Investment Trends for 2018
UK: decent performance overshadowed by Brexit
Despite Brexit pessimism and anxiety, the UK economy is performing better than most had expected. Still, GDP growth is not particularly strong, at well below 2%, and official projections for the coming years are uninspiring. That, along with inflation settling at about the 2% level, suggests UK interest rates will remain lower for longer.
Similar to what has happened in the rest of the world, such a low rate environment will provide a search for yield that should be positive for equities. On the other hand, if UK rates would rise, this could put pressure on the already stressed UK consumer.
UK equities did manage to post a decent return in 2017, getting a late boost into 2018 from a further jump in commodities prices. Given the significant size of the commodities sectors in the FTSE 100, any continued strength in oil and metals prices could support UK equities for 2018.
A key factor also is that only about 30% of the revenues of FTSE 100 companies are domestically sourced. Many of these companies still benefit from healthy global growth and generate revenue in US dollars.
The dollar exposure means they would benefit if the British pound weakens further. If these stocks are dragged down by poor UK sentiment, they could provide excellent value.
Political headlines will be closely followed.
Political risk remains a big factor. First, there’s the precarious hold on leadership by the Conservative party. Then, there’s also uncertainty on what kind of transitional agreement the country will reach with the EU, trying to avoid the significant downside risks of a hard Brexit.
Similar to other markets globally, growth stocks have been beating value stocks in the UK. This may continue in 2018 as many UK value stocks have a domestic focus and may continue to be more vulnerable to Brexit worries.
Their valuations already reflect this, however, and many of them provide attractive dividend yields, so there may be some beaten down opportunities in UK domestic stocks. This is especially the case if the UK avoids political or trade disruptions.
UK stocks may also react to US rate rises.
Like their global peers, UK investors will also want to pay attention to US interest rates, as rate rises could impact the sector performance of UK equities. Cyclicals and commodities have led UK stocks in recent months and, if US rates rise as expected, these sectors typically benefit, along with financials.
On the other hand, the consumer goods sector generally underperforms when rates rise. In terms of valuation, almost all sectors in the UK are trading near the long-term average, so they are not expensive.
The Oil & Gas and Industrials sectors are slightly above their averages, but these are also the sectors with the biggest expected rise in earnings for 2018. A further rise in oil prices would be positive for these companies but might also increase inflation and pressure UK consumers. This would be another cautionary factor against UK consumer goods companies.
Global markets: With euphoria comes caution
The consensus is overwhelmingly bullish for 2018 and that is often reason to be cautious. We should continue to expect the unexpected.
Over the last 18 months, there have been many surprises which greatly impacted the markets: the Brexit vote, Donald Trump’s victory, the passage of US tax reform, the stubbornness of low interest rates and the much anticipated (but often delayed) return of inflation.
Continuing a very long recovery, US equities are now at record highs and historically expensive Price/Earnings levels, and those alone could be reason for a more conservative position in 2018.
Why the enduring bullishness then?
Well, the impact of new tech stocks, such as Amazon and Google, and disruptive technology are proving to be even more significant than expected. Meanwhile, the US is passing new tax laws that will boost earnings and is arguably not yet fully priced in.
Furthermore, global growth is expected to remain above its potential for the second year in a row and inflation is not yet a significant threat. US stocks aside, global equities are not yet overvalued, as they are generally trading closer to their long-term average valuations.
Interest rate moves are key.
The focus on central banks will be even greater in 2018. Investors are looking at US interest rates to see if the 10-year rate can break out of the low current range. This would be bearish for credit markets but not for equities.
For example, European equities have historically climbed during times of rising US rates and growth stocks can continue to outperform also during these periods.
Positively, global interest rates outside the US are still low and inflation is non- threatening. US short-end rates have already moved higher, which could signal that a recession is on the way if short-end rates rise to the level of long-term rates.
However, at this pace, that might happen only later this year or into next year and equities typically continue to run up until this happens.
For corporate bonds globally, valuations are near historically expensive levels across the US, Europe and emerging markets (EM).
It is hard to imagine further significant outperformance from these levels, but the optimistic scenario is that we could see a repeat of the gradual, strong performance over a period of 3-4 years, similar to what happened in 2003-2007. Thus, while corporate bond prices have limited upside, the coupon interest received could provide a solid return in the mid/upper single digits, in the absence of any negative shocks.
The low interest rate environment in developed markets continues to drive a global search for yield that makes any credit market with positive yields attractive. European and Japanese government bonds have yields that are near zero, thus driving demand for corporate bonds and explaining the already tight valuations.
While equities held the spotlight in 2017, global high yield and emerging market bonds have also performed very well.
How fast and steep will rates rise?
A shockingly steep rise in US interest rates similar to the 2013 “Taper Tantrum” could be the trigger that drives bond markets into a tailspin. Investors fled emerging market corporate bonds after the Taper Tantrum and all eyes will be on the pace of any interest rate rises in 2018.
Fortunately, the Fed has been much more transparent since 2013 and is guiding for gradual increases in rates that credit markets find much easier to digest. When interest rates rise gradually, it is not uncommon for corporate bonds to still perform and provide decent returns relative to government bonds.
Indeed, markets have been preparing many quarters already for the rate rise to happen and the expectations keep getting pushed back further and further.
This time it may be different.
The US economy was hit so hard by the 2007 financial crisis that GDP was knocked far off from its long-run potential trend level.
The long, but slow, recovery since then means that GDP is only now getting back to its potential trend level. As unemployment gets closer to sub-4% figures, we may finally see wages and inflation pick up in the US. This would support interest rate rises.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.