Morningstar’s annual outlook for the Australian share market is benign in the short term but conditions in the second half of next year could turn nasty. Investors are advised to de-risk their portfolios.

The report, written by Peter Warnes, head of Australian equities research, as well as David Ellis, senior equity analyst, and Adam Fleck, director of equity and credit research, says that there is more upside in equity markets in the short term, with positive momentum as the driving force. After that, though, there is more downside risk to consider. The report is entitled: ‘Buckle Up. The Ride Could Be Bumpy’.

The authors say, after their optimism for Aussie equities for the first half of 2017: “However, we believe there is greater downside risk thereafter. Markets are expected to peak in the first half. As the Trump honeymoon fades and reality returns, expect markets to re-trace, perhaps meaningfully,” the report says.

“In a higher-risk environment, prudent investors should reduce their risk profile, not increase it. The higher risk environment reflects potential elevated volatility, actual or perceived. To reduce risk, investors should reduce their exposure to volatility.”

In other key takeaways from the report:

• Operating conditions will remain challenging for the Australian banks. The outlook for earnings and dividend growth is under pressure following recent weaker-than-expected economic news (GDP, building approvals, wages growth, and credit growth).

Economic risks are increasing and if the economy enters a sustained recession, bad debts will rise, profits will fall and dividends will be cut. This is not our base case, however, as we expect the economy to ‘muddle through’ with 2.8 per cent GDP growth likely.

•  Morningstar does not expect a strong year for metals and mining companies. Many commodities trade well above the marginal cost of production, notably copper, coal, and iron ore. China’s leading share of consumption means small demand changes have outsized impacts.

“We anticipate softer demand growth in 2017 as China’s fiscal stimulus abates and overcapacity and bad debt force a rebalancing. We also expect iron ore prices to weaken in 2017 and 2018. China’s port stocks are near record highs, and steel demand growth is likely to flatten through 2017 while supply continues to grow”, the report says.

• It will be difficult for the telecommunications sector to outperform the market. While the average 5.2 per cent sector yield remains high, the comparative appeal is likely to diminish given our expectations for gradually rising bond yields. As domestic economic growth momentum builds through the year, investors are also likely to favour pro-growth, cyclical sectors over defensives such as telecommunications. However, Morningstar believes there is long-term value in the sector.
• Robust competition interspersed with turnaround stories dampens an otherwise benign outlook for retail stocks. Continuing low unemployment is likely to underpin consumer sentiment, offset by below-trend wages growth keeping household disposable income in check.

A weakening $A could reduce consumer appetite for both goods offered by local retailers sourced abroad as well as online purchases from foreign sites, the report says. The shift towards buying online is set to continue, structural change which is a concern for traditional brick-and-mortar businesses such as JB H-Fi, Harvey Norman, and Myer.

• Morningstar has maintained a positive outlook on healthcare, with funding concerns weighing on the sector and providing attractive entry points.

“Despite implications of funding reviews for providers, we see the ageing of the Australian population and the importance of the private sector’s role in defraying the cost burden for government as underpinning the defensive nature of the sector,” the report says.