Economic and Market Outlook October 2016

This is general advice only, provided by Pitcher Partners Sydney Wealth Management Pty Ltd, AFS and Credit Licence 336950.

2

International economy Part 1: Overview Global growth projections have been further revised lower to 3.1% in 2016 and 3.4% in 2017, a reduction of 0.1% from those made in April 2016. In its World Economic Outlook Update in July, the International Monetary Fund (IMF) noted that “from a macroeconomic perspective, the Brexit vote implies a substantial increase in economic, political, and institutional uncertainty, which is projected to have negative macroeconomic consequences, especially in advanced European economies”. GDP Forecasts

2016

2017

2021

All World

3.1%

3.4%

3.9%

Advanced Economies

1.9%

2.0%

1.8%

Developing Economies

4.1%

4.6%

5.1%

The world growth figures imply the global economy will continue to expand, albeit at a slower rate. On a five year view the IMF posits that advanced economies will continue to show muted growth, but that emerging economies will increasingly provide the growth engine for global GDP. The US economy will be pivotal as to whether projected growth in advanced economies will be achieved. It is forecast to grow at 2.5% in 2017, the highest rate of any Group of Eight (G8) economy. Although the expected growth rate in the US for 2017 has not been cut, this growth has definite risks to the downside. The current growth rate for the US is 1.1% (annualised at the second quarter reading). Continued weak spending by state and local governments is adversely impacting national growth. As a result, economic output has been hampered. On a positive note, a strong labour market should continue to underpin economic growth. To this extent, although August provided a weak non-farm payrolls number, over 700,000 jobs have been added to the US economy in the past three months and the unemployment rate is now consistently below 5%, whilst industrial production is showing belated signs of improvement. The growth rate of the US, and by extension the global economy, may be revised lower if the strength in the US dollar persists. The latter may be a consequence of either the Federal Reserve raising US official interest rates, a general flight to safety (be it perceived or real) as a result of geopolitical tensions and/or economic uncertainty, or monetary stimulus in other economies. Economic growth in emerging countries is expected to be 4.1% this calendar year, increasing to 4.6% in 2017. China’s 2016 projected growth has increased from 6.3% in April 2015 to 6.6% in July 2016. One needs no reminder that China remains the bellwether when it comes to growth in emerging economies and indeed, global economic growth. The country is the biggest single contributor to world GDP growth. To illustrate, on expectations of a global growth rate of 3.1% for 2016, China’s contribution would be around 1.2 percentage points (or around four times the contribution of the US). Notwithstanding monetary and fiscal stimulus from both the Government and the People’s Bank of China (PBoC), Chinese growth has decreased as a result of a slowdown in the construction sector and the structural excess capacity (where the potential supply dwarfs the available demand) in the country’s manufacturing and mining sectors. The country continues to rebalance its economy from manufacturing and mining (for mainly export purposes) towards goods and services (for mostly domestic consumption). Such a transformation is proving far from seamless but authorities could assist the transition by managing the sub-optimal and inefficient use of capital by State-Owned Enterprises (SOE’s), who still account for over one-third of the nation’s fixed-asset investment, as well as tackling the problem of excessive (and ever-rising) corporate debt.

Conclusion Global growth remains moribund. Efforts to reflate the global economy through massive injections of liquidity via unconventional monetary policies such as quantitative easing and negative interest rates have had little effect. Excessive government debt levels in many developed nations means that efforts to revive growth via more fiscal stimulus will be limited at best. Business investment remains constrained by a lack of demand and a lack of confidence. Personal consumption remains restricted by stagnant real incomes. Banks in Europe and China remain constrained by troubled loans. In conclusion, global growth is likely to remain below trend for some years yet. The US cannot do all the heavy lifting alone. Meanwhile, the risks of a further slowdown from a hard landing in China continue to rise.

United States Economic snapshot

Last reported result

Comments

Growth (GDP)

0.3% q/q Jun’16

Growth in the second quarter remained weak and well down on the 0.6% figure recorded in the second quarter of 2015. The yearon-year growth figure of 1.2% has also declined from the rate recorded for the twelve months to June 2015 of 3.0%.

1.2% y/y Jun’16 Unemployment

4.9% Aug’16

The number of jobs created in August (151,000) was lower than both consensus and previous readings. However, this marked the 71st consecutive month of positive readings. The resultant unemployment rate remained steady at 4.9% for the third consecutive month.

