Economic outlook for 2017
Expect abnormal asset price volatility due to US uncertainties and higher geopolitical risks. Interest rates have begun to rise. But this year may be better than last – US earnings growth, continued easy money and some healthy hints of inflation from a largely skeptical market sentiment leaves the potential for upside surprises.
Whatever happens, it’s wise to focus on ‘Quality’ companies with good future earnings growth prospects – so there’s merit in industries with solid long-term fundamental drivers. Meanwhile, beware of over-investing in interest rate-sensitive areas like houses.
The three key drivers of equity market performance:
- P/E expansion (P/E = Share Price divided by Company Earnings, used as a simple valuation measure)
- Dividends and increasing payout ratios;
- Company Earnings Growth
As interest rates fell over the last 3-5 years, rather than accept low bank deposit rates, average company P/E’s expanded as investors preferred to pay more for future company earnings (and dividends). But with rising interest rates, P/E expansion is now unlikely to be a key driver of market returns in the next phase.
Over the last 3-5 years, companies pandered to dividend-hungry investors by increasing their profit payouts via dividends – and these are now at record levels. So, less was invested back into growing their businesses. But from now on, investor returns aren’t likely to be further boosted by growing payout ratios. This leaves company earnings (Earnings Per Share) as the most likely driver of share market returns from here.
So, what’s does the economic outlook tell us about industries with good prospects for earnings growth in this environment? Overall, the global economic environment is still improving. The US is growing strongly (even before any Trump policy) and Europe and China are recovering, albeit with risks.
- Interest Rates: low rates pushed asset prices up over the last 3-5 years as Australian cash rates fell from 4.75% to 1.5% and were almost zero in the US. Since July last year, bond markets began moving back up towards more ‘normal’ levels. A large rate rise late last year in long dated bonds was due to investors expecting higher interest rates worldwide in 2017 (starting with the US).
- In the short-term, record low Australian interest rates are still positive for growth assets. The US futures market is forecasting a US interest rise of about 2.5% over the next 5 years. Though we’re likely to lag the US rises, our Reserve Bank will be under pressure to follow eventually.
- Fiscal stimulus: while closely watching Central Bank moves this year, momentum is tilting globally away from easy money towards spending and tax relief (fiscal policy) to stimulate growth now. Government spending on infrastructure, tax measures and local economic bias (vs International trade) is likely – due to a rise in populist politics. Markets consider this inflationary in the long run – an about face from previous deflationary fears. It’s an important shift. Higher than expected commodity prices support this and should also support better domestic growth and a less deflationary environment globally.
- Currency: Since late 2016, the US$ has risen strongly but in this our A$ has held up relatively well due to rising commodity prices. The US$ is likely to stay strong in 2017 but unless commodities keep rising, our A$ may not rise further.
- The US: Its economy keeps improving – 4.6% unemployment (near 20 year lows); wages rising faster than any time since 1993 (median household incomes up 5.3%); and housing starts continue growing strongly. The US seems to be approaching the latter stages of its business cycle – rates rising and banks tightening credit terms.
- Equity markets responded favourably to Trump’s pro-growth and pro-business manifesto, though it doesn’t start till January 20th (let alone start legislating). So substantial uncertainties remain… especially possible isolationist trade policy that might affect Australia.
- Europe: major European economies are still steadily recovering from the GFC and the sovereign debt crisis. Labour market reforms have begun in France and Spain. In Spain, about 1.5 million jobs have been created in the last two years – unemployment is down from 26% to 19%. The European banking system remains a risk (e.g. Deutsche Bank) with increasing regulatory burdens and unresolved problems. So, there is still concern about political instability in Europe, the future of the EU and Euro. After the Italian referendum, investors will then wonder about the French election outcome and the triggering of the legal process for Britain’s exit from the European Union in March.
- China: Concern is about how sustainable the recovery is which was sparked by debt funded government spending. Even so, there are some positive signs with residential property inventories down in key markets – down from as much as two years to less than six months. Heavy truck and construction equipment sales are also up (from a low base). Electricity usage is at high single digit growth levels and rail volumes are also rising. These are real indicators of economic activity.
