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Outlook 2018

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MarketWatch January 2018

Different Folks...Not Different Strokes

aidan-donnelly-author.jpg Aidan Donnelly
Head of Equities

The post financial crisis equity bull market is now in its ninth year, and is one of the longest ever recorded. While it is true that bull markets do not tend to die of old age alone, the consensus opinion is that this one will slow down as it enters its twilight years.

Global Outlook 2018

This article is from our latest edition of MarketWatch, an in-depth report focusing on the Global Economic Outlook for 2018

 
 

 

The post financial crisis equity bull market is now in its ninth year, and is one of the longest ever recorded. While it is true that bull markets do not tend to die of old age alone, the consensus opinion is that this one will slow down as it enters its twilight years.

Although 2017 was another positive year for equity investors, returns varied considerably depending on the reporting currency due to dollar weakness. Most of the major regions clocked up double-digit price gains in local currency terms, as some combination of profit growth and valuation expansion drove markets higher.

We believe we are at a point in the cycle at which valuations have overshot fair value. This is typical of a late-stage bull market. Generally sentiment drives returns the later in the cycle we are and fundamentals take a back seat. As valuations are elevated investors should factor in the prospect of lower returns from equities as most of the good economic news is already reflected in today’s prices. We expect the balance of risk and reward to be finely balanced throughout 2018.

 

Will the bull market continue?

The argument for a continued bull market includes the belief that economic growth is improving and any Federal Reserve (Fed) action on interest rates will be gradual - both of which should allow continued growth in corporate profits. The bullish case for equities focuses on the relative attractiveness of equities to bonds. While on many measures, absolute equity market valuations are above historical norms, stocks still compare well relative to corporate and government bonds amid low rates and tight spreads.

Company profits are also forecast to grow by 10% against a backdrop of an accelerating global economy. In addition, significant upside to profits in 2018 will come from the US tax reforms. Even though many of the finer details are still to be ironed out, a lower tax rate and the ability to repatriate overseas cash will boost profits across most sectors. That said, followers of history will know that the last bout of major tax reform in 1986 was followed by a bear market - so be careful what you wish for.

 

Figure 1: S&P 500 equity market returns decomposed, 2012-17

Source: Bloomberg, Factset

 

Star Spangled Banner

If the bull market is to continue, earnings growth needs to be the main driver of returns. With European economic data improving, there is some hope that European equities can start to close the gap on US equities.

The primary reason for the disconnection between the two regions has been that earnings growth has been much faster in the US. Figure 1 and 2 illustrate this point and also show the decomposition of total market returns over the last five years in the US (S&P 500) and Europe (EuroStoxx). Given the more advanced state of the economic recovery in the US, it is not surprising to see that profit growth has been a more constant element of returns over the period.

 

Figure 2: Eurostoxx equity market returns decomposed, 2012-17

Source: Bloomberg, Factset

 

Will 2018 be Europe’s year?

The strength of the euro last year meant you could be excused for thinking that equity markets failed to shoot the lights out. Global equities increased 7.5% total return when converted back into euros. But after posting strong growth in 2017, corporate profits are forecast to increase again in 2018 (+7%) due to improving economic growth rates, profit margins and investment.

There is little evidence of inflation and the European Central Bank (ECB) has committed to continue its quantitative easing (QE) programme until September, albeit at a lower monthly rate of purchases. Interest rates look to be on hold until 2019 at the earliest.

One risk going forward is renewed strength in the euro. The European export sector has done much of the heavy lifting for overall profits in recent years. The euro's strength did cause a reduction in forecasts for more export-oriented companies as the year progressed. But this was offset by improvements in domestically focused companies. A repeat of this situation would be detrimental to profits.

 

Puts and takes

Of course at the start of any year we need to be aware of the issues that could trigger a bear market. A key risk in 2018 is an upside surprise in inflation. It would likely hasten the Fed’s rate hikes and could dent corporate margins as rising costs are hard to pass on to customers at this stage in the cycle. Most input costs have remained low in recent years, but any change to this could present a significant headwind to profit margins.

The key risk to today’s record profit margins is the cost of labour. Unemployment is at pre-recession lows. Growth in average hourly earnings, still tepid, has picked up, and quit rates in the professional/business sector have surpassed prior cycle peaks. Many corporates I have met recently - particularly in the construction, transport and industrial sectors - have highlighted labour shortages and increased wage pressures as factors for 2018.

Secondly, there is no denying that political and geopolitical risk levels have risen and will likely continue to cause concern. The stand-off between the US and North Korea, the ongoing Brexit negotiations between the European Union (EU) and the UK, and an administrative logjam in Washington are unlikely to be the only issues we have to consider.

However, all of these issues existed in 2017 and equity market volatility was at multi-year lows. There are many theories as to why this was the case, but these are significant risks and if the market begins pricing them in we could be in for more of a turbulent ride this year than we saw last. Time will tell

Warning: Past performance is not a reliable guide to future performance. The value of investments and of any income derived from them may go down as well as up. You may not get back all of your original investment. Returns on investments may increase or decrease as a result of currency fluctuations.
 
Warning: Forecasts are not a reliable indicator of future results.

 

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