Key Investment Themes and 2017 Outlook December 6, 2016
Key Investment Themes and 2017 Outlook
Author : iFAST Research Team

Key Investment Themes and 2017 Outlook

2017 Economic Outlook

Global economic expansion to accelerate

  • Following a year of slowing economic growth in 2016, we expect global economic growth to accelerate in 2017 to reach 3.1%.
  • While the US has posted a three-quarter average rate of 1.47% that is lower than its post-financial crisis average growth rate of 2.17%, the prospect of fiscal stimulus is expected to directly boost economic growth to 2.2% in 2017.
  • In Europe, with a recovery that is becoming increasingly widespread and entrenched, the continued monetary policy easing by the central bank will continue to support the recovery while any fiscal stimulus will provide a platform for further improvements in economic growth.
  • The dragon in the china shop, China’s multiyear rebalancing act has brought growth to a targeted range of 6.5%, a level that is sustainable over the long term and one that has been exceeded throughout 2016; with an average rate of 6.7%, China’s deceleration in growth could have possibly ceased.
  • Emerging markets such as Brazil and Russia have seemingly turned a page in 2016, 2017 should see continued improvement in their economic fortunes.
  • With both developed and developing economies set for growth in 2017 – we expect to see economic expansion accelerate into the New Year, albeit at varying paces for different regions. 2016 global GDP remains on track for a growth rate of 2.9%, down from 3.2% in 2015 on the back of a weak 1H 2016 and several shocks in 2H 2016; growth is seen accelerating back to 3.1% in 2017 before moving a gear higher to reach 3.3% in 2018.

Easy monetary policy to ease off

  • We think that central banks across the world have done a lot in the past few years, a lot.
  • While we expect global economic growth to accelerate in 2017, we are unlikely to see a hard reversal of the loose monetary policies implemented by many a central bank given that growth rates continue to remain moderate when compared to historical figures. However, we could be looking at a drought of new aggressive monetary easing that markets have gotten used to over the past 6 years given how much liquidity central banks have showered on the world.
  • In the US, the current stance adopted by the Federal Reserve has been a gradual normalisation in monetary policy due to a benign inflationary environment and moderate growth. Should inflationary pressures accelerate, policy-makers could normalise interest rates faster than expected. Investors are reminded to keep in mind that the Fed remains data-dependent in their approach – no policy stance is set in stone.
  • The Bank of Japan and the European Central Bank have been amongst the major central banks on an increasing easing trajectory in the past few years, but 2017 could see a directional shift in their trajectory. We expect few if any further easing measures, but more refinements and fine tuning of existing measures.
  • In Japan, the latest tool the Bank of Japan unleashed in 2016 was the “Yield Curve Control” which allows the bank to target a specific range of yields without committing to an asset purchase number and would allow them greater flexibility to control bond yields.
  • In Europe, the European Central Bank is unlikely to further ease monetary policy significantly especially with its negative interest rate policy. Rather, a similar approach to the Bank of Japan’s Yield Curve Control is a distinct possibility

Inflation to begin it's comeback

  • While low energy prices have remained a prominent theme since 2015 and early 2016; energy prices have stabilised in 2016 as per our expectations. 2017 is likely to see further stabilisation as the rebalancing between supply and demand dynamics continues with a new equilibrium to be found in the year ahead.
  • The low base effect provided due to low commodity prices, and low or even negative rates of headline inflation will contribute to higher inflation prints in 2017.
  • While core inflation dispelled fears of deflation as we expected in 2016, both headline and core inflation numbers around the world should track higher in the year ahead.

Investment Themes

Bye bye earnings recession, Hello earnings growth

  • While earnings revisions came down in 1H 2016, 2H 2016 saw the exact opposite with strong positive earnings revisions. We expect positive earnings growth in 2017 for the markets under our coverage.
  • With commodity prices having seemingly found a floor and inflation expectations rising, the cyclical sectors of the stock market are expected to see strong earnings growth in 2017, alongside markets which heavily exposed to energy and material sectors.
  • Following an ‘earnings recession’ in 2015 and 2016, the developed markets of US and Europe are each expected to post over 11% earnings growth in 2017, the strongest growth rates since 2010 and 2013 respectively.
  • Outside of the developed markets, earnings momentum has been fairly weak across various markets in 1H 2016, but the positive earnings revisions in 2H 2016 are most acute in the Asia ex Japan and emerging markets.
  • While much has been made of China’s rebalancing, few have talked about the anticipated 11% earnings growth being projected for the market in 2017 and the positive effects it will have on  the Asia ex Japan which is forecast to grow its earnings by a strong 12.5%.
  • Emerging markets such as Brazil and Russia which have seemingly turned a page in 2016 are expected to post double digit earnings growth rates in 2017, alongside improving economic fundamentals and without the energy and material sectors providing the headwinds they have done in 2015.

