2016 in Review & Looking Forward to 2017

As they say it’s better late than never, so welcome to the 2016 year in review and look forward into 2017. Once again my apologies for how delayed this article is, but hopefully you can take some important points away from it and use it to your advantage.

Market Performance

Overall it was a buoyant year for the Australian market in 2016. We started the year at 5,295.90 and ended it at 5,665.80. This gave us a return of +7.0% and if you include dividends this climbs to a +11.6%. This is well up on 2015 which saw us only bank a +3.8% return when you include dividends. Shareholders should be very happy with 2016 overall. The XJO finished the year with a PE of 17.16x and a yield of 4.08%. Our market cap grew to $1.938 Trillion in value and we may just see that magical $2 Trillion mark in 2017.

It wasn’t all beer and skittles though as in February we hit a low of 4,706, which was our lowest point since June of 2013. However due to numerous factors we would almost put on 1,000 points by the end of the year and see a 16 month high on the XJO in December.

So what factors guided our markets during 2016? We started off in January with a fairly substantial pull back which would see us hit that low in February. This was mainly attributed to the Chinese share market which had seen as much as 150%+ in gains during 2015 only to lose 22% of its value in January alone. This scared investors fearing the worst, a collapse of the Chinese economy. This wasn’t to eventuate which saw us recover. Late April saw the start of the recovery for commodity prices and in particular Oil, Iron Ore, Coking Coal & Thermal Coal. This gave our market buoyancy and gave a shot to the resources sector and the economy. In June this came unstuck as Britain surprised the world and voted to leave the EU in which was nicknamed Brexit. Once again this upset the XJO and we peeled off short term only once again to recover. Early August saw the RBA cut our official cash rate 25bp to 1.50%, our lowest rate on record. The market had factored this somewhat so it didn’t really have much effect on us at all.

In November came the most singular import factor to impact our markets for 2016 and one that will go down in history. This is when Donald Trump, much like Brexit, surprised the world and won the US Presidential election, beating Hilary Clinton. The day it happened will be etched into my memory similarly the same as when Lehman Brothers filed for bankruptcy in September 2008. The markets started the day up a healthy 1% only to finish the day off over 2% and losing as much as 4% at one point. The volatility and volume that happened during that day was the first time we had seen it in that magnitude since that day in 2008. However once again over the next few sessions the market would recover and wake up to the realization that Trump’s policies would be very bullish for global markets. This sent the XJO on a tear until the end of the year peaking at over 5,700 and finishing at just below it.

Of course during this time we also had the US Fed raise rates by 0.25bps to 0.75% and OPEC cut oil production for the first time in the best part of a decade. We also saw a large and continued sell off in US treasury Bonds which saw the yield climb from sub 1.50% to 2.50%+ on the 10 year notes. A move we haven’t seen since the late 80s and many say the end to the 35 year bond rally. It also gave strength to the notion that the world was moving away from a central bank focused monetary policy to drive economic growth to that of a fiscal stimulus.

Overall 2016 saw no major booms or busts, but it will go down in history as one of the most eventful and important in modern society.

From a sector perspective 2016 saw the Capital Goods and Materials sectors lead the way with nigh on 40% in gains for the year. Stocks such as BHP, RIO, FMG, NCM, a raft of Gold stocks, BSL and MIN all lead the way and gave shareholders some impressive gains. On the flip side we saw the Telecommunications and Pharma sectors cop a pasting and stocks such as VOC, TPM, TLS, BAL, SRX, EHE, BKL and BGA leave a very sour taste in investor’s mouths. The above summary shows that most sectors ended the year in the black with only very few posting negative returns. The below summary shows the biggest winners and losers for the year and as you can see most reflect the theme set out above.

Whilst it was mostly smiles for the XJO we didn’t outperform our US counterparts who had a stellar year on the markets by most measures. The Dow Jones posted gains of +13.4%, S&P 500 +9.5% and the NASDAQ +7.5%. Obviously the belief is Trump will have a big impact on the performance of the US economy in the coming years.

Australia

Turning to a more economic standpoint now we saw the Australian economy really have a middle of the road year.

- The economy grew around +2.3% down from the decade average of +2.7%.

Underlying inflation sits around +1.6% and is gaining momentum.

- Our jobs market grew with 87,300 new jobs being added. This was also down from the decade average of +183,200. Our unemployment rate sits at 5.7%.

- Wages grew by +1.9%, an 18 year low.

- Retail trade grew by +3.5%, which is close to the average.

- Australian house prices increased by 10.5% after increasing by 7.8% in 2015.

- The RBA cut the official cash rate twice in May and August, both times by 25bp. Our official rate sits at a record low of 1.50%.

