2017 Australian Equity Market Outlook
FOR SOPHISTICATED INVESTORS ONLY
By Brad Potter - Head of Australian Equities - 7 February 2017
Reflecting on 2016
At the start of 2016 it was difficult to envisage that, by the end of the year, iron ore prices would be up 86%, oil prices would be up 51%, the UK would be leaving the European Union and Donald Trump would be President of the United States.
The bond yield bubble that became unsustainably low, driven by unconventional global policy, has finally started to deflate. These low yields were distorting the price of yield-sensitive stocks, including low volatility sectors.
The litany of ‘fallen angels’ in 2016 feels unprecedented, however companies on unsustainably high earnings and trading on high multiples have often been a disaster waiting to happen.
Domestic economy 2016
A softening of business conditions and a slowing of the economy, particularly in the third quarter 2016, can be partly attributed to the impact of adverse weather conditions on the construction sector. The most recent business conditions survey rebounded strongly in December, reversing its multi-month slide, with it now sitting close to its highest level since 2008. Trading conditions are also now sitting at their equal highest level since 2007, while profitability also rose strongly. Business conditions improved across most industries during 2016, with the exception of retail and manufacturing, which recorded modest falls.
The strength in the domestic economy remains quite geographically biased, with NSW and Victoria strong and the mining states weaker, although they are much improved given recent commodity price rises, and volume increases from the commissioning of new liquefied natural gas and iron ore projects.
December credit growth surprised to the upside, with business credit expanding by 1.1%. The three- month annualised rate now sits at 9.4%, up from only 1.4% in August. Investor home loans are printing at a three-month annualised rate of over 9%, which is sitting close to APRA’s 10% cap. In contrast, owner-occupier loans are growing at their lowest pace in more than a year.
Geopolitical uncertainty remains
The current geopolitical uncertainty tends to feel like a dull, constant headache, given the market seems to have been consistently pricing in some type of geopolitical risk since the Global Financial Crisis in 2008-09. The current focus for the market is a new US President and the potential start of the formal Brexit process.
Policy uncertainty has taken a back seat to the view that the potential inflationary backdrop globally will be positive for equities. The market is still trying to come to grips with a Trump administration that does not act like a traditional government – particularly in its unusual daily rhetoric.
Europe needs to be carefully monitored in 2017, given the number of important elections, including France and Germany. A Marine Le Pen victory in the French presidential elections could have dire market implications, given the widely-held view that her government may initiate an EU breakup, which could trigger panic in European financial markets.
The iron ore paradox
The rally in iron ore in the first half of 2016 was driven primarily by a large re-stocking phase, based on confidence that China’s economy was doing okay. This compared to the pre-2016 view held by many, including iron ore and steel companies, that 2016 would be tough as steel consumption in China fell away. The rally in iron ore in the second half of 2016 was driven initially by the Chinese government implementing a 276 day (ie. no weekends) production rule on coal mines, which resulted in unintended shortages in both coking and thermal coal that pushed up prices of both substantially. As a result, steel mills, particularly the small producers, have been chasing imported high-grade iron ore on the spot market in order to reduce the consumption of coke in the blast furnaces. This drove up prices of high-grade iron ore, which was exacerbated by speculation on the Chinese commodity futures markets, often by retail investors. Iron ore has yet to correct, despite coking coal falling by nearly 50% from its peak.
Our recent visit to China, together with the ongoing rhetoric from its government, continues to suggest that China is committed to supply-side reforms, which may result in shutting down inefficient, ‘dirty’ production of steel, coal, aluminum and cement. The rise in steel prices in China is a reaction to the perceived shortages caused by these potential reforms. The logic that iron ore prices should also rise remains a mystery, when in fact a reduction in steel production should lead to less demand, and thus lower iron ore prices.
Our view is that iron ore should find a level in the first half of 2017 that is lower than current spot prices, given the combination of production increases from Australia and Brazil, and a likely longer-term reduction in demand from China, as it moves away from being dominated by fixed asset investment. The constant comments from Beijing regarding China’s desire to cut operational capacity in 2017, while attempting to achieve price stability in the steel and coal sectors, is also likely to put downward pressure on prices.
It has not been often over the past10 years that both ANZ and NAB have outperformed both Westpac and the Commonwealth Bank. This outperformance was significant (+10%) and was driven by one of those most powerful of market forces – value. ANZ and NAB became unsustainably cheap versus the market and their peers, resulting in a large re-rating that was helped by both banks embarking on programs to reverse past investments that have been problematic.
The well-known headwinds faced by Australian banks over the past few years are dissipating. Increased capital requirements are now largely priced in, with the rhetoric from regulators implying this process has been pushed out even further. Given the proposed and completed asset sales from ANZ, we expect it will need to initiate significant buy-backs, as it will have excess capital.
