Key themes for 2017
In this report, we have outlined key themes which we believe are likely to impact markets in 2017. Much like 2016, politics is again expected to play a role in the direction of global markets, with key countries in Europe heading to the polls. President Trump’s policies will start to take shape during his first year as president and this will no doubt create both opportunities and pitfalls for investors.
Key European countries go to the polls. We expect politics to again be a key driver of economics and markets in 2017, as election in key European economies could be major catalysts for global markets. Populist and protectionist social and economic policies are likely to be again at the centre of the following key elections – the Netherlands, France and Germany.
Trump economics. Trump’s election to the White House will likely throw several (disruptive) surprises during his first year and term as president. In our discussion, we outline how “Trumponomics” will likely impact key parts of the markets including global interest rates, infrastructure spend and the oil and gas industry.
Global reflation. President Trump’s election and inflationary policies have moved the needle on inflation expectations. In our view, the days of ultra-low inflation are unlikely to repeat. The devaluing of respective domestic currencies against the US dollar (which will be higher as a result of higher US rates and growth outlook) will accelerate price growth at home, as higher prices will likely be passed onto consumers.
Iron ore & coal prices unlikely to repeat their 2016 stellar run. We see downside risk to iron ore and coal prices in 2017 based on: (1) imminent low-cost new supply in iron ore; (2) destocking at Chinese ports; (3) potential disruption from protectionist policies (resulting in reduced Chinese steel exports); (4) unwinding of speculative trading; and (5) unwinding of Chinese government policies (i.e. reducing mining days per week). Further, it is also worth highlighting the price direction in commodities markets as a whole will also have an impact on global inflation.
Emerging markets’ (EM) performance to improve. EM’s recent performance has been sluggish, although EM markets have rallied from their January 2016 lows. We see improved performance in the coming year on the back of steady Chinese growth, improved earnings growth outlook and higher US growth should also be positive for the world including emerging markets.
Key picks for 2017. Our key picks for the next 12 months are ACX, GXY, HSO, QBE, NEC. Within these key picks, Aconex (ACX) represents the global growth story, Galaxy Resources (GXY) the thematic idea and Nine Entertainment (NEC) the contrarian view.
Key Global Themes for 2017
In the section below we have outlined key themes which are likely to have a material impact on global markets during 2017.
Disruptive politics – European elections 2017. We expect politics to again be a key driver of economics and markets in 2017 as elections in key European economies could be major catalysts for global markets. Populist and protectionist social and economic policies will likely dominate these elections:
The Netherlands (4% of EU GDP). The country goes to the polls in the general election on 15 March, with the far-right Freedom Party’s leader Geert Wilders looking to emulate Trump’s performance. The polls are showing a healthy support for Geert, who is supportive of calling a referendum on leaving the EU and anti-immigration.
France (14% of EU GDP). France was the target of a number of terrorist attacks in 2016 and is the most likely candidate to take a turn towards far-right, protectionist parties in its presidential vote in May 2017. Marine Le Pen, a far-right leader and an ally of Geert Wilders, wants to get rid of the euro currency and is also seeking a referendum on whether to leave the European Union. If France was to leave the union that could almost certainly mark the end for the European Union, given France was one of the founding nations.
Germany (20% of EU GDP). Germany is expected to hold its election by October 2017 (as required by German laws), with anti-immigration sentiment also on the rise post the Christmas market terror act in Berlin. While Angela Merkel remains a well-respected figure, a lot can change in 10 months.
Italy (11% of EU GDP). Whilst the Eurozone’s third largest economy does not officially have an election pencilled in for 2017 many political analysts are not ruling out the chance of a snap election. The current President Sergio Mattarella has until May 2018 to call an election, however, most parties, including anti-establishment ones, are constantly calling for an earlier election as the country battles with a banking system on a brink and migrant problems.
Figure 1: Split of 2015 nominal GDP in the EU
Trump’s election to the White House will likely throw several (disruptive) surprises during his first year and term as president. In the discussion below we outline how Trump economics will likely impact key parts of the markets.
The US Fed changes it rate hike path. One of the most notable impacts of Trump’s election was the market’s outlook on inflation and therefore, the course of rate hikes in the US (which invariably also set the directional tone of global rates). While the Fed hike in December was expected, of notable change was the path of rate hike the Fed set out in its Summary of Economic Projections (SEP). Interestingly, by and large, the Fed’s outlook for GDP growth and unemployment was unchanged. But the Fed now expects three interest rate hikes (previously two) in 2017, 2018 and 2019. However, bond traders continue to price in two hikes (previously one) in 2017. The divergence in view and how it plays out is likely to impact markets over the course of 2017, with bond markets likely to be more affected than equities.