- We had a federal election where Malcolm Turnbull was re-elected as our prime minister

As you can see these are not awe inspiring numbers, but signs of a solid economy none the less. It seems as if the country is still in transition from the mining boom into our more traditional construction and service based economy. The days of the big capex mining projects are well behind us. There has been a glimmer of hope though with commodity prices recovering mid-way through 2016 and exploration spend on the way up. If the AUD continues its downward trajectory then it will encourage manufacturing to start up again here as our goods continue to get cheaper.

China

The story for China in 2016 is not too dissimilar to ours. For some time now ‘experts’ have been calling for a hard landing in China from its boom day’s pre-GFC. This is mainly centred on China’s growing debt and slowing economy. However it seems if China has conducted a successful soft landing and has started to turn again towards accelerating growth. China’s economy grew at +6.7% for 2016, a little down from 2015’s +6.8%. However the trend seems to be on the rebound. This is where its GDP has settled after recording that figure for three consecutive quarters. It’s important as beforehand the figure had consistently been edging down for several quarters.

China’s manufacturing PMI saw a read above 50 (51.9) for the first time in almost four years in the second half of 2016 which suggests its manufacturing industry is again expanding. Its services PMI has been above 50 (53.4) for some time which suggests they are now increasing their internal consumption and moving more from an industrial/manufacturing based economy to a services style such as Australia or the USA.

Inflation is running at +2.1% after bottoming out at 1.3% a year ago. Although it did cool in December from 2.3% it’s still showing there is a healthy increase in prices. Industrial production, retail sales and fixed asset investment have all been accelerating at a solid pace during 2016, which leads us to believe, including other fore mentioned figures that China’s economy is in a healthy place.

USA

USA’s story in 2016 was about recovery and an acceleration of their economy. The world’s largest economy really does look like it is back on its feet and growing an increasingly faster pace. Their GDP for 2016 was +1.9% in the December quarter. This quarterly figure is down from the 3.5% in the third quarter, which had a few anomalies and once off figures contributing to make the figure so large. Like Australia’s third quarter the USA’s December quarter had an election within it. This means generally spending is much lower and investment decisions are held off as a new president creates some uncertainty. If you look at the 1.9% figure compared to the first quarter of 2016 where the US only grew at 0.8% you start to see the recovery. On an annual basis the 1.9% figure is greater than the 1.7% figure that was printed the previous quarter.

Importantly inflation now sits at +2.1% for 2016. This rose from +1.7% the quarter before and a low of 0.8% in July of 2016. Once again a healthy amount of inflation is important to help prices increase and kick start economic growth. More importantly it also met the Feds goal of reaching 2% inflation by the end of the year and gives more weight to multiple rate rises.

Unemployment in the US sits at 4.7% which it has done for most of the second half of 2016. A lot now consider this full employment for the US. They continued to add a solid amount of jobs to the economy every month for 2016. Obviously employment is an integral part in getting an economy to accelerate again. Also an important factor to take from employment figures is that wage growth has accelerated to +2.9% on an annualized basis. This sat below 2% earlier in the year and is another sign of a healthy economy whereby employers are willing to pay their employees more per hour. This means people have more to spend and that business’ are more confident moving forward.

The final major occurrence during 2016 in the US and what has really started a global trend centers around interest rates and Treasury Yields. The fed lifted the official rate from 0.50% to 0.75% in December of 2016. Whilst it was the sole hike for the year, after predicting 3-4, it did signal a major change in thought surrounding rates. Language used by the Fed has now become more hawkish and they are forecasting up to four rate rises in the US in 2017. This is none more evident than the 10 year US treasury yields. These are probably the best indicator of where rates are to go in the near future. In June of 2016 the yields sat at sub 1.50%. Since then they have rallied to consistently sit around 2.50%. Basically the market is forecasting rates will be moved a further 1.75% up within the next 10 years. Obviously this will continually change in correlation with other economic figures such as inflation and wage growth, but it does signal that rates have bottomed and are back on their way up. Probably not only in the US but on a global scale.

Commodities

After what was a bleak year for commodities in 2015, 2016 turned out to be the complete opposite. Oil, Iron Ore, Coking Coal, Thermal Coal, Copper, Zinc etc. all had significant gains off their lows in a move that would help support the XJO in the second half of the year. Oil was +45% to $53.72/b, Iron Ore was +85.3% to $79.50/t and Thermal Coal was +87.2% to $94.70/t. These were the year’s biggest improvers. Coking coal, in Chinese terms, rose 150% as well. Gold also made gains but it wasn’t as dramatic as others. Gold finished the year +8.6% to $1,151.70/ounce. It did rise to above $1,350/ounce before coming under pressure later in the year.

Looking Forward to 2017

Although we are already a month into 2017 there hasn’t been much out in the way of economic data to really change any of our views below. In fact if anything what has been released has strengthened it.

