Into 2017: Prepare for a volatile year

Robert Gottliebsen

Into 2017: Prepare for a volatile year

The 2016 year has been a bumpy ride but overall, apart from bonds, it has been a good one for most investors as broad areas of the share, property and other security markets have done well.

So we will all enjoy our Christmas festivities. In my last Eureka Report commentary for 2016 I want to take a peak at 2017, which I think will be a higher-risk year than the one we have just seen.

But first, some housekeeping. Our federal government, in its wisdom, has decided to tax superannuation in an even more complex way and to introduce contribution rules to add to that complexity. The extra complexity is going to mean higher costs for publically available superannuation funds and increase the attraction of self-managed funds, where individual situations can be easily managed without complex computer systems to cover all variations.

Relatively few people in the community have more than $1.6 million in their pension mode superannuation fund, but those that do have received some good news. In its various public statements the Government has indicated that people had to set aside specific securities into a $1.6 million fund which would be tax free. The remaining securities would be treated akin to an accumulation fund and income taxed at 15 per cent – a nightmare for many self-managed funds.

That option is still available, but for many it is a very complex one because you have to decide which securities you insert into the $1.6 million tax-free fund and which you leave outside to be taxable.

If you have a large property investment it is impossible. The indications are that a second option is available, which to my mind is a far more sensible option. Superannuation funds can be treated in their entirety, with actuaries calculating the $1.6 million tax-free component. Obtaining an actuarial certificate is relatively cheap for straightforward funds. That's what I will be doing.

The fallout from higher interest rates

The first feature of 2017 that will be very different to 2016 is that we are moving into a higher global interest rates environment. The yield on US 10-year bonds has risen from under 1.4 per cent to over 2.5 per cent in a short period of time and, at this stage, shows every indication of rising further.

That means that all those companies that borrow extensively overseas are going to pay more for their money, even though they might hedge the currency risk.

Banks have been amongst the first affected and we are seeing them lift interest rates on investment loans. But the higher interest rates over time will affect all companies that borrow heavily overseas and who to date have been basking in the benefits of low interest rates.

Rising oil and energy prices

The second major change is that we are going to head into a period of higher oil prices and, in Australia, higher energy prices. At the moment we have a surplus of oil but rising demand and the OPEC/Russian production cuts, even if there is some cribbing by the partners, will see that surplus disappear during 2017.

Of course, if Russia and Saudi Arabia allow the oil price to rise too far, and particularly if it rises above $US70, we will see a surge in US production. American shale oil production is governed by the number of new wells that are being drilled, and that trend is already beginning to rise.

President-elect Trump will be encouraging American oil production. Although the surplus will disappear I don't think the sustainable oil price will go through the roof, although there could be big blips if American production increases are too slow. Nevertheless, if the oil price goes above $US60 a barrel our LNG producers, particularly those in Queensland, will begin to breathe a sigh of relief. And BHP, which has maintained a bullish position on oil, will also be a winner.

On the other hand, Australia has shot itself in the foot by curbing gas production on environmental grounds. Gas was the natural replacement for high carbon coal and would have seen us through until much better solar and other carbon free technologies were developed. But now, as we cut back on coal, we face a shortage of gas which will lift our total energy costs, and combined with the higher interest rates will cause nervousness in the market.

Trump and the US economy

The big development in 2017 will, of course, be whether Donald Trump can really ignite the American economy. He is attempting something that has few parallels in recent political history. Trump is appointing to key cabinet positions businesspeople, rather than those that have made their way through the political ranks. As you would expect, this is creating enormous excitement on Wall Street.

The people he is putting in key positions have tremendous talent, but whether they can convert their talent into actions by government is a complete unknown. I think there is a very good chance that they will, but it will take much longer than markets expect. So don't be surprised that in 2017 there will be periods of disillusionment because of time delays. As a danger alert, veteran US economist and a long-standing friend, Al Wojnilower, describes what may happen this way:

“Few if any sizable longer-range US business investments will be launched until the tax and regulatory environment is clarified. At present, managements do not know what the tax rules will be, nor the trade rules, the energy rules, or the anti-trust rules. Probably they do realise that all rules are now subject to change on a whim, or that a negative tweet from the President might derail any decision. Risky projects will be deferred.

“For the next several months, investment in energy production may rebound in response to the recovery in oil prices. Other investment, however, which has been growing at a slow but disappointing pace, is likely to stagnate for the foreseeable future.

“Motor vehicle sales, which are a significant part of capital investment and a chief driver of the economic expansion, are probably levelling off amid deepening price discounts and rising defaults on sub-prime loans.

“Buoyed by large, albeit slowing, employment gains, consumer spending growth has been holding its own. Wage rates have crept a bit higher on average, but employers continue to “buy out” ageing workers in order to replace them with younger ones at less pay and benefits. This seems the smoothest way to offset the damage to profit margins from the rising dollar.

“With the unemployment rate at 4.6 per cent and nearing a bottom, a prolonged slowing in employment and retail sales growth will probably begin in a matter of months”.

