Market Focus: Ten for 2018—Midyear Update

“Goldilocks” Gives Way to Something More Complicated

What we said:  Though the strength of global economic momentum is undeniable, a confluence of factors—including tightening central bank policy, plateauing economic growth and rising market volatility—suggests that conditions are unlikely to remain “just right” for all of 2018.

What we’ve seen:  After a placid January, interest rate and inflation pressures and geopolitical disquiet introduced anxiety to markets, even as global economic fundamentals remained supportive if somewhat divergent.

Both Monetary and Fiscal Policy Are in Motion Globally

What we said:  As major central banks wind down unprecedented levels of monetary stimulus, their efforts are being met—and potentially complicated—by expansionary fiscal policy and reform initiatives taking root in a number of countries.

What we’ve seen:  Fed normalization has continued apace even as fiscal stimulus and tax reform complicate its path, though trade tensions and contentious elections threaten to exacerbate the already unprecedented challenge facing it and other central banks.

Geopolitical Climate Remains Unsettled

What we said:  Though 2017 mostly failed to deliver the electoral fireworks of 2016, elections this year in Italy, Mexico, Brazil and the U.S.—in addition to ongoing disrupters like North Korea, special investigations, Brexit, etc.—could upset the current order.

What we’ve seen:  While the Italian election threw markets for a bit of a loop, the back-loaded 2018 political calendar offers even greater challenges in the face of increasingly heated trade rhetoric.

China Accelerates Structural Reforms

What we said:  An emboldened Xi will be more aggressive in reducing leverage and re-orienting China’s economy toward more sustainable, high-quality development, to the potential detriment of near-term growth.

What we’ve seen:  China remains oriented toward reform, but trade tensions and their impact on already-slowing economic growth may further test Xi’s resolve.

No End to the Search for Yield

What we said:  Biased higher but still low, long-term interest rates continue to send investors into less-familiar corners of the fixed income markets in the hunt for yield, with high valuations leaving little cushion to absorb a volatility shock.

What we’ve seen:  To balance the need for income with the more challenging investment environment, investors are exploring strategies with varying degrees of risk, like bank loans, CLOs, lower-quality high yield, short duration and private credit.

Credit Drivers Begin to Change

What we said:  Continued low default rates suggest global credit spreads likely will be impacted less by fundamentals and more by technical developments such as hedging costs, LDI-related flows and regulatory changes.

What we’ve seen:  Despite an attractive fundamental environment, relative performance in credit was driven largely by technical factors, notably hedging costs and supply/demand dynamics.

Market Momentum Could Present Opportunities to Reduce
Beta Exposure

What we said:  Strong earnings growth could fuel equities in early 2018, providing investors with chances to trim holdings in high-valuation stocks and redeploy into more attractive risk-adjusted exposures.

What we’ve seen:  Though equity valuations on a forward basis have eased given expectations for very strong earnings growth in the quarters ahead, caution is still warranted given the ample risks to these forecasts.

Active Management Positioned to Shine

What we said:  Market dynamics continue to shift in favor of active management, which could extend the comeback mounted by stock pickers last year after a period of underperformance.

What we’ve seen:  Market dynamics have grown less supportive of active management this year, and relative performance has been mixed as a result.

Low-Vol Strategies for a More Volatile World

What we said:  Market-neutral and relative-value hedge funds may help investors earn returns with lower volatility.

What we’ve seen:  Though volatility eased after a first-quarter spike, we expect the respite to be brief, highlighting the benefit of strategies that can provide ballast against tumultuous markets.