Stocks to head higher, but expect volatility

  • An environment of accelerating economic growth, alongside modest inflation and still easy monetary policy by central banks should continue to be a positive for earnings, and hence, stocks.
  • Despite shocks along the way, markets such as the US and the UK continued to notch new record-highs in 2016, particularly after “black swan” events such as Donald Trump’s victory and Brexit. We expect more markets to follow suit in 2017, propelled by strong earnings growth.
  • For Asian equities, a turnaround in the earnings revision cycle should be a key catalyst for valuations to mean-revert from their low current levels – the North Asian markets are expected to do most of the heavy-lifting to allow the Asian benchmark index to head back towards its 2007 highs.
  • The continued normalisation of monetary policy in the US is expected to continue to remove some of the excess liquidity in the financial system, which could lead to relatively higher levels of volatility. Volatility levels have been historically low over the past few years (thanks to the monetary policies of the various major central banks) and a return to a normalised volatility regime in the US in 2017 and beyond should not catch investors unaware.
  • While stock markets faced a turbulent 2016 with volatility stemming from China, Brexit and the initial reaction to Donald Trump’s victory, many markets have ended the year higher. Investors who saw the opportunities and took them were rewarded. Don’t fear volatility in 2017; use it to your advantage.

Return expectations tampered

  • Returns for developed markets like the US and Europe over the past few years have outpaced the rate of earnings growth, with valuations having already more than normalised to fair levels and beyond, that see it trading at premiums to our estimates of their fair values. While a modest rate of return for investors looks likely for investors hence our 2.5 star - Neutral rating for the US and 3.0 star – Attractive rating for Europe, high double digit returns for either market would be really stretching their respective valuations.
  • As in our 2016 outlook, investors looking for strong double digit returns in 2017 from a well-diversified portfolio of global equities (with a fairly large allocation to developed markets) are more than likely to be disappointed given the valuation premiums attached to these markets today.
  • If it’s strong double digit returns investors seek, the Asian and Emerging market equity markets should be their focus in 2017.
  • In the fixed income space, historically-low yields mean return expectations are low. Rising risk-free rates mean investors could see higher yields in credit spreads that might affect Asian bonds as well as Emerging market debt.

Don't underestimate the value of active management

  • Following strong returns for both stock and bond markets over the past few years, investors have gravitated towards passively-managed investments such as Exchange Traded Funds (ETFs), with Morningstar data suggesting that passive mutual funds in the US have continued to see inflows on a one-year basis while actively managed funds have seen net redemptions (as of end September 2016). With bond yields at still low levels and selected equity markets trading at premiums, we think actively-managed investments are more appropriate, with active stock-pickers able to shun more expensive stocks in favour of more attractive ones, while an era of rising interest rates coupled with historically-low rates means credit selection, currency expertise and a more flexible positioning should aid in driving fixed income strategy returns to a greater degree going forward.
  • While ETFs have their benefits such as taking advantage of intraday volatility to capture low prices and avoiding the potential of underperformance by an active fund manager, strong active management is likely to provide investors with stronger returns over the long term.

A stronger USD likely ahead

  • Following the direction of higher bond yields and tighter monetary policy via anticipated rate hikes for 2017, the USD has strengthened by 3.5% as measured by the Dollar Index since Donald Trump won the Presidential election in November to hit a 13 year high.

...but investors should be wary of chasing the fastest rising currency

  • However, investors should note that forecasting currency movements is an incredibly difficult art as fundamentals for currencies such as interest rate differentials, balance of payments and fiscal balances can take years to play out or on the market’s whim.
  • Just as importantly, we would caution against mounting expectations of an ever-strengthening USD (or ever-depreciating EUR or GBP or JPY) – the currency has already posted strong gains since 2011 (the Dollar Index has gained 38.9% since May 2011, as of 28 November 2016) while many developed market, Asian and EM currencies are already trading at multi-year lows against the greenback.

What should investors do?

Overweight equities vis-à-vis bonds

  • Following our decision last year to go neutral equities vis-à-vis bonds for the first time in eight years, we have decided to overweight equities relative to bonds in 2017.
  • Given the stronger earnings forecasts, diminishing prospects of new aggressive measures by major central banks as well as the current lack of attractive opportunities in the fixed income landscape, we believe that equities warrant an overweight in 2017
  • Given that we expect the global economic expansion to accelerate, higher rates of earnings growth are expected and these should help the Western developed markets offset any contraction of the valuation multiple that could detract from healthy earnings growth and anticipated dividends. Given that a well-diversified global equity portfolio would still have substantial exposure to the developed markets that are above our estimated fair value, an underweight allocation to developed markets at best is warranted.
  • Comparatively, Asian and EM equity markets have material room for valuations to mean-revert and provide outsized gains than their developed market peers. Healthy earnings growth and stable dividends will aid in delivering a higher total return for Asian and EMs.
  • We are projecting returns of over 40% by the end of 2018 for both Asia ex Japan and the Global Emerging Markets.
  • Given some of the risks facing bonds in 2017 with interest rates yet to normalise, the dangers of rising bond yields should see investors be on the defensive for fixed income.

