Part 1: 2017 in Review

Welcome to my annual newsletter in which I review our financial markets performance over the last calendar year and look forward to what the upcoming year may bring. First of all I must apologise for how late this year’s newsletter is going out, but as many of you know we recently welcomed our second child into the world. This has meant I have been learning to adjust to having two children in the house which I feel I finally am getting the hang of. My life is now an endless loop of nappy changes, bottles and the wiggles. I was aiming to get this out within the first week of February, but we then had the selloff in global markets which forced me to concentrate on that. I will touch upon that briefly in this newsletter but I summed most of it up in the email I sent out the other week. Thus without further delay please enjoy my financial market review of 2017 and look into what 2018 may bring.

Chart of the S&P/ASX 200 (XJO) 2017

The S&P/ASX 200 (XJO) put in a really solid year in 2017 with a return of just over 7% on the index. If you include dividends the total return on the XJO was +12.5%. This is well above our long run average of 10.3% over the last 20 years. In fact the accumulation index, which tracks returns including dividends, finished the year on a record high of 6,007.80 (chart below). The XJO also managed to climb and finish above the 6,000 mark for the first time in 9.5 years. I’m not one to toot my own horn but if you go back to my forecasts for 2017 in last year’s newsletter I did state that I expected us to finish in that 6,000 – 6,200 point range based upon my technical analysis. The yield on the XJO finished at 4.05%, just below our 3 year average of 4.27% and the PE finished at 15.65x, below the long run average of 15.75x. Both these indicated the XJO is probably at fair value and far from being over cooked. To give you some perspective yields got down as low as 3% just before the GFC and our PE was around 17x.

Despite the XJO’s solid performance it fell well short of our US counterparts who had their best year in some time. The Dow Jones +25.29%, S&P 500 +19.43% & Nasdaq +30.75% all put in stellar performances which saw all three indexes close near to all-time highs at the end of 2017. This was mainly a result of strong earnings growth across the board, but in particular from the likes of Apple, Google, Amazon, Facebook, Netflix & Microsoft.

Global markets overall were very strong for the year. Most gains came in the second half of the year as concerns lingered around numerous elections to be held across Europe throughout 2017. The fear was far right wing parties could come out on top and force the breakup of the EU. This wasn’t to be the case with most conservative parties winning as expected and keeping the status quo. This gave financial markets the boost they needed towards the second half of the year as global growth also ran ahead of its long term average at +3.7%. It was the first time in well over a decade that most of the G20 nations were growing their economies in sync.

So what sectors performed the best and worst throughout 2017? The three best performing sectors were household & personal products, capital goods and food. This was mainly due to many Australian companies exporting their products and services to China who gained a real thirst for high quality Australian goods throughout the year, as their middle class continues to grow. We also saw residential housing construction peak in 2017 which saw more capital goods sold. The three worst performing sectors were Telecommunications, Retail and the banks. Telecommunications fell hard on the back of Telstra’s poor performance as margins were squeezed and dividends cut. It was a theme right across the sector in 2016, but TLS, with its size, was able to withstand it a little longer.

Retail fell hard on the back of the globalization of the industry and Amazon reaching our shores late in the year. Similar to telecommunications margins are being squeezed as lower cost providers such as Aldi & Liddle continue to grow on our shores. We also are seeing the continued growth of online spending which is putting more pressure on our retailers and especially the likes of MYR, HVN, BigW & Target. Finally the banks struggled as they had a multitude of factors that kept them down. The first being the low rate environment, keeping their net interest margins low and making revenue growth tough. The second being legislative as a levy was placed on banks with liabilities greater than $100bill and then finally a royal commission into the banks was announced towards the end of the year covering possible dubious lending practices among other things. This put a negative sentiment on the sector and hence its poor performance.

Finally we also saw our small & mid-cap sectors outperform the XJO by a great deal, +16.27% and +17.89% respectively. This is mainly because these sectors house a lot of the food, resources, IT and capital goods stocks that have performed well throughout the year. In fact I feel every one of the best performing stocks (below) was in one of these indexes at some point throughout 2017.

