expectation that central banks (primarily the Federal Reserve) will step in and put a floor in deteriorating growth momentum.

We agree with this view and it has been corroborated by the Fed in recent days. In fact, dare we say it, the outlook might not be as complicated as headlines would suggest.

The market is now implying more 25bps of further cuts to the cash rate

Source: Macquarie Research, MWM Research, June 2019

Green shoots that were emerging have been snuffed out with signs of data deterioration seen across Europe, Japan, China and selectively the US. We don’t expect to see a speedy resolution to the US-China trade stand-off with both sides requiring something that the other is not prepared to give. That is, the US wants China to provide free access to its market, to stop stealing its IP and to dial back support for its industry. China is not likely to relent. On the other side, China wants the US to give it back the status quo. The US is not likely to relent either with Trump’s fiscal support for American farmers providing a clear indication that the US is prepared to absorb the economic consequences for the time being. We think if trade concerns remain bilateral and not multilateral, then with some policy support the world is likely to get through the soft patch. However, if Trump is emboldened and tariffs are used for other political gains, then the potential for a global recession by 2020 rises in a non-linear fashion.

For investors, we don’t think the issue is about stemming economic weakness which we believe can be done. We think the issue is whether equity markets get what they want, in which case they can hold onto or even push through to new highs. But, anything less than the 3 Fed rate cuts being priced in would amount to a disappointment unless it was accompanied by good news from China (either economically or on trade).

We cut our global equity weight from overweight back to neutral in April. This was fortuitously timed with markets going sideways to down but with significantly higher volatility. We stick to this call. We raised our allocation on bonds in February – equally as fortuitous. Additionally, in April we became more discerning on sovereign markets – favouring Australian sovereign yields. We are prepared to run with our neutral position. From here we are more likely to see a tactical reversal rather than another major leg down in bond yields, although much of this depends on the patience of the bond markets and the continued resilience of credit spreads. However, before going more bearish bonds,

we prefer to wait for more concrete evidence of policy stimulus as predicting political outcomes is beyond our reach.

Valuation is not a headwind for Australian equities

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S&P/ASX 200 Index PE Ratio (12m forward)

Source: FactSet, MWM Research, June 2019

Domestically, we are upgrading Australian equities to overweight. The surprise Coalition election win is investor friendly. Add in further RBA rate cuts and easing of credit restrictions by APRA and we think support is being put in place for key equity market sectors. Lower interest rates and improving credit availability are preconditions but the government will need to follow up its election win with more pro-growth policies and the global backdrop will, at least, need to stabilise in order to kick start the economy. We have confidence that a more market friendly policy agenda will follow.

We think further rate cuts will continue to put downward pressure on bond yields. Similarly, the A$ is now in a tug-o-war between weaker interest rate support and (still) elevated commodity prices. We still believe the path of least resistance for both bonds and the currency is flat to marginally down but like for global sovereign yields, large declines are not necessary or likely. We don’t think downside risks to the equity market have disappeared as underlying fundamentals remain fragile. Nevertheless, better sentiment with greater policy support should allow further multiple expansion in selected (cyclically depressed), industries such as banks, retail, building and construction and residential housing exposed areas.

In line with this upgrade, we have also raised the REITs sector to overweight. We accept that the sector is dealing with three mini cycles across retail, residential and office and that none of these are aligned. But lower rates will support residential and to a lesser extent retail and our expectation of further rate cuts and a muted increase in long rates should continue to provide reasonable support for the sector. In addition, an attractive yield spread should look increasingly favourable as cash returns diminish.

Jason and the Investment Strategy Team

Asset class preferences

Quick takeaway

We have slightly reduced our overweight to cash as we increase our Australian equities and REITs positions.

Recommendation

We have moved to overweight in REITs. Lower short and long-term interest rates and easing credit conditions in the housing market should provide a supportive backdrop for property fundamentals. Residential developers and retail landlords in particular are expected to benefit from the improved housing outlook following the Coalition win, the RBA rate cut and APRAs proposal to lower credit hurdles.

We maintain our neutral allocation to fixed income and still favour credit markets to developed sovereign markets in general. Domestic government bonds remain our preferred exposure for interest rates despite the strong rally throughout May. We are sceptical that we will see any meaningful rise in domestic inflation expectations leading to higher rates in the long end while offshore government yields remain so low and the flight to quality remains such a factor. Given the uncertainty in the growth outlook we view it prudent to continue to hold our allocation to fixed income.

We have moved underweight Alternatives to provide funding for our overweight Australian equities. We view equities as having the greater risk-adjusted returns at this time. Within hedge funds, we continue to prefer strategies with low beta to global equity markets.

We have moved overweight Australian equities. Good news came in threes for Australia with a surprise Coalition election win, an RBA interest rate cut and APRAs proposed easing of credit restrictions. This will aid sentiment and put a floor under a housing market that has been struggling under constrained credit conditions. Economic fundamentals remain fragile but improved sentiment with greater policy support should allow further multiple expansion in selected (cyclically depressed) industries such as banks, retail, building and construction and residential housing exposed areas.

We maintain a neutral allocation to global equities. At the regional level we have an overweight to emerging markets. Volatility has increased as US-China negotiations heat up again however our base case remains an agreement is in the mutual interests of both countries. China’s stimulus measures are struggling to gain traction and further policy support may soon be at hand. Within developed markets, we continue with our preference to US equities ahead of European and Japanese equities. While the US economy is slowing, Fed commentary increasingly suggests the chance of rate cuts is increasing which should provide market support over the near term.

Source: MWM Research, June 2019

Economic update Global 4

Global economics – Recovery wobbles

• US leading indicators point to softening growth;

• China's green shoots turning brown;

• European growth struggles to find a floor as German unemployment spikes;

• Macquarie research suggest expectations of recovery are more forecast than reality.

