See Jason Widjaja and Aaron Costello, “Australia Outlook 2015: Still Cautious,” Cambridge Associates Research Note, February 2015.

Markets were volatile in 2015, dominated by themes of a strong US dollar, weak commodity prices, nervousness over China, and anxiety over when the US Federal Reserve would raise rates. This year seems to be more of the same: the market action in the first few weeks of January is eerily similar to that of  last August when weakness in Chinese equities and the renminbi shook global markets, and the price of oil continues to plummet. Indeed, in re-reading our outlook from last year we are struck with a sense of déjà vu, as many of our macro concerns and market views remain the same.

At the risk of repeating ourselves, we continue to see headwinds for the Australian economy, as the recovery in the non-mining economy will not be strong enough to offset weakness in the mining sector amid a less benign external environment. Thus, we expect bond and cash yields to move lower in Australia and the Australian dollar to remain weak in light of heightened volatility in global markets. Australian equities will also stay under pressure and will likely continue to underperform non-Australian equities. Yet, given that our base case is not for a full-fledged crisis in China or a recession in the United States, we do not think investors should drastically de-risk portfolios. Instead, investors should remain levelheaded, as 2016 may play out largely the same as 2015, or even 2011, with macro concerns ultimately blowing over, but with risk assets producing lackluster returns as global growth and corporate profits remain weak.

For now, markets are still in flux, and depending on how sharp drawdowns are in the interim, 2016 may represent an attractive buying opportunity for Australian equities, and perhaps distressed assets in the global energy and commodity space. Until more attractive opportunities present themselves, investors should hold steady and be prepared for a ride that is similar to last year, albeit already noticeably more volatile.

Macro: Risks Are Rising

The current bout of risk aversion has hit just when many economists had become relatively bullish on the Australian economy. While the economy slowed modestly over the course of 2015, the fourth quarter saw a rash of indicators surprise to the upside. The net result is that consensus forecasts in early January expected GDP growth to accelerate from 2.3% to 2.6% in 2016, with inflation also expected to rise modestly from 1.5% to 2.2%. The consensus also expected the Reserve Bank of Australia (RBA) to remain on hold and bond yields to tick up a bit to 3.1% (Figure 1). January’s market events mean all of these forecasts are being revised. But even before markets took a dive in January, we were skeptical of the view that growth and inflation would accelerate, given our concerns over the headwinds Australia’s economy faces.

Much of the resilience in the Australian economy over the past few years has been due to the ongoing housing boom, which has helped offset the drag from falling mining investment. A weak Australian dollar has also contributed, with non-commodity exports and services (such as tourism and education) doing well. Yet the construction industry and residential real estate market have reached a critical turning point. Multi-year highs in new dwelling approvals point to a housing supply that is starting to outweigh demand (Figure 2). House prices seem to be peaking at the same time that new loans to property investors have been curbed to only 35% of total new loans, a two-year low. It is unclear who will take up the new housing supply, as trends in migration are also slowing.

Meanwhile, household debt levels climbed from 180% in 2014 to 185% in 2015. Although this has occurred amid a fall in household interest payments due to record-low interest rates in Australia, households likely cannot continue to lever up at their current pace (Figure 3). The labor market seems to be improving, but real wage growth continues to be relatively weak at 1%. Further, the full impact from the fall in mining-related investment has yet to be felt, while non-mining, non-housing investment is flat. As such, we remain highly skeptical that the non-mining economy can continue to offset the weakness in the commodity sector, especially with the housing market rolling over.

This doesn’t mean a recession is imminent, although risks are rising. Rather, this analysis shapes our view that the RBA will remain dovish, and additional rate cuts are possible to boost to the economy if needed. However, pulling that trigger might get more difficult as the RBA is wary of reigniting house price appreciation and increasing household debt levels.

Unfortunately, the global picture is also not supportive. In our view, China is already experiencing a hard landing on the industrial side of the economy, which only grew 0.9% in nominal terms in 2015, down from 20% as recently as 2011. Although the service sector is growing at a relatively robust 10%, this part of the economy will also weaken in 2016, due in part to weak corporate profits, which will feed into lower wages and ultimately lower consumption. Thus, we continue to expect weaker economic data out of China, as well as a weaker renminbi, which may rattle markets. While we expect growth in China to continue to slow, we are not yet convinced that a financial crisis is set to occur, given the semi-closed nature of the banking system and ample room for the People’s Bank of China (PBOC) to lower rates and inject liquidity. However, stemming the flow of capital flight out of China is key for the PBOC, which means increased capital controls are needed. Failure to stem the tide of outflows raises the risk of crisis in China and needs to be watched carefully. Interestingly, Australia has been a major beneficiary of Chinese capital flight, particularly the Sydney and Melbourne property markets.

