Stick with equities over bonds as bull market recovers from unrest

IT’S been an interesting start to 2018 for stock market investors. No sooner had seasoned investors like Bill Miller and Jeremy Grantham warned of a melt-up in stocks than markets went into reverse, hitting three-month lows in the process. The big lesson for investors here is that corrections are very much par for the course for stock markets, particularly later on in the economic cycle. From 2009 to 2016, there was a 10pc correction in equities almost every year — but last month’s unrest was the first notable sell-off in two years. So while the correction was painful, it was also overdue given the 21pc cumulative gain in 2016 and 2017.

Despite February’s setback, the evidence still favours equities moving higher rather than lower over the next year or so. As we move through the economic cycle, growth, in the economy and also in corporate fundamentals, becomes increasingly important for stock market investors. There is plenty of evidence of strong growth to comfort investors. World economic growth is at its strongest since this recovery began, with both developed and emerging economies performing well. Global trade patterns also validate that economic improvement — trade volumes in developed economies are growing at the fastest pace in five years.

In addition, the US tax cuts inked late in 2017 should help extend the length of the economic recovery further and buoy corporate profit growth in 2018. Corporate profits are forecast to grow by around 14pc in 2018 and generally these forecasts have been revised higher of late, again reflecting the impact of the recent tax cuts. All of this underpins the case for stocks in the next 12 months.

The back up in bond yields since the beginning of the year has thrown something of a spanner in the works for equities however. Former US president Bill Clinton’s political adviser James Carville once famously said he’d like to be reincarnated as the bond market, as it can intimidate anybody. Bonds certainly bullied equities lower last month as yields moved higher — primarily on the back of higher inflation expectations. Last January’s US employment report fanned these concerns further with wages growing at the fastest pace since 2009.

However, the sell-off in government bond markets so far in 2018 should be seen as a healthy development — bond yields should be moving higher in the context of the strong global economic backdrop and the moves away from quantitative easing by central banks. Furthermore, US bonds in particular were pricing in little or no 2018 interest rate hikes from the US Federal Reserve late last year so the recent sell-off in the bond market has thankfully eradicated much of the complacency in that market.

However, what happens next for inflation is arguably as relevant for equities as for bond investors. There have been numerous examples over time where equities struggled as inflation spiked and central banks were forced to move aggressively to curb it. Inflation should move higher but right now we see little evidence that its path could be steep enough to cause central banks to substantially change their interest rate expectations. As long as this remains the case and the growth outlook holds firm, equities can grind higher and the burden of the stronger economy and higher inflation should weigh more on government bonds.

Consequently, we remain of the view that the bull market for stocks will continue in 2018 and that equities will continue to outperform government bond and deposit returns.

Any investment commentary in this column is from the author directly and should not be seen as a recommendation from The Sunday Independent