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The Outlook For 2017: Australia

Feature Stories | Dec 22 2016

This story was originally published on 13th December 2016. It has now been re-published to make it available to a wider audience.

Equity strategists and economists provide their views and forecasts for the Australian economy and stock market in 2017.

– Stronger economic growth in 2017-18
– Mining capex decline eases, LNG exports grow
– housing cools, AUD falls
– ASX200 bias to the upside

By Greg Peel

Strategists agree on at least one thing in their outlooks for 2017 – it will be a potentially more volatile year than 2016. That’s not particularly comforting for investors given the volatility experienced throughout the year now coming to a close.

So began the sister piece to this article, published last week: Outlook For 2017: International.

Trump has promised much but must now deliver, and therein lies a risk. If 2016 was the year of Brexit, there is no reason not to believe 2017 might be the year the European Union really does begin to fall apart. The Chinese government is very much in control of metals and minerals prices through its supply-side policies, while the supply side for oil is very much in the hands of OPEC.

These are all outside factors the Australian market cannot control. But they are also factors that cannot be expected or in any way incorporated into forecasts. It is with this in mind we must consider what Australian economists and equity strategists foresee as the path for the country, and its stock market, in 2017.

There is one element we can likely assume, and it harks back to the lead-up to the US presidential election. Back then, even the staunchest of Republicans – and Wall Street is awash with them – were praying for a Clinton victory, with the caveat being a Republican-led Congress. This would ensure the administration could achieve very little in policy terms, and the legislative gridlock that hamstrung Obama’s second term would continue.

There would be thus no bombshells from the government.

The situation is Australia is similar, if not worse. The centrist prime minister has to battle first with the Tea Party within his own camp before he even gets to the box of liquorice all-sorts we call the Senate. Policy bombshells? Highly unlikely. Unless there’s yet another coup.

So unlike the US, we can assume no great dose of fiscal stimulus from the federal government. We’d lose our AAA rating anyway, which allows us to borrow cheaply, amidst an historically low interest rate environment, so we can’t borrow, because then we wouldn’t be able to borrow cheaply.

Um…

And of course, it is beholden upon any government to return the budget to surplus, no matter how many bodies it has to crawl over to do so. Surplus is a pipedream in America. In 2011, the US subsequently lost its AAA rating, therefore we have a gauge as to the disaster that would follow were Australia to suffer the same fate.

The US stock market has doubled in the meantime. The AAA-rated Australia stock market is still trading at the same level it was eight years ago.

The Australian state governments will, nevertheless, provide their own stimulus boosts through infrastructure projects, helping to counter the ongoing unwind of private sector (mining) investment. But beyond that, the Australian economy will be on its own outside of RBA support, and the performance of the stock market in 2017 will be a reflection thereof.

Notwithstanding aforementioned offshore risks.

The Economy

The Australian economy shrank by 0.5% in the September quarter, its worst quarterly performance since the GFC. The annual rate of growth slowed to 1.8% from 3.3% in the June quarter. The weak September result was a bit of a surprise, but then so was the strong June result.

When economists were setting the economic forecasts published in this article, the September quarter result was unknown.

For those who like to believe a “recession” is strictly defined by two quarters of negative growth, there is no need to panic. The commodity price time lag should ensure a return to growth in the December quarter. Indeed, consensus among economists is that 2017 will be a better year for the Australian economy than 2016.

The RBA is forecasting growth of 3.0% in 2017 and 3.2% in 2018. The economists at the Commonwealth Bank have set forecasts a little lower at 2.8% and 2.9%.

Positive contributors to growth next year, CBA believes, will be net exports (that’s your commodity price lag), public investment (from the states), household consumption and dwelling investment. The contribution of dwelling investment will nevertheless be minimal given the construction cycle is now reaching a peak.

Once again the Australian economy will need to battle the headwind of falling resource sector investment. That’s the bad news. But the good news that on the RBA’s calculation, that investment unwind is now about 80% complete. The lingering tail mostly represents the big CSG and offshore LNG projects across the country which are still reaching completion. And when complete, LNG will soon rise to overtake iron ore as the country’s greatest export commodity, providing a significant contribution to growth.