Regarding the United States and other major developed economies, underlying economic data allow for cautious optimism. While the manufacturing sector everywhere is taking a hit from weak global trade and falling commodity production, the service sector has held up well and banks appear to be lending again for the first time in many years. The bull case centers around consumers spending the windfall from lower energy prices instead of saving it. This is particularly true in the United States, as wages are expected to rise amid a tightening labor market, but also applies to Europe, Japan, and even Australia.

That said, household spending and savings decisions are typically driven by consumer confidence. The risk facing the developed world is that the rise in financial market uncertainty may cause both businesses and consumers to continue to pull back. A variable worth watching is whether defaults among energy- and commodity-related borrowers cause credit markets to tighten up, further slowing growth.

In some respects, the current turbulence affecting global markets is similar to what struck in 2011, when markets became too complacent about signs of stalling growth momentum and were shocked back into reality by headlines about macro risks from a Eurozone break-up and US debt downgrade. After a sharp decline of nearly 20%, markets were able to recover, with the help of easy monetary policy from global central banks. Today, substitute China for the Eurozone, and energy companies for the US debt downgrade.

This time around, central banks will be more hesitant to pull the monetary trigger, as they are running low on bullets. But at a minimum, concerns about potential monetary tightening in 2016 are likely off the table. If China can avoid a financial crisis, and trouble in energy doesn’t spill over to broader credit markets, the major developed markets economies should be able to avoid a recession, and global markets should post a recovery in 2016. Much hinges on how quickly investor and consumer confidence is restored.

Australian Dollar: More Weakness Ahead

Given this backdrop, we expect continued volatility and weakness in the Australian dollar. The currency tumbled alongside markets in early January, reaching AUD/USD 0.68 at one point. Bloomberg consensus estimates are for the currency to end 2016 at roughly the same level, albeit with a potential range between 0.83 and 0.62 (Figure 4).

While we do not make explicit currency forecasts, we continue to see more downside for the Australian dollar. First, from a long-term valuation standpoint, the currency is not particularly cheap in real terms, unlike in 2008 or 2001. Second, we expect continued weakness in the renminbi and lingering China concerns to weigh on the Australian dollar. At the same time, the RBA views weakness in the Australian dollar as a key shock absorber for the economy, helping the transition away from mining-reliant growth. Thus, weakness in the dollar will not prevent the RBA from cutting rates if needed; nor will the RBA be inclined to hike rates to give the dollar a boost.

In the near term, a large rally in the currency cannot be ruled out should global risk appetite turn positive, which would result in a flat currency this year. However, we remain structurally negative on the Australian dollar, as the adjustment from previous overvaluation is not yet complete.

Australian Equities: Cheaper Prices, but Not Yet Value

Australian equities had a lackluster 2015, with the ASX 200 down 2.1% in price terms, but returning 2.6% thanks to a 4.7 dividend yield. This return was in line with broader developed markets equities. Australian equities actually outperformed US equities and fared much better than UK equities (another resources- and bank-heavy market) and China-centric emerging markets (Figure 5). But index-level returns continue to hide a bifurcated market, with the non-resources segment of the market returning 8.1% and small caps, 10.2%. Thus, 2015 was a good year for active managers that continued to shun resource-related stocks and banks, which also had a lackluster year.

Even before January’s market rout, it was hard to be too excited about equities; consensus forecasts expect ASX 200 earnings to be slightly negative in 2016 (-1.4%), driven by further falls in resource earnings and muted growth in other sectors.

One area investors should be critically examining is dividends, as Australian companies have maintained dividend policies despite pressure on earnings. This has resulted in high payout ratios that may not be sustainable if the economy weakens more than expected, especially for high-yield plays such as certain REITs and infrastructure stocks. These segments of the market have done very well in recent years; these stocks have appeared expensive, while leverage has been rising to maintain attractive yields in some cases.

In terms of the overall market, at the end of 2015 Australian equities were fairly valued, trading on par with their historical median composite normalized P/E^[1]The composite normalized price-earnings (P/E) ratio is calculated by dividing the inflation-adjusted index price by the simple average of three normalized earnings metrics: ten-year average real … Continue reading (Figure 6). However, this largely reflects the cheapness of resource stocks and fair value for the major banks; industrials and the rest look slightly expensive. All sectors have sold off at the start of 2016, with Australia 11% below fair value on our metric. Yet knowing what has been priced in and when fundamentals will improve is difficult. For instance, commodity-related sectors (17% of the MSCI Australia Index) continue to face overcapacity issues and fading demand from China, while heavyweight banks (37% of the index) are exposed to tighter capital regulations and a property market that seems to have peaked. Thus, Australian equities are not particularly cheap at the moment, especially compared to non-US equities (Figure 6).

