2017 Record Year
Overall, global equity markets had an excellent year in 2017, indeed the best since 2009 contrary to the pessimistic projections of many commentators. In fact, 2017 was about as good as it gets for equities. The MSCI World index, which is one of the broadest and well-respected measures of global equities delivered a positive return every month for the first time ever in dollar terms. This low volatility was exceptional – indeed, the US equity market had the lowest volatility since records began except 1964.
Positive Market Momentum
The positive market momentum was a consequence of several positive factors coming together. Firstly, there has been excess liquidity in circulation as a result of the loose monetary policy of central banks over the last nine years since the financial crisis of 2008, as well as the exceptional stimulus measures put in place, such as quantitative easing (QE).
Secondly, markets have been driven higher with strong and unusually synchronised economic global growth; thirdly, corporate earnings have been mostly significantly exceeding consensus estimates, particularly in sectors such as technology. Finally, the macro economic environment has remained supportive of equities with continuing low inflation, low unemployment and healthy business and consumer confidence.
2018 Investment Market Outlook
It is easy to feel nervous as 2018 gets underway. Valuations in most markets, particularly the US, are now stretched based on most historical measures. In addition, there are political risks everywhere which could potentially de-rail the positive sentiment. Bears point to the flat yield curve for US Treasury bonds – the fact that short-term interest rates are similar to long-term interest rates has historically implied a poor economic outlook.
Certainly, with President Trump’s recent tax cuts, it looks as though the 30-year bond bull market peaked in 2016 when US government bonds yielded under 1.4% over 10 years. The equivalent yield is now nudging 2.5%.
Back to the 1960s?
It is interesting to look for historical parallels in terms of where we are in the economic cycle currently. In the mid-1960s, inflation had fallen to under 2%, economic growth was strong and unemployment was low. President Kennedy implemented a significant tax cut in 1964 and there followed increased government spending for social initiatives and the war in Vietnam. There had been a couple of small increases in interest rates by the end of 1965, much as we witnessed towards the end of 2017. Just as now, at the time, there was uncertainty in respect of the result of loose monetary policy and a complacency about inflation spiking.
The head of the US Federal Reserve, William Martin commented that the US central bank is ‘in the position of the chaperone who has ordered the punch bowl to be removed just as the party was really warming up.’ In 2017, central bankers talked of tapering QE, but just as in the 1960s, action to tighten monetary policy was reluctant and slow.
Of course, we know that by 1970 wage demands had spiralled and inflation more than trebled in five years and authorities lost control of inflation with disastrous economic consequences.
Is it different this time?
Whilst it is impossible to ignore the lessons of the 1960s and 1970s, there are significant differences with 2018. Most importantly, there are secular forces of low inflation as a result of globalisation, disruptive technology and high levels of debt. The evidence for this is the fact that despite trillions of dollars of monetary stimulus around the globe, central banks have failed to stoke inflation. In addition, there is much greater transparency in fiscal policy now, particularly after the ‘taper tantrum’ of 2013 when Ben Bernanke spooked markets with talk of curtailing QE.
Central banks are now held accountable for their actions with every announcement carefully analysed. The next head of the US Fed, Jay Powell, has already confirmed he intends to continue with the measured approach of Janet Yellen. Moreover, pension funds are large owners of government bonds to match liabilities, so often hold bonds until maturity, rendering bond price movements irrelevant.
The challenge for 2018 at the macro-economic level is how to maintain a stable inflation and growth environment, whilst managing a phased exit from the exceptional economic stimulus measures post-2008 financial crisis. At the same time, governments need to address the increasing inequality in many countries, partly a consequence of QE measures, whilst dealing with record levels of debt. As a case in point, the recent US tax cut, estimated at $2 trillion, is likely to increase US debt to 100% of GDP and increase inequality.
UK and Eurozone in 2018 – Selective Opportunities
Undoubtedly, Brexit will continue to dominate the UK political landscape this year and economists will work to refine forecasts for different outcomes from the negotiations. Whilst prime minister, Mrs May, looked at time precarious in 2017, the agreement of a Brexit divorce deal has won her some breathing space to proceed with the next stage of trade negotiations. Furthermore, the fear of a Corbyn-led Labour administration is enough to unite the Conservative party, at least temporarily. From an investment standpoint, in our view it is easy to be too pessimistic about the UK’s prospects. Consensus economic growth forecasts for 2018 are 1.5%, which is above the laggards in the G7, Italy and Japan at 1.3%. As with 2017, the UK may in our view surprise to the upside. Weak sterling could result if Brexit talks stall benefiting UK exporting companies and well managed small and medium size companies present interesting opportunities in niche sectors.
