ANZ 2017 GLOBAL MARKET OUTLOOK · GLANCE 2017 AT A STRONGER GROWTH STRONGER GDP EXPECTED IN 2017 Global 3.7% AUS 3.2% NZ 3.3% CHN 6.5% East Asia 5.7% DEFLATION SHOCK PASSES PRICING

ANZ 2017GLOBAL MARKET OUTLOOK

2017 at a glance

Looking back: Echoes of an earlier deflationary shock

Looking ahead: The investment cycle clock resets but what time is it?

Investment implications as we approach late cycle in the US

Desynchronised investment clocks, synchronised asset allocation

CONTENTS

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ANZ 2017 GLOBAL MARKET OUTLOOK

GLANCE2017 AT A

STRONGER GROWTHSTRONGER GDP EXPECTED IN 2017

Global

3.7%

AUS

3.2%

NZ

3.3%

CHN

6.5%

East Asia

5.7%

DEFLATION SHOCK PASSES PRICING POWER RETURNS

Recent years have echoes of the late 1990s Asian crisis where a recession in Asia imparted a significant deflationary shock. Earnings are now recovering strongly as pricing power returns.

DIVERGENT INVESTMENT CYCLESUS IS LATE CYCLE

A synchronised global upswing is emerging. However, the stage of the business cycle varies from late cycle in the US to earlier cycle in Europe and emerging markets.

SHARES TO OUTPERFORM BONDS EARNINGS RECOVERY

We expect low double-digit earnings growth in 2017, which will likely see shares outperform bonds. Bonds are expected to underperform as higher nominal growth puts upward pressure on bond yields (prices fall). However, bond yields will be limited by high debt levels, easy monetary policy and moderate inflation.

COMMODITIESBEAR MARKET BEHIND

Oil, iron ore, coal and agricultural producers either unable or unwilling to increase production. Demand expected to be solid. Prices expected to be skewed to the upside.

FXUSD PEAKS, NZD SLIGHTLY WEAKER

While we consider the USD can stabilise through the first half of 2017 on the improved outlook, any signs that the Fed may need to lift rates faster could quickly translate into a stronger USD.

Source: ANZ Research

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LOOKING BACKECHOES OF AN EARLIER DEFLATIONARY SHOCK

Before delving into our outlook for 2017, it is important to take a step back and look at where we have come from

to get a better sense of where we are heading.

At the epicentre of the 2015-16 economic slowdown was the sharp decline in Chinese growth, particularly in the industrial sector, which spread globally. Weaker Chinese growth reflected shorter-term cyclical forces but also a longer-term structural slowing in Chinese growth. In essence, the 20-year Chinese supply side boom and double-digit growth that commenced before 2000, primarily absorbed by the increasingly indebted US households, came to an end.

the US Federal Reserve (Fed) put rates on hold, with investors responding to deflation risks by scrambling for historically low or, in many cases, negative bond yields and reducing exposures to growth assets such as shares. This all had a very late cycle feel to it with defensive assets outperforming shares.

The New Zealand economy struggled with a persistently high dollar, but overall strong construction, tourism and an improving dairy price provided the recipe for strong performance. The ongoing growth of the population, through both immigration and fewer kiwis leaving underpinned the strength.

Recent years have echoes of the late 1990s Asian crisis where a recession in Asia imparted a significant deflationary shock, although the activity slowdown in the developed countries was only moderate compared with prices (Chart 2). Profits then, and now, fell in line with the weakening in activity and prices, before staging a recovery.

By mid-2016 signs were accumulating that a recovery was building as the large Chinese stimulus package launched in late 2015 took effect, lifting demand and prices of steel and commodities. Commodity prices were also helped higher as China and other commodity and oil producers cut supply.

The recovery then broadened from commodities to other sectors supported by improved developed markets growth, particularly banks and financials supported by easing monetary policy in Japan and Europe.

While the recovery commenced before the US election, Donald Trump’s victory and, more crucially, the Republicans’ clean sweep of both the Presidency and Congress, created an expectation of greater fiscal spending in the US economy, further fuelling the recovery. By the end of 2016, the global market looked to have reset the investment cycle clock to a much earlier point in the cycle with cyclical assets like commodities preferred over defensive assets.

Chart 1: 2015’s deflationary shock

Sources: Bloomberg, ANZ Wealth

Global Prices Indicator Global Activity Indicator

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Instead of an outright collapse in demand, a large supply side overhang of industrial goods and commodities eventuated, driving prices down and intensifying global deflationary pressures (Chart 1). Global profits fell and nominal GDP growth in the major developed economies slowed towards 2% as inflation and real growth eased.

In response to slower growth, European, Japanese and Chinese policy makers stepped up policy support and

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In portfolios through 2016 we held an underweight to growth assets anchored by our view that a moderate recovery in global growth would lift global bond yields and rising expectations of monetary policy tightening that would likely exert downward pressure on elevated PE multiples. We considered equities vulnerable as valuations were moderately expensive, more so in NZ, and had been re rated primarily on higher multiples, reflecting lower yields, rather than a solid and sustained lift in earnings. Political risk in both the US and Europe also contributed to our underweight position. Part of the core of this investment rationale now appears changed as growth expectations have lifted much more strongly and broadly than we expected and the back up in yields has been relatively orderly with financial conditions stable or improving.

The current investment cycle has therefore been extended. Growth asset performance, despite some volatility, continued to improve throughout the year, meaning our underweight to these assets and corresponding overweight to cash assets, hurt portfolio returns.

BY MID-2016 SIGNS WERE

ACCUMULATING THAT A RECOVERY

WAS BUILDING AS THE LARGE CHINESE

STIMULUS PACKAGE LAUNCHED IN

LATE 2015 TOOK EFFECT, LIFTING

DEMAND AND PRICES OF STEEL

AND COMMODITIES.

Chart 2: Now vs Asian crisis


US Prices Indicator, Current

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WHERE ARE WE IN THE INVESTMENT CYCLE?