Macquarie’s view, in line with consensus, has been that after slowing materially last year, the stabilisation seen in Q1 GDP across the major economies would mark the low in global growth. However, analysis of the recent high frequency data indicates that this view remains more forecast than reality. Global industrial production growth remains close to zero and PMI surveys are still weak, importantly with the US and China softening.

In forecasting where economic growth is heading it is useful to look at several market related indicators rather than focus on coincident or lagging economic data series. Indicators such as higher credit spreads, yield curve flattening, equity markets softening and PMI’s heading towards contraction together signal that global economic growth remains fragile.

As if this wasn’t enough for the global economy to manage, the rhetoric of the US-China trade war continues to heat up. China’s release of a government report refers to the US “resorting to intimidation and coercion” and hit out at the US for barring US companies from using equipment made by Huawei. With the trade discourse clearly deteriorating it’s difficult to see what might deflate tensions. Macquarie research highlight that after growing 4.3% in the year to Q1 2018, real global trade looks to have fallen by around 2.5 percentage points in the year to Q1 2019.

It’s notable that falling global trade is feeding quickly into falling industrial production. Any global economic recovery would therefore require trade growth to at least stabilise. While global central banks stand at the ready to add more stimulus it seems that this would be an unfortunate time to see a material escalation in the US-China trade war. The risks appear to be building for the base case of gradual global recovery.

Global trade growth remains very weak


United States: Manufacturing close to contraction

The US economy remains in reasonably good shape highlighted by strong employment and consumer confidence. However, the fiscal stimulus effect is fading, and GDP growth is likely to slow after a positive surprise in Q1 driven in some part by inventory accumulation. Domestic demand is softening, and recent consumer spending growth has been volatile but still trending at a 2-3% real rate of growth.

The latest Markit Flash PMI data for May suggests US economic growth has slowed to its weakest level seen since the GFC. The Services Business Activity Index is now at 50.9, a 39-month low while the Manufacturing Index is at 50.6 (52.6 in April), a 116-month low. Other indicators suggesting a broad-based slowdown include durable goods and retail sales.

US Durable Goods growth close to zero

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US Durable Goods Growth (YoY, %)

Source: FRED, MWM Research, June 2019

Economic update Global 5

Wage growth has continued its gradual recovery post the GFC to a current rate of just over 3%. Macquarie research believe that consumption strength combined with a strong labour market suggests that a 2019 recession is unlikely. Inflation remains subdued and looking through the energy related bounce over the last couple of months it should not be a constraint on the Fed cutting rates should the economy continue to slow.

China: Another stimulus required?

China’s NBS Manufacturing PMI for May dropped back into contraction at 49.4, disappointing market expectations that the credit stimulus early in the year would be enough to put a floor under deteriorating economic growth. Both New Orders and Export Orders slumped with Employment hitting its lowest reading since Feb 09. Macquarie research believe that the PMI data together with very weak coal consumption in power plants suggest that economic growth is set to slow further in May.

China’s latest PMI miss is indicative of slowing economic momentum and continued pressure from the trade war and runs against optimistic consensus expectations post the credit stimulus in January. Macquarie’s view is that another significant stimulus would follow if the composite PMI fell through 50 but bad news is still bad news at this stage with weakening growth not weak enough to elicit a policy response.

Chinese manufacturing PMI contracting again

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China NBS manufacturing PMI

Source: Bloomberg, MWM Research, June 2019

While another policy response to slowing economic growth is likely at some stage, any easing/stimulus remains likely to be focussed on stabilisation rather than expansionary. With global bond yields pushing lower again together with commodity related FX, these global growth bellwethers seem to support the case that improved momentum in global economic growth can’t rely on Chinese stimulus in isolation.

Europe: Waiting for the recovery

After leading the slowdown last year, Eurozone Q1 real GDP growth came in at 1.5%, up from 0.9% in Q4 2018. Industrial production has also bounced slightly but manufacturing PMIs remain very soft. The latest Markit Flash Eurozone PMI highlights continued subdued business growth with the Composite Index coming in at 51.6 vs 51.5 in April. The Manufacturing Index remained in contraction at 49.0. Jobs growth slipped lower and Markit highlighted that firms have scaled back expansion plans in light of weak sales.

Exporting powerhouse Germany is feeling the effects of a global economic slowdown. In May the number of unemployed increased by 60 thousand from a month earlier vs market expectation of an 8 thousand decline. This was the largest monthly increase in a decade. Brexit has taken another turn following the resignation of UK Prime Minister May. The risk of a hard no-deal Brexit has increased but Macquarie research believe the odds remain low at around 15%.

With manufacturing PMIs still stubbornly in contraction, the trough in Eurozone economic growth remains elusive. The ECB has revised down its expectations for growth in the region and has implemented some marginal measures to counteract the slowdown. No “big guns” have been announced at this stage. It is questionable how effective further interest rate cuts and quantitative easing might be given already low rates and high indebtedness.

German unemployment spikes

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Germany registered umemployment change

Germany Unemployement Change SWDA (%)

Source: Bloomberg, MWM Research, June 2019

Economic update Australia 6

Australian economics – Domestic tailwinds provide renewed optimism

• Recent domestic events improve the economic growth outlook, but the global slowdown remains a headwind;

• The RBA has delivered a 25bp interest rate cut in early June. Macquarie expect another 25bp cut before year end 2019;

• Proposed easing of credit restrictions by APRA should relieve the pressure on housing credit availability;

• The election of the Coalition has cleared political uncertainty and the A$ is benefiting from the improved outlook domestically.

Australia’s successful economic run without a recession has come at the consequence of a build-up of household debt to levels rivalling the highest in the developed world. This vulnerability became exposed with the bursting of the house price bubble and quickly there was nothing but dark clouds on the economic horizon. Weak income growth has dragged on consumption and declining house prices, and therefore household wealth, has added to this pressure.

