Why The Market Can Hold A Higher PE In 2017
Contrary to the usual fears that dominate the financial headlines, the Australian share market ended up posting reasonable performance in 2016, and the outlook – despite a sluggish economy – appears encouraging as we head into 2017.
First a recap. Just for the record, the S&P/ASX 200 Index rose 7% last year, reaching the level of 5665.8 points. Adding in dividends, the total return was 11.8%, which is close to average performance for the market over recent decades.
How was this gain achieved?
So-called “forward earnings” – or a pro-rata rolling weighted average measure of expected earnings for the current and following financial year – lifted 4% last year. As is usual, earnings growth was somewhat less than what the market had expected at the start of the year (8%), but it still represented a market improvement on the 8% slide in forward earnings in 2015. And despite the sluggish local economy, the main driver of the lift in earnings was a stunning 50% rebound in resource sector forward earnings thanks to the rebound in coal and iron ore prices.
Also helping the market was the fact that bond yields, thanks to the Reserve Bank rate cuts, stayed comfortably low last year. US 10-year bond yields did overall rise modestly last year (from 2.3% to 2.5%), but reflecting local interest rates cuts from the Reserve Bank, Australian-US 10-year bond spread crunched in from 0.6% to 0.3%. That meant local 10-year bond yields fell marginally through last year, from 2.88% to 2.77%.
In turn, low yields allowed the market’s price to forward earnings ratio – which ended 2015 at a worrisome above-average 15.6, to in fact edge a little higher by end-2016, to 16.1. Higher earnings and a modest increase in the PE ratio are what’s behind the market’s rise.
Now that we know the underlying moving parts that drove the market, it begs the question: how will 2017 fare? For starters, we might worry (again) about the high PE ratio – after all, the average since 2003 has been 14 times earnings, or 13% below its end-2016 level.
But as seen in the chart below, perhaps the lesson of 2016 is that the PE ratio can stay relatively high if interest rates stay relatively low. Given super-low bond yields, the equity market was arguably not as overvalued as simple observance of the PE ratio would at first suggest.
Another way of considering this is to note the forward earnings yield (inverse of the forward PE ratio), ended the year around 3.5% - or close to the level it ended the previous year, and broadly in line its elevated average since the financial crisis of mid-2008, but still well-above its levels prior to the GFC. On a relative basis, the market ended last year still close to fair-value, if not somewhat cheap.
All this suggests that if interest rates do manage to stay reasonably low this year, lingering fears of a major PE valuation crunch might prove unfounded. On that score, the given stubbornly low local inflation and ongoing growth challenges, it’s unlikely the RBA will hike rates this year, and there’s still some chance it will cut them further.
In the US, Trump and Janet Yellen pose the biggest upside risks to bond yields, though as we saw last year, local rates might not rise by as much as those in the US if the RBA retains an easing policy bias.
If local bond yields rise to say, 3%, and the equity-bond yield gap holds at 3.5%, then the market would end the year at a forward PE ratio of around 15.5, or only 4% below its end-2016 level. If rising yields allowed the bond-yield gap to narrow a little, to say 3%, the market’s PE ratio would end the year at 16.5, a little higher still than at end-2016.
The bottom line is that an RBA easing bias and still seemingly attractive equity valuations compared to bond yields provides the market some downside protection.
Meanwhile on the earnings front, the very volatile performance of resource sector earnings will again likely to be major driver of overall performance. One of the surprises of 2016 was that China halted what appeared to be an emerging trend decline in steel demand, by boosting support for home building and public infrastructure. Combined with cut-backs in its own production of high cost and highly polluting coal and iron ore, it led to a boost in bulk commodity imports that help drive the performance of the local resources sector.
Given the challenges in keeping growth ticking over, China seems likely to keep steel production relatively high – even though it will continue to close more loss making plants with idle excess capacity. But this rationalisation across the steel sector also appears to be extending China’s reliance on imported bulk commodities even further – which is a boon the local sector. Provided iron ore and coal prices drop back only modestly this year, further upgrades to the resource sector earnings outlook seems likely. Which will support overall market earnings performance.
Of course, a lot can still go wrong this year – particularly if US inflation breaks out, Europe breaks apart, or a US-China trade war breaks out. But there also remain grounds for cautious optimism that the good times can continue somewhat further.
David is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist. He is also author of the online e-book, TheAustralian ETF Guide.