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The improvement of inflation expectations masks the fragility we have seen in the Q3 GDP numbers and it’s interesting that the consensus (among the economist community) of the -0.5% quarterly print (the first negative print in five years) should mark the low point, with calls for a snapback in quarterly growth of +0.6% in Q4, +0.7% in Q1, +0.8% in Q2, Q3 and Q4.
There are a number of key economic variables that need to be taken into account. Specifically, two areas that stand out as key considerations are property construction (and house prices) and employment trends. If we look at Credit Suisse’s financial conditions index (this captures the domestic price and availability of money, the international price of money and cash flow constraints for households), we can see this forward-looking indicator heading lower, providing a further headwind to Aussie growth in the coming quarters. Importantly, there has been a very strong correlation between this index and upcoming GDP prints, so perhaps the consensus of +0.6% quarter on quarter could be a touch too bullish here.
While Credit Suisse’s model suggests a weak quarter in Q1, the boom we have seen in commodity prices should boost exports sufficiently to avoid another negative quarter and a technical recession. The Q4 GDP print is released on 1 March.
The interest rate debate
The debate on the Reserve Bank of Australia (RBA) cash rate is heating up, with the median forecast (of the 26 economists polled by Bloomberg) expecting the cash rate to stay at 1.50% through to Q4 2017. Looking at the range in the forecasting, we can see the most optimistic call is one hike to 1.75% (TD Securities) by Q4 2017. On the other side of the ledger, there are six economists calling for rates to be cut 50 basis points to 1% (including NAB and Morgan Stanley) by the end of 2017.
The consensus view that we have reached the limits of monetary easing is echoed by the interest rate market pricing in just two basis point of hikes over the coming year. We know the hurdle to ease is extremely high, and it’s been prevalent in most of the recent narrative from the RBA. When the output gap (the level by which output of an economy is not meeting its potential) is at 1.4% of GDP, the probability suggests the debate still centres on whether the RBA cut rates further from here. One suspects that continued focus on record low wages, married with a renewed deterioration in employment trends and another quarter of poor inflation growth (Q4 CPI is released on 25 January) means the RBA could be feeling a little hot under the collar. The February RBA meeting may even be a ‘live’ meeting, with the market sensing a possibility of a cut.
With Australian growth a key theme in 2017 and the market expecting this to average 2.7%, one of the key talking points will centre around the current account deficit. The Bloomberg economist consensus is for a deficit of 3.5%, but the strength in commodity prices will be a welcome boost for the government revenue, as well as mining profits. The expected backdrop of global reflation could be a net positive for Australia and the demand from China isn’t going anywhere, so while the economists' calls for the deficit range from 5% to 1%, I personally feel the deficit will fall below 2% and even towards 1%. It is uncertain whether Australia will retain its AAA credit rating, but even if it is lost, it should in theory be more of a media and political story than one that deeply impacts economics.
Targets for the ASX 200
While Australian economics are by and large expected to improve into the first half, the financial markets are still anyone’s guess. There is no consensus target on the ASX 200 that I can see, but most analysts are constructive on the index (as they are every year), with the consensus earnings-per-share (EPS) growth sitting at 11% year-on-year.
It will not shock that the bulk of this growth will come from mining names (consensus sits at +138%), given the outrageous moves in metallurgical coal, thermal coal and iron ore. It’s interesting that, despite some huge gains in this sector in 2016, most mining companies’ price-to-earnings (P/E) ratios haven’t actually increased due to the earnings being revised higher. Double digit earnings growth should also come from the staples: telco, discretionary and transports.
Meeting ASX 200 targets is often met with much cynicism, but we need to question the (price to earnings) multiple investors are willing to pay. The long-run 12-month P/E for the ASX 200 is 14.2x and since the early 1990s we’ve not seen the index command a multiple higher than 18x. Given consensus 2017 EPS sits at $3.60, I feel investors are not going to be happy paying over 16.5x. This really caps the index at around 6000, although much depends on the earnings side. If things really fire up, we could see earnings of $3.80, which takes the index through 6000.
One consideration is the potential for fiscal stimulus. What if the government does manage to get a stimulus away to support the economy? That is certainly not a mainstream view, but if growth does falter, it will get an ever-greater discussion, even more so if Australia loses its AAA credit rating and they have free reign to increase the deficit. Recall, government debt in Australia is actually very low by comparison. In the scenario of fiscal stimulus, watch capital pile into Australia.