The Australian economy now looks set to benefit from three recent changes on the economic front, which we expect will arrest the downward momentum and provide some hope, at least over the short term. The return of the Coalition at the Federal election has removed several uncertainties. The result was not a positive based on the proposed policy agenda but for the removal of policies that threatened higher personal taxes, and changes to industrial relations, capital gains and negative gearing.

The rapid fall in Australian house prices look set to be arrested on the back of the RBA interest rate cut and the Australian Prudential Regulation Authority’s (APRA) proposed relaxation of the minimum interest rate hurdle for mortgages. Lower interest rates and improved credit availability are preconditions for a stronger economy as well as corporate earnings however they are not the only conditions necessary. The government will need to follow up its election win with more pro-growth policies in order to kick start the economy.

GDP growth per capita weakest since 2013

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Source: RBA, MWM Research, June 2019

Despite the improved domestic outlook, the global economic backdrop still presents a risk for an economy so exposed to commodity exports. Weaker economic data out of the US and the recent Chinese stimulus failing to generate any domestic let alone global momentum means Australia is still vulnerable. The slumping A$ and falling 10-year bond yield are an indication that global investors are not yet anticipating a material pick up in Australian growth.

Number of firms increasing employment has slowed


Economic update Australia 7

Key highlights:

• Labour market – unemployment now trending higher: After holding at around 5% for the last six months, the unemployment rate is now clearly heading higher with the April rate increasing to 5.2%. Full time employment declined in April following a period of strong growth with males suffering most, partly reflecting slowing construction employment. Forward looking indicators continue to point to a modest but not marked deterioration in the labour market.

• Wages – growth remains tepid: Q1 wage growth was a little softer than Macquarie’s expectations with the public sector noticeably weak. Wages growth has risen only slowly over the last 2 years, but wage growth expectations have turned down in line with slowing economic growth. Business surveys continue to indicate a weak outlook for business hiring.

• Inflation – below target for the foreseeable future: Soft wage growth and weak hiring outlook imply inflation will continue to track below the RBA’s 2-3% target band for the foreseeable future. This level of inflation won’t be a barrier to further RBA rate cuts.

• Consumer spending – expect improvement as house price pressure abates: Sentiment associated with stabilising house prices should improve but residential building approvals are still set to fall sharply and will drag on employment and wages for some time. Q1 real retail sales growth has moved into negative territory, suggesting that the broader household consumption number may disappoint. Retail trade volumes are now growing at their weakest level since 2011.

• Housing – APRA proposal eases pressure: APRA has proposed a reduction in the minimum interest rate threshold at which lenders must assess a housing loan applicant’s debt-servicing capability. Together with the recent rate cut this should help to stabilise house prices via improved sentiment and relaxing credit constraints by raising borrowing capacity. Macquarie are now forecasting a 10% peak-to-trough decline in prices at the national level from the current 8%.

Q1 retail sales volumes very weak

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Australia - Growth in Retail Trade

Year-ended values (%)

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Source: ABS, MWM Research, June 2019

The A$ remains the shock absorber for the Australian economy and Macquarie believe there is another rate cut priced in for 2019. For the currency to move decisively below US$0.70 we would need to see sustained deterioration in economic growth which would likely be followed quickly by additional RBA interest rate cuts. Our view remains that central bank policy and a flexible currency will be enough to ward off a severe downturn. While the election result, RBA rate cut and APRA’s proposal are unquestionably positive we continue to watch the global economy and China for any signs of renewed economic weakness.

High household debt leaves consumers vulnerable

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Household debt to disposable income surged to 190%Household debt to disposable income (%)

Source: ABS, MWM Research, June 2019

Asset class outlook International equities 8

International equities – Fed to the rescue again

• We are neutral global equities;

• Trade tensions will weigh on sentiment but are at least now priced into equity markets;

• Central banks have taken their cue and are now prepared to ease. We think this can put a floor under the market, but with the outlook remaining highly uncertain we maintain a neutral stance.

In recent months we moved from an overweight to neutral stance on global equities with the belief year-to-date returns had been front-end loaded. Investors had priced in a trade deal as a near certainty and been bolstered by the Fed’s dovish backflip. While we were a month too early, April brought a dose of reality with the S&P 500 declining 6.6%.

Emerging markets remain our largest overweight. While the call has gone against us in the last month, we believe there are compelling reasons to remain positive. Firstly, China’s official PMI was well below expectations and is now in contractionary territory. This suggests upcoming data will be weak and, when combined with trade uncertainty, will mount the case for further stimulus. Our China economist believes the data will need to get worse to justify such a move, but we think it would be a powerful catalyst to drive flows back to EM.

Secondly, the Fed’s recent dovish communications have seen a degree of dollar weakness re-emerging. Macquarie’s US economist now expects two Fed rate cuts in September and October. A sustained period of US dollar weakness would ease EM financial conditions and encourage investors flows. While it is still early days, it is worth remembering this was the catalyst for EM inflows through early January. EM flows were negative through May but increased sharply in early June.

EM outflows through May but early signs of recovery

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US$b Net Non-Resident Purchases of EM Equities7 day moving average 28 day moving average

Source: FactSet. MWM Research, June 2019

The recent correction has pulled valuations back to undemanding levels, at least relative to the last few years. MSCI World ex Australia is now trading on a 14.7x price/earnings multiple, consistent with levels seen last October and at the bottom of the range for the last five years. As such, we are moderately more positive relative to last month.

Valuations now looking more reasonable

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Source: FactSet. MWM Research, June 2019

This month we are upgrading Australian equities to overweight. Much has changed domestically in the last month and for once it is for the better. The recent weakness on global trade provides an opportunity to move to an overweight position. While the path to improved earnings is not yet clear, the building blocks are now in place with multiple layers of stimulus.

