Looking at the year ahead
21 Dec 2016
By Shadforth Financial Group
Before we look at 2017, let’s look at the year that has just passed for some background. The investment environment last year can be divided into two distinct halves with different characteristics. The first half was dominated by good performance from shares that act as bond proxies, such as utilities, REITs and infrastructure. As the long bond rate moved lower, these bond proxies benefited and traded higher. The second half that began in August then saw investors rotate away from bond proxies and into higher risk sectors, including the resources sector. After Donald Trump was elected as US president, there was a sharp increase in the 10-year bond rate, as can be seen in Graph 1 below.
Graph 1: Rotation
Are valuations high or low?
From a price to earnings (PE) perspective, as shown in Graph 2 below, the share market is trading at a slight premium to its long term average. The share market is expected to experience earnings growth of six to seven per cent during 2017. This will be driven
by the mining and resources sectors, which are expecting earnings upgrades along with a mildly positive outlook for the banking and industrial sectors. If we factor in the lowest interest rates in history, a slight premium to history is justifiable.
Graph 2: Forward PE
From the perspective of a price to book value (PB), as shown in Graph 3 below, the share market is trading slightly cheaply and below its long term average.
Graph 3: Price to book
Where to for the Australian dollar?
We believe the Australian dollar will be range-bound between US 70 cents and 80 cents for the year ahead as two contrasting forces affect the Australian dollar. The firmer commodity market traditionally supports the Australian dollar but the raising of interest rates in the US will be a drag as it makes the Australian dollar less attractive. Given the expectation for commodity prices to remain firm yet not exceptionally strong, it is doubtful that the Australian dollar will move much higher than US 80 cents.
Outlook for the Australian economy
The Australian economy is generally lethargic, with growth slightly below the long term average as it continues to try to transition and combats lower inflation and limited wage growth. However, a number of factors could surprise to the upside and will support asset prices. These factors include a stable Australian dollar, supportive commodity prices, low interest rates and potential infrastructure spending as Victoria and New South Wales embark on building infrastructure.
Weighing on the economy is the risk that Australia’s AAA credit rating is lost. Other negative factors are weaker consumer spending
combined with a housing market slowdown.
On a positive note, the economy could continue to transition slowly, while the commodity-based economies like Western Australia
and Queensland could show gradual signs of improvement. Unemployment remains stable, so all sectors could contribute to the
strength of the economy. We do not expect the two-speed economy to reappear but expect a more balanced economy, which is much easier to manage from the Reserve Bank of Australia’s perspective.
How will different sectors perform?
The resources sector should see earning upgrades as spot prices for commodities are well above analyst expectations, though we believe they will remain firm. Given the supply capability of the miners and the below average demand due to slower global growth we believe the upside for prices is limited. Resource company management appear far more confident in the outlook so we may see an increase in mergers and acquisitions. We recommend remaining invested in tier one asset owners, low-cost producers and well-capitalised companies like Woodside, Rio Tinto and BHP.
The bond proxies have now seen beneficial tailwinds start to weaken, but given slower global growth, aging demographics and the need for income, yield will remain a popular theme for investors. The easy gains are now behind us so investors will need to be far more selective in their pursuit of yield. They will have to seek yield plus commensurate growth, not yield for yield’s sake. Shares like Transurban and Tabcorp and some property companies, such as, Stockland and Lend Lease fall into this category.
The banking sector currently offers a combination of yield and growth underpinned by relatively attractive valuations. This is because banks have demonstrated good cost discipline and control, supporting their earnings growth. Bad debts may also dissipate as the mining regions and milk industry recover. Capital requirements are improving as banks maintain flat dividends, continue to sell assets and utilise dividend reinvestment plans. The major negative factor to be aware of is margin pressure, however, this could become a positive as banks look to increase lending rates for investors and longer term loans, allowing them to lift their margins in those lending areas.
The consumer sector faces the probability of previous tailwinds becoming headwinds as higher oil prices, higher interest rates, low wage growth and a potential housing price slowdown drag on consumer spending. Countering these headwinds is relatively low unemployment and a stable Australian dollar that should support tourism and domestic spending.
The healthcare sector is desirable as it continues to benefit from people living longer and desiring improved health services. Despite healthcare companies reiterating their guidance, healthcare shares have declined as a result of rotation out of bond proxies coupled with increased regulatory pressures.
What are the major risks?
Share markets are sensitive to changes in inflation and interest rates.Other risks are unsustainable credit growth in China and vulnerable banks in Italy and Germany. Many Eurozone countries will have elections in 2017 and given the rise of ‘popularism’ it is possible we will witness a dismantling of the European Union. With all these risks, and a new US president who is an unknown quantity, the year ahead will definitely be full of spikes in volatility. With the caveat of the above risks, particularly those within Europe, if we consider that the Australian market is not stretched to extreme valuations and should be supported by low interest rates and an economy that is potentially more balanced than it has been recently, 2017 could be a very good one for asset values.