The global economy, with the exception of the UK, is going through a period of rare synchronised expansion. Corporate profits are rising, trade is expanding and growth is robust. Asia is also benefiting from a continued uplift in China, while Japanese equities are finding a ‘sweet spot' due to increased strength in corporate earnings and ongoing corporate reform. On a monetary policy level, despite the US Federal Reserve modestly tightening, and the Bank of England raising rates, global monetary policy remains accommodating.
Against this it is not surprising equities are trading at current levels and they should continue to perform well in 2018. However, we must ask what could upset this outlook. In addition to historically-low credit yields and the absence of inflation, there are geopolitical risks including Brexit, potential instability in Europe, and US foreign relations.
UK and Brexit risk
UK corporate earnings have disappointed and the domestic economy is slowing as a result of Brexit. Should trade talks be constructive, we may yet see a framework within which companies and investors can make forward-looking decisions. As a driving force for the UK economy, the consumer's reaction to Brexit will be important. Coupled with a more hawkish tone from the Bank of England, consumers' enthusiasm to spend may be tempered in 2018. While UK equities look cheap, the earnings momentum makes them less attractive and a serious Brexit shock could make them unpalatable.
Political instability in Europe
The upward trend of support for European populist parties was not as widespread in 2017 as expected, yet the potential for instability remains: in Germany we are yet to see a cohesive government emerge, and the forthcoming general election in Italy could result in a lurch to the populist right. So while markets are sanguine about these events, they could impact Europe's current cohesiveness.
US fiscal reform and foreign relations
Tax reforms remain in play, but US earnings and growth will be impacted should they not materialise. US foreign policy could also affect markets. Relations between the US and North Korea have not yet moved beyond escalating rhetoric, while trade restrictions between the US and Mexico have similarly failed to evolve into serious policy proposals. Diplomatic ties between the US and China appear stronger than a year ago, but any souring of relations could lead to market dislocation. These factors are difficult to price into markets, but are worth paying attention to.
Potential inflationary shock
Inflationary pressure has been absent in almost all major developed economies for some time. In the US this is in part due to dollar appreciation following Trump's election and the disappointment of his policies not coming through as promised. More broadly, inflation expectations remain subdued across developed markets.
This has meant that policy settings have remained accommodative and provided support for risk assets. With global rates already near zero, an inflationary shock would leave central banks with little room for further stimulus.
Valuation risk in credit
As we are closer to the end of the credit cycle than the beginning, there is a rising risk of defaults as companies increase leverage and engage in late-cycle activities such as M&A and share buybacks. While this could be positive for equities, it could undermine credit valuations and unsettle markets. Credit valuations feel much richer than their equity counterparts and this is certainly the case for high yield credit. But we do not expect to see a bond market upset next year. In part, because of subdued inflation expectations and because aggressive, co-ordinated global monetary tightening seems unlikely. Demand for high-quality sources of income also remains strong.
China is arguably the biggest risk to global markets. Yet economic growth remains steady, disposable income is at a two-year high, industrial profits are growing firmly, and investment outflows have fallen as domestic investors take up the baton.
China and its investors appear to have accepted the country's need to rebalance its economy. However, we note that while headline exports and imports are rising, the current account surplus is being eroded. Also, it has been juggling with the paradox of pursuing a controlled exchange rate, free capital movement and an independent monetary policy - its ‘trilemma'. There are clear flashpoints over the next five years, but we don't believe this is a near-term risk.
The macro-economic backdrop is still supportive for equities, and in 2018 we envisage prices rising moderately driven by strong fundamentals and earnings growth. But there is unlikely to be much upside in credit markets because valuations are too rich, although that's not to say investors should avoid the asset class entirely. With an absence of monetary tightening or large-scale fiscal changes, Asia, Japan and Europe appear to be the best areas to take cyclical exposure to global growth. However, with potential geo-political and economic risks, 2018 will require the skill of active managers to find investment opportunities that deliver consistent returns.
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