Industrial production

-0.4% m/m Aug’16

Industrial production has declined over the year, driven by a 9.3% contraction in mining (which includes the oil and gas industries).

-1.1% y/y Aug’16 ISM manufacturing PMI

49.4 Aug’16 51.3 May‘16

Retail sales

-0.3% m/m Aug’16 1.9% y/y Aug’16

The PMI reading of 49.4 indicates a manufacturing sector in contraction for the first time in six months as new orders, production and employment all contracted. Retail sales contracted for the first time in five months, weighed down by weak readings in the motor vehicles and parts dealers sector as well as building materials, garden equipment and supply stores. The year-on-year growth rate was relatively weak.

Credit growth

5.8% y/y Jul’16

Credit increased by 5.8% year-on-year and now stands at US$3.66 trillion.

Outlook

We expect growth in the US to continue to slow to below 2% over the next twelve months. Investment is weak but personal consumption remains relatively strong. We expect such tepid investment to continue until at least the US elections in November. We also expect manufacturing and net exports to be somewhat subdued in light of the relatively strong US dollar and muted global outlook.

Eurozone Economic snapshot

Last reported result

Comments

Growth (GDP)

0.3% q/q Jun’16

Growth has slowed over the quarter, affected by stalling economies in France and Italy.

1.6% y/y Jun’16 Unemployment

10.1% Aug’16 10.1% May’16

Industrial production

-1.1% m/m Jul’16 -0.5% y/y Jul’16

Manufacturing PMI

52.6 Sep’16 52.8 Jun’16

Retail sales

1.1% m/m Jul’16 2.9% y/y Jul’16

The unemployment rate continues to be the lowest recorded for the Eurozone since August 2011. The weak monthly result was driven by the production of capital goods falling by 1.7%, energy by 1.4%, durable consumer goods by 0.7% and intermediate goods by 0.5%. Production of nondurable consumer goods remains unchanged. The PMI reading of 52.6 continues to show a manufacturing sector in expansion. However, this is the lowest reading since January 2011 and the recent weaker readings show the economy is losing momentum. Although retail sales are still subdued, the year-on-year growth figure is the highest in nine months and the recent readings show positive momentum.

Credit growth

1.8% y/y Aug’16

Credit growth continues to be weak.

Outlook

Growth continues to weaken in the Eurozone. The outlook remains particularly uncertain given the current vulnerabilities in the banking sector and general elections and/or referendums in Germany, France, Italy and Spain within the next twelve months, especially in view of the rise of populist parties throughout Europe.

3

Part 2: Key economic indicators

4

China Economic snapshot

Last reported result

Comments

Growth (GDP)

1.8% q/q Jun’16 6.7% y/y Jun’16

Recent growth has been buoyed by further stimulus measures as well as a modest improvement in real estate sales. The recent depreciation of the Yuan has also improved the competitiveness of its export industries.

Unemployment

4.1% Jun‘16

Chinese official unemployment remains stable.

Industrial production

6.3% y/y Aug’16

Industrial production has stabilised around current readings for the past five months, aided by strong growth in automobile manufacturing, pharmaceuticals and electronics manufacturing.

6.0% y/y May’16 Manufacturing PMI

50.4 Sep’16 50.0 Jun’16

Retail sales

10.6% y/y Aug’16 10.0% y/y May’16

Fixed asset investment

8.1% y/y Aug’16 9.6% y/y May’16

Outlook

The latest reading of 50.4 indicates the manufacturing sector is expanding. Retail sales have been aided by strong online purchases as well as automobile purchases due to government incentives. This measure, a proxy for infrastructure and property expenditure, sits at sixteen year lows.

China’s growth outlook remains supported by accommodative economic policies. However, its ability to sustain fiscal stimulus is compromised by the high level of government debt. China’s inefficient use of capital especially through State-Owned Enterprises (SOE’s) only exacerbates the problem. We believe the risk of a hard-landing and therefore much slower medium term growth is increasing.