Infrastructure spend and capital expenditure. President Trump has an aggressive infrastructure spend agenda intended to drive US jobs. However, he may come across opposition from within his own party over measures which lead to a significant widening of the budget deficit. Nonetheless, the policy will have a positive impact on industrial materials (cement, steel) and machinery sectors. Further, President Trump’s policies also include significant tax rebates for capital expenditure (plant and equipment), which may encourage corporates to bring forward capital expenditure spending to claim tax offsets. It is worth pointing out that sectors which are positively leveraged to this thematic have already seen a significant bounce in the share price, as measured by key industry ETFs.
Figure 2: US steel sector ETF Figure 3: US materials sector ETF
Oil & Gas sector. The US remains one of the largest consumers of oil and therefore should President Trump’s economic policies lead to GDP growth of 3-4% p.a. or even come close to it, it should result in demand for oil to accelerate. While your typically larger global oil companies will benefit from this, it should also have a positive flow on impact on explorers, drilling companies, logistic providers and O&G-related machine manufacturing equities.
Figure 4: US oil services ETF
Source: VanEck Vectors, Bloomberg
In the short term, this is likely to be supportive for the oil price to continue to trend higher, as the proposed OPEC cuts also assist in keeping a lid on supply. However, our expectations remain of oil prices to be in the range of US$60-70/bbl, as higher oil prices will also see US oil producers ramp up production. President Trump has explicitly stated that he wants to tap America’s US$50 trillion shale oil and gas reserve and coal reserves – “onshore leasing of federal lands, eliminate moratorium on coal leasing and open shale energy deposits”. Since 2014, US crude oil production has been on a decline. However, recent US oil rig count data, a key leading indicator of future activity, suggests activity will likely pick up as oil price stabilises. Therefore, we expect there to be a ceiling on global oil prices around US$70/bbl, as any acceleration in US demand should be met with ample supply over the long term.
Figure 5: US crude oil production (mbpd) Figure 6: US oil-rig count
Source: EIA, Bloomberg Source: Baker Hughes, Bloomberg
Discussion around inflation no doubt will again heavily feature in markets in 2017. Many are asking the question whether we are at the inflection point, given where inflation is around the world. President Trump’s election and inflationary policies have moved the needle on inflation expectations. In our view, we believe the days of ultra-low inflation are probably unlikely to repeat. With employment on a steady footing in the US, the proposed cuts to US tax rates and substantially higher government spending will drive interest rates in the US higher, along with the dollar against all major currencies. The devaluing of respective domestic currencies against the US dollar will accelerate price growth at home, as higher prices will likely be passed onto consumers. Price growth will also depend on competition, regulatory rules and technological advancements, which could constrain the overall rise in inflation.
Figure 7: US 10-Yr yield Figure 8: Australian 10-Yr Yield
Source: Bloomberg Source: Bloomberg
Coal & iron ore prices to retreat in 2017
The movement in iron ore and coal prices surprised on the upside in 2016, driven by increased production at Chinese steel mills (in response to higher prices) drove demand for iron ore and metallurgical coal. Further, metallurgical coal prices were also assisted by Chinese government’s restrictions on mining days as well as supply disruptions (e.g. floods in China). However, we see downward pressure on iron and coal prices in 2017 based on: (1) imminent low-cost new supply in iron ore; (2) destocking at Chinese ports; (3) potential disruption from protectionist policies (resulting in reduced Chinese steel exports); and (4) unwinding of speculative trading. The world’s three largest iron ore producers – Vale, BHP Billiton and Rio Tinto – are expected to contribute 250 million tonnes of new iron ore supply through to 2018. To put the supply & demand equation in some perspective, as the basic model in figure 10 below illustrates, only a bull case of 2.0% p.a. growth in demand (that is, China’s property market continues to run hot) would result in a supply deficit by 2020.
Figure 9: Global seaborne iron ore supply/demand model
However, we note the March quarter historically has been seasonally strong for iron ore prices which may see price support in the early part of the year. With respect to coal prices, the most prominent impact on price in 2016 was the Chinese policy on production (i.e. reducing the number of operating days for mines). These measures are expected to be relaxed in 2017.
Emerging markets to see improved performance
Emerging Markets’s (EM) recent performance has been sluggish, as measured by the performance of the iShare EM ETF, although EM markets have rallied from their January 2016 lows. We see improved performance in the coming year on the back of steady Chinese growth, improved earnings growth outlook and are of the view that higher US growth should be positive for the world including emerging markets (higher US dollar should make EM exports attractive).