The scene we set in the preceding section raises the question: Where are we now in the investment cycle? The rotation to cyclical assets has occurred eight years on from the end of the global financial crisis (GFC), with asset markets having already posted strong returns across both growth and defensive assets over the same period. While the global economy’s pace of recovery has been more moderate than typical following a recession, this has not been the case for the unemployment rate.

The unemployment rate is a key indicator of the business cycle watched by central banks, and low levels in the past have suggested moves into weaker phases of growth. As Chart 3 illustrates, the current decline has been in line with or faster than the 1990s cycle, which lasted for close to nine years, and the shorter 2000s cycle. Unemployment is now at the level of previous cycle lows.

Whether the cycle ends or not is critical for asset markets.We can view the investment cycle as comprised of four phases representing stages of growth in the economy and typical asset market performance (Table 1):

• Recession: Period of shrinking economy when share markets and high-yield bonds underperform long-run returns while investment-grade fixed income outperforms. Growth shares typically outperform value.

• Recovery: Both shares and high-yield bonds witness higher than average returns as the economy begins to recover, growth stocks underperform value and investment-grade fixed income underperforms.

• Boom: Mature phase of the economic cycle. Capacity constraints begin to emerge where fixed income returns lag the cycle, share returns moderate but remain somewhat above average and growth outperforms value.

• Slowdown: The economy begins to slow and moves below trend, shares and high-yield bonds underperform while investment-grade fixed income returns move above average. Growth shares underperform value.

LOOKING AHEADTHE INVESTMENT CYCLE CLOCK RESETS BUT

WHAT TIME IS IT?

Chart 3: Unemployment now at critical low


Chart 4: Inflation in line with previous cycles


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LOOKING AHEAD

So what typically brings an end to an economic cycle? According to the late, famous MIT economist Rudi Dornbusch, “none of the post-war expansions died of old age. They were all murdered by the Fed”! The motive for this ‘crime’ is usually the threat or reality of inflation as the economy’s growth reaches full capacity, driving the Fed to raise interest rates, which ultimately triggers a recession.

We believe the developed economies are on the cusp of moving from the recovery to the boom phase, led by the US (see Investment cycle clock, right).

But every cycle is different in some way. This time the concern has been that inflation is too low, not too high, so compared with previous cycles, monetary policy remains very accommodative, with official interest rates still negative in Europe and Japan and less than 1% in the US. While core inflation is modestly tracking higher (Chart 4), it nevertheless remains below the 2% target of most central banks. All major central banks are still encouraging the recovery, not trying to slow it. We assess that there is still some way to go.

Recession (%) Recovery (%) Boom (%) Slowdown (%)

S&P 500 -0.9 6.9 0.7 -11.5

MSCI emerging markets -10.8 4.7 -1.5 -4.9

Growth vs value 6.9 -3.8 3.2 -4.2

US 10-year bonds 9.8 -2.3 -2.3 1.0

US government/credit 3.5 -2.8 -2.9 4.3

High-yield bonds 0.9 2.3 -3.7 -3.2

Table 1: Average annual returns vs trailing 10-year returns

Source: Morgan Stanley Figures are relative to 10-year rolling average returns.

INVESTMENT CYCLE CLOCK

US Australia eurozone Japan New Zealand

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Favours shares Favours bond

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GLOBAL RECOVERY TO HAVE LEGS

The post-GFC environment has been characterised by a number of start-stop recoveries – signs of recovery emerge, markets respond, but something arises to short circuit the improvement. In our view, however, there is little on the economic horizon to short-circuit the current recovery. For 2017, financial conditions and monetary and fiscal policies, in our view, are all looking supportive for growth in the major economies. After a couple of years of running at a 3.2% pace, we expect growth to accelerate by around 0.5% with stronger growth expected in both the developed and emerging-market economies. Overall we start 2017 with more optimism than last year (Table 2).

We consider potential growth to now be much slower as compared to recent decades as population growth falls.

As such, we expect that most developed market economies will grow above this new lower trend pace in the coming year. This will drive unemployment rates lower and wages and inflation gradually higher, but not dramatically so. Of the major three developed market economies only the US is likely to have inflation around target of 2%, with Japan and the eurozone still expected to be around 1% in 2017.

The net result of this mix of forces, which might best be characterised as ‘better but not great’, is that easing cycles have ended in virtually all of our key markets of interest. We believe the timing of the European Central Bank’s (ECB’s) taper will be important for bond markets generally. If we start to see a pickup in wage growth that is anywhere close to the rates historically consistent with near capacity levels of employment, then interest rates seem to be too low.

Real GDP (%) Inflation (%)

2016 2017 2018 2016 2017 2018

US 1.5 2.2 2.3 1.2 2.2 2.3

eurozone 1.6 1.7 1.6 0.2 1.3 1.6

UK 2.0 1.5 2.0 0.6 2.4 2.3

Japan 0.7 0.7 0.8 -0.1 0.9 1.5

China 6.7 6.5 6.3 2.1 2.4 3.0

India 6.8 8.0 8.2 4.3 5.4 5.2

Australia 2.3 2.5 3.3 1.3 2.0 2.1

New Zealand 3.3 3.3 2.4 0.6 1.6 2.1

World 3.2 3.7 3.7 4.4 4.8 3.8

Table 2: Global economic forecasts

Source: ANZ Research

Chart 5: Annual growth in global GDP

Sources: Thomson Reuters Datastream, ANZ Wealth

Chart 6: Global employment rate

Sources: Thomson Reuters Datastream, ANZ Wealth

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US TAKES THE LEAD

We expect growth to be led by the US, where growth had not just accelerated in the second half of 2016 but became more broadly based with a rebound in dwelling construction and a waning in the sizeable drag from weaker oil and gas investment supporting growth. There are signs building of a solid recovery in US capital goods spending that should support growth above trend in 2017 (Chart 7). Alongside improved growth has been a sharp lift in overall (headline) inflation largely due to a washing out of the sharp decline in energy prices. By contrast, core inflation, which excludes volatile items such as food and energy, has been relatively flat. However, we are expecting a gradual pickup in coming months given the economy is close to full employment, growth is above trend and inflation is expected to be around the target level of 2%.

