2016 was an exciting year for the Australian equities market due to the combination of volatility and uncertainty. Broader market performances were below those experienced in the 2010–2014 period. Total returns, measured by the S&P/ASX 200 Accumulation Index to 14 December, was still a respectable 9.5%. The Australian economy performed relatively well, as east coast building and construction activity, mainly in the residential sector, helped offset the impact of sharply falling resources investment in Western Australian and Queensland. Major infrastructure spending led by New South Wales added to the east coast bias. External factors, including the 25% fall in the Chinese stock market in January, upheaval surrounding the Brexit vote in June, and the Trump victory in the November U.S. Presidential election also influenced markets, causing bouts of volatility.
Key Takeaways from 2016
- In our Outlook Forecast 2016, we anticipated volatility would undermine investor confidence with the S&P/ASX 200 trading in a range between 5,000 and 5,800. We suspected the commodities drag would be less intense but the recovery in iron ore and coal prices surprised, particularly in the final quarter of 2016. Metals and mining and materials sectors meaningfully outperformed the market, and were back to where they were in May 2015—an almost perfect V formation.
- In July, just after the Brexit vote, we trimmed the top end of our benchmark target noting the upper end forecast for the S&P/ASX 200 of 5,800 was going to be a stretch. We thought without the major banks at least holding their ground, the 5,800 task would be even more difficult. We argued a credit rating downgrade would probably seal the market’s fate for 2016 due to the negative implications for the banks. We expected earnings of the non-resources sector to remain subdued in second-half 2016 and consequently reduced our upper end S&P/ASX 200 forecast to 5,500.
- Looking to 2017, we are living in a higher risk world. Risk-on investments have performed strongly since the Trump victory, as investors flocked to resources and cyclical sectors believing Trump’s proposals to lift economic growth and inflation will deliver and “Make America Great Again.” A vibrant and growing U.S. economy would be good for the world economy. These sectors are now crowded trades. Investors deserted bonds and bond-proxies – REITs, infrastructure and utilities. These are now uncrowded trades.
- In a higher risk environment, prudent investors should reduce their risk profile, not increase it. The higher risk environment reflects potential elevated volatility, actual or perceived. To reduce risk, investors should reduce their exposure to volatility. Volatility tends to be higher in crowded rather than uncrowded trades. Hedge funds will ensure volatility continues to test investor nerves and patience.
Looking towards 2017
The new year shapes as another one dogged by volatility. Offshore factors will impact on domestic markets while Australia’s own issues, political and fiscal, will provide its own undercurrent.
Valuations are stretched, reflected in elevated price/earnings multiples and lower earnings yields. Thanks to surging bond yields, which set the “risk-free” rate, the equity risk premium—the gap between the earnings yield and the risk-free rate—has narrowed. The equity risk is in fact much higher than the market is currently pricing. The margin of safety is lower and risk higher. Tread carefully.
The strong performance of global equities markets since Trump’s win sees all major U.S. indices at all-time highs. The higher they go, the greater the potential disappointment in 2017. U.S. markets are priced for little to go wrong to derail the Trump express. We know it is an unlikely scenario.
The first year of the Trump administration promises much but realistically there will be disappointments. The markets have already factored in much success. Europe is a potential cauldron with elections in the largest and second-largest member countries of the European Union.
There is more upside in global equity markets in the short term, with positive momentum as the driving force. However, we believe there is greater downside risk thereafter. Markets are expected to peak in the first half. As the Trump honeymoon fades and reality returns, expect markets to re-trace, perhaps meaningfully. Global debt remains a meaningful headwind. Estimates suggest global private debt or bank credit around USD 90 trillion. The fragile state of the global economy as measured by excessive debt is reflected in the Bank of International Settlements statistics relating to total bank credit and GDP. Three countries, China, Canada and Australia top the list with total credit over 200% of individual GDP at 31 March 2016. The U.S. sits at 150%. U.S. Senate Majority Leader Mitch McConnell thinks “this level of national debt is dangerous and unacceptable.”