What only now appears to be making headlines is the negative impact Australia’s LNG boom will have on the economy. Being about the only country in the world not to have domestic energy quarantine laws, Australian households and businesses will have to pay whatever the Chinese are prepared to pay for our own gas. Already we have seen large factories unable to secure future gas supply at commercially viable prices, therefore forcing a decision whether or not to shut down and retrench workers.

While CBA is not as quite as optimistic as the RBA regarding economic growth, the economists do believe the central bank’s inflation expectations are too low. The RBA says slightly below the 2-3% target range, CBA is forecasting 2.0% in 2017 and 2.4% in 2018. But the economists do admit they might be proven wrong by weak wage growth. There’s still plenty of spare capacity in the labour market.

Nevertheless, CBA believes the RBA easing cycle has come to an end. The current 1.50% cash rate will be the bottom. The economists have not suggested when any tightening cycle might begin.

The UBS economists have. They, too, believe we’re are the bottom, but that the current rate will prevail all the way through to late 2018, when the first hike will take us to 1.75%. UBS does not see inflation returning to within the RBA’s 2-3% target band before early 2018.

UBS is forecasting 3.0% GDP growth in 2017, falling back to 2.8% in 2018. The fall-back represents both a reversal of the housing construction cycle and a fade-off of public infrastructure investment. The stronger 2017 forecast represents an easing of the headwinds of the past few years, most notably commodity price falls.

Nominal GDP growth (real GDP plus inflation) is forecast to rise to 5.5% in 2017, representing the fastest pace of growth since 2011. This strong growth rate will aid fiscal trends, UBS notes, and corporate profits, and take the pressure off the RBA.

Ord Minnett’s economists are also forecasting 3.0% real GDP growth in 2017. The supporting themes are familiar – an ultimate easing in the long running decline in mining investment and increasing LNG exports. Ords also gives a nod to the non-mining economy.

The non-mining economy has been gradually improving since 2013, the economists note, since the Aussie dollar peaked. Services activity has since grown strongly and the more labour-intensive output of such sectors has supported employment growth. Ords expects the “pillars” of this recovery to remain broadly in place.

Ords nevertheless expects the “shock” of low inflation witnessed in 2016 to persist into 2017. To that end, the economists do not see 1.50% as the bottom of the RBA cash rate cycle. They see a bottom at 1.00% in mid-2017.

Macquarie’s economists concur. They see the focal point for the cash rate as being the labour market and the Aussie exchange rate. A supportive Aussie (ie lower) is needed to keep the labour market healthy.

Macquarie is forecasting 2.8% GDP growth in 2017 and 3.1% in 2018, for all the same reasons as everyone else. Macquarie does nevertheless make the point of suggesting the non-mining investment upswing, public and private, will broaden beyond NSW. It will be a tale of two halves however, with consolidation from the slowdown being witnessed in the second half of this year giving way to growth in the second half of next year.

While commodity export growth is fundamental to Macquarie’s forecasts, so too is population growth. Fiscal consolidation (gotta have a surplus) and a continued delay in a hoped for upswing in non-mining investment are key drags. The economists expect the consumer to start 2017 slowly and the housing upswing to level off. A better public investment profile provides an important offset.

Macquarie is forecasting only 5.2% nominal GDP growth in 2017 compared to UBS’ 5.5%, but this would still represent the fastest pace since 2011. The economists nevertheless warn a stronger Aussie, thanks to stronger commodity prices, may hamper the economy’s rebalancing.

Morgan Stanley expects stronger global growth in 2017 (see link above). Firmer global growth and a Fed tightening cycle does some of the RBA’s work for it but the MS economists still see one final RBA rate cut to 1.25% in the third quarter next year, on labour and housing market concerns.

They suggest the last cut will lead the Aussie down to US63c by early 2018.

The Stock Market

Morgan Stanley is forecasting net 6% earnings growth for ASX200 companies in 2017. Applying an assumed price/earnings multiple of 14.5x, or close to long-run average, provides a year-end index target of 5450.

In other words, where it is right now, give or take. Modest positive returns will nevertheless be provided by a forecast 5% dividend yield on top of little to no capital gain.