The more positive US growth outlook had been building in advance of the election of Donald Trump as US president. The initial financial market reaction to the prospect of a Trump presidency was consistent with the view that he will be pro-growth and pro-inflation. On the positive side of the growth ledger, President Trump has spoken of spending US$1 trillion on infrastructure, boosting military spending and cutting corporate and personal tax rates. On the negative side of the growth ledger are Trump’s trade and immigration policies. In sum, while we expect a Trump presidency to result in a modest fiscal stimulus to the US economy from 2018 onwards, considerable risks exist.

As we look into 2017 and 2018, a number of Trump’s proposals in our view appear inflationary, which suggests that the Fed may need to act more aggressively than is currently priced by the market. Although it remains to be seen just how stimulatory Trump’s policies can be, we expect there will be some tax cuts and fiscal spending. This is more a story for 2018 though.

EUROZONE: THE RECOVERY CONTINUES

This year marks the fourth year of recovery for the eurozone economy but the region appears to still be hampered by slow growth, high unemployment, low core inflation and negative interest rates. On average, growth has expanded at 0.4% quarter on quarter over the past 14 quarters since the recovery began and 2017 is expected to be no different, with the economy forecast to grow by 1.7%.

Despite the ongoing recovery, the ECB is expected to continue with its policy of generous monetary accommodation as there is little material evidence of a sustainable pickup in core inflation and wage pressures. Although headline inflation is looking like it is picking up owing to factors including firmer energy prices, core inflation remains muted (averaging just 0.8% year on year in 2016) and well below target. Eurozone inflation is proving very slow to recover. Low inflation also makes securing a dynamic economic recovery and investment more difficult owing to an absence of pricing power by firms.

Politics will be a key focus in the year ahead. With the rise in populist support for anti-establishment parties, for example the Brexit vote in the UK and Trump’s victory in the US, there is increased focus on the election cycle in Europe this year. Elections will be held in the Netherlands (March), France (April/May) and Germany (September), and right-wing parties such as the Front National in France and Alternative fur Deutschland in Germany are enjoying record support.

Chart 8: US inflation picking up


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Chart 7: Outlook for US capital goods spending recovers

Sources: Bloomberg, ANZ Wealth Axes have been calibrated to exclude the outliers.

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JAPAN: SUSTAINED INFLATION STILL NOT SECURE

The first three quarters of 2016 all registered positive GDP growth in Japan, the longest stretch of positive growth since 2013. Fiscal stimulus and private spending contributed to this. Household consumption grew positively in 2016 amid rising real wages and fiscal incentives. Net exports also contributed positively to growth as foreign demand was bolstered by Chinese stimulus.

Although we expect GDP growth of around 0.7% in 2017, a similar outcome to 2016, there are downside risks to our view despite a sizeable fiscal stimulus remaining in the pipeline. The outlook for consumer spending is patchy as real wage growth is expected to stagnate. In addition, the prospects for private investment and exports are highly uncertain following Trump’s election victory and the risk of rising protectionism.

A sustained upward trend in inflation is still hard to find. Core inflation is trending down, inflation expectations are drifting lower, and nominal wage growth remains subdued. We expect inflation of close to 1% in 2017 and we expect the Bank of Japan (BoJ) to continue to target 10-year bond yields at 0% through the year.

EMERGING MARKETS: GROWTH IMPROVES BUT MORE CHALLENGES

Emerging-market growth is expected to accelerate this year to around 4.75% despite a further slowdown in China as Russia and Brazil emerge from recession and India adjusts to demonetisation. However, despite an improved outlook for growth, emerging-market economies may still face challenges in 2017.

Firstly we expect the Chinese economy to slow, with GDP growth of 6.5%. A large part of China’s economic vibrancy is now coming from the services industries and domestic consumption instead of low-level manufacturing and investment. In 2017, the services sector is forecast to expand by 7.1%, which will offset the sluggish performance of manufacturing and construction. However, investment demand will remain tepid in China. Investments in machinery and equipment will be constrained by lacklustre exports and a potential downturn in construction activities in 2017. Local governments will be more cautious in pushing through their infrastructure projects ahead of the 19th Communist Party Congress in the second half of 2017.

This line of thought does not align with the recent strong price action in China’s commodity market, where steel and coal prices have surged sharply as the markets responded well to the pace of capacity reduction in these two industries. This has assisted the return to positive producer price inflation and has successfully prevented China from falling into a deflationary trap. Given a GDP growth forecast of 6.5% in 2017, we do not believe additional fiscal nor monetary stimulus will be required. We expect the People’s Bank of China (PBoC) will still aim to offer a stable interest rate environment for structural reforms.

India is confronted with domestic factors that look less promising for growth in the short run. The early November announcement by the government to demonetise INR500 and INR1000 currency notes has entailed disruptions in consumption and cash intensive sectors. Despite the short-term disruptions, we continue to remain positive on India in the medium term. An increase in banking liquidity is aiding monetary transmission and will be positive for sagging investment.

Brazil is expected to return to moderate growth in 2017 following a 3.3% contraction last year, as commodity prices post a recovery and recent political and policy uncertainty declines. Higher oil export revenues are expected to provide relief to the Russian economy, with a return to growth in 2017 following a 0.8% contraction in 2016. The somewhat improved outlook for Russia is expected to support activity elsewhere in the region.