From a technical perspective, on a longer term weekly chart, the XJO is trading in a very bullish pattern. We sit in a long term uptrend which established itself early in 2009 defined by the green tram lines. Within that trend we have started a separate smaller uptrend defined by the blue tram lines. Ultimately what it is telling us is that we should have one last pull back to 5,550 – 5,600 by March and then, all things being equal, should head up and test that 6,000 level again. There is probably a physiological barrier there so we may just test it a few times with smaller pull backs to 5,700/5,800 before finally busting through. From there we would like to see us consolidate around 6,000 before breaking out to the upside late in 2017 and seeing 6,200. Of course none of these are certainties, but based on the previous pattern of the market and what the chart it currently telling us this is what we see happening.

Over the last 30 years the average gain in the XJO index, per annum, is +5.1%. If we are use that based on where we closed in 2016 this takes us to about 6,000. However we believe that world growth will grow above trend so we would not be surprised to see the index climb 8-10% which brings us right up to that 6,200 level.

So we have looked at the technical side of the market what about the fundamentals? What will help push us to that 6,000 – 6,200 area? To me it will be what lead the charge pre-GFC, the financials and resources. With above trend growth and higher rates we should start to see a much better environment for the banks. Margins should expand again and earnings start to grow. Then of course with China and the USA embarking on infrastructure spends it should see an increased demand for commodities. This will obviously be beneficial for our resources sector, including mining services. Industrial stocks will also benefit as companies expand and invest more in themselves. This will also mean an increase spend on IT and telecommunications hence why we believe our telecommunications sector will also thrive again in 2017.

Sectors we feel will underperform or struggle in 2017 are Healthcare, Infrastructure, Listed Property & Retail. We believe healthcare will underperform due to its defensive nature. Investors will exit healthcare stocks looking for better returns in the high growth end of the market. Earnings should continue to be solid but not as strong as other sectors.

Infrastructure stocks such as Transurban, Sydney Airports, APA Pipelines etc., will underperform due to the higher cost of debt. It is expected the US will increase rates 3-4 times in 2017 which means stocks carrying high amounts of debt will incur higher costs, which will put pressure on earnings. Listed property you can put into the same basket. They usually carry high amounts of debt which means higher costs if rates go up. This will also put pressure on their earnings.

Finally I feel Retail will struggle. I have said it before I am an AVOID on Australian retail on a longer term basis. The sector is going through some disruptive changes with new entrants such as Aldi, Liddle and soon the US behemoth Amazon. This will squeeze their margins and ultimately ability to increase earnings. This could also carry onto the Listed Property space as well if retail shops close stores or go out of business. This leaves more vacancies in shopping centres/malls and less rental income for their owners i.e. Westfield. This doesn’t factor in an increase in online trade. Our online purchases only account for roughly 7-8% of our overall spend. This compares to the UK where it is 14-15% and growing. We often follow their trends and with Amazon setting up shop here our online spend should be going up as well.

With a healthy resource sector comes some solid opportunities in the small/micro-cap space. There will be many chances to make large gains in the area so if you have the risk tolerance for it 2017 could be a very good year for you. In particular we like base metals such as Copper, Zinc and Nickel and then also new age metals such as Lithium, Cobalt and Graphite. All the metals that are used in battery and high end electronic manufacturing. We feel you will need to be wary of the Gold sector as the price of Gold will come off. Other areas in the small cap space we like are IT/Telecommunications and Industrial. There are some companies that have been increasing earnings nicely in those sectors in 15/16 that have been ignored due to the overall view on their sector. These are High risk and highly speculative areas so are not for everyone.

Big Issues of 2017

Donald Trump: The first major issue of 2017 is Donald Trump. Most see him as unpredictable and irrational at times. To be honest you get the feeling we may be one tweet away from a market meltdown at certain points. However his policies are highly growth orientated for the US and he has set a target of 4% growth. This is double their current rate. Now it might be a bit optimistic but even if he can achieve 3% that’s a lot of extra jobs and spending for an $18 Trillion dollar economy. He has been a man of his word thus far and put into place a lot of what he declared in his pre-election promises. One would think that he will keep his word and focus on more jobs and spending on infrastructure. Whilst some of his policies are all about America first a healthy and strong US is nothing but good for world growth.

Inflation & Rates: Inflation is starting to rear its head again, mainly in the US, China & the UK, which is also bullish for world growth. The right amount of price inflation is needed for an acceleration in growth. With the all the printing of money that has gone on in the last 5 years and devaluing of currencies worldwide it was only a matter of time before it picked up again. Consequently in 2017 we should see 3-4 rate rises in the US and maybe even in the UK, depending on how Brexit pans out. In Australia we’ve been on record in saying there could be a rate increase here late in 2017. If this isn’t the case then by end of Q2 2018 we will definitely have a rate increase or two. One thing is for sure. Rates have bottomed globally and are only going to go up from here.