Figure 10: iShares Emerging Market ETF
Source: iShares, Bloomberg
Emerging markets were sold off on the back of the US election result, as a rising US dollar and interest rates are viewed as a negative for emerging market equities (that is, rising borrowing costs and increased cost of commodities). However, figure 11 below illustrates, rising US rates have not always spelt doom and gloom for emerging markets.
Source: Franklin Templeton, FactSet, MSCI
European equities to close the gap on the US
Despite several downside risk catalysts for the Eurozone in 2017 (elections plus Brexit discussions), we believe the area represents better relative value to the US markets (and relative to other EM markets as well). PMI and inflation expectations continue to improve in the region, which may see a rotation out of bonds into equities. Further, should the Brexit discussions indicate a more “not as bad as initially thought” environment, this will no doubt lead to a positive re-rating of European markets.
Figure 12: Relative valuation – European versus US equities
Portfolio Positioning for 2017
Banks to sustain their dividends
APRA is likely to be in a consultative mode for most of 2017 given the Basel Committee on Banking Supervision has delayed the release of its most recent guidelines on how to best standardise the definition of risk weighted assets across global banks. The delay could indicate that the banking authority is perhaps looking at less onerous guidelines. We believe Australian banks remain well capitalised and the new guidelines are likely to be less restrictive than what the market may be anticipating.
Taking a selective approach to bond-proxies
The pro-cyclical rally, along with rising global bond yields, in 2016 saw a sell-off in the domestic bond-proxies – Sydney Airport (SYD), Transurban (TCL), REITs and utilities etc. However, we remain of the view, that a selective approach to investing in “bond-proxies” is still warranted, especially where the underlying company is expected to deliver attractive earnings & dividends growth.
Oil & Gas should be well supported in 2017
Commentary out of the key OPEC jurisdictions suggests the proposed agreement to curb production will be sustainable. The oil price is likely to be stable at current levels. However, the early (i.e. easy) gains have passed as a further spike in oil price is likely to be constrained by increased production in the US. Consensus is estimating 2017 WTI oil price of US$55.24/bl versus current spot price of US$53.01/bl.
Pro-cyclical rally should be supportive of deep value
In our view, investors should consider looking at stocks at the lower end of the valuation spectrum given the marginal buyer (investor) is significantly underweight in these stocks. Should pro-cyclical rally continue, we see the deep discount these stocks are currently trading at reduce.
USD-earners to benefit from Trump’s policies
With diverging economic prosperity between Australia and the US, we may see the AUD/USD come under additional pressure and test the 0.70 level (versus current 0.73). Stocks which are highly leveraged to a falling Australian dollar will see market support. However, investors need to be cautious as these USD-earners also derive revenue/earnings from other parts of the world, where a rising US dollar against domestic currencies will have a negative impact.
Our view is based on the fact that the Australian housing construction has peaked its current cycle and there may be downside risk. We expect the banks to benefit from rising global interest rates and less onerous regulatory guidelines to come from the latest Basel meetings. The attractive dividend yields in a low interest rate environment should also provide the sector some valuation support.
We see competitive pressures and therefore subdued insurance premium growth for the industry. Our specific call on QBE is around a falling AUD and significant leverage to rising rates in the US.
Real Estate (Underweight)
Valuations in the REITs sector have come back recently and could see further downside if global interest rates continue to rise. However, given the low interest environment, the sector should see some support. Within the sector, we remain attracted to the aged care sector, leverage to domestic non-resi construction and offshore exposure.
Consumer Discretionary (Neutral)
We remain buoyant on domestic consumption spending, with low mortgage payments (due to low interest rates) leaving more in the consumer wallet. We retain our negative view on traditional retailers and instead seek exposure through companies with clearly identifiable catalysts and value proposition to drive earnings.
We prefer stocks which are not entirely hostage to the business cycle and offer leverage to offshore earnings, company specific catalysts, emerging market exposure and structural disruptors.
Telcos, Utilities (Overweight)
We have retained our overweight position based on stock specific calls, as well as a hedge against potential downside from President Trump unable to deliver on his lofty promises. However, we have reduced the size of our overweight position.
Global earnings, which are largely defensive and strong balance sheets to carry out capital management initiatives, will see the sector well supported. However, we have reduced the size of our overweight position.
Consumer Staples (Overweight)
We appreciate the threat of strong competition within the groceries channel but believe the threats are largely understood and in the price.
We expect oil prices to trend up in the medium term.
Metal & Mining (Underweight)
We expect the current run up in global commodity prices (iron ore and coal) to come under pressure from new low cost We prefer exposure to the sector through the majors. However, we have reduced the size of our underweight position.
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