AUSTRALIA: GROWTH EASES BUT SUPPORTED BY BETTER GLOBAL OUTLOOK

In 2017, we expect to see the economy almost completely shake off the drag from the wind-back in mining investment. Non-mining business investment is likely to grow modestly, with strength concentrated in NSW and Victoria. Housing construction is likely to level off after a period of strong growth, and consumer spending is expected to continue to grow at a moderate pace. Export growth is set to remain solid as liquefied natural gas export capacity comes on stream and services exports continue to benefit from the lower Australian dollar (AUD) and rising household incomes in China. Solid economic growth is likely to continue to drive the unemployment rate modestly lower.

With spare capacity remaining in the labour market, wage growth is likely to remain low. The wage price index stepped down to a record low in Q3 2016, with annual growth down to 1.9%. Economy-wide wage growth looks to have bottomed, but is likely to remain soft given compositional shifts in the labour force towards part-time employment. Underlying inflation is expected to remain well below the Reserve Bank of Australia’s (RBA) 2-3% inflation target until late 2017.

Persistently low inflation is likely to see the RBA keep the cash rate on hold at the record low of 1.5%. The Q3 2016 inflation and wage data suggest the risks to the RBA’s forecast profile are to the downside – suggesting the Bank still retains an easing bias.

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NEW ZEALAND: LET THE GOOD TIMES ROLL

Times are good in the New Zealand economy, with annual real GDP growth running at about 3.5%. Some sectors such as construction and tourism are flat out, with labour shortages and long wait times on key construction materials. Exceptionally strong net migration has also been an important part of the story, contributing around three-quarters of the annual population growth of 2.1% in the year to June 2016.

Dairy prices such as milk powder rose following a squeeze in production across New Zealand and Europe towards the end of 2016. Higher prices and warmer weather conditions are likely to encourage greater production into early 2017 which may limit the extent of further price gains. On the demand side, China remains a swing buyer but we expect that as conditions surrounding import restrictions lift, there could be more activity in the coming 12 months.

Inflation has been stubbornly low, and the Reserve Bank of New Zealand (RBNZ) has until recently been concerned. There are now signs that the inflation worm may finally be turning, but given that structural deflationary forces remain, we expect the cash rate to stay low for a considerable period.

The RBNZ needs a weaker currency to support the export sector of the economy and this, in combination with some strength in the greenback, will eventually see the New Zealand dollar (NZD) weaken. We also expect the NZD to be softer against the AUD as interest rate differentials narrow while dairy prices consolidate and underperform hard commodities.

However, some warning signs are flashing: record high household debt and extreme housing affordability in Auckland. But banks are now more proactive than in previous cycles and this tightening in financial conditions, while dampening activity in the short run, is in the best interests of sustainable growth.

RISKS SIT IN US AND CHINA

The sting in the tail of stronger growth is that the US economy is not early cycle; rather, it carries many late-cycle features with unemployment likely falling to around 4% by end 2017, near full capacity levels. As the other major economies catch up to the US, we consider financial markets in 2017 will be framed by the rate at which monetary policy support is withdrawn as more markets reach full employment. Clearly, a stronger recovery than we have factored in for the US would result in capacity constraints emerging sooner than 2018. Moreover, the importance of US policy and the US dollar (USD) has lifted due to the rapid build-up in USD debt across emerging-market economies. In general, the USD tends to soften when the global outlook improves. While we consider the USD can stabilise through the first half of 2017 on the improved outlook spread across the global economy, any signs that the Fed may need to lift rates faster could quickly translate to a surge in the USD and a rotation to more defensive exposures to protect against downside risks.

The other key risk for 2017 which is deeply intertwined with the outlook for the US economy is whether Chinese growth and the value of the Chinese RMB relative to the USD can stabilise. The cross rate between the RMB and the USD will also likely be a key focus of the Trump Administration with respect to trade sanctions.

Sources: BIS, Bloomberg, ANZ Wealth Axes have been calibrated to exclude the outliers.

Chart 9: Improved global outlook weakens the USD

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APPROACHLATE CYCLE IN THE US

INVESTMENT IMPLICATIONS AS WE

A synchronised global upswing emerged in late 2016. However, the state of the cycle across economies remains highly divergent. The US is clearly most advanced in the cycle and in our view the trajectory of US rates and the USD could dominate

returns in 2017. This is particularly the case as the recent share rally has been led by earlier cycle exposure and valuations are now moderately expensive across

most developed markets. The main risk to returns is that the US economy appears to be approaching late-cycle boom with near full employment.

OUTLOOK HAS IMPROVED AND IS SYNCHRONISED ACROSS MOST REGIONS

In our view, the lift in growth and earnings through 2016 is solid and synchronised across most of the major economic regions. For 2017 we expect low double-digit earnings growth for global and New Zealand shares with likely upside.

While we have been constructive on the outlook, the recent lift in economic momentum is currently stronger than we expected. The sharp recovery in earnings is primarily driven by commodities and energy exposures; we expect this lift will consolidate in 2018.

Sources: Bloomberg, ANZ Wealth Sources: Bloomberg, ANZ Wealth

Chart 11: Surge in global cycle indicator points to strong US earnings growth in 2017

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Chart 10: Surge in cycle indicator points to strong New Zealand earnings growth in 2017

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Overall, better growth and a steady lift in inflation suggests that growth assets will likely outperform defensive assets such as bonds and cash until the cycle hits late-cycle boom and transitions to slowdown. This view underpins our outlook for international, Australian and New Zealand shares, warranting a benchmark positioning in our portfolios. We expect that US bond yields will grind higher to around 3% resulting in flat returns for international bonds in 2017. A slightly higher return is expected for Australian and New Zealand bonds.

While we consider the 12-month outlook is constructive for shares, we have four main concerns that suggest maintaining some caution.

1. Share valuations top of range for most developed marketsOur first short-term concern is that the recent strong rally in shares has resulted in share valuations across most developed markets more than fully capturing the improved outlook for earnings in 2017 and the possible fiscal and regulatory support from the Trump administration. Expectations for global earnings captured in current valuations are around low double digits for 2017, which is broadly in line with our expectations although we consider there is upside potential (Charts 10 and 11). As a result of moderately expensive valuations across most developed markets our return expectations across most share markets in 2017 are much more subdued. In contrast to most developed markets, current valuations for emerging markets are around fair value (Chart 14). Despite the improved growth outlook, emerging markets continue to be impacted by the risks of trade wars and higher US rates.

