Outlook: Shane Oliver

The sharemaret is gaining ground but look out for the danger signs

This year has had its share of worries – around President Trump, European elections, North Korea, the Fed and the usual talk of a recession in Australia. However, it has mostly turned out well for investors.

But can it continue? The cyclical bull market in the direction-setting US sharemarket, at nearly nine years old, and the current US economic expansion, at 8½ years old, are both longer than average, suggesting some vulnerability. And, of course, growth assets such as shares are no longer as cheap as they were a year or two ago.

However, there are several reasons to believe that returns will remain reasonable for a while yet.

First some context. A typical cyclical bull market in shares has three phases: scepticism, when economic conditions are weak and confidence is poor but smart investors see value; optimism or the “sweet spot”, when profits and growth strengthen and investor scepticism gives way to optimism while monetary policy is still easy; and euphoria, when investors become euphoric on strong economic and profit conditions, which pushes shares into clear overvalued territory and excesses appear, forcing central banks to become tight, which combines with overvaluation and investors being fully invested to drive a new bear market.

Our assessment is that we are still in the “sweet spot” phase, albeit more advanced now. Global economic indicators are strong, growth forecasts are being revised up and this is driving stronger profits. But thanks partly to the slow postGFC recovery, there are still few signs of the sort of excesses that characterise the “euphoria” phase that ultimately leads to the next bear market:

• There is no over-investment globally.

• Overall private sector debt growth is modest in most countries.

• Spare capacity still remains and this, along with technological innovation, has been constraining inflation.

• As a result, global monetary conditions remain easy and without a surge in inflation they look likely to stay that way. The Fed is continuing to tighten but it’s “gradual” and from a very easy base and other central banks are on hold, including the Reserve Bank in Australia, where a rate hike is unlikely until late 2018 at the earliest.

• Sharemarket valuations are mostly OK. Measured against their own history, shares are no longer cheap. This is particularly so for US shares. But once allowance is made for low inflation and still-low bond yields, shares are fair value to cheap depending on the market.

• Finally, while short-term investor sentiment is bullish, long-term measures of positioning are not.

Overall, we are still not seeing the signs of excess, euphoria and exhaustion that typically come at economic and sharemarket peaks ahead of recessions and deep bear markets. So barring some sort of external shock, the cyclical bull market in shares looks as if it still has further to go through the year ahead.

What to watch? The key to the next big bear market are signs of excess – eg, over-investment, rapidly rising inflation, aggressive tightening in monetary policy, clear overvaluation and investor euphoria. This would then set the scene for the next economic downswing and hence a more severe bear market. At the moment, it’s hard to see much excess but we do expect US inflation to start rising from here, which will likely see higher bond yields through 2018.

There are two big implications for investors. First, corrections should be anticipated, with Trump, North Korea, the Fed, maybe the upcoming Italian election and concerns about Australian house prices being potential triggers. But despite this we still appear to be a long way from the peak in the investment cycle.

Second, non-US sharemarkets and economies are less advanced in their cycles and provide more opportunities for investors. Similarly, unlisted non-residential property and infrastructure are likely to see more upside.