Equity market preferences

Allocation

Australian Equities

International Equities

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EM

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We continue to prefer fully unhedged international equity positions. Recent A$ strength will be disappointing for the RBA and likely further the case for more cash rate cuts.

Asset class outlook Australian equities 9

Australian equities – A brighter outlook emerging

• The surprise Coalition election has removed a raft of downside risks related to ALP policies;

• Expected RBA rate cuts and easing of credit restrictions by APRA supports the housing market and several key equity market sectors;

• The path to a stronger economy and earnings recovery is not yet clear, but we think the building blocks are now falling into place;

• We upgrade Australia to overweight but continue to prefer a sector-specific approach given the domestic economy remains soft.

Over the past year domestic equities have been hampered by political uncertainty with expectations for an ALP federal election victory resulting in a large price discount being applied to a broad range of stocks and sectors.

The election result was a very welcome surprise, primarily for the policies that will not be implemented. No personal tax hikes, no changes to franking credit refunds, no changes to capital gains discounts and negative gearing on housing, no major changes to industrial relations laws and of course, no increase in emission standards or targeting of electric vehicles.

As such, the election outcome was a clear unexpected positive which justifies the recent re-rating of domestic cyclicals. Fund managers were quick to neutralise their underweights via the banks with less liquid names showing ongoing strength in recent weeks. We think international investors will also be encouraged by policy continuity and increased likelihood of a stable government. All else equal, the equity risk premium should decrease, implying higher valuations.

Equity risk premium should fall from elevated level

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At the sector level, we view the key winners as: housing (banks, retailers, real-estate industry), healthcare (health insurers, private hospitals), wages (unionised workforces, retailers) and franking credits (high yield equities, hybrids, listed investment companies).

Housing was arguably already the largest beneficiary from the election due to renewed confidence in policy direction (negative gearing, capital gains tax, first home buyer deposits) but was given an additional boost from expectations for looser credit (RBA, APRA).

This is a powerful change in direction which has been clearly coordinated for maximum impact with the housing market already showing tentative signs of turning. Macquarie’s economist believes the national housing market could record +5% growth by 2020 with up to 10% growth in Sydney and Melbourne.

Macquarie’s equity strategist believes housing could start recording gains as early as July, based on past cycles which have seen gains recorded 5-7 months after the trough had been reached.

Housing stocks – valuations leading earnings


We expect the housing related stocks to be well bid in the coming months as data begins to support the cycle turning (auction clearance rates, RBA cuts, loan volumes etc). Preferred housing exposures include Stockland (SGP), Realestate.com.au (REA), Nine (NEC), Adelaide Brighton (ABC), CSR Ltd (CSR) and Westpac (WBC).

The global backdrop of ongoing volatility may provide opportunities to ‘buy the dip’, but we expect domestics will hold up better as fund managers look to reposition ahead of the next earnings cycle. We have more confidence in an earnings uptick for direct retail housing exposures (Nick Scali, Harvey Norman) than broader retailers which will rely on a sustainable improvement in wages and consumer sentiment.

Asset class outlook Australian equities 10

We continue to watch the iron ore market closely. While spot prices are hovering well above marginal cost (US$65-70/t), recent pricing has been driven by supply disruptions resulting in Chinese steel mills destocking port inventories. However, our commodities team thinks the worst of the supply pinch has now passed. Crude steel production should slow as summer approaches, Australian supply is running above average while Brazilian cargoes are recovering from April rain delays.

Given this backdrop we do not believe the diversified miners (BHP, RIO) can lead the market higher again unless supply disruptions reoccur. Indeed, the two majors have now retraced to levels last seen in February, trading in a range rather than in line with spot pricing. We continue to believe profit taking is the most prudent approach with iron ore ultimately to return to equilibrium.

The surprise election victory combined with expected RBA rate cuts warrants a refresh of our preferred income exposures. Firstly, we think investors can take some long-term comfort from the election result i.e. we would be very surprised if franking credits were to feature at the next election campaign. Secondly, most higher yielding stocks have domestic revenues and are now supported by an improved outlook. Thirdly, the declining cash rate should see income stocks well supported as investors seek to replace income from lower term deposit rates. Lastly, self-managed super funds remain heavily allocated to cash – the potential for a cash rate below 1% could be the catalyst required to shift SMSF funds away from cash towards higher returning asset classes such as equities.

Rate cuts should force SMSFs to reduce cash

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Source: ATO, MWM Research, June 2019

At the sector level we see several implications of the lower cash rate. Firstly, it appears likely the search for yield is set to continue particularly when factoring in the recent collapse in global bond yields. Secondly, the

property sector should remain well bid as the yield spread over cash remains attractive and downside risks for residential and retail property have decreased. As the chart below shows A-REITs have historically outperformed following a rate cut (2016 was the exception as long-yield re-rated on the US election result). Our property team currently prefers GPT and Vicinity for investors seeking yield.

Rate cuts support A-REITs

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REIT sector outperformance 3 months after rate cut


Lastly, we continue to view the banks as range-bound and most appropriate for income portfolios as we struggle with the earnings outlook in a declining rate environment. While loan volume growth should improve from recent levels, our bank analysts remain cautious as lower rates will eat into margins and pressure bank earnings. The chart below illustrates this with Bendigo (BEN) most impacted due to its reliance on low rate deposits and absence of hedging.

But banks face headwind from low rates

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Asset class outlook Fixed interest 11

Fixed interest – Safe haven

• We remain comfortable with our overall neutral position in fixed income and our preference for Australian sovereigns over other Global Developed Sovereign markets;

• Our preference remains for credit spread product over a 6 to 12-month horizon, however we expect to see some spread widening in the near term;

• We expect to see a continuation of the increased volatility in sovereign bond markets as long as uncertainty surrounding global growth momentum and political and trade risks remain elevated.