In terms of global equities markets, our bull case sees the S&P 500 reaching 2,600, a 15% increase from current levels. This would require everything to go right with no problems in the implementation of quite dramatic policy changes. We rate chances at 20%. The base case is the S&P 500 at 2,350, a more sedate increase, before retracing. We rate chances at 50%. The bear case sees the S&P 500 touching 1,750 as policy fails to deliver, infrastructure spending gets bogged down, a trade war and escalated protectionism with both China and the eurozone unfolds and inflation spooks bond markets. We rate the chance at 30%.
For the Australian market, the bull case sees the S&P/ASX 200 Index around 6,000 with the base case 5,600 and the bear case 4,800. We rate the chances as like those for the S&P 500.
The U.S. – All Eyes on Trump
After eight years of monetary stimulus which failed to generate satisfactory economic growth and reignite inflation, Donald Trump will unleash significant fiscal stimulus to “Make America Great Again.” With little spare capacity in the economy, the implementation of the policy is certain to drive inflation toward the top end and possibly through the Fed’s 2% target range. Having only tightened twice in more than eight years, and with inflation outside their comfort zone, could the Federal Open Market Committee, or FOMC, become unpredictable? Fed speak may take a back seat. Recall the words of Paul Volcker, one of the best chairman of the board of governors of the Fed, who said “inevitably, you will end low interest rates too soon or not soon enough. If you worry too much about ending them too soon, it’s too late. The easy part is easing; the hard part is tightening.” Janet Yellen will find out how hard in 2017.
Eurozone – Another Battleground?
After the surprise of Brexit in June 2016 and the “No” vote in the Italian Referendum, many nervously await 2017. What is on the radar? Will the dominoes continue to fall? The Netherlands has a general election in March. France chooses a new president in May. Later in 2017, Germany goes to the polls with Angela Merkel seeking a fourth term.
The anti-elitist movements that delivered Brexit and a Donald Trump presidency are at work throughout Europe. There is little doubt the EU and possibly the euro are under increasing threat.
The European Central Bank has extended the quantitative easing program. Some suggested the reduction in monthly asset purchases from EUR 80 billion per month to EUR 60 billion per month from March is a taper. But the program was supposed to end in March 2017. It has been extended to December adding another EUR 540 billion—not much when said quickly! Continued easing while the Fed is tightening should drive the euro lower—probably to parity against the U.S. dollar and stimulate a strong export response, particularly if the U.S. economy moves into third gear. What will be the response of the Trump administration to EU imports? Surely there won’t be a departure tax on Americans wishing to visit cheaper climes? Developments across the eurozone are a wildcard for 2017.
China – Reform and Restructure Rather Than More Fiscal Stimulus?
The fiscal stimulus of early 2016 caught most by surprise and ignited the commodity price recovery. Inventory restocking and supply disruptions in Brazil and Australia exacerbated the situation in iron ore and coal. China is on track to achieve GDP growth just above 6% for 2016 and 2017 is likely to be similar. Positive purchasing manager indexes and recent data on industrial production, fixed asset investment and retail sales indicate a solid finish to 2016. In the 11 months to November, fixed asset investment was up 8.3%, driven by a 20.2% increase by state-owned enterprises and just 3.1% by the private sector.
Despite a slight slowdown in economic growth, a hard landing is unlikely, unless the debt situation implodes. The fallout would be significant globally and for China. However, the means of achieving growth is likely to change with more focus on reform and restructuring and less on fiscal stimulus driving infrastructure and construction. More attention will be given to the now more important services sector, which represents 55% of China’s GDP. Consequently, the impetus provided to commodity prices in 2016 is unlikely to repeat.
Further restructuring and merger activity among state owned enterprises is likely to lift efficiency. The recent merger of Baosteel Group and Wuhan Iron and Steel is the pathway to a more efficient Chinese manufacturing sector by addressing chronic overcapacity in many industries while creating fewer but more profitable enterprises. Chinese steel mills lifted monthly production by 5% in November, the fastest growth since June 2014. Despite significantly higher iron ore and coking coal prices, margins remain attractive as steel prices also increase. For the 11 months to November, production was up 1.1% to 739 million tonnes.