From a company point of view the top & worst performers largely reflected the sectors above. Eight of the ten top performers came from food and resources. The two that didn’t came from those sectors were Information Technology (WTC) and Media (SVW). However whilst SVW holds a large portion of media assets it does also hold some large investments in the resources sector such as Caterpillar and Coates Hire. The worst performers were a mix from all sectors but largely reflected companies that under performed their earnings expectations and had profit downgrades during the year. I am happy to say that many of you had a few stocks from the top performers, but none from the worst which means we have identified the trends of the market for 2017 well. The challenge is to keep that going into 2018.

Australia

A quick summary of the Australian economic climate in 2017 is below:

- Australia’s GDP probably grew around +2.5%, below the +2.7% long run average

- Inflation is at 1.8%

- Unemployment is at 5.4% and down from 2016’s 5.8%

- The economy added 383,000 jobs in 2017. The biggest in over 12 years

- Wages grew at 2.0%, and up from the record low 1.9% seen in 2016

- Australian population grew by +1.6%, down from the decade average of +1.69%

- Annual trade surplus stands at a record high $19.9billion

- Australian house prices rose by +4.0%

- Cash rate is at a record low of 1.50%

It was much of the same in 2017, as it was in 2016, with the Australian economy, but with some slight improvements. We still are living in a very low rate environment with many wages linked to CPI this is keeping wages down as well. The jobs market remains very strong, with job advertisements continuing to grow. We may just see the unemployment rate dip below 5% in 2018.

Overall the economy is solid without being spectacular but there are many signs that there is improvement on the horizon. We are seeing the recovery in the resources industry as exploration spend increased for the first time in a few years. This is on the back of commodity prices recovering substantially in 2017. Whilst there is a slowdown in residential construction it seems we are about to see a large lift in infrastructure spend as the country looks to improve its main arterials to accommodate for the above trend immigration we have seen in the last few years. If we see a pickup in resources as well on top of that it would put a lot more froth in the Australian economy. The AUD remains largely resilient trading in a short term range of 77-81c to the USD. This is probably due to increased commodity demand, but I wouldn’t expect it to remain above 80c for too long. If the US continues to raise interest rates and we remain on hold this will attract more investment into the US. A lower AUD obviously benefits our resources, healthcare and manufacturing industries the most.

China

China once again defied the bears with its continued strength and growth. Most had a forecast growth of 6.5-6.7% for the year in GDP, but China came in well above forecasts at +6.8%. This is more than likely going to slow regardless as obtaining higher percentage gains as the economy grows larger is a very difficult task, especially when you are a $US12trill economy.

2017 was a year of maturing for China as it looked to clean up some of its debt with tighter restrictions on lending and trying to create a higher quality of wealth within its middle class. We also saw China focus hard on improving its air quality by reducing pollution. It forced the shutdown of many steel mills and iron ore and coal mines. This meant it had to import a lot higher grade commodities from outside its borders. We actually saw China import a record amount of Iron Ore in 2017 at 1.075bill ton of the commodity, +5% on 2016. Just under 700mill of that came from Australian shores. It is forecast that is set to grow to 1.12bill ton in 2018 as China continues to flesh out its infrastructure and also look to continue its ‘silk road’ project which already has $US1trill of construction under way. This obviously bodes well for Australia and our resources industry.

We also saw China start to push electric vehicles (EV) with subsidies and a total production target of 10% of all cars manufactured in China to be EV by 2019. This equates to roughly 3mill cars to be EV by that date. In 2017 China produced just under 1mill EV as battery makers scrambled to secure lithium and cobalt supply. Once again this is aimed at improving air quality by taking fossil fuel cars off Chinese roads. You all know how bullish I am on lithium, on which I will have an updated article out very soon.

The manufacturing and services sectors both remained in above trend growth territory with both PMI’s reading well above the important 50 point range. This bodes well for their economy moving into 2018 and their continued demand for our resources, services and food items.