Continue to favour Asia ex-Japan equities

  • Corporate earnings disappointments have been a feature of Asian equity markets since 2011, which has weighed on stock performance in the region. The stabilisation in China’s economic growth alongside improvements in developed market growth rates should promote a recovery in Asian earnings and forecasts; the upward-revisions seen for Asian earnings in 2H 2016 could be the start of great things to come in 2017 for Asian equities.
  • At just 14.0X 2016 earnings, Asian equities remain undervalued at this juncture, and we believe that a recovery in the earnings revisions cycle for Asia ex-Japan equities will be a key catalyst for Asian equity valuations to mean-revert higher. We are targeting a 16.0X PE for Asian equities which would see the market deliver a 22% annualised return by end-2018 (including dividends), with the North Asian markets accounting for most of the potential returns.

Developed markets still necessary for portfolio diversification, consider underweights

  • Our forecasted returns for developed markets like the US and Europe have risen slightly for 2017 on the back of upward-revisions to earnings growth. The main detractor of their potential upside for both markets are the likelihood of a contraction in valuation multiples, which could be reset via a correction in the stock market.
  • For 2017, we still expect both markets to deliver fairly reasonable (single-digit) returns for investors and continue to advocate an allocation (albeit underweight) to developed markets for portfolio diversification purposes, with the expectation that 2017 should be another year of positive earnings growth for developed market companies.

China is cheap and ready to outperform

  • Seemingly in a state of continuous “rebalancing”, the world’s second largest economy remains in a transition phase towards a consumption-led economy. Guiding for a growth rate of 6.5% in 2017, China’s economy has moderated from the double-digit growth rates seen in the 2000s. The ongoing anti-corruption crackdown has continued to impact the corporate sector, with the earnings of Chinese equities continuing its trend of disappointment.
  • That having been said, we think the worst of the Chinese economy appears to be behind us, with no meltdown. Domestic consumption remains robust and growing
  • For the “old economy”, the industrial sector could be poised for a rebound given that the current 22-month long industrial destocking may be over soon; allowing a restocking cycle to begin. The acceleration of industrial profits growth also point to better times ahead as estimated earnings for 2016 were revised upwards by 0.4% in September 2016 after being cut 7% by analysts on a year-to-date basis.
  • While monetary policy has been easy in 2016, we expect a tightening bias to it in 2017 given the sharp rise in property prices in certain cities, with the intent of controlling run-away home prices.
  • Valuations remain very undemanding at this juncture having undergone a momentous correction in the middle of the year; China equities trade at just 10.6X 2016 earnings (as of 28 November 2016), a long distance away from the 13X fair PE we attribute to the market. On our estimates, the China equity market is on track to deliver a 25.8% annualised return by end-2018, driven primarily by an expansion of the market’s PE ratio.

Chinese financials – the dark horse for 2017

  • The Chinese financial system has been the subject of intense pessimism in recent years. Be it due to concerns of a property bubble, wealth management products or fears of bond defaults and a rise in non-performing loans, the Chinese banking sector has been very much unloved by markets.
  • We think that a systemic banking crisis is unlikely to unfold, given that Chinese banks are adequately capitalised with their capital adequacy ratios well above the Basel III requirements of 8% as well as the stricter ratio of 10% that is imposed on Singapore banks by the Monetary Authority of Singapore.
  • While a further rise in soured loans over the next few quarters that could reduce their profitability is a possibility, it is important to note that most debt defaults stem from state owned enterprises; with the Chinese government retaining control over these state owned enterprises and banks, foreign exchange and capital flows, the government is in a position to contain this debt burden and limit the risk of a systemic financial crisis.
  • The Chinese banking sector is expected to post positive earnings growth in 2017, despite several purported headwinds.Sporting valuations based on 2017 estimates that are at a significant discount with sufficient negative sentiment to make the sector a contrarian call, the sector could be poised to outperform in 2017 against market expectations.

Seek out safer bonds for capital preservation in fixed income

  • Part of our decision to overweight in equities is due to a lack of attractive opportunities for fixed income as a whole at this juncture, which sees us shifting our portfolios towards a more defensive stance for capital preservation. We expect the fixed income landscape to be lively in 2017, which should provide us with tactical opportunities.
  • While interest rates in the US are still on its up-cycle, the current stance adopted by the Federal Reserve has been a gradual normalisation in monetary policy due to a benign inflationary environment and moderate growth. Should inflationary pressures accelerate, policy-makers could normalise interest rates faster than expected which could lead to volatility in bond yields in 2017.
  • While there is currently a lack of opportunities in the fixed income space that are attractive from a risk-return basis, we maintain that fixed income remains an integral and relevant part of an investor’s portfolio, and should be seen as a portfolio stabiliser.
  • Given that yields on safer fixed income instruments like G7 sovereign bonds remain unattractive at this juncture (and are also expected to be hurt more should the Fed hike rates quicker-than-anticipated) despite having risen recently, investors might think that the riskier segments of fixed income are more attractive. However, in the current environment, we prefer the safer segments of fixed income such as short duration bonds over credit spreads such as high yield and emerging market debt due to the risk of rising risk-free rates which will send yields rising for credit spread related instruments.
  • While our long-standing preference for short duration bond does not offer yield hungry investors a mouth-watering return, we believe the segment is best placed to offer investors capital preservation, especially if bond yields or rates rise quicker than anticipated.

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