Monetary Policy v Fiscal: In 2017 we will have a confirmation of a switch of economic policy. For years economic growth has been driven by monetary policy and lowering of rates. The central banks have done their jobs and now it’s up to governments to stimulate their economies via fiscal spending. This means spending up on infrastructure and tax reform. Maybe Trump foresaw this and is why he focused so heavily on it in his campaign, or maybe we are giving him too much credit and he was just at the right place at the right time. As mentioned before the US & China have already made their intentions clear. Europe should be the next to follow although I wouldn’t expect much from them. God knows in Australia we need some infrastructure spend but normally this is done in conjunction with the federal and state governments so it may be more gradual.

China: China is always a big issue for us, but it probably sits more on a knife edge than ever. Their economy is transitioning from an industrial focused one to more services. The transition isn’t an easy one to manage, but thus far China have managed it well. One would think with a population of 1.4billion people there will be plenty who wish to start living like us with a house, car, Big TVs, educations, holidays etc. It’s only natural then that services will be the driver of the economy that size. China must try and avoid that hard landing in this transition. Its main concern are its debt and housing sector. If this implodes it would have huge ramifications for global markets.

The EU: It’s a peculiar time in the EU. We all know that Britain voted to leave the EU last year and that was ratified by their parliament recently. The process will start in May so we will have to wait and see what the ramifications of that are. We also have French, Dutch and German elections this year. One would suggest we can’t rely on polling anymore to give us a solid indicator on who would win those elections. If far right wing parties do win we may see more countries deciding to leave the EU. This would have large ramifications and probably put a handbrake on world growth.

Australian Housing: For many years ‘experts’ have been calling for a housing crash. It’s been a good 25+ years since we have seen a large downturn in our market. The recent acceleration in house prices has fueled this fire again, with many citing they are too high. One thing is for sure there a few factors that are always present when housing crashes occur. They are high unemployment, high rates and a major influx of supply. We have none of those factors present. Our unemployment rate sits around 5.7% which is solid. Our rates are the lowest they ever have been and will be gradually increased when they eventually do rise. We are constructing more houses than ever before but even so we are just meeting demand. If we look at economic forecasts for Australia for the next year it seems we are in for another solid year. I feel we will come in at the high end of forecasts or even beat them due to China and the US accelerating. It will be a black swan event that will cause the next crash, likely from overseas. When that happens is anyone’s guess, but current metrics suggest the housing market should remain healthy. We may see a cooling of the sector if people decide to invest in other asset classes instead, but we remain confident we won’t see a crash in the near term.

Gold: Many suggest Gold will be on the rampage again due to Trump and fear as people flock to it for safety. However history will tell a different story. History shows us when rates are rising and hence treasury yields are too, gold performs very poorly. This is climate we are faced with now. When Gold was $1,350/ounce yields were sub 1.50%. It made sense to flock to gold then as you couldn’t get a return in bonds anyway. However since this yields have risen to 2.50% and gold has fallen to $1,200/ounce and got as low as $1,130. Why would you invest in gold, which doesn’t yield, when you can get an increasing return in one of the safest asset classes in history, US Treasuries? 2017 and beyond does not bode well for gold at all in my opinion. Rates and yields will continue to rise and hence people will switch from gold to bonds. It’s happened many times in history and it will happen again. We feel by the end of 2018 gold would have seen sub $1,000/ounce again and maybe as low as $800. We are avoiding long term gold holds at the moment and only investing short term in the space, within the speculative end of the market, in rallies.

Farewell

Well that’s enough from me for now. I hope you have enjoyed our review on 2016 and look into the year ahead. Our main hope is you have learnt something from it and can use this in your investing. Of course I don’t expect everything we have said in here to come to fruition as the landscape can change so quickly. We are simply putting out there our read on it at this point. You will read a hundred different takes on the market over the next few weeks and not one will be 100% right. Our best piece of advice is to manage your risk and don’t venture outside your comfort zone. No point in losing sleep on an investment as there are far more important things in life.

I am happy to discuss this article at any time whether it be via phone, email, twitter. My details are freely available and I enjoy hearing other points of view. You never stop learning in this industry and if you ever think you know it all then it’s probably time for you to step away. Think it’s time I put my feet up, pour a nice glass of wine, and enjoy my weekend. I will speak to you all next week when the ‘ASX Weekly Wrap’ returns. Until then have a lovely weekend, stay safe and Go the Crows!

heath@hlminvestments.com.au

0413 799 315

@heathmoss83

Important Notice

Any advice in this article should be considered General Advice only and does not take into account your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate to you and whether you should act upon it. I am happy to assist you in this process. To do so, I will need to collect personal and financial details from you before providing my recommendations. Please note the author may own shares in the companies mentioned in the above blog.