Part 1: Overview The Australian economy continues to grow above most market expectations. Despite much lower prices (the terms of trade has declined by about 35% since 2011), strong growth in the volume of mining commodities such as iron ore and LNG has provided a significant contribution to overall growth. Historically low interest rates, stable employment conditions and pent-up demand have fostered strong growth in housing prices, particularly in Victoria and New South Wales. Developers have seized on this opportunity, creating a residential construction boom in some states. Similarly, activity in the home renovation market is also strong, with demand for trades far exceeding supply. The flow on effect continues to support sales of whitegoods, furniture and other homewares. The sharp depreciation in the Australian dollar in the last few years has benefitted import competing manufacturers, tourism operators and education services. Should US interest rates normalise as expected, then the Australian dollar should drift back to the low 70 cent range. Demand for healthcare services and moderate activity in financial services continue to provide broad support for the economy. Nevertheless, areas of weakness persist. Demand for mining services and non-residential construction activity remains low. Income growth has been subdued by virtue of spare capacity within the labour market as well as the fact that many higher paid mining jobs have largely been replaced by lower paid occupations within the services sector. This helps explain why retail sales growth has not been as strong as otherwise would be expected.

Conclusion The RBA expects economic growth in 2016 and 2017 to be between 2.5%-3.5% and in 2018 between 3.0%-4.0%. We would expect the 2016 and 2017 estimates to be reasonably reliable given the underlying strength in the economy. However, the probability of the 2018 forecast being realised appears highly uncertain. This is because the foundations of the current strength in the Australian economy are primarily based on 1) continued demand for iron ore, coal and LNG; and 2) continued strength in the housing market. In our view both of these foundations appear rather shaky. Firstly, the risks of a hard landing in China continue to grow as years of debt fuelled overinvestment in infrastructure and housing may well prolong the downturn in demand for resources. Secondly, the boom in Australian housing has been created by an environment of unsustainably low interest rates that has artificially increased the borrowing capacity of investors, which in turn has helped asset prices far outstrip income growth. With supply showing signs of exceeding demand in some areas, the risks of a disorderly ending to the latest boom are only increasing.

5

Australian economy

6

Part 2: Key economic indicators Indicator

Growth (GDP)

Retail trade

Manufacturing PMI

Business investment

Unemployment

Last reported result

Comments

0.5% q/q Jun’16

GDP has increased at the fastest rate in four years.

3.3% y/y Jun’16 12 month outlook

We continue to forecast above-average growth of above 3% over the next twelve months.

0.0% m/m Jul’16

The retail trade figure was softer that previous estimates and confirms a weakening trend.

2.7% y/y Jul’16 12 month outlook

This indicator is likely to remain well-supported by accommodative monetary policy settings and stable employment.

46.9 Aug’16

The Manufacturing PMI indicates the manufacturing sector is in a contractionary state.

51.0 May’16 12 month outlook

Despite the current weakness, this indicator may be expected to remain in an expansionary phase over the next year, aided by increasing exports and new construction projects.

-5.4% q/q Jun’16

Business investment continues to fall as mining infrastructure spend continues to be wound back.

-17.4% y/y Jun’16 12 month outlook

We continue to expect business investment to decline further as the transition from a mining economy to one more reliant on services involves far less infrastructure expenditure.

5.6% Aug’16

The unemployment rate dropped to 5.6% in August due to a decrease in the participation rate, notwithstanding the fact that the economy lost 3,900 jobs over the month.

5.7% May’16 12 month outlook

A modest improvement is expected in line with the above-trend growth forecasts.

Inflation:

The Consumer Price Index (CPI) has fallen even further below the lower end of the RBA’s inflation target band of between 2.0% and 3.0%.

0.4% q/q Jun’16 1.0% y/y Jun’16 Inflation & interest rates Interest rates: 1.50% Cash Rate Sep’16

Australian Dollar

The RBA decided to hold the official cash rate steady at 1.50% at its September meeting.

12 month outlook

We expect inflation to remain subdued. However, we expect rates to remain on hold given the underlying strength in the economy at the present time.

AU$1 = US$0.77

The Australian dollar is at close to its yearly high, benefitting from a pickup in commodity prices (with the exception of oil) and sound economic data.

12 month outlook

A devaluation in the AUD from these levels is expected over the next year as downside risks are numerous (e.g. a potential hard landing in China and/or a potential normalisation of interest rates in the US).

7

Australian equities Overview The S&P/ASX 200 Accumulation Index returned 5.1% over the three months to 30 September 2016.

