Market Outlook – September 2017


Equity markets have performed strongly over the past year on the back of an improving outlook for the major economies. Global growth continues to show positive signs, confirming the debt deflation cycle is rolling over to a more traditional industrial cycle. Global PMI data is pointing to the first synchronised global growth cycle seen in many years. However, geopolitical risks, including tensions with North Korea, will continue to weigh on the market. These geopolitical factors and central bank policy dynamics will continue to provide challenges to investment market performance and economic optimism.

The prospects for the Australian economy are improving with business confidence at high levels and public spending via investment robust. However, the economy needs wages to pick-up such that household consumer expenditure can return to a trend growth rate, given that household expenditure comprises 55% of GDP. Despite the weak wages and out-of-cycle rate rises, discretionary spending data continues to be resilient.

The Australian market has seen quite a large rotation away from defensive and bond proxies towards the cyclicals and value end over the past 12 months. Our view is that this correction still has some way to go, given the extent of the bubble, and should be driven by rising global inflation, and therefore earnings growth in the more economically-sensitive sectors. Recent comments from both the US Federal Reserve and European Central Bank suggest they are on a path of reducing their balance sheet. This is likely to put further upward pressure on bond yields, albeit recent geopolitical tensions have resulted in yields falling again.

The reporting season in aggregate was a touch below average, certainly helped by resources and banks offsetting some of the weakness elsewhere. Consensus has downgraded 2018 EPS growth by 0.4% which is in line with the last 30 reporting periods. Increasing capital expenditure and declining payout ratios surprised, however it was not surprising to see increased cost pressures given power costs are rising fast. The increased capital expenditure does provide some hope that the animal spirits may be returning along with this investment. Balance sheets and debt service ratios look very strong.

The current market PE ratio appears around fair value, based on the average of the past 20 years of low inflation. It appears we have entered into an earnings expansion phase that could last many years. The typical earnings expansion results in rising markets and falling PE ratios. Under-earning and undervalued stocks typically do well in the early stages of such a recovery.

Our expectation is that the market return in 2017 will be driven by the continuing rotation that commenced in August 2016 and earnings growth. The risks to this view are geopolitical volatility and more muted earnings growth, which could both provide obvious headwinds.