Outlook for 2018 Remains Positive Despite Recent Sell-Off

2017 was a bumper year for stock markets, as major indices around the world hit record highs and posted some of the best calendar-year returns of the decade. The S&P 500 cracked the ‘perfect’ year, delivering positive total returns (including dividends) every month, for the first time ever and the current S&P 500 bull market (a market period without a 20% decrease) is the second-longest in history.

 DJ EURO STOXX 50-2.81%-14.10%18.06%21.51%4.01%6.42%3.72%9.15%
 FTSE 10012.62%-2.81%9.97%18.66%0.74%-1.32%19.07%11.95%
 HANG SENG8.57%-17.38%27.46%6.55%5.48%-3.92%4.30%41.29%
 MSCI EMERGING MARKETS14.10%-12.74%16.99%3.44%5.17%-5.76%9.69%30.55%
 MSCI WORLD10.01%-5.49%15.71%28.87%9.81%2.08%9.00%18.48%
 NIKKEI 225-3.01%-17.34%22.94%56.67%7.12%9.07%0.42%19.10%
 S&P 50014.37%1.47%15.22%31.55%12.99%0.75%11.23%21.10%

Calendar-year returns for major global indices, Source: FE Analytics

However, investors are growing concerned that market valuations are becoming too stretched and over the last week, US stocks suffered their biggest fall in over six years. We discuss with AAM’s Investment Research Team whether this recent sell-off signals the start of a market crash or if we should remain optimistic for 2018.

OS: With many debating how to position their investment portfolios for 2018 in the wake of the recent losses in global stock markets, what do you see as the lynchpin in determining the direction financial markets may take over the next 12 months?

DA: The recent sell-off was primarily driven by inflationary fears on the release of better-than-expected US hourly average earnings data. However, many analysts see this sell-off as oversold because of technical factors. The positive earnings data indicates a strengthening economic backdrop and as long as inflation and interest rates do not pick up too quickly, our outlook for 2018 remains positive.

The key for 2018 is how quickly reinflation will occur and the magnitude of interest rate rises in response. While there is a need for interest rates to increase in order to control inflation as well as restore central bankers’ ability to fight off recessions by loosening monetary policy, this is finely balanced against the need to continue to support aggregate demand, as well as avoid increasing rates so quickly that current levels of debt become unserviceable.

OS: How quickly do you expect the rate of inflation to rise?

DA: Temporary factors held back inflation in 2017 but I would expect the rate of inflation to increase over the next twelve months. Inflationary pressures are mounting in the US as the economy nears capacity limits with unemployment hitting record low levels. However, while wage growth is ticking up, it is still far below previous levels when the labour market was comparably strong. Nonetheless, the increase will be slow and steady over 2018. The weaker dollar will push imported goods prices higher, but the global savings glut will help to dampen inflation somewhat.

US inflation including forecasts, Source: Capital Economics

OS: And how quickly do you expect interest rates will rise?

DA: The US Federal Reserve has long-signalled its intention to hike interest rates, doing so three times since late-2016 already and stated last month that there will be a further three increases in 2018. Despite this, many market analysts are forecasting the Fed will need to raise rates four times in order to cool an overheating economy, and believe that current asset prices are already reflecting this. Aside from the UK, other major economies are likely to raise interest rates slowly, or not at all.

Average 2004-2013201420152016201720182019
 UNITED STATES1.9%0-0.25%0.25-0.5%0.5-0.75%1.25-1.5%2.25-2.5%2.5-2.75%
 UNITED KINGDOM2.4%0.5%0.5%0.25%0.5%1.25%1.75%

Global interest rates including forecasts, Source: Capital Economics

OS: What are the consequences of higher interest rates for asset prices?

DA: The effect of interest rate movements on bond prices is clear cut. All other things held equal, an interest rate rise will lead to a fall in bond prices. Bond yields move inversely to prices and therefore increase as a result of interest rate hikes. The recent financial landscape has been characterised by very low bond yields so the uptick (the yield on the benchmark 10-year US Treasury note climbed to its highest level in three years last week) marks a significant shift and indicates growing expectations for a stronger economy.

In contrast, the effect of higher interest rates on stock prices is more nuanced but in general, higher interest rates (indirectly) negatively impact stock prices. However, it is important to note that prices reflect expectations about the future. As mentioned earlier, assets are already pricing in further increases so there would need to be an unanticipated rate increase or a change in expectations for stock and bond prices to be impacted. While stocks may be relatively expensive by some measures, earnings growth has been strong and recent announcements have, for the most part, justified valuations. Further, most stock markets outside of the US still look relatively cheap.

OS: Could higher interest rates lead to a slowdown in economic growth?

DA: Higher interest rates can negatively impact economic growth because they make borrowing money more expensive, and a higher cost of capital reduces the number of worthwhile investment opportunities available to companies. However, borrowing costs still remain relatively low and strong earnings and wage growth will help to maintain private investment and household consumption. In the US, economic growth is likely to increase over 2018 as monetary tightening is offset by the Trump administration loosening fiscal policy. A slowdown could come as a result of an increase of defaults on bond and loan repayments. However, credit spreads have tightened suggesting greater confidence in companies’ ability to service their debt. At the same time global speculative-grade default rates – a key indicator of stress in credit markets – have fallen from 4.4% per year in 2016 to 2.9% per year in 2017, and ratings agency Moody’s forecast further decline to 1.9% for 2018.

OS: How is AAM approaching investing in 2018?

DA: At AAM we maintain model portfolios for four distinct risk profiles: Cautious, Balanced, Growth and High Growth and we set risk bands for each. At present, our model portfolios are positioned towards the upper risk limits within their respective bands reflecting the positive outlook for 2018. Despite some headwinds, most analysts expect economic growth to continue its upward trajectory, at least over the next twelve months.

At the same time, as equity markets continue to climb to all-time record highs so do fears that the turning point is right around the corner. The need for portfolio diversification as well as active management are increasingly pressing. At AAM, all of our model portfolios are spread globally across asset classes and we would also look for signs that inflation is growing ahead of expectations, or that financial markets are underestimating how quickly that interest rates will rise as indicators for taking profits and de-risking our portfolios.

Our in-house Investment Research Team are positioning portfolios to capture the upside expected over 2018, but are also poised to react should pressures escalate in financial markets.

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