Developed Sovereign yields – uncertainty to remain elevated

Yields on sovereign bonds tumbled throughout May. Three key drivers of this were:

1. Slower than expected global growth;

2. Falling inflation expectations; and

3. Flight to safety.

While we think that the first two are largely priced in, the latter is likely to remain in play for as long as it takes to see some sort of resolution to the trade negotiations between the US and China.

At the time of writing, 10-year US Treasuries were trading at approximately 2.12%, up a little from lows at under 2.1%. The US 2-year yield sits at 1.82% after falling circa 44bps throughout the month.

Policy rates too tight or term premium too low?

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Bps 10/3m UST Spread 10 Year UST Term Premium


The 10y/3m part of the US yield curve has been inverted now for 10 days – a well-known leading indicator of recession. Many studies have shown that should the yield curve remain inverted, recession usually follows within about 12 months. The rationale is that monetary policy is too tight, keeping the short end of the yield curve elevated, while the long end reflects falling real yields as economic growth expectations fall. However, as has been widely discussed, the Fed’s QE program alongside the asset purchase programs run by the European Central Bank (ECB) and the Bank of Japan (BoJ) have suppressed long end yields. This has led commentators to suggest that it is the low term premium that has led to the curve inversion rather than too tight monetary policy. Which side is right remains to be seen, however, we remain cautious about dismissing the signal from the yield curve when there are signs that global growth momentum is faltering and inflation expectations remain low.

Australian Sovereign bonds

As widely anticipated by the market, the RBA delivered a 25 bp cut taking the cash rate down to a historic low of 1.25%. Markets expect at least a further 25 bps later this year. Historically, when central banks enter an easing cycle, this has caused the long end of the yield curve to back-up as real yields and inflation expectations increase.

Easing cycles usually see a steepening of the curve

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1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019

US yield curve vs. Fed PolicyUS Fed Funds Target Rate (LHS, %)

US 10Y2Y yield spread (RHS, bps)


We are sceptical whether one or two rate cuts are enough to raise inflation expectations or economic growth enough to sustain 10-year bond yields at markedly higher levels. The reasons for this are two-fold:

1. Further rate cuts are already priced in and real yields and inflation expectations remain supressed; and

Asset class outlook Fixed interest 12

2. Global developed bond markets take their lead from the US and while German and Japanese bond yields remain in deeply negative territory it is likely that US yields will remain low due to demand. This same dynamic impacts Australian bond markets – particularly given the AAA credit rating.

Corporate bonds – near term volatility expected

We remain comfortable with our preference for credit spread product relative to sovereign bonds over a 6 to 12-month horizon. In contrast to developed sovereign bond markets, spread products have shown a muted reaction to the current market uncertainty. Despite the uncertainty surrounding trade, global high yield option-adjusted spreads (OAS) have only moved wider by 70bps (investment grade spreads have widened ~7bps) in stark contrast to moves seen in December 2018 when investors feared the Fed would tighten so much as to push the US into recession (global high yield OAS widened circa 180bps from October 2018 to the end of December.)

Risk assets remain supported by the view that the Fed will react to slower growth by cutting rates and that this will keep risk assets supported. Credit markets appear ripe for disappointment if the Fed does not deliver the rate cuts priced into the market. There is a risk of significant widening in credit spreads should the Fed simply fail to signal that easier policy is “coming soon” particularly if the uncertainty around a resolution to the trade talks persists for too long.

While we remain comfortable with our position on credit given there has been no material change to the health of corporate balance sheets, we see a greater risk of spreads widening in the short term. Certainly, some of our comfort with our current positioning comes from the strong total returns from fixed income markets over the past 4 months since we moved from underweight to neutral providing us with a cushion.

Recent strong total returns provide us with a cushion

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4

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8

10

1M 3M YTD 1Y

Short term total returns in fixed income

Bberg Barclays Global Agg (Hedged AUD)

Bloomberg AusBond Composite 0+Y

Source: Morningstar, MWM Research, June 2019

Macquarie economists’ base case revised

Macquarie economists’ outlook for Fed policy has changed from one rate hike in December (published mid-March) to two rate cuts through to year end. The base case for timing is September and October. Macquarie believe that there is a possibility for more aggressive easing should the growth data substantially deteriorate.

Global Fixed Income Preference

Allocation

Duration

Australia

Develop. Sovereign

Global Credit Spread

Investment Grade

High Yield

EM Hard Currency

EM Local Currency

Ove

rwei

ght

Str

ong

Ove

rwei

ght

Str

ong

Und

erw

eigh

t

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eigh

t

Neu

tral


Asset class outlook Alternatives 13

Alternative assets – A way to hedge the tail

• We reduce our overweight in alternatives to slightly underweight to fund our move in Australian equities;

• Private markets to remain well supported as allocations to equity and debt raisings remain strong;

• We continue to prefer strategies with low beta to listed equity and credit markets.

We move to a slight underweight alternative assets despite our expectations that volatility will remain elevated across sectors and all financial markets. At this time, we view the risk-adjusted return potential to be greater in Australian equities. However, within alternatives we continue to favour fundamental long/short strategies, diversified macro and trend following strategies as well as relative arbitrage strategies.

Private markets

Private equity Dry powder levels continue to get headlines as do the size of some of the deals announced. Blackstone Group announced the largest private real estate deal in history at U$18.7bn for a portfolio of US warehouses. Meanwhile in Australia, there are signs that activity in the private capital sector picked up, reversing the declining trend seen in the market since 2016 according to a report released this month by the Australian Investment Council. Assets under management were at A$30bn, with A$11bn in dry powder. In the Venture Capital (VC) space there are signs that institutional investors are warming to the market and the segment is maturing with some positive changes in the landscape. For example, the average fund sizes are growing, LPs are co-investing and funds are now more focussed on specific opportunities or themes.