Before applying the Wojnilower forecasts to markets, let's look at some other developments.

Russian power plays and a troubled Europe

Of particular importance and controversy will be the US involvement with Russia. I think President-elect Trump has made it very clear to the Europeans that they are going to have to bear a lot more of the cost of NATO than they currently do.

At the same time, I can't conceive that the new American president will be an enthusiast for the Obama stance against Russia in the Ukraine and places like Montenegro and even the Latvian states.

At the same time, Europe itself in 2017 will undergo enormous pressures because of deep divisions in its population and the weakness of its banks. Conceivably it could start to split.

The problems in Europe and the new relationship between Russia and the US will be big issues in 2017.

The problems with China

But, for Australia, the biggest issue will be the progress of China. The Chinese crackdown on corruption has gone much further than anyone thought possible, and the message I am getting out of China is that there could be ramifications to the economy.

At the same time, the new Trump administration is promising a hard line against China. This will create risks of military confrontation in our region.

Look at all the above and you can see that we have the beginning of a very volatile environment for 2017.

Add to that the inevitable surprise events that we haven't even thought of. So my prediction for 2017 is that there will be considerable volatility in the market and there is no certainty that this time next year we will be feeling as good as we are in 2016.

Review your portfolio

If you need to adjust your portfolio, then now is the time to do it. It is much easier to make changes to your portfolio in a strong market than when it is collapsing.

So when you have finished your Christmas celebrations spend some time in your new year break looking at your investments and make sure you will be comfortable to ride through periods of volatility.

Readings and Viewings

This is our final Weekend Brief for 2016. It may not seem like it as we near the end, but it was definitely a monumental year on so many different levels.

There are the obvious big stories, which are yet to play out in full: Syria; Brexit, Trump, Putin and China. Here's a handy world map that lists most of the key events from 2016, and you can find more by scrolling down the page and also hovering over each month of the year.

Of course, the news never stops. So here's a few links to some of the interesting stories we spotted during the last week, and a couple of older ones.

In the US, President-elect Donald Trump continued to show he really means business. His biggest appointment of the week was Exxon boss Rex Tillerson, also known as T. Rex.

Goldman Sach's also announced a changing of the senior guard after Gary Cohn was poached by Trump to head the White House National Economic Council

Bolstering his power team even further, he also added the top execs from Uber, Tesla and Pepsi to his Strategic and Policy Forum.

And Trump also met with senior tech execs in Silicon Valley after months of clashing.

It's all go for Trump. Here's a long read on the psychology of Trump (from mid-year). “More than even Ronald Reagan, Trump seems supremely cognisant of the fact that he is always acting. He moves through life like a man who knows he is always being observed.”

In New Zealand, an article claims that while others leaders aspire to change the world, John Key sought to manage the small change.

Back on home soil, as our government prepares to weigh a crackdown on the ‘cash economy', including removal of the $100 note, economics commentator Phillip Soos argues for their retention.

Elsewhere, here's a smattering of miscellaneous items.

Victims of Bernie Madoff's massive ponzi scheme finally received some cheer this week.

Is this a sign of a property crash? Lego is raising its bricks prices in the UK.

Give us a break! A European court has ruled that KitKat can be copied after Nestle lost its trademark protection.

It's a brave new world. A virtual reality start-up lab has been established in New York, the first of its kind.

Meanwhile, Amazon's first air drone delivery landed in the UK.

Some Christmas encouragement: a lot of the great composers were fond of the bottle.

A nuclear climatologist on what the world would look like if, say, India and Pakistan detonated 50 Hiroshima-sized nuclear weapons.

We stumbled across this oldie but goodie this week. The Comedy Company's Colin Carpenter, aka Kym Gyngell, on investing in shares/chairs.

Australiana of the week: Farmer out yabbying is set upon by a goanna.

Recipe of the week: Forget the curry, here's the real deal. In a past life I whipped this one up for a Christmas in Darwin. It was a sweaty kitchen, with the oven going for over two hours.