2. Share valuations vulnerable to higher interest ratesOur second short-term concern is that current share valuations do not fully reflect either (1) the impact of likely higher interest rates that generally reduce price earnings multiples or (2) lower earnings expectations through the slowdown phase of the business cycle. This is not to say that we expect a rapid lift in interest rates – we don’t – we expect the US Federal Reserve to tighten by 0.5 to 0.75% this year and the ECB to taper their current bond buying program again. Overall, we think central banks are targeting inflation around 2% and in most instances will look to cement this target before shifting policy towards a more contractionary stance. This marks a shift in central bank policy from recent cycles where 2% inflation was likely the upper target rather than now a possible mid-point of the target range.

Chart 12: US shares upper end of band

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Chart 14: Emerging-market shares around fair

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3. Share markets have already built in Trump tax cutsOur third shorter-term concern is the belief that the lift in growth expectations and expected US policy stimulus have already been built into current valuations, meaning it is now much harder to surprise markets on the upside as market psychology has started to shift from recovery to boom. This is potentially opening the window for downside surprises, particularly with respect to US tax cuts and economic reports. Reflecting the sharp lift in investor expectations, a large rotation away from defensive yield exposures to shares has unfolded and this shift has also likely increased vulnerability.

4. US could more rapidly approach late cycleOur final, and prime, concern is somewhat longer term and of greater importance in deciding whether to be underweight or benchmark shares over the next 12 months. The current lift in growth momentum is going on as the US economy approaches full employment (the unemployment rate currently hovering around what is considered full employment at 4.7%). But the US economy could hit capacity constraints more rapidly than the market expects, resulting in more aggressive rate rises in the US.

While we do not expect a rapid lift in wages and inflation, we do think they will grind higher as unemployment declines through 2017. We detect some similarities between the environment in 2016 and in 1998 when both growth cycles were interrupted. In 1998 the Asian Financial Crisis clipped global growth and inflation but the developed market economies avoided recession. This extended the cycle by a couple of years with the cycle ending in a mild recession in 2000. In the current episode the sharp slowing in Chinese growth and the large decline in global prices have likely also extended the cycle a few years. Overall, we expect the cycle to be extended but the risk is that the US economy could more rapidly transition from boom to slowdown. This would slow earnings growth, tighten financial conditions and sow the seeds of the shift from boom to slowdown and negative share returns.

OUTLOOK FOR INTERNATIONAL BOND YIELDS TO REMAIN CHALLENGING

We consider the outlook for international bond returns will remain challenging as growth and inflation lift through the boom phase of the cycle. Shorter term we consider that bond yields could likely consolidate, although the US unemployment rate could fall to the low 4% range by end 2017. We expect the US 10-year bond yield will approach 3% towards end 2017. In addition, we expect that the ECB will further taper its asset purchase program through the latter part of 2017 as growth holds and inflation gradually lifts. As a result we expect international bond returns to be flat in 2017.

This underpins our underweight to this asset class and our preference for cash. We expect this asset class to deliver its strongest returns in the recession phase of the cycle.

OUTLOOK FOR NEW ZEALAND BONDS MORE CONSTRUCTIVE

We are more constructive on New Zealand bonds, where higher starting yields and a lack of monetary policy tightening will see New Zealand yields tighten to US. The curve will likely steepen so expect to keep duration short as inflationary risks rise.

SYNCHRONISED LIFT IN ECONOMIC AND EARNINGS MOMENTUM UNFOLDS ACROSS MOST REGIONS

The global economy has entered 2017 with the headwinds from the 2015-16 slowdown and price deflation falling away. All regions have lifted and a synchronised upswing is emerging. However, while the upswing is synchronised we consider that the stage of the business cycle varies widely from early boom in the US to mid-recovery in the eurozone and Japan. Even when we factor in the improved outlook, share market valuations across most developed markets are now moderately expensive.


Chart 15: Stronger growth flags higher US bond yields

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Chart 16: G4 yields suppressed by central banks in Europe and Japan

G4 Nominal GDP

2017 G4 Nominal GDP estimate

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The outlook for the US economy has improved with the prospect for tax cuts providing further support. Headwinds for the US share market are primarily driven by current moderately expensive share valuations and the prospects for higher interest rates as the economy progresses to late boom.

The outlook for European shares has improved supported by central bank easing and a lower exchange rate. Also, we expect economic conditions to continue to improve. That said, headwinds could re-emerge due to: continued political uncertainty with French and German elections; fragile European banks; and the possibility that bond yields, particularly in the peripheral economies, could rise sharply as the ECB gradually shifts to further taper its quantitative easing (QE) program through the latter part of 2017. Overall, we believe valuations have captured the improvements and are moderately expensive, although Europe is earlier in the business cycle than the US. Within European shares, we expect that UK shares will continue to be supported by a lower pound as prospects for Brexit firm up.

Japanese shares have also been buoyed by a weaker exchange rate, while valuations are more attractive hovering around fair value.

The recent sharp rally in Australian shares has resulted in what seem expensive valuations. Despite a solid recovery in earnings, the uplift is primarily driven by the commodity sector, with most other sectors factoring in low to mid-single-digit earnings growth. The prospect for ex-commodity earnings to recover more strongly will likely be limited by signs that the residential construction cycle will likely peak through the first half of 2017 while the outlook for non-residential construction, including for mining, will remain soft.

The outlook for New Zealand shares has improved with the expensive valuations now correcting and earnings and dividends set to remain solid.