Private debt activity continues in both domestic and global markets as traditional lenders exit the market. Private debt opportunities are presenting themselves across many aspects of the financing space from trade finance, asset financing and operating leases in the global transport sector and more traditional loans to SMEs. Much of this opportunity has been driven by banks exiting the lending due to changes in the regulatory environment and the risk weighted cost of capital. Data released from Preqin this month forecasts the assets under management in private debt strategies to double over the next five years to U$1.4trillion. Certainly, we continue to see opportunities in this space from both domestic and global fund managers. Yields on offer are sitting around 8-12% after fees depending on the market segment and the liquidity terms making this attractive relative to yields available in developed public debt markets.

Australian private equity markets showing signs of life

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Buyout Venture Capital Growth Other Private Equity

BnAustralian PE and VC Assets under Management

(June 2018)Dry powder Unrealised value

Source: Australian Investment Council, MWM Research, June 2019

Hedge funds – continue to prefer low beta strategies

Within hedge funds, we continue to prefer strategies that have low equity market beta. Merger arbitrage strategies remain our preference however, lower interest rates can result in lower deal spreads.

Macro and systematic strategies can provide diversification

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Equity marketneutral

Equity growth bias Merger Arbitrage Macro/CTA

Beta to MSCI World (USD)

Up market beta Down market beta

Source: Preqin, MWM Research, June 2019

Fundamental macro and systematic strategies are also typically low beta, although fundamental macro strategies may find the increasingly accommodative stance of central banks difficult to navigate. We continue to like systematic macro/trend follower strategies as an effective tail risk hedge however, expect some volatility in upcoming return numbers due to the sudden shifts in macro policies that have driven rapid changes in market direction and positioning

Asset class outlook Real assets 14

Real assets – Policy underpins downside

• We are upgrading REITs to overweight;

• While there are three distinct cycles in play (retail, residential and office), recent policy support should help put a floor in key areas of weakness:

• We believe long rates will not rise on a sustainable basis until confidence on growth/inflation rises. This should continue to support relative performance of the sector:

• The dividend-cash yield spreads remain strongly tilted in favour of REITs and is likely to get wider as cash rates continue to fall.

Long rates continued their decline throughout May as uncertainty around the global growth outlook and trade tensions dogged the broader market. Falling rates, along with changes in APRA’s policy and a continuation of the Coalition government saw REITs finally outperform the broader equity market for the month.

Defensive sectors have lagged despite falling yields Returns % (excluding dist r ibut ions)

Week ro lling Month ro lling Quarter ro lling YTD Year ro lling

Telecoms 1.37 7.32 13.72 25.85 23.91

Health Care -0.63 3.27 6.84 11.99 9.20

Materials -0.01 3.10 2.96 16.79 9.64

Property Trusts -2.83 2.47 5.87 13.77 11.53

Consumer Discretionary -1.09 1.78 7.90 17.92 2.90

Financials -0.63 0.85 2.30 10.34 2.76

Industrials -0.83 0.09 4.23 13.95 9.58

Utilities -2.69 -1.06 -0.67 8.22 2.87

Energy -2.29 -3.80 -6.95 10.25 -4.00

Information Technology -1.38 -4.06 5.60 23.50 24.02

Consumer Staples -2.93 -4.22 6.57 6.98 3.92

Sector

Source: IRESS, MWM Research, June 2019

We believe the changes to lending criteria and further declines in the cash rate will provide strong downside support for residential property. Increased participation from all players in the housing market should help drive price growth. Given current land banks held by the listed developers, our property team envisage upside risk to residential operating margins from here. Easier access to credit should also benefit sales volumes and reduce the probability of defaults, which is good. Under coverage, the preferences to leverage this thematic are Lend Lease (LLC), Mirvac (MGR) and Peet Ltd (PPC). SGP (rated Neutral) will benefit from this change as well, although Macquarie remain cautious on its sub-regional retail portfolio, which continues to be its largest exposure.

REITs DPS spread to Bond yield


Retail: The election result also appears to be a positive for retailers on face value, but the structural headwinds remain a concern. We think it will take time for income growth to pick up but the sector should get an increasingly positive tailwind if residential property prices rebound.

Office: Office remains solid, with comparable NPI, incentives and occupancy trending in the right direction. Given upcoming supply pipelines, we believe metrics will likely moderate from here (lower rental growth, higher capital intensity, etc.), but we believe this will be a gradual slowdown and fundamentals will remain positive within the context of ongoing retail headwinds and a gradually improving residential outlook.

Asset class outlook Currencies and Commodities 15

Currencies – Growing chance of US rate cuts pressures US$

Commodities – Trading copper

US$ navigates rate cuts and safe haven appeal: The US$ has dropped back to April levels on the back of a slowing economy and regional Fed commentary that a rate cut may be warranted. We may see a similar scenario play out to that where the Fed moved dovish in late December and the US$ sold off quickly only to rally back to new highs as global economic concerns grew. Despite the rate cut outlook in the US the US$ retains its safe haven appeal as the “go-to” currency in uncertain times.

A$ turning point: Macquarie believe that with the Australian electoral uncertainty out of the way the worst may be over for the A$. The preservation of existing tax concessions for property investment will help in stabilising the property market. The downside risks remain ongoing global trade tensions and further RBA interest rate cuts.

Renewed optimism benefits the A$

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AUDUSD

Renewed economic optimism benefits the A$


CNY slow depreciation: Rather than being US-China trade war specific, Macquarie research believe the current market anxiety emanates from uncertainty around a new ‘world order’ involving a low-level economic war, rather than just a tariff war. In this environment China may prefer a slow depreciation of the yuan rather than quick revaluation.

