Grudging year
Picking winners will be critical in a ‘sideways’ market Tom Stevenson
As an investor, it is often better to travel than to arrive. It was telling last week, for example, that the US stock market hit a set of new records on the day before Congress approved President Trump’s tax reforms. Investors are good at pricing in positive developments ahead of time. Once the event itself is in the headlines, the smart money has already moved on.
It is likely that the corporate and individual tax cuts announced before Christmas will give US company earnings a short-term fillip. But the net effect of the reduction in the corporate tax rate from 35pc to 21pc is less than meets the eye, because few of the big companies that dominate the stock market indices actually pay the headline rate. The average increase in earnings, as a result of the cut, will likely be no more than about 6pc.
That will help to justify the current level of the US stock market, and may prolong and extend the bull market a little. Before the cuts were confirmed, 2,700 looked a sensible level for the S&P 500. Maybe that target should be 2,850 now. It’s hardly a game-changer. Valuations have got a little bit less stretched, that’s all.
The more interesting impact will be at the sector level, where some of the most highly taxed areas, such as energy and financials, should see some ongoing benefit. Financials, in particular, will enjoy a double whammy if the $1.5 trillion, 10-year stimulus leads, as it should, to a slightly higher interest rate trajectory. More profitable lending and a bigger slice of those profits remaining with shareholders is a good combination.
So, my view of equities in 2018 is not much changed. The drivers of the nine-year bull market are largely played out but, in the absence of recession or runaway inflation next year, I see no reason to expect a material change of direction in the stock market. After a year in which there has been almost no volatility, a correction is overdue. But I don’t believe it will turn into anything worse. A sideways-moving market is a distinct possibility in 2018, with a slice of next year’s expected returns brought forward into what was an unexpectedly good year for investors in 2017. In such an environment, picking winners and avoiding losers will be rewarded. Passively tracking the index at this late stage in the cycle makes no sense.
Choosing the right countries to invest in will also pay off as currency moves might have a greater influence than they did in 2017. A stronger dollar on the back of higher interest rates will provide a tailwind to both the European and Japanese stock markets. These are the most interesting destinations for investors next year, with positive earnings growth, supportive central banks and more reasonable valuations a winning cocktail.
The other market that is looking interesting to contrarian investors is our own. The UK missed out on the party in 2017 as investors fretted about Brexit. On one level that made sense because the economy has certainly lost momentum. But, as we know, the London market is peculiarly international. A synchronised global economic recovery and a weaker pound versus the dollar might allow the UK market to play catch-up in 2018. What looks more interesting than the Trump reforms’ impact on the stock market is how they might influence bonds next year. The long-awaited reckoning for the 30-year bond bull market was once again postponed in 2017 as inflation failed to show up and central banks were able to stay lower for longer.
If the tax cuts are seen to be acting as a meaningful stimulus along the Reagan lines then the market’s relaxed view of the interest rate outlook may start to look complacent. We currently don’t expect the yield on the 10-year Treasury bond to rise further than about 2.75pc in 2018. If, instead, it were to rise to 3pc or higher next year then it will be harder to justify current prices. This will be particularly the case with corporate bonds, where the premium investors demand to compensate for greater default risk has dwindled this year to a dangerous degree.
Companies have taken advantage of ultra-cheap borrowing costs to raise record sums in the bond market. This is classic end-of-cycle behaviour and it is starting to worry fixedincome investors. Their counterparts in the equity market should be wary, too, because the cracks in a long bull market usually show up in high-yield bonds before the contagion spreads.
So, equities look a mixed bag and bonds are moderately worrying as we head into 2018. Where else might investors look to park their money next year? Commercial property has also had an extended run of betterthan-expected returns, unsurprisingly so in a lower-for-longer rate environment. Property continues to be a source of attractive and highquality yield. But here, too, selectivity is key. Investors are paying too high a price for the security of income offered by a long lease in a trophy building. As with bonds and equities, 2018 looks like being harder work for real estate investors.
If all this sounds a little tentative and cautious there’s a good reason for that. The bull market since 2009 has been long and lucrative, but unloved. A prolonged period of rising prices such as we’ve enjoyed would normally have generated a bit of excitement. That it hasn’t done so is counterintuitively good news. Here’s to another grudging year.