Prospects across the emerging markets will likely improve in 2017 with share valuations around fair value. Therefore prospective returns for emerging-market shares are relatively attractive, although possible headwinds include: US protectionism that could further hurt global trade; and higher interest rates which would increase the cost of the large build-up in debt across many emerging-market economies. Currently these risks appear to be abating with signs that: the USD is peaking; China is stabilising its currency; and the Fed is only likely to raise rates gradually.

Asset class Position relative to benchmark/outlook

Growth assets – equities Neutral

Australia Neutral

New Zealand Neutral

Developed markets Neutral

Emerging markets Neutral

Defensive assets Neutral

Fixed income Underweight

Australian Neutral

New Zealand Neutral

International Underweight

Cash Overweight

Currencies

AUD/USD Negative

NZD/USD Negative

USD TWI Neutral

Table 3: Current asset allocation

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SYNCHRONISEDASSET ALLOCATION

DESYNCHRONISED INVESTMENT CLOCKS

A synchronised global upswing emerged in late 2016. However, the state of the cycle across economies remains highly divergent. The US is clearly most advanced in the cycle and in our view the trajectory of US rates and the USD will dominate returns in 2017. This is particularly the case as the recent share rally has been led by earlier cycle exposure. Valuations are now moderately

expensive across most developed markets. The main risk to returns is that the US economy is approaching late-cycle boom near full employment.

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US OUTLOOK

US economic conditions improved sharply through the latter part of 2016 as the headwinds from the shale oil capex bust moderated and manufacturing recovered. Steeper yield curves are supportive of the well capitalised US banking system. While the recovery preceded the Trump clean sweep, clearly confidence has been boosted by prospects of tax cuts and reduced business regulation. Looking into 2017 we expect economic growth to lift as US capital goods spending starts to recover from recession-like conditions. We expect the Fed to lift rates two or three times in 2017 and the USD to peak through the first half of 2017.

Our economic indicators point to continued expansion as capital goods spending recovers and the drag from shale oil capex unwinds on higher oil prices. We anticipate real GDP growth to be around 2.2% in 2017. The labour market is expected to continue to improve with the unemployment rate likely shifting down to the low 4% level by end 2017. We expect core inflation to lift to around 2% by end 2017 as wages continue to recover to above 3%. Company earnings are on track to deliver low double-digit or better growth this year primarily due to higher nominal growth. Overall the US is in the boom phase and much more advanced than other regions.

Valuations indicators for US shares are moderately expensive even incorporating sharply improved earnings. Bond market valuations have improved but with growth prospects lifting and the Fed raising interest rates, we see moderate upside to 10-year yields to around 3% by end 2017.We expect that the USD has peaked.

Behavioural indicators are neutral. Sentiment across shares is positive as a stronger growth pulse supports earnings growth.

Politics/policy remains a key risk with prospects for trade tensions, particularly with China, to worsen. We consider the current surge in key US lead indicators are likely exaggerated on expectations of tax cuts and the risk is that they pull back into 2017 as policy implementation proves more difficult.

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EUROPE OUTLOOK

Europe is somewhat earlier in the business cycle as compared to the US. Conditions in Europe have improved considerably as central bank easing, a lower exchange rate and a pickup in credit demand have continued to drive economic growth above trend. However, this has been weighed down by continued political uncertainty such as Brexit and the Italian referendum. Looking into 2017 we expect economic conditions to continue to improve against a background of continued political uncertainty with French and German elections; fragile banks; and the possibility that bond yields, particularly in the peripheral economies, will rise sharply as the ECB gradually shifts to further reduce its QE program through the latter part of 2017.

Our economic indicators point to continued expansion in Europe as industrial activity and consumption pickup and earnings recover after five years of stagnation. We anticipate real GDP growth for the region to be around 1.7% in 2017 aided by ongoing support from the ECB and weaker currency. Labour markets are expected to improve gradually which should aid some lift in inflation. Company earnings are on track to deliver low double-digit or better growth this year which will break the earnings stagnation of the previous five years. Overall Europe is less advanced in the economic cycle than the US and is sitting around mid to slightly later in the recovery cycle.

Valuations indicators for European shares are also moderately expensive even incorporating sharply improved earnings. Bond market valuations remain stretched due to strong ECB and investor demand and a decline in bond issuance. The ECB’s accommodative policy settings of negative interest rates and QE have limited the lift in yields.

Behavioural indicators are positive. Sentiment across shares is positive as a stronger growth pulse supports earnings growth.

Politics/policy remains a key risk to the improved European outlook. In France, two rounds of electoral voting on April 23 and May 7, 2017 will be tightly contested between populist party (National Front) leader Marine Le Pen and Republican leader Francois Fillon. Meanwhile, the German general election in the second half of 2017 is set to be a tight showdown between the Christian Democratic Union’s Angela Merkel who is running for a fourth term and the populist party (Alternative Fur Deutschland), which has received strong support for its anti-immigration policies. Italian politics have also likely entered into a period of elevated volatility with the resignation of prime minister Matteo Renzi.

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JAPAN OUTLOOK

Japan is still early in the cycle. Japanese growth has remained positive due to accommodative central bank policies, fiscal stimulus and a weaker Yen. A challenge for policy makers could be to maintain the 10-year Japanese Government Bond (JGB) yield at 0.0% if global yields track higher on Fed tightening and perceptions that the ECB will taper further.

Our economic indicators suggest growth in 2017 is likely to remain below 1.0% as measures of industrial activity and investment pickup. However, there are some downside risks to this view as the outlook for consumer spending is patchy. Wages growth remains low and pension reform has dented confidence. The prospects for private investment and export growth remain uncertain following Trump’s protectionist policies which could target Japan’s large trade surplus with the US. The inflation outlook remains soft as measures of core inflation trend down although the recent sharp depreciation of the Yen may add to both headline and core measures. However, this is not likely to be a sustained lift. The Japanese economy is around mid cycle.

Valuation indicators for Japanese assets show a neutral valuation for share markets. Earnings prospects are high following the sharp decline in the Yen which has boosted competitiveness and assisted Japanese corporates to take market share from competitors. For bonds the large intervention from the Bank of Japan (BoJ) has anchored yields although this could be tested if global yields continue to rise in 2017.