Last Week

Shane Oliver, AMP Capital

Investment markets and key developments over the past week

• The past week saw share markets have a few wobbles in response to a somewhat more hawkish than expected Fed. However, US shares still managed to push higher thanks to good economic data and European and Japanese shares continue to benefit from falls in the Euro and Yen along with good economic data too. Against this, Australian shares slipped and Chinese shares continued to pull back not helped by the People's Bank of China continuing to tighten liquidity and macro prudential controls. Thanks largely to the Fed's more hawkish message bond yields continued to push higher as did the $US. Commodity prices fell slightly, including oil despite some non-OPEC oil producing countries agreeing to cut back production along with OPEC. The $A fell in response to the rising $US.
• Fed undertakes a somewhat hawkish hike. No one can claim surprise that the Fed hiked its key Fed Funds rate by 0.25 per cent to a range of 0.5-0.75 per cent. It had been well flagged and was easily justified by economic conditions. What surprised some though was a shift up in the median “dot plot” of Fed meeting participants' interest rate expectations from two to three rate hikes in 2017 suggesting a more hawkish bias at the Fed and this drove a "risk off" reaction in markets. There is a danger in making too much of this as a year ago the dot plot pointed to four hikes in 2016 and we only got one so it's hardly reliable and the post meeting statement and Fed Chair Yellen's comments were benign, but it does seem that the Fed is turning from somewhat dovish to somewhat hawkish. With the Fed at or close to meeting its objectives and fiscal stimulus on the way we are also allowing for three rate hikes in 2017.
• However, it's  way too early for US monetary tightening to be a cyclical negative for shares and growth assets as monetary policy is still very easy and we are long way from any cyclical excess that presages an economic slowdown or recession. Meanwhile, the strong $US will continue to act as a brake on the Fed getting too aggressive in raising rates.
• If you're wondering what happened to Italy after the No vote and the PM resigned…basically a new government was formed led by the same party (the Democratic Party) backed by the same coalition and with the same policies (except Senate reform). Only the PM and a few ministers have changed. So an early election has been averted and they may hang in there till the next elections are due in 2018. The next big event in Europe will be the elections in the Netherlands in March where the Eurosceptic Party for Freedom may do well but not nearly enough to form government.
• India's demonetisation coming to Australia? It has been reported that the Government is considering removing the $100 note in order to crackdown on the cash economy. Of course you won't see your $100 bills become worthless but to convert them to smaller denominations you may have to deposit them in a bank..at which point the tax office could raise questions if there is a lot of them. It's understandable that the Government is upset at missing out on tax because of the cashless economy. But such a move may not go down well with some who legitimately earned and paid tax on their notes but just don't trust banks. India's recent demonetisation experience also highlights that it runs the risk of short term economic disruption – but this should be much smaller in Australia where the cash economy is estimated to be around 1.5 per cent of GDP compared to much more in India.

Major global economic events and implication

• US economic data was mostly strong. Industrial production fell and retail sales were weaker than expected. But the weak retail sales followed two very strong months and everything else was strong. Gains in New York and Philadelphia regional manufacturing indices and continued strength in the Markit manufacturing conditions PMI point to stronger manufacturing going forward. Small business optimism also rose strongly in November and home builder's conditions rose to their highest since 2005. Meanwhile jobless claims remain low. Inflation readings were mixed with a stronger rise in producer prices but falls in import prices as the strong $US hit and core CPI inflation remained in the range it's been in for the last year.
• Eurozone business conditions PMIs remained unchanged at a solid level in December and continue to point to some acceleration in growth.
• Japan's Tankan business survey and December manufacturing PMI showed improved conditions for manufacturers.
• Chinese economic data for November was stronger than expected with a pick-up in retail sales, industrial production and total credit suggesting that December quarter GDP growth may have picked up a bit from the 6.7 per cent yoy pace.

Australian economic events and implications

• Australian data was a mixed bag with a fall in business conditions and consumer confidence but a slight rise in business confidence and stronger jobs growth. A fall in consumer confidence was to be expected in December following the weak September quarter GDP news but the November jobs data was surprisingly healthy. Yes unemployment rose but this was all due to higher labour force participation and monthly jobs growth was strong for the second month in a row with two months of strong full jobs growth. Leading jobs indicators such as job ads and vacancies point to reasonable jobs growth ahead.
• Finally, Australians continue to see paying down debt and bank deposits as the wisest place for savings and remain sceptical of shares. The latter tells us that the share market is a long way from being over loved which is a good sign from a contrarian perspective. Interestingly real estate remains out of favour too.

Shane Oliver is chief economist of AMP Capital.

Next Week

Savanth Sebastian, CommSec

• The cupboard is largely bare in terms of key domestic economic indicators or events until January 3. Still, the Federal Government will release its Mid-year estimates of the Budget position on Monday. On Tuesday the Reserve Bank Board minutes are released, while private sector credit figures are released on New Year's Eve.
• The Reserve Bank minutes is unlikely to surprise. Policymakers are pretty much talked out when it comes to 2016. The Reserve Bank remains optimistic about the medium term prospects for the economy, and no doubt the lift in commodity prices would give them further confidence.
• In terms of private sector credit, lending probably advanced by 0.5 per cent in November, lifting the annual growth rate from 5.3 per cent to 5.4 per cent. While housing remains the core driver of lending the lift in business borrowings is encouraging.
• In contrast to Australia, there are still plenty of indicators to watch in the US, focusing on consumer spending, consumer confidence and the housing market. But also the influential regional manufacturing surveys are released over the next couple of weeks and will feed into the ISM manufacturing gauge released in the New Year.
• Overall, US economists are forecasting modest improvements in indicators to be released over the coming fortnight. The final reading on September quarter economic growth should confirm that the US recovery is on track, supporting the decision by the Federal Reserve to lift interest rates for only the second time in almost a decade. Similarly house price growth remains healthy, while activity and new construction in the sector remains strong. It's clear the US economy is in good shape with firm economic growth and low unemployment. No doubt the focus in the New Year will be on the discussion around further US interest rate hikes.

Savanth Sebastian is a senior economist at CommSec.