The MS strategists cannot see any reason for another year of PE multiple expansion. Given little in the way of earnings growth prospects for the banks (the Big Four represent about a quarter of index market cap) and ongoing pressure on industrial earnings, a range-bound market is seen ahead. Upside risk could be provided by greater fiscal stimulus, and downside risk from a sharper housing market correction.

Morgan Stanley retains an Overweight on resources, likes global earners that will benefit from the weaker Aussie, and remains cautious over so-called “bond proxies”, being high-yield defensive plays.

Macquarie is forecasting 10% earnings growth for the ASX200, and has set an end-2017 index target of 5875. Australian corporates are now very ‘lean”, the strategists note, after years of debt reduction and cost cutting. This is expected finally to pay off beginning in 2017. Consensus expectations for consumer cyclical stocks remain too pessimistic, Macquarie believes, while resources and capex-related stocks offer upside earnings risk.

On a 16x one-year forward  PE, the market is not expensive, the strategists suggest, but if 2016 has taught us anything it’s that high PE stocks require “bulletproof growth” or low interest rates to “paper over the cracks”. Low rates are not coming back.

That said, Macquarie points to history in noting the beginning of a Fed tightening cycle does not prove to be a drag on equities. The strategists are somewhat lonely among peers in being quite positive on the banks, believing them to be a low risk, high expansion story. Energy is seen as a high risk, low expansion story. The banks are the go-to for those chasing yield, Macquarie recommends, rather than telcos.

Rate sensitive stocks (high yielders) offer neither earnings upside not valuation support, Macquarie suggests. The strategists prefer cyclical sectors for which consensus is betting the drags of the past few years remain.

Macquarie’s top picks for 2017 are Aristocrat Leisure ((ALL)), BHP Billiton ((BHP)), Incitec Pivot ((IPL)), Link Administration ((LNK)) and Qantas ((QAN)).

Like Macquarie, Credit Suisse is forecasting 10% earnings growth for the index. But CS is assuming a higher PE multiple and as such has set an index target of 6000. ASX200 profits should rise for the first time in three years. What this means is that profit growth will become less scarce, as has been the case in recent times, and therefore companies with solid growth profiles will no longer attract PE multiples as high as they have been.

Lowly valued companies are the ones set to benefit, Credit Suisse believes, and they include BlueScope Steel ((BSL)), Caltex ((CTX)), Henderson Group ((HGG)), Metcash ((MTS)), Myer ((MYR)) and Suncorp ((SUN)).

As US bond yields push higher, the global search for yield will ease, Credit Suisse suggests, and the focus will switch to the prospect of dividend growth rather than today’s dividend yield. On this basis, CS likes ANZ Bank ((ANZ)), Eclipx ((ECX)), Fletcher Building ((FBU)), Lend Lease ((LLC)), and Wesfarmers ((WES)).

Of course, the Australian stock market is not immune from The Donald. We can thus close this article where we opened – with the prospect of Trump risk.

What if US economic growth does rise to 3-4% from a current 1.5-2%, the US corporate tax rate does drop to 15% from 35%, the US ten-year yield does rise to, say, 2.75% (and 3% in Australia) and the Aussie does drop to, say, US70c? Which Australian stocks would benefit?

Deutsche Bank has pondered the question and decided stronger US growth is best for Treasury Wine Estates ((TWE)), Flight Centre ((FLT)) and Aristocrat Leisure.

A lower US tax rate would be most helpful for Aristocrat, News Corp ((NWS)), James Hardie ((JHX)), Brambles ((BXB)), Incitec Pivot and Orora ((ORA)).

A lower Aussie dollar would be particularly beneficial for Incitec, Aristocrat, Macquarie Group ((MQG)), Comptershare ((CPU)) and QBE Insurance ((QBE)).

Higher US bond yields would be positive for Computershare and QBE and bad for Australian infrastructure stocks.

The chances of all of this coming together smoothly are not that strong, Deutsche warns. It’s hard to envisage, for one, the corporate tax rate coming down that fast. It is unlikely US interest rates will rise as quickly or seamlessly. But is does seem the direction for US growth is up.

Deutsche’s model portfolio thus contains Amcor ((AMC)), Incitec, Aristocrat and Macquarie Group and is Overweight miners.

 

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