Behavioural indicators across the Japanese economy are neutral to slightly positive. Investors are modestly bullish on domestic shares. Business confidence has remained firm following measures from the Tanken survey and household sentiment has remained stable given prospects of higher growth.

Politics/policy: One key risk for Japan is the outlook for the BoJ. The central bank recently introduced its new monetary policy framework of targeting the yield curve in response to the implications of negative interest rates. In an environment of rising bond yields the BoJ may have to increase the scale of its purchases which may put the current QE limit of JPY80 trillion at risk given supply constraints in the market and bring about further downward pressure on the currency. At some stage in 2017, we expect the BoJ to reduce the extent of JGB purchases.

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NEW ZEALAND OUTLOOK

New Zealand has put together an enviable run of economic growth over recent years despite the key dairy industry struggling over the past couple of seasons. Record levels of inward migration has underpinned demand and helped keep wages subdued. Despite a strong NZD tourism has thrived; construction struggles to keep up with housing demand.

For 2017 we see these themes continuing with perhaps some small easing back of the rate of growth from 2016’s pace. Improved terms of trade, a more diversified economic base, inward migration and booming construction signal at the very least a solid first half for 2017.

One theme that the RBNZ will be watching is the behaviour of households: to date spending behaviour has been restrained; however signs have emerged of behaviours more reminiscent of pre-2006, which, if they develop, may see earlier interest rate hikes from the RBNZ.

However, most risks to the economy are likely to be the result of international events, whose effect could be particularly material as the New Zealand economy moves towards the top of the cycle.

Our economic indicators indicate growth will be in the 3.0-3.3% range, down a little from 2016’s 3.5%. We see the economy as heading gradually towards the mature end of the business (and investment) cycle. Inflationary pressure is expected to rise slightly allowing the RBNZ to relax somewhat over the recent shortfall in the data relative to the 2% target. Sentiment indices all remain at robust historic levels boosted most recently by higher scores from the rural sector as dairy prices rose.

Valuation indicators have the share market still around 10% overvalued following its appeal to offshore investors over 2016 who see strong economic growth, attractive dividend levels and stable politics. Fixed interest also remains expensive even after the late-2016 rise in yields.

Behavioural indicators are around neutral for equities, having been stretched through much of 2016, though remain perhaps a little negative given the technical backdrop. Fixed income indicators remain pointed towards maintaining an underweight position.

Politics/policy: New Zealand has an election on 23rd September this year as the incumbent National-led government try to gain a rare fourth consecutive term, this time without charismatic leader John Key. However the main political stories will continue to emanate from the US and these remain somewhat unpredictable, but clearly with risks to trade and geopolitics. It’s also a big year for European elections which will be closely watched for further signs of drift towards nationalism.

Risks of a credit downgrade for Australia heighten this year which may result in a downgrade to bank credit ratings. Risks around this within portfolios is largely offset by stronger bank balance sheets.

On monetary policy we expect no change over the year, however depending on how inflationary pressures develop globally there will be some risk of a late 2017 rate hike.

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AUSTRALIA OUTLOOK

Australia has continued its extraordinary run of economic growth with the large drag from the end of the mining boom largely offset by a recovery in residential construction and support from a weaker AUD.

For 2017 we see this as a battle between two main forces, one of which is the growth drag from a slowdown in housing construction and the other the lift in the terms of trade on the back of higher commodity prices. On balance the drag from construction and soft wages growth will be greater particularly as we expect softer bulk commodity prices. This may open the door for the RBA to cut rates further. With some slack in the labour market Australia is around mid cycle, although residential construction is late cycle.

Our economic indicators suggest growth is likely to remain around 2.5%, around average, following a lift in public demand, stronger exports and a gradual recovery in non-mining capex. That said, given the slowdown in housing we expect some pullback in household confidence and consumption as the debt burden is high with rising borrowing costs. We anticipate the economy is heading gradually towards the maturing end of the cycle phase with conditions still conducive to stable growth but at a lower rate. The late-2016 surge in bulk commodity prices is already easing and we expect prices to be lower in 2017 but remain well above the 2015 lows.

Valuation indicators across Australian assets point to a degree of overvaluation in share markets. Sectors that have performed best include energy, mining and banks; meanwhile, defensive sectors of the market including telecoms, health care and REITs have struggled. We expect these themes to continue as global economic conditions improve. In bond markets, Australian yields rose considerably. In contrast to the US we expect the RBA will hold rates at 1.5% due to softer housing construction and inflation below target.

Behavioural indicators across Australia are around neutral. Sentiment across shares is positive but not overly exuberant with bond market positioning for a rise in bond yields but not at extreme levels. Sentiment is set to cool further across the property market in 2017 following the introduction of tighter loan conditions and regulation on banks which result in higher borrowing costs.

Politics/policy: Australia has been placed on a negative credit watch by S&P and the government has likely six to 12 months to improve the fiscal position. While higher commodity prices are supportive this has been more than offset by softer wages growth and the possible drag from weaker residential construction through 2017. However, we expect some softening in bulk commodity prices through 2017, following the 2016 surge.

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CHINA OUTLOOK

Our assessment of where China is positioned on the investment clock varies by sector. Some sectors are stretched while other sectors linked to the consumer and services have greater growth capacity. Policy appears committed to further reducing excess supply, restoring profitability and reducing or refinancing debt across the commodity/industrial sectors. While trend growth has slowed reflecting the reform of the debt-bloated industrial and state-owned enterprise (SOE) sectors and softer population growth we acknowledge the firm commitment of China’s government to keep real GDP growth around 6.5%, (although announced growth will likely be somewhat below this pace in 2017 as the policy focus shifts from stimulus to reform in 2017). A major challenge in 2017 with the possibility of greater trade tensions with the US is to stabilise the renminbi (RMB), the associated large swings in capital outflows and reserve depletion. The quality of the 2016 recovery has been relatively low, being heavily stimulus and debt funded.