Sterling in limbo: Macquarie’s bullishness on sterling has been toned down recently as the currency failed to capitalise on the passing of two no-deal deadlines. The market is harbouring deeper misgivings and the recent success of the Brexit Party led by Nigel Farage has again raised the probability of a no-deal exit.

• Macquarie's commodities team believes recent weakness has created an attractive entry point for copper, eyeing a recovery to $6,400-6,600/t.

• Supply-demand drivers remain supportive with supply disrupted and demand expected to respond to lower prices.

• US dollar weakness has provided support but a US-China trade deal or further China stimulus are the key catalysts that can drive base metals higher.

Copper declined 9.2% during May as US-China trade tensions escalated and investor flows exacerbated the retrace. Our commodities team points to CTA selling during the month as well as global macro funds using both the Hang Seng and copper futures to express views on China (see chart). A US-China trade deal remains our base case with our commodities team looking for a recovery to $6,400-6,600/t.

Macro dominating but fundamentals supportive

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IndexUS$/t Copper (LHS) Hang Seng (RHS)


While trade will dominate copper’s path, further upside is possible as news flow increases around China’s new scrap import policy. Importers of high-grade scrap copper will require permits from 1 July. The policy has created a high degree of uncertainty with potential in the short-term for significant supply disruption. Ultimately, we expect lobbyists will be successful in relabelling copper imports from ‘waste’ to ‘raw materials’, but when this happens is not yet clear.

While arguably playing second fiddle for now, copper’s supply-demand profile remains supportive. Africa has been the main source of supply disruptions with tax hikes in the DRC and Zambia resulting in mine closures and curtailments.

At current levels we expect demand will respond with interest in restocking expected provided the market has bottomed – hence the $5,800/t level will need to hold.

Monthly performance 16

Monthly performance - May 2019

Australian equities The positive return of Australian share market in May was a standout among the wounded global equity markets. The S&P/ASX 200 Accumulation Index closed last month trading 1.7% higher. The best performing S&P/ASX 200 sectors were Telecoms (+7.3%) and HealthCare (+3.3%) while Consumer Staples (-4.2%) and Information Technology (-4.0%) were the worst performers.

Amongst larger companies the best returns were from Telstra Corporation (TLS, +8.0%) and National Australian Bank (NAB, +7.8%), while the underperformers were Macquarie Group (MQG, -8.0%) and Insurance Australia (IAG, -2.9%), showing a widening return range among Financial stocks.

The S&P/ASX Small Ordinaries Accumulation Index (-1.3%) underperformed the S&P/ASX 200 Accumulation Index, dragged lower by Costa Group Holdings (CGC, -30.3%) and Liquefied Natural Gas Ltd (LNG, -29.9%). The outperformers were rare-earths miner Lynas Corporation (LYC, +54.1%) and Kidman Resources Ltd (KDR, +45.2%), both of which surged on the back of bids from Wesfarmers unveiled in the last two months.

International equities Outside of Australia, concerns about the global trade war rose to new heights after US President Trump announced new tariffs on goods imported from Mexico, which evoked a new round of speculation on global economic recession. Main US equity indices lost ground in May, with the Nasdaq (-7.9%) giving back some of its returns since the beginning of the year, followed by the Dow Jones (-6.7%) and S&P 500 (-6.6%). European markets felt the same pain and were broadly in line with the US markets. Regional equity indices all ended last month in the red, including Italy (MIB 30, -9.5%), France (CAC 40, -6.8%), Spain (IBEX 35, -5.9%), Germany (DAX, -5.0%), and the UK (FTSE, -3.5%). In Asia, Hong Kong’s Hang Seng Index dropped 9.4% in a single month, which has not been seen since last October. China’s Shanghai Composite index (-5.8%), being at the centre of the trade war storm, also witnessed a large scale sell-off. May was a poor month for Japan’s Nikkei as well, which dropped 7.4%.

Property Australian REITs reversed April’s weakness and advanced 2.47%. Stockland (SGP, +17.5%) and Mirvac Group (MGR, +7.1%) were the main contributors, underpinned by the constructive outlook for the residential market provided the joint forces from the Coalition, the RBA and APRA. The shopping centre manager Unibail-Rodamco-Westfield (URW, -11.4%) was the laggard of the sector.

Fixed interest and cash US Treasury yields fell to multi-month low, driven by fund flows from risk averse investors. US 10-year bond yield plunged to 2.1%, which was last seen in September 2017. The 10-year Australian government bond regained investors’ favour in the light of a bumpy equity performance, with the month end yield reaching a record low of 1.46%. The Bloomberg AusBond Composite 0+Yr Index increased by 1.7%, with both Government bonds (+2.1%) and Corporate bonds (+1.2%) rising steadily. The long term (+10-year, +4.3%) bonds outperformed the short term (0-3 year, +0.4%).

