Market Outlook – May 2017

With the Australian equity market performing well so far in 2017 one can’t help but ask how the market will fare as we enter the part of the year that, for largely inexplicable reasons, has often seen weaker returns. From a fundamental perspective, the key risk is probably that valuations in most sectors other than Resources are starting to look a bit stretched, especially in the so-called yield proxy stocks. The rebound in these parts of the market sees stocks in some cases trading more expensive relative to bond yields than at any point in the last 12 months. As we’ve written before, we see the risk for bonds as being to the downside (i.e. higher bond yields), and we believe it wouldn’t take much to trigger such a move. Despite the increased geopolitical risk and further falls in commodity prices, which typically would see a flight to “safe havens”, bond yields have been gradually moving up since about mid-April. More  recently bonds have been spurred-on by the US Federal Reserve’s commentary that it still intends to raise cash rates further in 2017 as it sees weaker first quarter growth in the US as transitory. This, coupled with continued positive economic and political signals coming out of Europe, is supportive of our view that global growth will tick up in 2017.

Recent weakness in commodity prices is perhaps at odds with this view, and of course particularly relevant for the Australian equity market. To us, the sharp selloff of the iron ore price appears to be driven by positioning rather than a change in underlying demand. Just as buyers were trying to get ahead of the curve by buying early when prices were moving up, they have now stepped aside and are running down inventories while hoping for a better price in coming weeks or months. This process may have some way to run but, as we concluded from our recent visit to China, underlying demand remains robust. Market observers are also fretting about the implications of tighter credit restrictions on economic growth in China. We find this slightly confounding as Chinese authorities have proven to be particularly adept at keeping its economy on a stable growth path, and we would have thought the incentive to do so is particularly strong in the lead up to China’s October Party Congress.

In summary, we wouldn’t be surprised to see some correction in the Australian equity market over coming months. Valuations, especially in some parts of the market, look on the expensive side, commodity prices may continue to be volatile in the short term, and the bank reporting season will likely remind investors that this large sector’s earnings growth remains subdued. Countering that, a largely supportive global growth outlook and the back-stop provided by solid dividend yields on many shares should limit any downside.