It has been impossible to ignore how well underpinned global growth has been this year. All thirty five countries tracked by the OECD are set to have grown this year – the first time in over a decade that we have witnessed such a synchronised expansion. At the same time, in the world’s largest economy, inflation has been below the central bank’s target rate allowing interest rate policy adjustments to take place at a measured pace. Hence today, US government bonds yield the same as they did at the end of 2016. Companies too have delivered decent earnings, with analyst expectations rising in 2017 and forecasts for continued growth in 2018.
Unsurprisingly, financial markets have responded positively to all of this and real returns in most markets have been strong this year. However, with such a benign environment for risk-taking and ever higher valuations, what should we look out for as we head into 2018?
First, one of our key metrics, the real effective Fed funds rate, is starting to move towards zero and into positive territory. The opportunity cost of holding cash at 1.5% interest, when inflation is at 2%, and financial markets are at record highs, is far less than it was at the start of 2017. This may well curb risk-taking, particularly in real assets.
Second, the Federal Reserve will be accelerating its balance sheet reduction programme. While the “QE unwind” has been well-flagged, the impact on financial conditions will matter, particularly in 2019 when $600bn worth of debt will effectively be recycled back into the market. Bond markets have been supported as much by technical central bank policy initiatives as they have by low inflation.
A further concern will be that job creation cannot go on forever without some impact on growth and/or inflation. Either productivity must rise to sustain growth or the rate of growth must fall. The length of the current expansion and today’s record low unemployment levels suggest the risks of a breakout in either direction are growing.
While these themes are taking shape and as we consider how to position portfolios for next year, our current asset allocation work points to a continued bias towards Japan and Emerging Markets in equities and a balance of risk diversifiers in shorter duration (both cash and fixed income) assets. Our outlooks by region are as follows:
US Economy and Markets
Our latest asset allocation reaffirmed the positive fundamentals bolstering US growth. GDP, manufacturing, consumer confidence and employment all suggest activity levels are strengthening while inflation is contained. We estimate that the impact of a reduction in corporate tax rates and its effect on earnings is fully priced by the market, though this will do little to dampen the demand for stocks, as long as the economy continues its slow but steady expansion. Valuations are our biggest concern, as P/E ratios continue to rise and relative to the rest of the world, US stocks look expensive. We are reluctant to change our neutral view on US stocks as long as the fundamental and valuation inputs remain balanced, and the pace of additional rate hikes in 2018 conforms to plan.
Fixed income markets are less appealing as bond yields and credit spreads afford little opportunity for further gains. Where we own US fixed income, we consider TIPS (Treasury Inflation Protected Securities) to be more attractive again, given the relatively better pricing compared with earlier in the year, and the risks of a larger increase in inflation expectations.
Europe and Markets
Europe has surprised all year. Growth will likely accelerate above 2% this year, ahead of the UK and Japan. Business and consumer confidence are at record highs and consumption has picked up. It appears that cyclical headwinds have dissipated as the tail winds of a lower oil price, a weaker Euro and increased Chinese demand support further expansion.
For European stocks, forward valuations seem reasonable given the strong earnings outlook. This has persuaded us to remove our negative rating and to revert to a more neutral exposure. We have cautioned before that a stronger Euro and the lack of reform momentum may check the performance of European stocks, but our liquidity preference model suggests that, relative to the UK, fundamentals are improving more consistently.
UK Economy and Markets
The prospects for the UK economy stand in stark contrast to that of most other developed economies. Consumer confidence has fallen sharply as have retail sales volumes.
Rising prices and falling real incomes are constraints to growth as the economy adjusts to a weaker pound and the machinations of Brexit. We have downgraded our view on UK equities in favour of Europe. While much of this news appears to be discounted, the policy mix of higher rates and inflation, and investment uncertainty caused by Brexit, suggests downside risks remain. We are looking for companies that are less sensitive to currency risks and cyclical uncertainty in our allocations to mitigate against this.
We had reverted to a more neutral view on the pound in our September meeting. Despite the likely gyrations in the currency as we move towards an exit from the EU in 2019, we consider the prospects for the currency to be somewhat better, particularly on a fundamental basis, and given the negative sentiment from Brexit negotiations. For UK Gilts, the reverse is true as ten year bonds offer poor value at just over 1% yield so we remain negative on UK government bonds.
We continue to like Japanese equities for both fundamental and valuation reasons. The Japanese economy has been growing for the last seven quarters, which represents the longest period of expansion in sixteen years. The Bank of Japan has maintained its zero interest rate policy and its asset purchase programme in contrast to the Fed, Bank of England and most likely, the ECB. This has helped boost activity with a modest pick up in inflation. Forward P/E ratios are still attractive compared to other regions and distributions to shareholders are increasing. All of this supports our continued liking for Japanese equities.
Despite the strong performance this year, we believe emerging markets can continue to outperform in 2018 helped by accelerating earnings growth and a solid global expansion. As a higher beta play on global growth, and with valuations attractive, we prefer to allocate to both emerging market debt and equity in preference to developed country markets.
The risks to this view are somewhat higher than last year though. A stronger US dollar may weigh on returns but most Emerging Market economies are less geared to US dollar financing than was the case in previous cycles. If the more benign deceleration in Chinese growth turns negative, perhaps led by the President Xi Jinping’s reforms, this will have a negative impact on emerging markets overall. Recognising this, we are trimming some of our exposure back to target weights, but will remain overweight in the region.
We have adjusted our UK and European equity exposures and prefer TIPS to nominal bonds in the US. Overall, we maintain our view that the broad-based expansion in most economies and the relatively benign actions of central banks will help investors derive reasonable returns from public markets. Policy adjustments are increasing, however, and inflation may yet bite. We therefore maintain our exposure to better risk diversifiers such as cash, short-dated debt, and gold where permitted.