Deviating from Goldilocks stocks
The first half of 2018 could turn out to be reasonably benign for investors, with markets continuing in the same vein as they have done in 2017. Equity valuations might be towards the top end of their historical range, but the cyclically adjusted P/E ratio can seem more reasonable if you factor in today's high returns on equity and low economic volatility, as well as below target core inflation and low 10-year Treasury yields. These are the forces that have underpinned strong performance from riskier assets this year, and which might herald further upside.
That support could unravel as we move further into 2018 and markets will have to face materially tighter monetary policy, with stronger growth and greater price pressures encouraging central banks to turn more hawkish. While US inflation has been unexpectedly subdued throughout 2017, the labour market is getting increasingly tight. Unemployment has now reached its lowest level since 2000, and workers are beginning to demand higher wages in sectors like housing and trucking.
With the oil price having also risen to a two year high, the Fed could find itself with little room for manoeuvre to placate equity investors. Markets are not prepared for a deviation from Goldilocks - valuations are high, volatility is low, and risk appetite is extended.
Surprises for bond investors
I think the shape of the yield curve could surprise investors in 2018 - it's just a question of whether bond or equity investors are taken unawares.
If inflation rises and we see interest rates move upwards then, theoretically at least, the yield curve should steepen. That would surprise bond investors, for whom secular stagnation has been an article of faith since the financial crisis. Fixed income markets, particularly the lower yielding areas like government and investment grade bonds would sell-off, as they were forced to accommodate the new outlook.
The question is, how sustainable is that situation? We are not signed up ‘Secular Stagnationists,' but we do share some concerns. In particular, we think the debt burden is an important constraint for many economies. If that collides with higher rates, the system could prove to be very fragile. Early signs of weakness in interest rate sensitive areas of the US and UK economies point in this direction. The worst-case scenario would be if we saw the yield curve inverting, potentially signalling a recession.
Where are the opportunities?
How best to capture opportunities is potentially the most interesting question for 2018. If markets continue to rally, then you'd expect those areas of the equity market which have lagged in recent months to perform better. On the other hand, momentum stocks could simply keep on winning, with areas like technology having re-rated on strong earnings growth.
Looking for positions which offer you asymmetrical returns, or which can work out in more than one market environment, will be important for 2018. Energy companies are a good example of the first of these, with conservative valuations not reflecting the fundamental improvement in the supply and demand of oil over the course of 2017.
US equities are a good example of an asset class which could work in more than one environment. The US is home to several of the big technology companies that have done well in 2017, as well as having plenty of business that could fit into a technology-driven growth narrative. They will offer exposure to a momentum-driven rally, but if equity markets turn more volatile, US stocks tend to be reasonably defensive.
Important information
The value of investments and the income from them can go down as well as up, so you may not get back what you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. The price of bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may, therefore, vary between different government issuers as well as between different corporate issuers. Liquidity is a measure of how easily an investment can be converted into cash. It is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.
