A World of Potential Trouble
Moving into 2018, we believe there is still plenty for investors to be worried about. Surely you’ve heard this list in some form, but here’s our spin.
Diminishing Monetary Stimulus
Central banks are pulling back; not completely, but at the margin. In the US, the Fed is both raising rates (probably 3 times next year) and reducing its balance sheet. Yes, the normalization process will unfold slowly, but quantitative tightening will happen at an ever-increasing pace. In Europe, the European Central Bank (ECB) has already begun tapering, and bond purchases may be fully phased out by the third quarter of 2018. Moreover, while few expect the ECB to raise rates, there are rumblings among the hawks at the bank that yields are too low, creating an outside possibility of an unpleasant surprise next year. Finally, the Bank of Japan will likely keep rates pinned near 0%, but its quantitative easing (QE) program will likely expand at a slower rate.
While we believe central bank action will be gradual, markets could still react negatively to draining liquidity, even at a slow pace. In addition, an unintended consequence of unwinding such an extraordinary amount of post-crisis stimulus is that we simply cannot know which over-levered player might spark the next liquidity panic – or when.
Geopolitics Remain in Focus
It’s hard to imagine geopolitics getting more headlines in 2018 than they have already received. But we are hardly out of the woods yet. German Chancellor Angela Merkel’s ability to further integrate Europe economically and politically has been hindered by her struggle to form a governing coalition at home. A President Trump-Kim Jong Un throw-down in North Korea could still be on the horizon, Brexit moves from theory to reality as we approach the March ’19 exit date, and the risk of populism continues to have potentially negative implications for elections in Italy, Mexico, and Brazil. Thus far, buoyant markets have overpowered geopolitics, but that could change in 2018. Such is the nature of black swans.
After nearly $18 trillion in global QE, it is universally understood that most broad asset classes are expensive to one degree or another. Price-to-earnings ratios (P/Es) are high across the global equity markets while base sovereign yields1 and credit spreads2 are near historic lows. Valuation alone isn’t generally a problem; it usually takes a catalyst to trigger a selloff. But if an investment’s margin-of-safety3 is the inverse of valuation, elevated prices remain a source of potential risk.
What, Me Worry?
In spite of these headwinds, risk assets have continued to perform well. Many observers see a disconnect between today’s market risks and sky-high equity prices, but investors shouldn’t overthink the situation. We believe this disconnect has a straightforward explanation: robust and synchronized global growth. Following years of positive but sub-par growth, the economic acceleration that began in mid-2016 has masked these economic and political concerns. This is the global “status quo trade” we’ve discussed for months: As long as the global economy is chugging along, investors seem content to ignore these risks.
This status quo trade makes it very easy to distill our 2018 investment outlook down to one question: Will the global economy remain on track? If so, we are likely in for more of the same – positive returns for stocks and bonds. However, if the global economy falters, we think the pain could be significant, as there would be little valuation or central bank support against falling prices.
In simple terms, we believe investors are playing a dangerous game of macro chicken. With low yielding sovereign bonds offering little competition, investors are compelled to ride the “carry train” (credit spreads in bonds and the earnings yield in stocks) for as long as they can – hoping of course that they’ll be able to jump off before the economy goes off the tracks.
Outlook for 2018
We remain on the carry train too, although half-heartedly at best. Our themes for next year include...
- The global economy shows almost no signs of weakening as yet. The resulting earnings growth should support stock prices while credit fundamentals remain solid. The market remains “risk on” (for now).
- As we push later into the year, geopolitics, tighter monetary policy, and growing inflation may make the second half a little more harrowing.
- We expect equity returns to be positive but below average. Stocks across most regions and cap ranges may only fire on one cylinder (earnings growth) as P/E expansion has been largely depleted at these valuations.
- In the bond market, we expect real yields to push only modestly higher. Inflation is a far bigger wild card. Regardless, high quality bonds remain in an environment where investors will be lucky to realize their yield (as it is partially offset by some level of rising rates/price depreciation). Credit spreads can remain fairly tight as the economy grows, but spread volatility could rise in the second half.
- The US yield curve may continue to flatten4 somewhat as hikes at the short end modestly outpace rising rates at the long end. Even so, we’re still some time away from the curve presaging recession.
- Solid fundamentals and strong relative value arguably make emerging markets (EM) the most attractive play in both equities and fixed income. However, our enthusiasm is constrained as EM already appears to be universally loved by investors which could equate to a very crowded trade.
- We believe the US dollar will see some modest strength thanks to attractive interest rate differentials, the Fed’s relatively tighter policy, positive business sentiment from US corporate tax reform, and a flight-to-quality if markets get more skittish (as we expect).
- Volatility across asset classes has been muted by stronger growth, the market’s overall direction (up) and by central bank largesse. We believe markets could become bumpier as central banks begin to pull back in earnest.
2 A credit spread is the difference in yield between to bonds of similary maturity but different credit quality.
3 The term margin-of-safety refers to the difference between the intrinsic value of a stock and its market price.
4 The term yield curve refers to a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity. A flattening yield curve can result from long-term interest rates falling more than short-term interest rates, or short-term rates increasing more than long-term rates.
Important Risk Considerations
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments.There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
Foreign and emerging market securities may be subject to greater political, economic, environmental, credit, currency and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and are as of December 18, 2017. There can be no assurance that developments will transpire as forecasted, and actual results may vary. Other industry analysts and investment personnel may have different views and make different assumptions. Accuracy of data is not guaranteed, but represents best judgment, as derived from a variety of sources. The information is subject to change at any time without notice.
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