Our economic indicators suggest growth into 2017 is likely to remain around 6.5% due to continued policy support even though the government’s growth target will likely be at a reduced pace as the focus shifts to reform from stimulus. Stable growth will provide support for industrial activity, consumption and factory prices at a much reduced pace as compared to the large lift in 2016. Steel and bulk commodity prices, while likely higher than early 2016, will likely pull back from the late-2016 peak.

Valuation indicators for Chinese assets show a neutral valuation for sharemarkets. Bond yields and inter-bank interest rates are gradually rising as the PBoC reins in excessive credit creation. One area of concern for investors remains the outlook for the RMB. Given market expectations for tighter US monetary policy the outlook for the RMB is skewed to the downside which may put some pressure on capital outflows.

Behavioural indicators across the Chinese economy are neutral to slightly positive. While investors are not outright bullish on domestic shares or fixed income, the sentiment surrounding property has been strong. This is likely to carry into 2017 as prices continue to rise. We expect to see some rotation from property to listed shares that may further improve household confidence and encourage consumption.

Politics/policy: The key event for China is the 19th Communist Party Congress in the second half of 2017 which will mark President Xi Jinping’s second term. Appointments to the Politburo will further bolster Xi’s power base and reinforce his ideology of furthering a socialist model for governance and economic development. Meanwhile, on a short-term horizon the implications of a Trump presidency raise the prospect of either a trade or currency war with the US. China will likely act to dampen this risk by stabilising the RMB at least in the lead-up to the late-2017 Congress.

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Sources: JP Morgan, Bloomberg & ANZ Wealth, 31 December 2016.Indices: New Zealand Shares – NZX50 (with Imputations), Global Shares (hedged NZD) – MSCI All Country World ex Australia, Global Shares (unhedged NZD) – MSCI All Country World ex Australia, Global Listed Property – FTSE EPRA/NAREIT Developed Rental Index (ex New Zealand, hedged NZD), Cash – NZ 90 Day Bank Bill Index, New Zealand Fixed Income – NZ Government Stock Index, International Fixed Income – Barclays Global Aggregate Bond Index, Global Credit – Barclays Global Corporate Bond Index (hedged). Please note: Past performance is not indicative of future performance.

Asset classes 12 months 5 years (p.a)

New Zealand shares 10.10% 17.51%

Global shares (hedged) 10.56% 14.06%

Global shares (unhedged) 5.81% 11.98%

Global listed property 7.27% 14.80%

Cash 2.51% 2.93%

New Zealand fixed income 3.44% 3.84%

International fixed income 5.84% 6.37%

Global credit 7.98% 7.53%

Currencies At close on 31/12/2016 % change 12 months

NZD/USD 0.6973 1.86%

NZD/EUR 0.6611 4.90%

NZD/JPY 81.33 -1.24%

NZD/AUD 0.9630 2.34%

Table 4: Asset class returns as at December 2016

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DISCLAIMER

This ANZ 2017 Annual Outlook (this “document”) is current as at 7 February 2017 and has been prepared by Australia and New Zealand Banking Group Limited ABN 11 005 357 522 or its affiliates (“ANZ”).

This document contains factual information and may also contain professional opinions which are given in good faith and based on information and assumptions believed to be reliable as at the date of this document. The views expressed in this document accurately reflect the authors’ personal views, however the authors make no representation as to its accuracy or completeness and the information should not be relied upon as such. Any opinions, estimates and forecasts herein reflect the authors’ judgments on the date of this document and are subject to change without notice.

Any prices or values herein are as of the date indicated and no representation whatsoever is made that any transaction can be effected at such prices or values or that any prices or values may be provided at a later date. The value and income of any of the securities or financial instruments mentioned in this document may fall as well as rise and an investor may get back less than invested. Foreign-currency denominated securities and financial instruments are subject to fluctuation in exchange rates that could have a positive or adverse effect on the value, price or income of such securities and financial instruments.

In preparing this document ANZ may have also relied on information supplied by third parties and whilst ANZ has no reason to doubt the accuracy of information used to prepare this document, ANZ makes no representation and gives no warranty as to the accuracy, timeliness or completeness of any information contained in this document or its relevance to the recipient. Copyright in materials created by third parties and the rights under copyright of such parties are hereby acknowledged.

This document is issued on the basis that it is only for the information of the particular person to whom it is provided. This document contains confidential information and it is not to be reproduced, distributed or published by any recipient for any purpose without the prior written consent of ANZ.

Nothing in this document constitutes a representation that any investment strategy or recommendation contained herein is suitable or appropriate to a recipient’s individual circumstances or otherwise constitutes a personal recommendation and it does not take into account the specific investment objectives, requirements, personal needs or financial circumstances or tax position of any recipient. This document does not contain and should not be relied upon as containing investment recommendations or advice and does not constitute an offer or an invitation to deal in, or a recommendation to acquire or sell any product or subscribe to any service. The recipient should seek its own independent financial, legal, credit, tax and other relevant professional advice and should independently verify the accuracy and appropriateness of the information contained in this document having regard to its objectives, financial situation and needs.

Changes may be made to products and services at any time without prior notice to you.

While the information in this document is based on sources believed to be reliable, ANZ (together with its directors and employees) makes no representations or warranties, express or implied, as to the accuracy, completeness or timeliness of any of such information. ANZ shall not be liable for any loss, damage, claim, liability, proceedings, cost or expense (“Liability”) arising directly or indirectly (and whether in tort (including negligence), contract, equity or otherwise) out of or in connection with the recipient relying on, in any way, the contents of and/or any statements, representations or omissions made in this document (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof except where a Liability is made non excludable by relevant legislation.

Past performance is not indicative of future performance. The value of investments may rise or fall and the repayment of subscribed capital is not guaranteed.

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