Asset quality deteriorated a little in 2016, due to a handful of single-name exposures, and we do not expect this will be repeated in 2017. Bad debts may be an area that the banks can surprise on the upside, given this is not captured in the market’s earnings forecasts.
The downward pressure on net interest margins (NIM) is receding, as competition for deposits has abated and investment mortgages have been materially repriced.
In early 2016, the banks looked as cheap as we have seen within our longer-term valuation process. The re-rating now places the banks as modestly attractive but with more upside in earnings. Outside of ANZ, which is seriously attacking costs, the other three have yet to look at costs in a different way, other than the age old process of keeping cost growth below revenue growth. Given revenue growth remains hard to generate, there is a massive opportunity for the banks to improve their bottom line through cutting costs and re-positioning their business for the new world.
Banks will be a beneficiary of rising global inflation, don’t look that expensive and arguably have earnings upside that the market appears not willing to reflect as yet – not to mention investors receiving a fully-franked yield approaching 6%.
Yield spread between debt and equity is likely to continue to drive M&A
The gap between earnings yield and debt yields remains wide and should encourage further M&A activity, as companies look to buy top-line growth. Globally, M&A was a feature of 2016 and Australia certainly participated, with this expected to continue in 2017. The expectation that interest rates have likely bottomed, and a more positive economic outlook, should prompt company boards to give the green light for further M&A.
In FY 2016, earnings-per-share growth declined by 11%, driven by a near on 50% decline in resources. The outlook for FY17 looks better, particularly the mining sector, which is coming off a very low base but should largely be reflected in share prices. The Australian market ex-resources is forecast to grow earnings by 4.9% in FY17, and 6% in FY18. The aggregate earnings growth in FY17 is expected to be 17%, primarily due to the expected 82% growth in resources.
The confession season has been relentless since the AGM period in October/November 2016, with a number of downgrades, particularly at the small to mid-cap end. It seems rare for IPO stocks of the last few years to not be announcing downgrades. We tend to have a pathological aversion to IPOs from private equity, given the information disadvantage that is typically on offer.
Snap back to value
We highlighted during 2016 the huge differential in pricing between ‘value’ stocks and the ‘quality’ low volatility stocks and growth stocks. The defensive bull market that saw the ‘safe’ companies and secular growth stocks rally to unsustainable highs essentially ended in August 2016. This rally appeared to be unprecedented in both magnitude and duration. Multiples of these stocks have compressed significantly since then, as rising interest rates and an improving global growth outlook acted as the catalyst for bursting the bubble. The litany of large earnings disappointments that saw some ‘market darlings’ become ‘fallen angels’ also helped to exacerbate this fall.
The re-rating of low PE stocks, which include many industrial cyclicals, now see the aggregate PEs much closer to long-term averages. However, we believe that the initial re-rating that has been driven by the large value differential will be replaced by earnings growth, helped along by rising global inflation that is supported by strengthening macro data and improving earnings expectations. The market traditionally underestimates the earnings leverage, both on the downside and the upside, and this should drive the outperformance of these stocks for quite a while yet.
The Australian market has seen quite a large rotation away from defensive and bond-sensitive stocks towards the cyclical and value end. Our view is that this correction still has some way to go, given the extent of the bubble, and should be driven by rising global inflation, and therefore earnings growth in the more economically-sensitive sectors.
The valuation dispersion between the cheap stocks and expensive stocks has come in considerably, suggesting stock picking may become more difficult.
We enjoy this environment, as it plays to our strengths of detailed, disciplined and extensive research to identify those stocks that look cheap on long-term sustainable earnings.
The current market PE appears relatively high, based on the average of the past 20 years of low inflation, but it has not moved over the last few months with the EPS upgrades, although it has been skewed by resources.
Based purely on the combination of the market dividend yield of 4.5% and EPS growth of high single digits, it is not unreasonable to expect a 12-15% total return in the Australian share market for 2017.
Our expectation is that the market return will be driven by the ongoing rotation that commenced in August 2016. The risks to this view are geopolitical volatility and more muted earnings growth, which could both provide obvious headwinds.
This material was prepared and issued by Nikko AM Limited ABN 99 003 376 252, AFSL 237563 (NAML). Nikko AM Limited is part of the Nikko AM Group. The information contained in this material is of a general nature only and does not constitute personal advice, nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives, and does not take into account the objectives, financial situation or needs of any individual. The information in this material has been prepared from what is considered to be reliable information, but the accuracy and integrity of the information is not guaranteed. Figures, charts, opinions and other data, including statistics, in this material are current as at the date of publication, unless stated otherwise. Past performance is not an indicator of future performance. Any references to particular securities or sectors are for illustrative purposes only and are as at the date of publication of this material. This is not a recommendation in relation to any named securities or sectors and no warranty or guarantee is provided.