Source: S&P

Outlook Our outlook for some of the major sectors of the S&P/ASX 200 is as follows:

Banks Recommendation: Maintain underweight The share prices of domestic banks have declined significantly since the first half of 2015 and are now back to more reasonable levels. Total shareholder returns from current share prices are likely to be driven by dividends rather than capital appreciation. Balance sheets have been stabilised as a result of significant capital raisings and the banks, in general, continue to maintain comfortable buffers against specific Basel III capital ratios, reducing the probability of dilutive capital raisings going forward. To preserve such buffers, lower payout ratios can be expected in the future. Banks continue to focus on controlling costs, which has the effect of supporting earnings during periods of weak growth. Active management of costs should improve cost-to-income ratios, lending support to earnings. The slowdown in core earnings was evident in the past twelve months due to net interest margin compression, muted loan growth and banking fee income, in addition to subdued wealth and markets income. Wholesale funding costs continue to be elevated, volatile and, since a portion of a banks funding is obtained from offshore, susceptible to shocks in already stressed global credit markets, potentially threatening wholesale funding availability. Coupled with fierce pricing competition in the lending and deposit markets, this could potentially pressure net interest margins even further. Consequently, this would constrain return on equity. The Australian credit cycle has shown signs of normalising after a period of low credit losses. Impairments are likely to continue to increase towards long term trend levels.

8

The banking sector is highly exposed to deteriorating economic conditions. Higher interest rates, inflation and unemployment have the potential to reduce loan growth and increase defaults. Banks remain vulnerable due to the excessive debt exposure in the housing sector. The banks are also heavily regulated and therefore exposed to adverse regulatory changes. Earnings from their wealth-management divisions are heavily dependent on the direction of equity markets. However, the income yields of the major banks continue to be attractive. We maintain our underweight recommendation.

Resources Recommendation: Retain neutral Given the prognosis for lower for longer growth in the world economy, commodity prices are likely to be subdued for the foreseeable future. Stimulus measures by Chinese authorities have helped cushion the blow to commodity prices and soften the overall economic slowdown. Excess capacity in many commodities does not look like resolving in the short term due, in part, to the continued sub-optimal and inefficient use of capital, primarily by China’s State-Owned Enterprises (SOE’s). Commodity prices have not collapsed to the point where marginal producers are forced to halt production and potentially mothball projects, which would ease excess capacity. The large, diversified, low-cost producers appear attractive on a long-term view at current prices. Such companies also find it easier to strip costs out of their operations and focus on the more profitable parts of their businesses, as well as leverage any uplift in commodity prices. Balance sheets for such businesses are generally solid due to a combination of equity raisings and the selling of non-core operations. Resource companies face increased cost pressures as governments around the world tackle budgetary pressures by raising mining taxes. We believe current share prices already reflect the gloomy growth outlook and retain our neutral recommendation.

Retail Recommendation: Maintain neutral The strong housing market continues to spur sales of household consumer goods, whilst favourable interest rates have contributed to an increase in disposable income, increasing discretionary expenditure. The retail sector is also benefitting from the strong numbers of overseas arrivals, especially from Asia. We remain neutral on the sector over the next twelve months.

Australian Real Estate Investment Trusts (AREITs) Recommendation: Retain underweight The AREIT sector returned 25% over FY2016, the low-interest rate providing a tailwind for the sector as investors have searched for yield and reliable earnings. This has led to many AREITS within the sector trading at 15% premiums to their Net Tangible Assets (NTA’s). The sector is exposed to adverse changes in the interest rate environment. However, this risk is mitigated to a certain extent by balance sheets across the sector being much more robust than they were a decade ago, preceding the financial crisis. Gearing across the sector is around 25%. Companies have utilised the lower interest rate environment to lower borrowing costs and increase the average debt duration. At an operating level, Funds From Operations (FFO) have been growing at double-digits and distributions have been raised accordingly. We maintain our underweight recommendation. Commercial property prices remain expensive on a through-the-cycle basis, propped up by unsustainably low interest rates. Stock prices reflect this overvaluation.

Conclusion Recommendation: Neutral The outlook for Australian equities is mixed. Whilst many sectors trade at lofty valuations (e.g. infrastructure, AREITS – although these prices have pulled back recently), there are other sectors where current valuations are somewhat more reasonable. Domestic economic conditions overall remain sound, which should provide a platform for modest share price growth over the next twelve months, although economic uncertainty overseas remains a key risk.