USA

It was a fantastic year for the US economy as it built on the solid foundations we saw in 2016. It was also reflected in the performance of the local share markets as I said earlier. GDP rose to +2.5% on an annualized basis and the fastest we had seen since July 2015. We saw earnings grow at +16%, on average within the S&P 500, and that is forecast to hit +18% in 2018. You now understand how their markets can be trading on such high growth multiples compared to the rest of the world. In comparison I believe the earnings growth on the XJO was around +7% for the last round of full financial year results. This also shows why we have lagged their index as well.

The wildcard in all this, Trump, appeared to finish the year on a high as he was able to get the biggest tax legislation overhaul in 30+ years across the line before the end of the year. This will see corporate tax rates fall to 21% down from 35% in the coming years. This should give a huge boost to the economy with it expected to boost EPS by 12% in that time. It also makes the US a more attractive investment case for corporates as it now becomes one of the lowest corporate tax regimes in the world. On top of this Trump was also able to get a once off tax break of 15.5% for money brought back from overseas into the US. Hence for companies such as Apple, Google, Microsoft etc. who had huge amounts of cash held in offshore accounts due to more favorable tax conditions are now bringing that cash back into the US. This money is likely to be reinvested into the company in various ways and also result in larger capital returns to shareholders. This is once again a huge boost to the US economy.

A big consequence of the new tax laws, that’s wasn’t foreseen, was the ‘trickledown effect’. Hundreds of major US corporates have been handing out one off bonuses to employee’s as well lifting minimum wages within the company. For example Walmart lifted their minimum wage from $10ph to $11ph. They have cited this was a result of the new tax legislation being passed allowing to free up the cash flow necessary to pass it on. This was totally unexpected and another huge boost for the US economy because obviously if people have higher wages, and more money, they are more than likely to spend it and put it back into the economy. This has also raised fears of inflation rising faster than expected, but this is something I will cover in the 2018 preview.

Finally the US is currently considered to be at full employment with the unemployment rate hovering around the 4% level. We have seen US corporates go on a hiring spree due to the strength of the economy which has led to the highest average monthly employment gains since the Clinton era. We also have seen unemployment amongst the African American community at historic lows. This also saw wages grow at +2.9% in the most recent employment update. The fastest rate we have seen in 8.5 years. Again this has inflationary implications which I will touch upon in the 2018 preview section of this newsletter.

Commodities

As I stated earlier commodities, in general, had a very good year. Most base metal prices were up 25-30% on 2016. Bulk commodities were also strong with the likes of thermal coal +6.4%, but Iron Ore actually fell -8.3% ($72.90t) from the end of 2016. This is still well up on its lows we saw in 2014 & 2015 though. Oil climbed to a two and a half year high, rising +12.5% ($60.42b) on the back of continued OPEC cuts and demand and supply reaching equilibrium again. There is some thought that the oil glut is over and we will be in a supply deficit through the second half of 2018. Precious metals had a strong year after 2016 was one of the weaker on record. We saw Gold rise +13.3% ($1,305.20oz) as debt and inflation fears mounted, hence we saw Gold become a store of value again. Finally, and probably the best performing metal of 2017, was Copper which rose an astounding +31.35% ($3.295lb) for the year. This was attributed to many factors. First and foremost the bounce and strength in the global manufacturing sector placing much higher demand on copper. Second the fact that no new major supply is coming online and that a lot of the existing older mines are winding down or becoming higher cost producers as head grades decrease. Finally new demand from the electric vehicle push, mainly seen in China, saw a new industry place extra demand on Copper in 2017. This demand is only going to increase moving forward in 2018 and beyond.

Below is the chart for the CRB commodity futures price index which is the index that measures a basket of commodity prices. As you can see from mid-2017 commodities really did rip hard and gave the XJO a much needed boost to end the year.

Well that does it for the 2017 review portion of my article. It’s turned out to be quite lengthy so I will split this up into two separate articles for you all. Nothing worse than having to read an extremely large body of text. Look out for 'Part 2: The 2018 Preview' portion of my annual newsletter in the coming days. I’m sure you will all enjoy, and maybe be shocked, at some of my thoughts and forecasts I have for 2018. Please feel free to share among your family and friends and contact me via email, mobile or social media if you have any questions or comments in relation to anything I have written in the above.

heath@hlminvestments.com.au

0413 799 315

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.