As the year closes, our 2017 bull case target for the S&P500 of 2,600 has been met. Momentum is still positive and is likely to take global equities markets higher in the near term. Without forecasting closing year index levels, we believe the U.S equity markets will close 2018 at a lower level than the exit level of 2017. The magnitude and cause of a market correction is difficult to predict. Investors are currently oblivious to an exogenous factor but there is abundant fertile ground in which one can sprout.
In 2017 global equities markets, led by the U.S., enjoyed a Trumping time. In 2018, they may well suffer a Thumping. Risk assets have enjoyed an extremely favourable environment. Excess liquidity, low interest rates and a high level of complacency have driven risk asset values to high, and in many cases, very stretched levels. U.S. markets have been supported by significant growth in passive investments led by value agnostic exchange traded funds and a record level of share buybacks.
While the synchronisation in global economic growth is a positive there is little synchronization in the monetary policies of global central banks. The U.S. Federal Reserve is tightening. While the presses of the European Central Bank and the Bank of Japan are still printing, albeit at a slower rate, they are still adding liquidity to their respective systems. The Bank of China is slowing credit growth which will have implications on China’s economic growth in 2018 and beyond.
2018 will see the clash of monetary and fiscal policy on a major scale. The clash of the largest U.S. monetary tightening process in history with equally the largest ill-timed non-wartime fiscal stimulus. As the U.S. Federal Reserve embarks on a five to six-year monetary policy tightening journey to normalise its balance sheet and interest rates, the U.S government is on the brink of major tax reform which could add US$1.4trn plus to the deficit in addition to a promised US$1trn boost to infrastructure spending over 10 years. As GDP growth accelerates, fiscal policy should be moderating, not expanding. This clash will potentially make the task of the new Chairman of the U.S. Federal Reserve Jerome Powell and the Federal Open Market Committee (FOMC) more difficult.
Record U.S. margin debt cannot be ignored. It currently stands at over US$580bn and is at a record level relative to U.S. GDP at 2.9%, higher than both the peaks prior to the collapse of the 2000 dot.com boom and the GFC. Nor can the rapid build up of funds in open-ended equity exchange traded funds (ETFs). Equity ETFs will attract over US$300bn in 2017, with November end totals at US$294bn. This is more than the whole ETF industry, which boasts funds over US$3.4trn, has ever previously attracted in one year.
With major U.S. market indices making new records over 60 times in 2017, it is little wonder the flow of funds has reached current levels. The fear-of-missing-out (FOMO), high levels of complacency/low volatility and low costs have combined to drive ETF exuberance.
When the market turns, the untested redemption phase could be associated with a violent and volatile correction. When greed turns to fear, it is unlikely investors will treat EFTs as long-term investments and watch profits evaporate. They are likely to act, which could trigger market volatility, as computers rather than humans transact.
China – A slowdown and different drivers
While the resilience of China’s economic growth has surprised many with GDP growth nearer 7% than 6% over the past two years, structural change is likely to gather momentum in 2018 and lead to a slowing in economic growth. GDP growth is likely to trim to near 6% in 2018 and slip below 6% in 2019. This is still meaningful growth particularly as the economic base has increased significantly over the past decade.
The journey of transition to a consumer-driven economy has moved well past the half way mark. Fixed asset investment, which has been a major driving force behind China’s incredible growth of the past 15 years, is and will continue to moderate. The loss of momentum is natural, but it was punctuated by government stimulus measures in late 2016 and early 2017. As the stimulus effect fades so will FAIs importance in its contribution to GDP growth. The property sector, boosted by speculation in housing, has been the other driver of economic activity and its importance is also likely to fade in 2018 and could be the main drag on overall economic growth. There is little likelihood there will be stimulus for the sector with Xi Jinping’s recent comment, “houses are for living in, not for speculation”.
Offsetting lower contributions from FAI and the property sector will be domestic consumption and exports. As the economy has morphed into a more traditional western-style consumer driven economy, household consumption has and will continue to be more relevant to economic growth. Continued solid wages growth will drive domestic demand for goods and services.
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.
