Our monthly market view

January 2018: 2018 - Another good year? - Updated


  • Equities overweight
  • Fixed Income underweight

Stick to the equity overweight

After the exceptional strength of the early autumn, the two last months of 2017 proved more
volatile for risky assets. Indeed, market developments were broadly consistent with our view
back in early November to tone down the equity overweight, as investors were exhibiting
excess enthusiasm. Looking at the fundamental picture, the outlook remains promising.
Specifically, the global economy still enjoys solid momentum, supporting continued strength
in corporate earnings growth. Furthermore, valuation, while not exactly a tailwind for risky
assets, is far from levels that would impede further gains in the stock market. Meanwhile,
although monetary policy is slowly tightening across the developed world, overall monetary
conditions remain easy. Finally, while politics is a concern for investors, a lot needs to go
wrong for the supportive underlying picture to change. We thus remain positive on risk and
recommend investors keep an overweight position in equities.

The global economy motors on

Recent economic data have continued to support the markets, moving from strength to
strength. Even the recent pullback in some countries’ manufacturing sectors has reversed,
providing further support to the synchronised global growth we have witnessed since
summer last year. The service sector, meanwhile, also remains on a solid footing across the
developed countries, with both the Eurozone and Japan still showing above-potential
expansion. In other words, the overall picture remains promising in developed economies.

Emerging countries have also, by and large, provided markets with positive data. China has
continued to produce impressive growth figures, despite some weakness in, for example, the
housing sector. A controlled slowdown there should, however, be welcomed as part of the
Chinese economy’s needed ‘rebalancing’. In addition, Eastern Europe and Brazil remain on
the right track, exhibiting accelerating growth, although the steepest rises are likely behind
us. India, on the other hand, has disappointed somewhat of late, but as the reform drive
continues, growth should pick up again. From an investor’s viewpoint, then, the global
economy continues to steam ahead in a particularly synchronised manner.

We expect corporate earnings to remain strong

As the global economy motors on, so do corporate earnings at a pace witnessed only once
after the financial crisis. On top of a strong, synchronised economic upswing, companies’
results are also supported by base effects as the relentless fall in commodity prices reverses.
These effects, however, will fade as the base becomes less flattering in 2018. That said, the
outlook for earnings growth remains stable and at impressive levels. Specifically, 2017 is likely to end with growth in double digits, in the 15% range.

Looking forward into 2018, the pieces remain in place for continued strength in the corporate
sector. However, the drivers of this strength will have to be somewhat different from last year,
as the flattering base effects in commodities continue to fade. In fact, we will have to
increasingly rely on the continued strength of the global economy. With growth estimates
continuing to edge higher, we can indeed put some confidence in this. On top, the tax cuts
being pushed through in Washington are set to add some 5 – 10 percent to US earnings,
single-handedly pushing the global aggregate up by up to five percent. Overall, then,
corporate earnings will remain a firm support for equities going forward.

Central banks to wean markets off stimulus slowly but surely

The monetary policy outlook remains relatively benign. Although central banks in the US,
Europe and to a limited extent even in Japan are slowly ‘normalising’, monetary conditions
will remain easy in the near future. Puzzlingly, inflation in developed economies, the UK
aside, does not seem to be picking up despite the falling unemployment. Therefore, central
banks are likely to err on the side of caution also going forward.

The Federal Reserve (Fed) in the US is the furthest along when it comes to ‘normalisation’,
with the process of tapering its balance sheet set in motion in October, accompanied by a
moderate pace of rate hikes. While there are certain unknowns related to unwinding liquidity
from the markets, the outgoing Fed Chair Janet Yellen’s reference to the process as ‘the
policy equivalent of watching paint dry’ seems to be a reasonable description of the likely
investor experience.

In Europe, the European Central Bank (ECB) managed yet again to put a dovish tone on
tapering its quantitative easing programme, while interest rate increases are still nowhere in
sight. This, like the Fed’s tightening, is unlikely to prove a problem for risky assets. In fact, if
anything, the combined impact of the resynchronisation of central bank policies between
Europe and the US is likely to hamper the performance of low-risk bonds, further supporting
the relative outlook of equities.

In the emerging countries, monetary policy is still on the ‘easy’ side of the spectrum. Asian
central banks are, on balance, on hold, with the Chinese authorities tightening regulation
and thereby also financial conditions, and at the same time adjusting reserve ratios in order
to increase liquidity. In the majority of the remaining emerging economies, easing cycles are
also nearing an end, meaning that the likes of Brazil and Russia may lower their policy rates
a few more times before they stop.

In terms of risky assets, we do not see the process of gradual and patient policy
normalisation and an upward move in yields as having a deleterious impact. Gradual is the
key word here and anything but will almost certainly increase very low market volatility in
rates, FX and equity markets down the road. For now, though, it is too early to worry about a
monetary derailment of financial markets.

Valuations should not prove a hindrance to equities

Broadly speaking, global equities are still fairly priced. Indeed, during the last couple of years,
global equity valuation has been flat, and going forward, valuation by itself is unlikely to
hinder equities. There are, however, pockets of stretched valuation, such as US equities and
some sectors such as Consumer Staples and Energy, meaning in some markets downside
buffers are exceedingly thin. Nevertheless, on the global aggregate level stocks are not
especially expensive. Thus, we still assert that equities can rise at least in line with earnings
growth in the foreseeable future. Earnings growth will have to do the heavy lifting but given
our expectation of continued earnings and margin expansion globally, valuation might edge
slowly higher. Given that most risky bonds are yielding very little in excess of government
securities in historical comparison, and riskless rates still hover near record lows with risks
tilted to the upside, equities remain unmatched in terms of risk/return outlook.

Sentiment still a drag

Investor sentiment remains on the bullish side. In contrast to the late summer ‘fear-ofeverything’
sense in the markets, investor mind-sets have become considerably more
exuberant. Equity overweights are above the historical average, speculative positioning is
currently favouring stocks, and a large share of retail investors are expecting higher equity
prices in the future. While this will not impede markets from rallying further, it does mean that
the steepest gains from this rally are likely behind us. In other words, the tailwind provided
by exaggerated negativity during late summer has faded.

Politics continue to create noise

Investors are clearly placing more scrutiny on the political environment than they have in
recent years. However, although early-morning tweets from Washington and sabre-rattling
with North Korea continue to create headlines, they will not cause material or lasting market
movements, barring a serious escalation.

The passage of tax cuts in the US has provided some tailwind to risky assets, but also
proved a source of volatility. While the immediate effects are priced into equity markets, we
may yet witness some unforeseen boost to the economy, potentially via an upturn in the
investment cycle , thereby providing a further boost to risky assets.

In Europe, the political noise is back in the form of German coalition uncertainty, Brexit
anxiety and the uncertainties surrounding Southern Europe. However, although these issues
do create headlines, their market impact will remain muted unless they impact corporate
fundamentals materially.

Finally, in the emerging countries, politics is ever present as a source of investor uncertainty
and oscillations in the markets. Eastern Europe and Latin America retain the spotlight, with
the former under stress from geopolitics and the latter from investors’ fading confidence in
local politicians’ ability to push through reforms. While the situation in the Middle East will
continue to rattle oil markets, it will only matter for risky assets globally if it spirals out of control, which still looks unlikely.

In conclusion, then, the investment outlook is supportive for risk-taking. We remain in
something of a sweet spot for risky assets, marked by broad-based and resilient economic
growth, strong corporate earnings as well as largely benign monetary policy dynamics. We
continue to favour equities over fixed income.