We were in London last week, expanding on our views for 2018 at our flagship conference for the EMEA region, “Solving for 2018.” Our theme was “The Good, the Bad and the Ugly.” Synchronized global growth and market momentum are “good” aspects of the current environment. The “bad” is that many years of central bank stimulus are ending. Evidence of market complacency we marked down as “ugly.”
Which do we view as more likely to play out in 2018? And how might investors prepare?
While the global economy will likely slow in 2018, we expect corporate earnings to continue growing. U.S. companies have a more favorable regulatory environment and tax reform, which should incentivize investment. In Europe, Japan and the emerging world, further earnings expansion can come from the uptick in growth and trade.
When we polled the audience, more than two-thirds were expecting economic expansion into 2019 or 2020. A similar proportion thought equities could be the best-performing investment category in 2018, and most of the rest picked commodities.
We go into 2018 broadly positive on equities. Our Asset Allocation Committee (AAC) prefers alternative investments to nominal fixed income and is positive on inflation-linked bonds and commodities as we anticipate rising prices. That seems consistent with our audience’s votes.
The audience voted decisively for either rate hikes or inflation as the biggest risk for 2018.
Inflation went missing-in-action in 2017, but the 1960s showed how unemployment could fall for years with no effect on inflation until, eventually, a threshold is crossed. We expect that in 2018, but we also think the rise in inflation will be gradual. Linkers seem to us a reasonably priced way to hedge that risk. By contrast, investors are currently not being well compensated for investment grade bond risk, in our view.
With central banks behind them, markets have become complacent. Volatility is historically low; yields remain depressed and credit spreads tight despite rising leverage; equity valuations are not stratospheric, but we would describe them as full.
It has been 399 days since the last 5% drawdown for the S&P 500 Index and many believe we are due a correction. The catalyst could be an election result in Italy, Mexico or the U.S. midterms, uncertainty around NAFTA, a shock from central bank policy adjustments or a marked slowdown in growth—most likely in China.
It is true that markets have plowed through a series of shocks over recent years, but experience tells us that they ignore these things until they don’t.
How might investors prepare? In London, we discussed our AAC 12-month outlook and our view that the current economic and market momentum could continue through at least the first part of 2018. Should the first half play out as we anticipate, it could present an opportune time to begin positioning for higher inflation and adopt a more defensive profile.
Becoming more defensive does not necessarily mean substantially cutting back equities and credit. Instead, it could mean reducing equity-market sensitivity (perhaps by using alternatives such as low-volatility hedged strategies and put writing), improving credit quality (by considering emerging markets debt over U.S. high yield, for example) or seeking to take advantage of opportunities in less liquid strategies. Most importantly, we think it means recognizing that 2018 is unlikely to be a re-run of 2017.
As Clint Eastwood might put it, in this world there are two kinds of people: those who are prepared for elevated risks, and those who aren’t.
In Case You Missed It
- Bank of Japan Policy Decision: BoJ maintained its current policy rate
- U.S. Existing Home Sales: -3.6% to SAAR of 5.57 million units in December
- U.S. New Home Sales: -9.3% to SAAR of 625,000 units in December
- European Central Bank Policy Meeting: ECB left policy rates unchanged
- Japan Consumer Price Index: +1.0% in December year-over-year
- U.S. Durable Goods Orders: +2.9% in December (excluding transportation, durable goods orders increased 0.6%)
- U.S. 4Q17 GDP (first estimate): +2.6% annualized rate
What to Watch For
- Monday, 1/29:
- U.S. Personal Income and Outlays
- Tuesday, 1/30:
- S&P Case-Shiller HPI
- Euro Zone 4Q17 GDP (first estimate)
- Wednesday, 1/31:
- U.S. Pending Home Sales
- FOMC Minutes
- Thursday, 2/1:
- ISM Manufacturing Index
- Friday, 2/2:
- U.S. Employment Report
Statistics on the Current State of the Market – as of January 26, 2018
|S&P 500 Index||2.2%||7.5%||7.5%|
|Russell 1000 Index||2.1%||7.3%||7.3%|
|Russell 1000 Growth Index||2.3%||8.6%||8.6%|
|Russell 1000 Value Index||2.0%||6.0%||6.0%|
|Russell 2000 Index||0.7%||4.8%||4.8%|
|MSCI World Index||1.9%||7.0%||7.0%|
|MSCI EAFE Index||1.5%||6.5%||6.5%|
|MSCI Emerging Markets Index||3.3%||9.9%||9.9%|
|STOXX Europe 600||1.6%||6.6%||6.6%|
|FTSE 100 Index||-0.8%||-0.2%||-0.2%|
|CSI 300 Index||2.3%||8.7%||8.7%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||-0.2%||-0.2%|
|Citigroup 10-Year Treasury Index||-0.2%||-2.0%||-2.0%|
|Bloomberg Barclays Municipal Bond Index||-0.3%||-0.6%||-0.6%|
|Bloomberg Barclays US Aggregate Bond Index||0.0%||-0.9%||-0.9%|
|Bloomberg Barclays Global Aggregate Index||0.9%||1.4%||1.4%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.2%||0.9%||0.9%|
|ICE BofA Merrill Lynch U.S. High Yield Index||0.3%||0.9%||0.9%|
|ICE BofA Merrill Lynch Global High Yield Index||0.6%||1.6%||1.6%|
|JP Morgan EMBI Global Diversified Index||0.3%||0.2%||0.2%|
|JP Morgan GBI-EM Global Diversified Index||1.7%||4.7%||4.7%|
|U.S. Dollar per British Pounds||2.4%||4.8%||4.8%|
|U.S. Dollar per Euro||1.7%||3.5%||3.5%|
|U.S. Dollar per Japanese Yen||1.9%||3.7%||3.7%|
|Real & Alternative Assets|
|Alerian MLP Index||2.2%||10.0%||10.0%|
|FTSE EPRA/NAREIT North America Index||1.3%||-3.5%||-3.5%|
|FTSE EPRA/NAREIT Global Index||2.1%||2.1%||2.1%|
|Bloomberg Commodity Index||2.6%||3.1%||3.1%|
|Gold (NYM $/ozt) Continuous Future||1.4%||3.3%||3.3%|
|Crude Oil (NYM $/bbl) Continuous Future||4.5%||9.5%||9.5%|
Source: FactSet, Neuberger Berman.