Some of the sectors on the Australian Securities Exchange (ASX) that investors may be watching in FY17 are likely to be:
Materials and energy
The S&P/ASX 200 Materials Index has been the best-performing sector so far this calendar year, up by almost 14%, but when looking at the financial year, the sector has fallen by 8.5% in FY16.
The S&P/ASX 200 Energy Index had climbed 3.1% year-to-date but is the worst-performing sector in FY16 - down almost 25%.
As both of these sectors are cyclical businesses, their outlook in FY17 will be largely dependent on global economic growth, particularly in China, according to CommSec Advisory investment adviser Justin Wynne.
“It is my general feeling that these sectors are going to be a wild ride, and it is also important to note that many of the individual companies have invested at the wrong time in the cycle leading to capital losses for investors – as such don’t expect the stocks to rally to where they were 18 months ago.
“These sectors are also only likely to appeal to growth investors, as dividends are likely to be minimal broadly across the sector,” he wrote in an emailed reply on June 17.
Supply and demand
Wynne added that the levels of supply and demand vary from one commodity to another, which makes it even more important to carefully examine the prospects of individual companies.
Citing iron ore as an example, he said global supply of the mineral is substantial, unlike other commodities that have “far more balanced” levels of supply and demand.
Peter Warnes, head of equities research at Morningstar, concurred. He said low-cost iron ore miners such as BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO), alongside the world’s largest producer Vale, are increasing output to reduce their unit costs.
Fortescue Metals Group (ASX: FMG) is doing the same, he noted.
“On the iron ore price, the demand is not robust and the supply is ever increasing. There’s no supply-side benefit in iron ore that you’ve got in oil.
“I’m more bullish on the energy sector than on the materials sector. I’ve said it in presentations three months ago and I still hold to that view that the oil price will finish higher than the iron ore price at the end of the [calendar] year,” he stated in a phone interview on June 20.
The price of Brent crude oil, which rose to above US$50 per barrel recently after dropping to below US$30 a barrel early in the year, has encouraged some of the US shale oil producers to resume drilling activities, Warnes said.
Due to the complexity of drilling involved in extracting shale oil, the costs for shale oil producers are often higher than those of conventional oil explorers. That means they need a higher oil price to break even.
Healthcare stocks in the ASX 200, which as a group gained more than 16% in FY16, were thrust into the limelight during FY16 on news of potential regulatory changes.
One of the main issues was an ongoing review of the government’s funding on certain medical services, which could affect some healthcare providers.
Warnes believes investors have generally factored in these uncertainties.
CommSec’s Wynne noted that an ageing population was a point worth noting.
“Individual healthcare stocks have been among the strongest performers this year," he said.
Financials in the frame
The financial sector, which has the heaviest weighting on the ASX 200, was down by around 7% so far in FY16, with the overall share market posting a subdued performance, mainly due to a bleaker global economic outlook and volatility.
Focusing on the major banks, Wynne said they are facing “significant challenges” due to stricter regulation and capital requirements on key home loan products.
Investors might be wondering about the level of shareholder returns – comprising share price changes and any dividends paid – that are “acceptable” in the coming year, he said.
“Are the bank yields that are a multiple of the cash rate enough to satisfy investors or do they want growth too?” he said.
What about the cash rate?
Interest rates in Australia have been at all-time lows, with Commonwealth Bank economists expecting two more cuts in the official cash rate by December. That means income available from interest-earning assets generally remains low compared to the dividend yields of some of the stocks on the ASX 200.
Therefore, investors seeking higher-yielding assets could provide “material support” to certain companies in the industrials, healthcare, utilities and consumer discretionary sectors, Wynne stated.
“The key risk here is that a year’s dividend can be lost very quickly in stocks, so investors need to weigh up the risk of higher volatility versus the additional return,” he added.
It is in this low-interest rate environment that Morningstar’s Warnes holds on to his conviction that the major banks, together with other dividend-paying companies, will remain relevant in FY17.
Added to the picture is the US Federal Reserve’s “fairly dovish” approach to rate hikes, and the fact that yields from long-term government bonds – essentially risk-free rates of return – in countries such as Australia, Germany and the US continue to fall, Warnes said.
The bull market in bonds – where bond values increase while yields decline – is “alive and well, and it’s reflecting a very ordinary and sombre economic growth outlook for the world”, he said. “That’s not likely to change for some time. Therefore, income becomes imperative.”
Sectors vs stocks
Sector analysis is useful to determine how each sector has performed and what might be ahead. It doesn’t mean putting all your money into a particular sector. Before investing in shares, it remains vital to study individual companies within the sectors you have identified as potential investment options.
For FY17, Warnes believes investors should consider a focus on defensive and income stocks, characterised by sustainable cash flow and free cash flow.