More of the same?
A look at what 2018 may bring Seema Shah
It’s been a stellar year for investors; the strong global recovery provided the economic muscle to push equity markets to new highs. In the UK, the FTSE 100 index has more than doubled since it bottomed in 2009 and the United States is now seeing its longest stretch since 1929 that the S&P 500 index has gone without a correction of 3pc or more. I see the potential for another positive year in 2018, but these tremendous gains mean that equity markets are priced for perfection.
Perfection means that economic growth will need to be sustained across the world. I believe the recovery will continue for a good couple of years yet, and recession is not on the cards for 2018. As always, though, central bankers hold the key. Low inflation enabled most central banks to keep monetary policy very expansionary in 2017, allowing equity markets to bask in the stronger economic environment. Yet, in 2018, inflation is likely to make a reappearance as low unemployment finally feeds through to wage growth.
But this will likely not be inflation that gives central bankers sleepless nights. It will be inflation that allows them – and investors – to sleep easier at night. Fading concerns about deflation will give the Federal Reserve and European Central Bank confidence in pulling back their emergency monetary policy measures. As inflation is unlikely to exceed central bank targets, the Fed will be able to raise policy rates at a glacial pace, while the European Central Bank will probably leave rates unchanged. Central bank policy should not stand in the way of further equity market gains in the United States and Europe.
The Bank of England, on the other hand, will not enjoy that luxury. Even as the UK economy under-performs, the drop in the pound since the Brexit vote last year will keep inflation above the 2pc target. So, at a time when political uncertainty and slow-moving Brexit negotiations are taking their toll on investment plans and business confidence, the Bank of England will instead need to slam on the brakes as rising costs eat into shrinking household incomes. Global equity markets should perform well, but the UK equity market may be the exception next year.
In fairness, political struggles will not be unique to the UK. European political risk was exaggerated in 2017, and now expectations of a populist win have diminished significantly… maybe too much. Italy’s election in the first quarter of 2018 presents a meaningful risk of an antiestablishment, anti-euro government. Admittedly, the electoral system makes it difficult for a populist party to win. But since the market is not priced for a political upset, simply the threat of a victory means that market volatility is set to rise in Europe in early 2018 – a worrisome prospect when equity markets are so rich.
However, European equity market under-performance should be short-lived. Robust growth momentum and a supportive European Central Bank mean that European markets should regain their upper hand once the Italian election is over – provided the euro currency doesn’t get too jubilant about the positive economic performance, forcing the central bank to tighten financial conditions too much.
In the United States, President Trump has taken credit for the positive equity market performance this year, defying all the negative commentary and expectations about his presidency. His tax reform legislation will likely provide a second life to risk assets in the first half of 2018. As next year’s midterm elections approach, however, his luck may run out. Political uncertainty will abound – and US equity markets currently leave no room for uncertainty. So, just as US equity markets should outperform Europe in the first quarter of the year, this relative performance may reverse towards the end of 2018.
Growth globally will be supported by China as the government manufactures a soft landing. In fact, emerging market equities could be the overall winner of 2018. Not only are they experiencing superior growth, but some emerging market central banks will be cutting interest rates, and political risk is much diminished from previous years. Most importantly, emerging market equities are not as expensive as developed market equities, and investors are not at maximum exposure. All this implies that there is still room to grow. Of course, emerging markets are not immune to danger, and President Trump’s trade policies and the strength of the dollar need to be watched very carefully.
No region is immune to risk. Threats can come from any direction, usually the one you aren’t looking in. With equity markets at such lofty valuations, they are increasingly vulnerable to a spike in volatility and a shift in investor sentiment. True, as long as economic growth is strong and interest rates are rising only gradually, any negative market impact from political uncertainties should be short-lived and shallow. But being priced for perfection leaves no room for investor complacency.
Seema Shah is global investment strategist at Principal Global Investors
‘Global equity markets should perform well, but the UK equity market may be the exception next year’