Last year was a strong one for capital markets. Most countries’ stock markets posted positive returns, with many markets, including the U.S., posting double-digit gains. Globally, and in the U.S., the best-performing sector was technology. Energy was the worst-performing sector globally – and was one of the worst-performing sectors in the U.S.1
With accommodative monetary policy in many parts of the world, it’s no surprise that risk assets were buoyed and volatility was low. Most commodities experienced positive returns, led by industrial metals, with some exceptions. In terms of currencies, the U.S. dollar was particularly weak, falling in value relative to most major currencies, including the euro.
With this as a backdrop, below are 10 expectations I have for markets and the economy going into 2018.
1. Upward bias for stocks globally
As we enter 2018, there are two key drivers that I believe are creating an upward bias for stocks and other risk assets globally: improving global growth and the continuation of accommodative monetary policy. These are two very powerful influences that I believe should support risk assets in general and stocks in particular. Now, that doesn’t mean we won’t experience a correction, particularly in the U.S., but it does suggest it could be shorter-term in nature.
2. More disruption and greater volatility
Disruption is abundant right now, which increases the chance that volatility will rise from its extremely low levels.
Geopolitical disruption. Tensions are rising in a variety of places around the world, from North Korea to Saudi Arabia. However, geopolitical disruption typically doesn’t impact the stock market unless it becomes extreme. And, if it does have an impact, it’s usually short-term in nature. What I worry more about is the potential for countries around the world to adopt more protectionist policies in response to the geopolitical disruption created by nationalist movements intent on de-globalization. We can’t forget that many economists blame protectionism for exacerbating the Great Depression in the 1930s, and we can’t ignore the threat of protectionism that is very real today.
Monetary policy disruption. The large-scale asset purchase plans that have been a major policy tool of key central banks over the past decade are experiments that have had a very significant impact on asset prices – and market volatility. Now that central banks are starting to “normalize” this experimental monetary policy, there is the potential for disruption to capital markets. While this is not my base case, this is a distinct possibility, especially given that this potential is amplified by several different factors that all increase the odds of a policy error. First, in the U.S., there will be a significant number of new Federal Open Market Committee (FOMC) members in 2018, including the chair and the vice chair. Second, the U.S. Federal Reserve (Fed) is utilizing two different monetary policy levers simultaneously – the Federal Funds Rate and the Fed’s balance sheet. Finally, several other major central banks are starting to normalize monetary policy, albeit ever so gently.
3. Lower for longer rates and a continued hunt for income
While a number of central banks have begun to get slightly less accommodative – including the Fed, the Bank of Canada, the Bank of England (BOE) and the European Central Bank (ECB) – they still remain very accommodative in relative terms. This suggests that interest rates may stay relatively low, and the hunt for investment income will continue in 2018.
4. Debt becomes a growing concern
I expect leverage, including government and private debt, to increase and become riskier in some regions in 2018. A number of countries have high debt levels, and I expect them to come under greater pressure to deal with their debt loads this year. In addition, corporate debt levels may prove problematic for highly leveraged companies, particularly for those in the U.S. given the new U.S. tax reform bill. And household debt levels are rising in many countries, suggesting a small margin of error if a new crisis arises.
5. Continued U.K. uncertainty, with fatter tails likely
I believe the odds are increasing that there will be an extreme outcome to the Brexit negotiations – either a pre-Brexit relationship between the European Union and the U.K., or no relationship at all. The longer it takes to reach an agreement, the more likely it is that companies begin to relocate. In addition, the U.K. faces another headwind to its economy: the BOE decided in November to raise rates for the first time in more than a decade. While there is no strong growth that the BOE needs to moderate, it is attempting to move the pound sterling higher in order to combat the relatively high level of inflation that the U.K. is experiencing as a result of Brexit-related currency shifts. However, the BOE intimated in its decision that it is not on any kind of significant tightening path, so sterling didn’t show the strength that the BOE hoped for. This is problematic and suggests the potential for a stagflation scenario. We will want to follow sterling and inflation closely.
