Outlook for Investment Markets
The world economy continues to improve, and investors have been further encouraged by the U.S. tax cut package they have been anticipating for some time. The economic fundamentals are still signalling support for growth assets in coming months. Even allowing for the positive outlook, however, valuations are expensive across many asset classes, investors appear to be systematically discounting true levels of risk, and it is difficult to see how 2018 will be able to repeat 2017’s strong investment returns.
International Fixed Interest — Outlook
The process of normalisation of interest rates in the major developed economies is, very slowly and gradually, getting under way, and interest rates look likely to rise in 2018, creating issues for bond investors.
At the Fed’s latest meeting, the policy participants made forecasts (the “dot plot”) of where they think the fed fund rates will go over the next few years. This time round, the forecasts were, on average, for three further 0.25% increases by the Fed in 2018. That’s rather more than financial markets currently think will actually happen. Futures prices, as recast in the CME Group’s “FedWatch” tool, say there is only a 7% chance of all three increases, with only one looking rather more likely. But either way the Fed is clearly moving away from its previous very stimulative stance, via both higher short-term rates and a wind-down of its bond-buying, which had been keeping bond yields low.
Some other major central banks have also moved away from their previously ultra-easy policy, notably the Bank of Canada and the Bank of England. However, the European Central Bank thus far has only reached the point of buying fewer bonds each month than previously: It is still adding to its stock, whereas the Fed has progressed to running down its stockpile. At its latest policy meeting on December 14 the ECB made it clear any outright retreat from its current stimulus is still a long way away. And the Bank of Japan will be keeping to its current very low interest-rate policy for the indefinite future.
Overall, however, the outlook is that the regime of ultralow interest rates is gradually likely to be chipped away, which is to be expected when all the evidence suggests that the global economy is strengthening and less in need of such unusual levels of monetary policy support. Even in Europe, the recent strength of the eurozone economy suggests that we may see the ECB moving a bit faster to normalise policy than it currently expects. The upshot is that bond yields—more in the U.S. than elsewhere—are likely to rise. The latest Wall Street Journal poll of U.S. economic forecasters expects a 2.9% U.S. 10-year yield by the end of 2018, and 3.25% by the end of 2019. The expected rises are not dramatic, but they are likely to be a consistent headwind for fixed-asset performance.
There are alternative scenarios. One is the major puzzle, which economists and policy makers have not cracked, of inflation staying very low even when economies like the U.S. are in strong shape (the latest U.S. unemployment rate is only 4.1%). If inflation continues to surprise on the downside, upwards pressures on bond yields could be less. Another potential positive is the value of bonds as insurance against any unexpected setback to the U.S. or global economies. While that does not look likely at the moment, the current U.S. expansion is already quite mature: The American economy came out of the global financial crisis recession in late 2009, so the current expansion is eight years old, quite lengthy by historical standards. Late in economic cycles, accidents can happen, and might reignite demand for safe-haven government bonds.
On the other hand, an unexpected economic setback would be very unwelcome news for the parts of the bond market that have lately been most in favour—the junkier end, and the emerging markets. There have been some genuine reasons for these sub-classes doing well—turnarounds like Ireland and Portugal, and a largely synchronised global cycle that has lifted many emerging economies with it—but any unexpected slowdown would be likely to see a rapid re-evaluation of what investors need as compensation for the true risks involved.
International Equities — Outlook
The strength of world equities has some solid backing from the economic fundamentals. In the U.S. the economy continues to do well, the much-awaited tax cuts finally look likely to kick in, and the global economy has been strengthening.
In the U.S., the key indicator of progress is the monthly jobs numbers, and they continue to meet or exceed expectations: There were 228,000 extra jobs in November (more than the 190,000 expected), and the unemployment rate stayed at a low 4.1%. And, after a very rough passage through Congress, the Republicans’ tax cut package was (at time of writing) very close to being voted through. It has been helpful that the latest Fed increase in interest rates and its prospective schedule of further rises have been and gone without upsetting investor sentiment. A “policy mistake” by one of the big central banks has been one of the key risks fund managers have talked about as a potential disruptor of strong equity markets.
Good economic conditions have translated into good profit outcomes: According to U.S. data company FactSet, corporate profits for the S&P 500 companies will have risen by 9.5% this year. While the number is exaggerated by a huge turnaround in U.S. energy companies’ profits, and some sectors (notably those closest to consumer spending) missed out, there were large increases in some sectors (materials, information technology). FactSet, which collects brokers’ forecasts, finds that 2018 is expected to be clearly better again, with a further 11.1% gain in S&P 500 profits, and that performance will be more widely spread. Materials and IT are still expected to do especially well, but so are the financials, and consumer-linked sectors also are likely to see significantly better outcomes.
World equity markets have not been flying on the one wing, however. Outside the U.S., the world economy also remains in good shape. The J.P. Morgan Global Manufacturing and Services Index, which aggregates a wide range of national indexes (including the Commonwealth Bank PMI for Australia) found that “November saw the rate of expansion in global economic output remain at its joint-highest over the past two-and-a-half years. The outlook also remained positive, with new business intakes rising at the strongest pace since September 2014 and backlogs of work increasing to the greatest extent in four years.” The same information sliced by sector (in the IHS Markit Global Sector PMI) showed that all eight high-level sectors were growing in November, led by technology, and, remarkably, all 23 more detailed sub-sectors were also growing. There is clearly a broadly based momentum to the current world economy.
The outlook also looks upbeat. The Economist’s collation of forecasts for virtually every country of any importance continues to show ongoing growth next year, with remarkably strong GDP growth expected for the two emerging-markets powerhouses, India (7.4%) and China (6.5%). Only one country (Venezuela) looks to be missing out on the benefits of widespread global growth.
To date, warnings about very expensive valuations and investor complacency about risk have made no difference to the outcome. Investors who backed the current synchronised global business cycle have been richly rewarded, and the current outlook suggests the cycle has further to run.
Even so, the warnings are still worth repeating. The recent monthly surveys of fund managers run by Bank of America Merrill Lynch, for example, have revealed that the big fund managers—while on board with the view that the global economy is likely to keep on doing well—are also convinced that equities, especially in the U.S., are expensive, even allowing for the good outlook. And the latest annual survey of equity managers run by Boston Consulting Group found that “Nearly half of the survey respondents (46%) are pessimistic about equity markets for the next year, a substantial jump from 32% in 2016 and 19% in 2015 ... Overall, 68% of respondents think the market is overvalued—by an average of 15 percentage points. This is more than twice the 29% of investors in last year’s survey who thought the market was overvalued. Among self-described bears in the 2017 survey, 79% cited market overvaluation as the reason for their pessimism.”
Risk is also being underestimated. Investors in U.S. shares, for example, were alarmed earlier in the year by the North Korean atomic weapons scare, as they should have been. But going by the VIX measure of expected volatility in S&P 500 share prices, they did not get very worried by comparison with previous unsettling episodes, and they did not stay alarmed for long. The VIX is now back to all-time lows, as are similar measures (for example, expected volatility in bond prices, which is also exceptionally low). Investors no longer see much of a threat from Kim Jong-un, or indeed from anyone or anything else.
So far, the optimists have had the best of it, and investors will be hoping that 2018 will bring more of the same. It could well do, but investors should be aware that, in the U.S., they are buying into assets which are expensive this late in the current U.S. business cycle, that the tide of monetary policy liquidity that has supported equity prices everywhere is starting to go out, and that the true level of geopolitical and other risk is actually higher than is currently allowed for in asset valuations.
Performance periods unless otherwise stated generally refer to periods ended December 15, 2017
The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation.