Are global equities heading for a fall in 2018?
THE MARKETS have started the year strong. The Standard & Poor’s (S&P) 500 Index has risen more than 4% and the Hong Kong Hang Seng Index is up nearly 5%. This strong performance comes on the heels of a 6.1% rise in the S&P 500 last quarter.
Although at Ashburton our overall view of the equity market is constructive, we are doubtful that the current pace of gains can be sustained in the near term. Markets are becoming overheated and beginning to exhibit signs of euphoria. The equity market’s risk-reward profile is deteriorating.
AAII Investor Sentiment data (as at January 3) showed that 59.8% of individual United States investors were bullish on the markets on a six-month view – the highest reading since December 2004. Only 15.6% of individual investors held a bearish view – the lowest reading since June 2003. On a net basis, the sentiment indicator is at its most bullish level since December 2010.
Extreme levels of investor sentiment are often a precursor to a market turning point. The previous two highest readings of the AAII sentiment indicator were in December 2010 and November 2014. These proved to be useful contra-indicators, because the peak in AAII sentiment heralded a decline in the markets the following year. The S&P 500 ended 2011 flat and fell 1% in 2015. As Warren Buffett once warned investors, “be fearful when others are greedy and greedy when others are fearful”.
The growing clamour for Bitcoin and other cryptocurrencies is a further sign of overheating sentiment. Although we see value in blockchain technology, the rally in cryptocurrencies is a textbook example of irrational exuberance.
Bitcoin does not exhibit the characteristics of a currency or an investment. Bitcoin is a bubble, plain and simple.
Looking forward, we expect the cryptocurrency market to come under increasing regulatory scrutiny.
The current lack of market volatility is another concern, as the VIX index of volatility remains close to records lows. Does this indicate investor complacency? Perhaps, although we think it serves to highlight the market’s vulnerability to negative surprises.
Equity valuations are high, with the S&P trading on a 12-month forward price-toearnings ratio of 18.4, a 16% premium to the five-year average and a 30% premium to the 10-year average.
Although valuations appear rich, the outlook for corporate earnings remains robust, with S&P 500 companies forecast to grow profits 11.8% this year.
All 11 sectors of the S&P are expected to grow earnings this year, led by the energy, materials and financial sectors.
Net profit margins are expected to reach 10.9% this year – a level not seen before the 2008 financial crisis. The margin for improvement is broad-based, with margins expected to rise in nine of the 11 sectors this year.
The fourth-quarter 2017 results are likely to be a nearterm catalyst for the market. A strong earnings season, leading to material upgrades in corporate profit forecasts, has the potential to drive equity markets higher. Conversely, we see scope for profit-taking if corporate earnings fail to beat expectations.
Although we expect markets to exhibit more volatility in 2018, the outright risk of a bear market remains low. Bear markets are normally triggered by recessions, and there appears a limited risk of that currently.
GLOBAL ECONOMY
The growth outlook for the global economy continues to improve, with economic growth synchronised across all major geographies.
The consensus forecast expects global gross domestic product (GDP) growth of nearly 4% this year, an acceleration from growth of about 3.8% in 2017 and 3.1% in 2016.
The US economy should continue to perform well in 2018. The consensus forecast is that GDP growth will be 2.5%.
The US labour market remains tight, with employment at, or close to, a cyclical peak.
Although the inflation outlook appeared benign for much of 2017, we expect the rise in energy prices and recent dollar weakness to result in higher inflation into the second half of this year.
The US Personal Consumption Expenditures Index – the US Federal Reserve’s preferred measure of inflation (it excludes food and energy prices) – has been slowly ticking up since August and looks set to rise further.
The Core US Consumer Price Index rose to 1.8% in December, up from 1.7% the previous month.
We therefore continue to think that the market is underestimating the scope for a rise in inflation this year – both in the US and globally. We also believe the market has potentially misjudged the Federal Reserve’s desire to normalise its interest rate policy as we approach a peak in the economic cycle.
The consensus forecast expects the Fed to raise rates between two and four times this year, which should, in turn, lead to greater dollar strength than the market is anticipating.
On balance, we expect global equity markets to rise this year. However, we expect the rate of increase to moderate, following the stellar performance in 2017.
Current high levels of investor sentiment, coupled with low volatility, are a risk to shortterm performance. As such, we expect markets to exhibit greater volatility this year. The easy money has been made in equity markets, and we expect 2018 to be a more challenging year than many are anticipating. Robert Lea is the head of global equity research at Ashburton Investments.