6. A focus on critical structural reforms
Structural reforms are critical for the sustainability and continued growth of many economies around the world. French President Emmanuel Macron has embarked on ambitious labour market reforms for his country, as well as corporate tax cuts. This has already inspired much-improved business sentiment that could result in higher capital expenditures. Macron also intends to take a lead on reforms for the European Union, which are vital to its future stability and growth. Japan is also focused on achieving significant structural reform, including corporate tax reform. In addition, Indian Prime Minister Narendra Modi is in the process of a transformative reform agenda for his country. In 2017, India enacted a Goods and Services Tax, a de-monetization plan, a new bankruptcy law, an inflation-targeting framework for its central bank, and a Real Estate Regulation Act. India’s growth is moderating, and in my view the country needs continued and more successful reforms for growth to accelerate.
7. Infrastructure spending accelerates
A number of major economies are desperately in need of infrastructure spending – including the U.S. and India. Infrastructure is a priority focus for India going forward, both rural (housing, roads, electricity) and national. In the U.S., there is a need to replace and rebuild a variety of different types of infrastructure, including water pipes, bridges and tunnels, and telecommunications structures. Infrastructure can be a very powerful form of fiscal stimulus in both the short term and the longer term. I expect more pressure on countries in 2018 to spend on infrastructure, which could result in a significant tailwind to economic growth and benefits to several different sectors (industrials, materials, telecommunications). Conversely, failure to focus on infrastructure in the new year may have negative implications over the longer term.
8. Currency moves continue to surprise
This past year saw significant and unexpected weakness for the U.S. dollar, as expectations for a dovish Fed as well as political setbacks weighed on the currency. However that could change in 2018 – particularly if inflation becomes a concern and/or we have a decidedly different FOMC at the helm. In addition, emerging markets currencies have reacted to recent political developments. I would expect more surprises and fluctuations in 2018. A number of central banks will likely continue to slowly tighten monetary policy, which should, depending on timing, cause changes in the relationships of different currencies. A less-than-fully-synchronized global economic recovery could also contribute to currency fluctuations.
9. A mixed outlook for commodities
Relationships seem to be changing among different commodities, with metals prices more greatly impacted by emerging market demand. I expect industrial metals to continue to benefit from improving global demand, and gold to move based on several different influences, particularly the fear trade and the inflation trade. In general, I expect a mixed performance by commodities in 2018, but with a relatively lower correlation to equities and fixed income.
10. Possible rotation in leadership
We need to recognize that this is still a very macro-driven environment. Political and economic developments – such as the implementation of tax reform or the possibility of an infrastructure spending plan – will likely cause relatively swift rotations in leadership between different sectors and investing styles in the U.S. stock market for the year. We are also likely to see rotations in leadership among asset classes, styles and sectors globally, as the global economic recovery will not be perfectly synchronized, favouring certain regions and asset classes at different times.
In summary, despite all the outstanding risks, my base case scenario remains that the stock market will continue to perform well in 2018, albeit more modestly than in 2017. However, given rising risks to capital markets, we need to be mindful of the potential for downside volatility.
- Now is the time for investors to review asset allocations and ensure adequate diversification. This may include exposure to alternative investments with relatively low correlations to equities and fixed income, including commodities, real estate, and long-short and market neutral strategies. And it may also include global equity exposure, given that home country bias is a very real problem in many portfolios
- Since low yields will likely be a continued problem in 2018, I believe investors will need to pursue income from a variety of sources, including dividends and a wide variety of fixed income sub-asset classes
- Technology will likely continue to be a high-performing sector this year, in my view, given its growth potential. In particular, I believe it should benefit from a rise in capex spending as well as an increase in personal tech spending as economic growth improves
- And investors cannot forget that, while inflation is low, it has the potential to rise. Therefore, they may want to consider adding some inflation-hedging investments to their portfolios