Currency The $A/$US continued to trade below the psychological $0.70 rate and closed at $0.6935 amid a strong US dollar. The $A against other major currencies was mixed, whereas the $A appreciated against the UK Pound (+1.5%, 0.5491) and New Zealand Dollar (+0.4%, 1.0607), it weakened against the Euro (-1.2%, 0.6209) and Japanese Yen (-4.4%, 75.10). Market Performance – May 2019

1.7

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-5.9

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9.0

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Aust Equities

Aust Small Companies

Int'l Dev Mkt Equities (Unhedged)

Int'l Emerg Mkt Equities (AUD)

Australian Listed Property

Australian Fixed Int

Int'l Fixed Int (Hedged)

Cash

Return %

1 month 12 months

Source: IRESS, Bloomberg, MWM Research, June 2019

Monthly performance 17

Market performance – May 2019

Market Indices 1 month %

3 month %

YTD %

1 year %

3 year %pa

5 year %pa

31-May-19

Australian Shares S&P/ASX 200 Accumulation 1.71 4.88 15.46 11.08 10.60 7.74 S&P/ASX 200 1.13 3.69 13.29 6.40 5.95 3.10 All Industrials Accumulation 1.80 5.94 14.90 10.71 8.02 7.99 All Resources Accumulation 1.37 0.88 17.66 12.56 24.35 6.30 All Industrials 1.07 4.79 12.79 5.95 3.27 3.17 All Resources 1.37 -0.45 15.30 8.19 20.25 2.51 S&P/ASX 100 Accumulation 2.12 5.31 15.62 12.07 10.68 7.70 S&P/ASX Small Ordinaries All Accumulation -1.25 2.69 15.75 2.06 9.84 8.82 International Shares

MSCI World Index Hedged in A$ -6.10 -1.36 8.92 -1.10 7.94 6.30 MSCI World Index (A$ Unhedged) -4.47 0.46 10.36 6.71 8.44 9.87 MSCI Emerging Markets (A$ Unhedged) -5.94 -2.75 5.00 -2.81 8.85 5.44 Regional Markets (local currency returns)

Dow Jones -6.69 -4.25 6.38 1.64 11.74 8.22 S&P 500 -6.58 -1.16 9.78 1.73 9.49 7.43 Toronto Comp -3.28 0.24 11.97 -0.15 4.47 1.89 Nikkei -7.45 -3.67 2.93 -7.21 6.13 7.08 STOXX® Europe 600 Net Return -4.94 0.67 11.48 -0.80 4.94 4.25 German Dax -5.00 1.83 11.06 -6.97 4.55 3.35 FTSE 100 -3.46 1.23 6.44 -6.72 4.75 0.91 Hang Seng -9.42 -6.05 4.08 -11.71 8.93 3.11 NZSE 50 0.86 7.13 13.28 12.90 8.76 9.81 Property

S&P/ASX 200 Property Trust Accumulation 2.47 6.06 14.58 17.00 7.90 13.43 Cash and Bonds

Bloomberg Composite Bond All Maturities 1.70 3.85 5.49 8.96 4.33 5.01 Bloomberg Bank Bill Index 0.15 0.48 0.84 1.99 1.87 2.10 Citigroup World Government Bond Index Hedged 1.75 3.39 4.09 6.25 3.13 4.87 Citigroup World Government Bond Index Unhedged 3.33 5.24 4.63 12.25 2.97 6.66

Source: IRESS, Bloomberg, MWM Research, June 2019

The Wealth Investment Strategy Team

Jason Todd, CFA Leah Kelly, PhD Aaron Lewis, CFA

Head of Investment Strategy Team

Senior Investment Analyst Senior Investment Analyst

Stephen Ross, CFA Lizette Mare, B Com (Hons) Fred Zhang, CPA

Senior Investment Analyst Investment Analyst Investment Assistant

References

Aussie Housing Outlook – As night follows day, 30 May 2019

APRA to relax mortgage rate ‘buffer’ – RBA still set to cut, 21 May 2019

Aussie Macro Moment – RBA in a pickle as unemployment rises

Aussie Macro Moment – RBA plays a straight bat, 7 May 2019

Global Outlook: still no clear recovery… A bad time for the trade war to escalate! 8 May 2019

Trade War and the US Economy – The Fast and the Furious, 24 May 2019

Australian Equity Strategy – Safe as houses, 30 May 2019

Australian Equity Strategy – How good is Australia! 24 May 2019

Australian Equity Strategy – Still positioning for an improving cycle, 17 May 2019

Australian Equity Strategy – Banks & Health insurers revel in Coalition win, 20 May 2019

Listed Property Sector – First place, 13 May 2019 Listed Property Sector – Time to floor it, 21 May 2019

Investment Matters June 2019 was finalised on 7 June 2019.

Recommendation definitions (Macquarie - Australia/New Zealand)

Outperform – return >3% in excess of benchmark return

Neutral – return within 3% of benchmark return

Underperform – return >3% below benchmark return

The analyst principally responsible for the preparation of this research receives compensation based on overall revenues of Macquarie Group Limited ABN 94 122 169 279 AFSL 318062 (“MGL”) and its related entities (the “Macquarie Group”, “We” or “Us”) and has taken reasonable care to achieve and maintain independence and objectivity in making any recommendations. No part of the compensation of the analyst is directly or indirectly related to the inclusion of specific recommendations or views in this research.

This research has been issued and is distributed in Australia by Macquarie Equities Limited ABN 41 002 574 923 AFSL 237504. It does not take account of your objectives, financial situation or needs. Before acting on this general advice, you should consider if it is appropriate for you. We recommend you obtain financial, legal and taxation advice before making any financial investment decision. It has been prepared for the use of the clients of the Macquarie Group and must not be copied, either in whole or in part, or distributed to any other person.

Nothing in this research shall be construed as a solicitation to buy or sell any security or product, or to engage in or refrain from engaging in any transaction. This research is based on information obtained from sources believed to be reliable, but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice. We accept no liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this research and/or further communication in relation to this research.

We have established and implemented a conflicts policy at group level, which may be revised and updated from time to time, pursuant to regulatory requirements, which sets out how we must seek to identify and manage all material conflicts of interest. Our officers and employees may have conflicting roles in the financial products referred to in this research and, as such, may affect transactions which are not consistent with the recommendations (if any) in this research. We may receive fees, brokerage or commissions for acting in those capacities and the reader should assume that this is the case. Our employees or officers may provide oral or written opinions to its clients which are contrary to the opinions expressed in this research.

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