2016 was certainly a year of surprises. To most the political shocks of Brexit and the victory of President-elect Trump through populist uprisings dominate their recollections. I would add the OPEC agreement to curb future oil supply, the attempts by the Chinese authorities to reverse the relative appreciation of the yuan, and the restoration of Brazil as an investor friendly location just as momentous, and possibly more reflective of changing future investment conditions.
The performance of asset prices in 2016 contains many lessons and is a reminder that markets can move irrationally for extended periods. The first of these lessons is that a sharp rise in prices that is not accompanied by an equivalent rise in fundamental values is the equivalent to ‘borrowing’ returns from the future. While we don’t pretend to be able to forecast near-term asset price movements, it is worth noting that in our view, fundamental valuations have remained largely steady across most major asset classes. Consequently, the expected returns of most asset prices as we start 2017 is lower than in 2016, and multi-asset portfolios are unlikely to generate return objectives on a buy and hold basis.
The Australian equity market enjoyed a strong run in the second half of the year, led first by the recovery in the balance sheet position and free cash flow for the likes of BHP, RIO and Woodside Petroleum, and then by the Trump-led rally in financial companies, given the prospect of higher future inflation (and consequently, the expectation of higher interest rates).
Despite the recent rise in the price of energy companies, our valuation analysis remains supportive of large integrated energy companies and those materials companies operating in industries that have significantly reduced both costs and capital expenditure in the last two years. However, it is important to note this is not a judgement of the oil price or iron ore price, but rather an assessment of corporate profitability measures against their long-term fair values. Larger companies have balance sheets, cost models and profitability margins that can withstand lower output prices yet still generate free cash flow to pay investors via a dividend. Royal Dutch Shell, BP and RIO Tinto are good examples of these larger companies that in 2016 initially increased debt but maintained their dividends throughout.
Within emerging markets, the rumours of a Chinese economic slow-down is creating a predicament for investors. An ongoing slow-down in such an important economy could act as a significant drag on global growth in the short term, with global GDP estimated to grow at just 2.4% in 2016 and 2.8% in 2017 according to the World Bank. A combination of slow growth and high debt levels can place stress on the financial system and should not be ignored. It is also worth remembering that China will have their 5-yearly Communist Party Congress in the latter half of 2017, which could add to geopolitical tensions as President-elect Trump seems committed to continue with his anti-Chinese rhetoric.
2017 is shaping up to be potentially no different. There will be no shortage of events that seemingly throw knock-out punches for markets. U.S. debt ceiling negotiations set for March, the French election set for May, the German election likely in September/October and further stresses about high Chinese debt – all of which could trigger panic and column headlines on trading message boards and financial newspapers. As always I expect there to be changes in investment environment that do not happen so quickly or with such fanfare often in locations that are under the short term investor’s radar. Supply cycles and capital expenditure on production of ‘real assets’ – e.g. iron ore, oil, apartments, US factory plants – will determine long-term pricing dynamics, productivity and the ability for a company to generate profits. We suggest that these are the real drivers of future returns.
While this may be an unexciting way to view the markets, it is the only right way. Forecast election results at your peril. With this in mind, we share some of our Investment Team’s thoughts and analysis as we head into 2017:
What are the fundamentals telling us as we enter 2017?
While we remain sceptical of Trump’s ability to defy economic headwinds, we consider the evolution of our valuation framework. By doing so, we assess the broad value opportunities as we enter the new year.
Are emerging markets a dangerous place to be?
Trump’s ongoing anti-Chinese rhetoric is contributing to investor fear towards emerging market assets. We investigate a day in the life of the volatile market and whether it offers sufficient reward for risk.
Should an investor accept currency risk?
While most emerging markets currencies and the pound sterling look undervalued on most measures, using unhedged currencies as portfolio insurance for Australian investors is becoming more specialist. Hedging costs are rising and therefore, we are investigating which currencies are worth applying protection to, given the rising expense to do so.
This content is issued by Morningstar Investment Management Australia Limited (ABN 54 071 808 501, AFS Licence No. 228986) (‘Morningstar’)
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