It is our belief that 2016 marked an inflection point for the global economy, with the momentum shifting from disinflation to growth. To use a baseball reference; this likely signals we are into 7th innings or thereabout.
Prior to 2016 we experienced a consistent trend of declining growth and inflation expectations, with a high focus on tail risks (politics, economics, emerging markets, banks etc.). In 2017 we witnessed a reversal of this trend as hopes for a normalisation of growth have taken hold. This led to a more optimistic outlook with improved growth expectations reducing the perceived risk of a tail event; this is highlighted in the performance of cyclicals against defensives.
2017 really was the ‘Goldilocks’ year. Dovish central bank policy and a weaker US dollar resulted in loose financial conditions, which supported risky assets, especially emerging markets. There has also been an usually benign combination of strong and synchronised global growth coupled with stable bond yields. So whilst economic growth is finally nearing pre-Great Financial Crisis (GFC) levels, interest rates and monetary policy are not even close, due mainly to the fact that inflation continues to lag historic norms. But is low inflation always bad? Or are technological advances simply keeping prices lower (low inflation is not due to weak demand)?
What will 2018 bring?
Risks are rising but a bear market seems unlikely in 2018. The concerns include an already mature economic cycle and a long (but largely hated) equity bull market leading to stretched valuations. But these factors alone are unlikely to kill-off the bull market.
The positives include assurance around the strength and durability of the economic cycle. Yes, the cycle has been long but the unwinding of the GFC has meant that, at least until recently, it has been sub-par in terms of strength.
Major drawdowns require triggers. The worst are a consequence of the unwinding of major economic imbalances (typically a financial bubble). With pre-crisis imbalances largely reduced or shifted to the public sector, we see this risk as low. Cyclical bear markets are a function of the economic cycle and are nearly always triggered by a tightening of monetary policy in response to inflationary pressure. Inflation is low and stable and as a consequence the yield curve remains upward sloping. Without higher inflation it is unlikely that we have the conditions for a recession, and therefore a bear market.
The main question remains about the absolute level of returns in 2018. Equities are likely to outperform bonds on a relative basis, but are unlikely to be as strong on an absolute basis as they were in 2017. On a regional basis the US could be strong in first half 2018 as tax reforms drive the market higher, but this is likely to offer a short-term boost. Over the year the non-US markets should continue to outperform the US as they play ‘catch-up’ in terms of their journey through the economic cycle. US margins are back to highs whereas Europe’s are yet to achieve this. Asia and emerging markets look most attractive in terms of potential to re-rate on margins. Japan is back to highs but the highs were much lower than the global average; there is scope for reforms to drive margins higher.
We continue to see growth (technology) and value (cyclicals) as the styles to be exposed to. Defensives sectors like consumer staples should continue to underperform as historically high valuations, which were a product of the low growth and low yield years since the GFC crisis, begin to unwind.
Overall we expect another strong showing from equities (although not with the same exuberance of 2017). In this respect 2018 will present a not-quite-Goldilocks scenario of continued growth with some higher, but still controlled, inflation.