In terms of the Eurozone, the Italian election could be a key political turning point for the future direction of the wider EU. In Germany, Mrs Merkel’s power is on the wane, which is likely to make an agreement with President Macron of France over a budget to fund and absorb future potential economic shocks more difficult. Nevertheless, provided that euro strength can be contained, there is scope for many European companies to deliver attractive returns in 2018, such as the ‘Mittelstand’ or mid-cap companies in Germany, where there is a high level of entrepreneurship to take advantage of disruptive technologies.
US Markets – Vigilance and Volatility
On the one hand, the high valuations of US equities suggest that caution is required. Particularly, as the political risk of President Trump cannot be ignored – Robert Mueller’s investigations continue with the ultimate worst potential outcome of impeachment. President Trump may also focus on protectionist measures this year, possibly a trade war with China involving tariffs on steel and subsidised aluminium, as well as intellectual property. There is also the possibility of the Democrats regaining control of the House of Representatives in the mid-term elections, if they can win at least 24 seats.
Nevertheless, the US economy looks in robust health. Consensus earnings are forecast to grow by 12% in 2018, helped by the $2 trillion tax cut, which was arguably unnecessary with economic growth clipping along at over 3%. The US administration has focused on a weak dollar, which boosts US competitiveness and flatters investment returns in dollar terms. This has in turn had the effect of boosting emerging markets.
However, the risk is that interest rates will need to rise to contain inflation from the tax cut, resulting in the repatriation of dollars. A stronger dollar would in turn impact US exporters and stall emerging markets, which have significant borrowings in US dollars.
For sure, 2018 will see more volatility than 2017 as the world economy seeks to re-calibrate emerging from the special measures of the 2008 crisis. Jay Powell will certainly need to get up to speed quickly when he takes the helm at the US Fed to keep the US and world economy on track.
Other Key Global Markets
Japan in our view presents some interesting opportunities in 2018. The governor of the Bank of Japan, Mr Kuroda, is focused on keeping interest rates low despite the US starting to raise rates. The continued loose monetary policy in Japan is likely to benefit Japanese exporters and support their economy with liquidity. Japan also has a number of world leading companies at the cutting edge of technology, in particular robotics, automation and artificial intelligence.
President Xi Jinping of China has consolidated his position in the government and the recent 5 yearly Party Congress set out ambitious growth plans. Whilst the economic growth forecasts from China are difficult to analyse, in our view the GDP growth target of 6.5% is likely to be met. This robust growth will see the continuing transformation and rebalancing of the Chinese economy from investment to consumption as the middle classes grow. In addition, China will be ready to fill any gaps in Asia if the US retreats economically from the region. Although high risk, selective investment in China in our view is likely to be rewarded over time.
Emerging markets are likely to experience the greatest volatility in 2018 as market sentiment will be buoyed or quashed by US monetary policy. On the one hand, with a recovery in Russia and Brazil, GDP growth of around 5% is potentially achievable, but if the US raises interest rates or withdraws QE more than anticipated, emerging market investments could sell off with a flight to quality in the US.
Summary
After an excellent year for investment in 2017, increased vigilance and diligence is required to continue delivering attractive returns in 2018. In our view the bull market will continue climbing the ‘wall of worry’ in 2018 based on supportive central banks, a positive economic backdrop, and strong corporate earnings. However, we are alert to a possible seismic change of direction in markets – this could be flagged up by a technical change such as the bond yield curve becoming inverted, meaning short term interest rates exceed longer term borrowing costs; or, the key 10-year Treasury yield jumping from 2.5% to 3%, warning of inflation expectations. In the meantime, we consider that equities will continue to outperform other asset classes. Happy, healthy and prosperous 2018!
Please note, this article is for information only and does not constitute investment or tax advice. Past performance is not necessarily an indication of future returns; the value of investments and any income from them is not guaranteed and can fall as well as rise; pension rules and tax legislation are subject to change. If you would like investment or pension advice on your individual circumstances, please do not hesitate to get in touch on 01392 875500 or info@SeabrookClark.co.uk