- We expect real GDP growth to average approximately 2.8% for 2017, with momentum likely building as the year progresses.
- Inflation is likely to remain weak during 2017, expected to average about 2.0%, with downward pressure continuing to come from anaemic wage price inflation which will likely remain below trend under 2.0%.
- Unemployment is likely to range between 5.5% and 6.0% as the domestic economy continues to transition away from the mining economy. We expect the participation rate to remain under pressure and the trend towards higher levels of part-time employment to persist.
- The Australian dollar is likely to continue to weaken against the U.S. dollar, particularly as the U.S. reprices benchmark rate expectations upwards. We expect the Australian dollar/U.S. dollar to trade between 0.70 to 0.75 for most of 2017, with the risk to the downside. This risk becomes more pronounced in the event Australia loses its AAA sovereign credit rating.
- We expect the domestic cash rate to remain at 1.50% during 2017, although a 25-basis point move down wouldn’t surprise, unlike any move up. In the U.S., we anticipate a benchmark federal-funds rate of about 1.25% to 1.50% by 2017’s year-end.
Challenges Remain, but Enough Tools in the Kit to Manage the Risks
- The transition away from the mining to the nonmining economy will continue, though a slowdown in the construction cycle could present a material risk to employment and spending.
- The risk of a sharp correction in housing is increasingly skewed towards apartments in Melbourne and Brisbane, though should this scenario eventuate, we would anticipate spillover to other cities and types of housing.
- A low cash rate environment with capacity for further cuts, a lower Australian dollar compared with previous years, a stable inflation environment, healthy population growth, and strong employment, should provide support to the domestic economy in the event of any negative surprises.
Government Bond Yields and Corporate Spreads to Move Higher
- We expect the 10-year Australian Government bond yield to maintain its long-time correlation with the U.S. 10-year bond yield and trend upwards towards 3.25%.
- Domestic issuer credit profiles should remain resilient, although funding costs are expected to increase, providing a headwind that hasn’t existed in several years. We prefer exposure to issuers with economic moats as a way of offsetting these risks.
- We expect corporate spreads to widen as credit conditions become less favourable relative to recent years. The Australian iTraxx Index, currently trading at about 105 basis points, is likely to end the year higher.
Banks
- Operating conditions will remain challenging with the outlook for earnings and dividend growth under pressure following recent weaker-than-expected economic news (GDP, building approvals, wages growth and credit growth). Economic risks are increasing and if the economy enters a sustained recession, bad debts will rise, profits will fall and dividends will be cut. But this is not our base case as we expect the economy to “muddle through” with 2.8% GDP growth likely.
- The urgency to raise large amounts of additional capital is abating, however, the Australian Prudential Regulation Authority is expected to announce tougher regulatory rules to ensure the major banks are “unquestionably strong.” Balance sheets are expected to remain well-capitalised with key metrics in the top quartile of global peers. We expect any further capital requirements to be satisfied organically and from dividend reinvestment plans.
- Australia’s political landscape has changed for the worse and we are increasingly cautious of the risks to the profitable banking oligopoly. The concerns stem from increased public and political scrutiny of the lenders and tougher regulatory oversight. Nevertheless, we believe the major banks’ pricing power will ensure return on equity is maintained above the cost of equity with recent loan repricing evidence the negative impact to NIMs can be managed.
- The major banks have attractive income yields relative to alternatives of cash, term deposits and investment-grade bonds. Fully franked dividend yields between 5.5% and 6.6% gross up to 7.8– 9.5%. All four major banks are trading close to our fair value estimates. In order of major bank preference, we like Westpac, Commonwealth Bank, National Australia Bank, and ANZ Bank.
Metals and Mining
- We don’t expect another strong year in 2017. Many commodities trade well above the marginal cost of production, notably copper, coal and iron ore. Coking coal is at peak China-boom prices.
- Relaxation of China’s 276 day working rule for coal mines in late 2016 will increase supply in the first half of 2017. We expect coal markets to normalise quite quickly, as with previous shocks, and forecast the coking coal price to fall to USD 120 per tonne by 2018, from USD 300 per tonne now.
- China’s demand is key. Its leading share of consumption means small demand changes have outsized impacts. We expect demand growth to soften in 2017 as China’s fiscal stimulus abates.
- Overcapacity and bad debt will force a rebalancing. State-owned enterprises have driven the recent fixed asset investment growth, which will exacerbate overcapacity and inefficient capital allocation.
- We expect iron ore prices to weaken in 2017 and 2018. China’s port stocks are near record highs.
- Inventory restocking added about 20 million tonnes to demand in 2016, but is unlikely to repeat.
- We are positive on gold’s outlook, tied to growing consumption in India and China.
