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2017 was a vintage year for global equity markets, with indices delivering strong double-digit returns in dollar terms. Markets have heavily discounted future earnings growth and some stocks have been pushed up to lofty valuations. As a result, markets have essentially ‘brought forward’ or front-loaded much of 2018 returns into 2017. By extension, 2018 looks like being a much tougher environment for equity investors to navigate.
I think we will be lucky to see positive returns from equities over the next 12 months. That said, I don’t think we will see an outright bear market in stocks either as the conditions are not yet in place. Rather, we are likely to see a sustained consolidation phase or perhaps a slight downward drift in equity markets. This is certainly a year to concentrate on active alpha rather than market beta.
2018 returns? You mostly had them in 2017…
We have travelled a long way in this bull market now and the drivers that have sustained it are beginning to look played out. When you begin to run out of fundamental reasons for the market to go up, then you are entering bubble territory. We have seen some remarkable price moves in hot areas of the US stock market - particularly in the IT sector - that look to be sentiment driven and go beyond the fundamentals (chart 1).
When you experience a bull market that has run as hard as this one - the second longest in the post WWII era - it is understandable that investors are nervous. This bull market has been unloved since the recovery from the 2009 financial crisis. The fact that we have not seen strong and sustained retail investor buying and widespread euphoria around stocks is unusual - but it does make me more sanguine on the risk of a significant correction.
I think you would have to change your interest rate expectations quite dramatically to justify a significant decline, or you would need to see a recession. Neither of these risks carries a high probability in my view.
Yet, the outlook is certainly tempered by the fact that markets have front-loaded 2018 returns. Given that such strong expectations on earnings growth have already been baked into current share prices, I think we are likely to see a de-rating in the late part of this cycle, as investors realise markets have run ahead of reality. Such a de-rating would be closely connected to any evidence that interest rates will gradually begin to normalise around the world.
A few years ago, I predicted the US S&P500 to reach 2,700 by the end of the decade. We are currently hovering around 2,600. Since I see no fundamental reason to change my target, this suggests nominal upside of 3-4% between now and the end of the decade, plus dividends. For these more modest returns to be attractive to investors we need volatility to stay relatively low; if volatility rises this may not be a sufficient level of return to warrant the risk.
The opportunity for emerging markets to pick up the baton at this late stage of cycle is, I think, problematic. Much of the good recent performance has been driven by circumstances in which emerging markets always tend to do well: firmer commodity prices; a weakening in the dollar; and a lower discount rate.
A new interest rate regime
2018 could well be the year that central banks will follow through and actually do what they have said they will do on interest rates. One of the notable features of capital markets over the last four years is the disconnect between central banks’ own forecasts of interest rate trajectories and the market’s expectations for interest rate rises.
Markets have taken a long-running stance that interest rates would not be going up as much as central bankers’ forecasts or dot plots indicated. The reason for this is that markets rightly decided that inflationary risks lay much more to the downside than to the upside.
However, that could change in 2018, where I think central banks are going to be right, not markets. The risks to inflation are now much more symmetric than they have been in the past. This will encourage central banks to deliver on the interest rate rises they promised and for the first time in a while it is markets and investors that risk being wrong-footed.
The collapse in real interest rates over the last 30 years provided a significant tailwind for the gains we have seen in equity and bond markets. If and when real interest rates begin to move up, then that tailwind becomes a headwind.
Possible surprises in 2018
In terms of macroeconomics and geopolitics, the focal points of investor concerns are likely to rotate around as they have done for some time. Markets have been relatively resilient until now, but this resilience could be challenged as the process of interest rate normalisation gathers momentum.
The risk of an economic growth slowdown in China remains the principal and perennial macro concern, while geopolitical worries have flitted from European election risks to North Korean confrontation, and more lately to the growing tension between Saudi Arabia and Iran.
Indeed, a serious escalation in the latter situation would be a potential ‘black swan’ event for financial markets, and investors need to give careful consideration to both geographic and sector portfolio exposures.