Overall, the major risks are geopolitical; looming elections in Europe and uncertainty about Trump’s behaviour. The key lesson from 2016 is to avoid getting too caught up in headlines – Brexit shock, Trump victory, and repeated scares regarding Chinese growth. Despite this, there were positive market returns. It is best to focus on the underlying growth trends, which now appear reasonable.
- Australian Equities: In 2016, resource companies led the market and during the year, analysts/brokers begrudgingly upgraded their Earnings Per Share (EPS) forecasts. Begrudgingly because they’d incorrectly forecast commodity prices at the start of the year and were then chasing their tails. This catch-up momentum created by broker upgrades was supported by supply cuts/disruptions enhancing resource sector performance – particularly in global coal markets. This is unlikely to occur again in 2017, so demand growth now needs to drive ongoing commodity price gains. China will be a critical driver of demand sentiment, as always. But the debt-fueled activity boost in early 2016 and yuan depreciation is unlikely to happen again in 2017.
- Improving iron ore demand in India (growth) and the US (fiscal stimulus) has helped. But iron ore demand in those countries pales into significance when compared with China, which consumes around 60% of global iron ore (66% of the seaborne market) and is almost 10 times larger than the next largest consumer (Japan).
- This rally in commodities, banks and selected cyclicals may continue early in 2017 at the expense of high P/E and/or small to mid-cap ‘quality’ companies and assets with bond-like exposures like infrastructure and AREITs. But this rally could be short-lived in the context of long-term investing. So, it is best to focus on ‘quality’ and sound fundamentals (e.g. long-term structural moves away from ‘dirty’ energy as opposed to the short-term spike in the coal price) rather than fall into the short-term focus of the herd. Often the most excitement about certain stocks and sectors occurs at their pricing high point.
- Companies with significant US$ revenues ought do well and we prefer large companies to small ones due to their international exposures.
- Overall, it still seems a climate of low-market returns, in the absence of strong, broadly-based earnings growth and limited scope for a sustained valuation re-rating (i.e. P/E’s). But the market can keep making steady gains in 2017, particularly if underpinned by a moderate economic growth which doesn’t accelerate such that tightening is needed.
- Longer-term, companies exposed to the highly indebted household sector, like retailers, property developers, REITs (ASX listed property) and banks, may confront a more challenging earnings environment as interest rates become less favourable.
- International Equities: This sector performed poorly in 2016 partly due to a rising US dollar but in 2017, positive earnings growth in the US and other large economies with a potentially weaker A$ could see this sector performing well. Favouring larger international constituents over emerging economies may still be wise for now, though not in the long run.
- Direct Real Estate: Rental yields are low and prices are stretched. Combined with apartment oversupply in some areas could make 2017 a lacklustre year. Recalling the early 1990’s, real estate office staffing has grown to about 6 times their recessionary size – an overheated scale that has become accepted as normal (though it is not). Overall, 2017 seems a good time to re balance out of this asset class to other sectors.
- Fixed Income: with international interest rates rising again, this sector is likely to do it tough. Credit and floating rate inflation-linked instruments should perform better than fixed rate issues.
- Cash: Term deposit rates may creep up a little late this year from rising inter-bank competition. Unfortunately deposit interest of 3% can’t sustain a 5% compulsory pension income drawing.
The cautious view: 2017 is potentially dangerous for investors with more than normal asset price volatility due to US uncertainties and higher geo-political risks.
- The Trump ‘honeymoon’ will eventually end
- Europe’s experiment will keep juggling its need for structural change
- Rising global interest rates will eventually put pressure on stock prices, probably pulling money out of emerging markets.
The optimistic view: The coming year should be better than last. Signs of US earnings growth, prevailing loose global monetary conditions, some healthy hints of inflation and two years of largely skeptical market sentiment leaves the potential for upside surprises.
Either way, it’s critical to focus on ‘Quality’ companies with good prospects for future earnings growth. Hence, we see merit of investing in industries with solid long-term fundamental drivers. Meanwhile beware of over investing in interest rate-sensitive assets like houses and rationalise your borrowings.
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Disclaimer: All information in this article is intended to be general in nature for discussion purposes only. So you should not rely on it and seek personalised professional advice before making any decision.