9

International equities Overview The MSCI World Index (ex-Australia, in local currencies) returned 4.3% over the three months to 30 September 2016. In US dollar terms the MSCI World Index (ex-Australia) also returned 4.3% over the same period.

Source: MSCI

Outlook Despite the top 500 companies in the US reporting negative earnings growth over the last five quarters, US and global equities have remained remarkably resilient and remain near record highs. The S&P 500 is currently trading on a multiple of 19.4 times 2016 expected earnings, well above the longer term trend of 16 times earnings. Other measures of value such as Price to Book and Price to Revenue ratios remain well above long term averages. Similarly, stocks in Europe remain buoyant despite ongoing concerns about growth and the safety of banks in the region. In recent years, most of the improvement in earnings has come from cost cutting and share buybacks rather than revenue growth. This trend is unsustainable. Unconventional monetary policies by central banks have encouraged investors into equities to escape the very low interest rates on offer for cash and bond type investments. This trend is also unsustainable. With the Federal Reserve set to finally raise interest rates in coming months, the US dollar is likely to rise. As over 40% of earnings from the top 100 companies in the US are derived from offshore, earnings are set to come under even more pressure given the already subdued levels of global trade.

Conclusion Recommendation: Maintain moderate underweight We believe global equities remain overvalued. During the past few years, stock prices have grown much faster than underlying earnings. In addition, corporate debt is also twice as high as it was during the financial crisis. The much anticipated normalising of US interest rates together with the US Presidential elections remain potential trigger points for a possible correction. We maintain our moderate underweight exposure to global equities.

By Dr. Riccardo Biondini and Martin Fowler

10

Abbreviations used in this report m/m

month on month (e.g. Feb’15 v Jan’15)

q/q

quarter on quarter (e.g. Dec’15 qtr v Sept’15 qtr)

y/y

year on year

pcp

prior corresponding period (e.g. 0.4% pcp Feb’15 means a gain of 0.4% in Feb’15 v Feb’14)

PMI

Purchasing Managers Index (unless otherwise stated)

P/E

Price to Earnings ratio

GDP

Gross Domestic Product (proxy for economic growth)

Interpretative

Manufacturing In Australia this survey is done by PMI the Australian Industry Group and is known as the Performance of Manufacturing Index. A reading above 50 means that manufacturing output is improving, a reading below 50 means that it is contracting. PMI index data obtained relies on survey participants and so its reliability as a leading indicator is only modest.

11

Get in touch... Charlie Viola

Martin Fowler

Partner, Wealth Management

Partner, Wealth Management

+61 2 8236 7798

+61 2 8236 7776

[email protected]

[email protected]

Jordan Kennedy

Haris Argeetes

Client Director, Wealth Management

Senior Adviser, Wealth Management

+61 2 9228 2423

+61 2 8236 7851

[email protected]

[email protected]

Lino Abruzzese

Chris Mackenzie

Finance Specialist, Wealth Management

Senior Insurance Advisor, Wealth Management

+61 2 8236 7761

+61 2 8236 7819

[email protected]

[email protected]

Dr. Riccardo Biondini

Louis Stergio

Investment Analyst, Wealth Management

Risk & Compliance Manager, Wealth Management

+61 2 8236 7856

+61 2 8236 7823

[email protected]

[email protected]

Copyright © 2016 The information provided is not personal advice. It does not take into account the investment objectives, financial situations or needs of any particular investor and should not be relied upon as advice. While the information is provided in good faith and believed to be accurate and reliable at the date of preparation, we will not be held liable for any losses arising from reliance thereon. We recommend investors consult their personal financial adviser to discuss suitability and application to their individual circumstances. Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFS & Credit Licence number 336950.

MELBOURNE +61 3 8610 5000 [email protected]

ADEL AIDE +61 8 8179 2800 [email protected]

SYDNEY +61 2 9221 2099 [email protected]

BRISBANE +61 7 3222 8444 [email protected]

PERTH

PITCHER.COM.AU

+61 8 9322 2022 [email protected]

NEWCASTLE +61 2 4911 2000 [email protected]

Pitcher Partners is an association of independent firms. Liability limited by a scheme approved under Professional Standards Legislation.

Economic and Market Outlook_Oct 2016