Last year, we recommended Australian investors remain neutral on Australian equities, while tilting global allocations away from US equities and toward Eurozone and Japan on a hedged basis. We further advised considering modest overweights to emerging markets equities, with a preference for Asia ex Japan. These tilts largely paid off, especially underweighting US equities in favor of Eurozone and Japan. Although emerging markets exposure was a drag, Asian equities did outperform broader emerging markets, especially once adjusted for currency movements.^[2]In AUD terms, emerging markets equities returned -3.9%, compared to 2.5% for the Asia ex Japan index.

Please see Sean McLaughlin and Wade O’Brien, “Outlook 2016: Do You Know Where Your Risk Tolerance Is?,” Cambridge Associates Research Report, December 2015.

For 2016, we retain these views. We are neutral on Australian equities, as a compelling valuation case for or against does not yet exist, especially as valuations excluding resources are not yet cheap. Within Australia we continue to prefer active managers given the top-heavy and bifurcated nature of the market, although we would be wary of chasing yield plays. Outside of Australia, modestly underweighting US equities in favor of non-US equities is attractive on valuation grounds, as are emerging markets equities, although such an exposure may not pay off in the near term.

Australian Government Bonds: Still One of the Best Yields on Offer

Australian government bonds’ yield premium over their global counterparts (Figure 7) resulted in the asset class (2.3%) outperforming global government bonds (1.3%) in 2015 in local currency terms, and rising risk aversion has benefitted the asset class into 2016. The Australian ten-year government bond yield ended 2015 modestly higher than 2014, at nearly 3.0%. In early 2016, bond yields went to 2.70% at one point.

While Australian government bonds look overvalued at current levels, we think investors should maintain allocations. First, given macro risks, yields certainly have scope to move lower. We doubt the RBA will raise rates this year, and the Fed may be on hold as well. Even amid rising US rates, Australian yields could move lower should economic conditions warrant; in the late 1990s/early 2000s, Australian government bonds effectively had no spread over US Treasuries (Figure 8).

While Australian bond yields could sell off sharply if negative macro sentiment appears overdone, such an outcome should see equities rally and thus overall portfolio returns turn positive. In short, we are not concerned about bonds, and we would keep some mixture of cash and long-duration government bonds in the portfolio given our views on the macro environment and attractive yields relative to global bonds.

Conclusion

Rising macro risks make it hard to have conviction in the outlook for 2016. We suggest investors remain calm and be prepared to ride out another volatile year, much like 2015 or 2011. The reality is that investors never know in real time whether a recession is at hand, nor can they necessarily profit from knowing so. Australia has not had a technical recession in 24 years, yet has experienced three major equity bear markets over that period.

The good news amid the January turmoil is that markets are increasingly priced for bad outcomes. The price of oil has fallen below US$30, while yields on US energy-related high-yield bonds have reached 19%, effectively pricing in potential defaults to come. Global equities have fallen nearly 20% from their 2015 highs, the cusp of a bear market. While there may be further downside in asset prices in the near term, the quicker asset markets price in negative outcomes, the faster markets can recover should the worst-case scenario not unfold.

Last year, we were cautious on the outlook for Australian asset classes and the Australian economy. This year, our views remain much the same.

Economic data improved somewhat toward the end of 2015, and the RBA does have room to further ease monetary policy. However, headwinds from low commodity prices, indebted households, and a property market that seems to be losing its steam have not subsided and will continue to weigh on Australian economic growth and inflation. The RBA has communicated its preference to use a weak Australian dollar to assist in the economy’s transition from the mining boom, while headwinds from China and lingering overvaluation keep us structurally bearish on the currency.

We are neutral on Australian equities on an absolute and relative basis. While valuations have become more attractive versus the past 12 months, we would caution that it is unclear how much of the macro headwinds have been priced in. Australian earnings growth and dividends may come under pressure if the economy weakens further. We still prefer active management. With respect to equity allocations outside of Australia, we uphold our advice to overweight Eurozone and Japanese equities and hold a small overweight to Asia ex Japan equities.

We still recommend holding Australian government bonds, despite concerns about overvaluation, as macro risks remain and Australian bond yields are more attractive than most other developed markets.

Jason Widjaja, Associate Investment Director
Aaron Costello, Managing Director