What a difference a year makes. The start to 2017 has been vastly different to 2016. In January last year, markets had just had their worst week since the 2011 European crisis and the ASX200 was over 7% lower in the opening fortnight of trade.
Fears over China’s currency coupled with more pressing domestic concerns relating to the pending recapitalization of Australia’s banking system had the market gripped with pessimism.
Iron ore prices were $35/t and BHP (BHP) and Rio Tinto (RIO) were dogged by the need to cut dividends, which in BHP’s case would prove to mark the first absolute dividend cut since the 2001-2002 financial year.
Circle forward to where we stand today and the world is very much a different place.
Where pessimism and fear gripped investors 12 months ago, they are now undeniably more sanguine.
The Chinese Yuan did devalue and is now -5% lower than where it was on 1 January 2016, but investment markets and risk-appetite managed to shrug off concerns around the effects from the Yuan’s fall.
In the last 12 months, Australian equities returned +11.8% (ASX200) and made it their 5th year on the trot of positive returns. From their lows, Australian banks are now +17% higher today, and somewhat more spectacularly, Australian miners are a whopping +90% higher.
Buoyed by Chinese policy to bolster both infrastructure demand and restrict supply across steel and coal industries, iron ore prices are now $77/ton and up over 100%. More impressively, coking coal prices are +130% to $175/ton having round-tripped to $300/ton from $80/ton at the turn of 2016.
By the end of 2016, Australian equity total returns eclipsed bonds by +17% from the early January lows.
Where the market’s fear over China’s leveraged economy proved undeserving, investors are now buoyed with an optimism premised around resurgent US, European and Chinese growth and the hope of new stimulatory policy under a Trump administration.
With economies in a much better state now, this optimism is warranted. US wage growth is at 8-year highs and employment is deemed to be ‘full’. Depending on the measure, all of US, German & French consumer confidence indices are now at decade or more highs. It is important to note that all of this occurred in spite of the surprise results of Brexit and Trump, both of which were viewed to be extreme negatives for economic confidence and investment markets just prior to the votes.
In spite of this, Australian-domiciled investors have reasons to be more than modestly concerned for the year ahead.
Australia’s economy & investment market in context in January 2017
Though the world is an undeniably better place, Australia’s economy has failed to keep pace with the improving sentiment seen beyond our shores during 2016. Looking into the available data, unlike its other major counterparts, the Australian economy has not accelerated. Australian consumer confidence ended 2016 at a lower level than it entered it.
Australian job advertisements for December posted their worst monthly decline in two and a half (2.5) years, and indeed in spite of tailwinds from the lower dollar, rising house prices and buoyant commodity exports, Australia’s economy only managed to add +32,000 new full-time jobs in 2016 for a tepid growth rate of +0.4%. From an employment standpoint, 2016 was a year for part-time employment with casual jobs growth of +125,000 and a more credible +3.4% growth rate.
Part time jobs cannot service mortgages. The Australian wage growth is now at record lows of +1.9%. The underemployment rate in Australia is also currently just shy of its record level, at 9.1% of the workforce.
More concerning is the apparent slow-down in future construction work slated for 2017 and beyond. Building approvals for apartment dwellings have fallen significantly in the latter part of 2016, with the three months to November 2016 seeing approvals running at -21% below the 2-year monthly average.
It is not just apartments, monthly approvals for new private houses are also falling, with the 6-month average a discernible -4% lower than the rate for the previous 2-years.
The construction industry is Australia’s third largest employer as a sector, behind only healthcare and retail, and comprises about 9% of the workforce. It dwarfs the mining industry by a factor of almost five times.
The concern here relates to the impact a pending slowdown in new residential construction work in 2017 & 2018 will potentially have on an already questionable employment market.
Compounding these concerns is the ever increasing level of household indebtedness borne by Australians. Household debt-to-income is now at 185%, and well beyond the 135% levels seen in the United States before its housing market collapse (incidentally, the US ratio is now down to 103%).
The first chart shows a measure of household debt to income for both Australia (green) and the United States (red), and shows that Australia’s debt burden relative to the income generated to service it continues to escalate.
The second chart (below) is again Australia (in green) and the United States (red), but this time shows household debt relative to the size of each country’s domestic economy (GDP). This is another measure to demonstrate the rising consumer indebtedness locally.
The charts show a pervasive and ongoing trend that the employment conditions in Australia has failed to improve in spite of the recent interest rate cuts. Jobs and wages need to improve in order to not only service the debt, but to repay it and bring debt levels down to more sustainable levels.
Despite the above concerns, Australian equity valuations are at their highest levels in over a decade.
The risks are building, and the rewards offered by the ASX200 at 5650 are diminishing.
Whilst this is not a call for a collapse in the Australian property market, there are enough warning signs to have a sensible and grounded conversation about the risks to Australia’s economy, banking sector and share-market if Australia’s questionable employment growth cannot be improved upon.
Putting the above remarks in context – our view
The weaker economy means domestic investors will again feel hard-pressed for income generation. Australian interest rates are likely to be kept on hold, or even at risk of being further cut, meaning that domestic cash investors will continue to struggle to make significant returns.
Despite the low returns and based on our growing caution on Australian housing and the economy, the safety of cash still looks sound.
In contrast with the Australian economy, it is important to acknowledge the improvement in global economic activity to multi-year highs, and these conditions are a sound backdrop under which to invest in during 2017 even in spite of the gains made in 2016.
For this reason, we are more optimistic on international equities versus Australian equities.
We expect international equity returns to better Australian returns by +10% to 20% in 2017 inclusive of the any moves in the Australian Dollar. With this view, we will be looking to add to our international equity exposure over the year.
On the property side, we expect continued income safety and moderate asset value gains from the AMP Wholesale Australian Property Fund.
In the fixed income space, hybrid securities have performed significantly well in 2016. These have comprised the majority of our fixed income allocation but having seen a significant rally during 2016, we feel that bank-hybrid securities now look more like fair-value at current levels. We expect to take some profits off hybrid exposures and look to add more traditional fixed income exposure (bonds).
It is important to note that while bond yields will likely grind higher, putting downward pressure on the bond market, the bond market is vastly differentiated and good returns can still be made. On this notion, we advocate for the differentiated approach applied by our preferred managed funds.
The disparity in economic momentum between Australia and the United States and Europe in particular means the following:
a) Australian Dollar is highly likely to fall further during 2017.
b) Australian interest rates will remain on HOLD or at risk of falling further
c) Australian shares will underperform their international counterparts in 2017
The Federal Budget in May also runs the risk of triggering a downgrade of Australia’s coveted AAA credit-rating, which would have a knock-on effect to government and corporate borrowing costs and to the Australian Dollar.
For more information on the above please contact your Partners Wealth Group advisor directly or on 1800 333 143.