You are here
2018: Will the bears return in the Year of the Dog?
IF one word described 2017, it was "Goldilocks". It was a strong year for asset returns with global synchronised growth combined with lower than expected inflation. How long can Goldilocks last? What will be the words to characterise 2018? The return of volatility?
How long the dog's tail will wag happily in 2018 is dependent on the key risks, which we'll analyse below.
(1) Peak of the decline of geopolitical risk?
The first risk and the hardest to quantify is the decline in geopolitical risk we saw in 2017. European elections did not yield a populist surprise in 2017, protectionism did not lead to a trade war, and the North Korea situation has not ignited into a broader crisis. Is this a temporary decline before an increase again or is the market being too complacent?
We don't have a crystal ball on the outcome of some of these events but we would point to the fact that the markets have overrated the impact of geopolitical events. On average, looking at some of the biggest geopolitical events in the last century, including the Cuban missile crisis, the First Gulf War, and US presidential impeachments, the market has been seen to regain its prior peak within a short period of 16 days or less.
On the other hand, in more extreme cases, such as the Arab Oil Embargo in the early 70s or 9/11, it took several years or more to regain its prior level due to stagflation and the final burst of a market bubble.
Protectionism is something we are monitoring and in that regard, the one-off tariffs on selected goods has been going on for years. However, larger targeted, broader tariffs would be of more concern.
(2) Peak of the central bank policies?
After US$14 trillion in stimulus since the Great Financial Crisis, the pace of the growth of central bank balance sheets is expected to slow in 2018 and will likely be in gentle decline by 2019. Coming from this size of central bank balance sheets is largely unprecedented. Furthermore, there has been a correlation at times of this balance sheet expansion and rising equity markets.
In addition, the Federal Reserve's balance sheet will be declining precisely at the same time that the Treasury bond is increasing with tax reform and higher fiscal deficits. A new Federal Reserve chairman, Jerome Powell, along with a number of Fed vacancies mean the market is anticipated to be sensitive to any future policy actions.
However, we believe the Federal Reserve is determined to start reducing the size of its balance sheet ahead of the next downturn.
(3) Peak of the economic cycle in the US?
One of the key questions on how long the dog can bark in 2018 is where we are in the economic cycle. Currently, the US is in its third longest economic expansion in history.
However, after financial crises, recoveries are typically anaemic and it usually takes time for the global economy to recover.
Therefore, you might ask what is left in the tank?
Presently, the US recession probabilities as measured by the New York Fed probability of US recession in the next 12 months are low.
The US economy is experiencing low unemployment, tax cuts, high business confidence, and robust consumer spending. It is this delta or change in probability which we will be monitoring this year.
Finally, it is important to note that European and Asian economies are in mid-cycle. Hence, with global growth finally synchronised, their recoveries can continue in 2018.
Our forecast is for global growth in GDP to average more than 3 per cent for another year.
Incredibly, the global equity markets just went for more than 400 days, without a 5 per cent correction, the longest in 30 years.
Prior to the sell-off in February, sentiment had reached extremes, technical conditions became extremely overbought, weekly fund flows towards equities rose to record levels and the analysis of investor positioning showed that investors were most overweight on equities relative to government bonds since August 2014.
We had a short-term neutral stance, expecting a long overdue correction, while maintaining a medium-term overweight.
After a strong January, the market finally growled in February.
Firstly, Treasury yields have started to rise, as was our expectation, with a higher than expected wage inflation figure in the US at 2.9 per cent annualised, larger deficits, and lower than expected demand at selected Treasury auctions.
Secondly, a bout of "Volmageddon" (Volatility Armageddon) was unleashed as strategies which were short volatility, or expecting lower volatility, had to cover their positions leading to the largest one-day spike in the VIX (S&P 500 volatility index) in history. It may take time for investors to get used to this "normal" level of volatility.
However, we have now reinstated a moderate overweight equity view after the correction in Asia ex-Japan, European, and Japanese equity markets. Incidentally, the median correction since 1945 in the S&P 500 has been about 15 per cent.
The S&P 500 thus far in mid-February, had a peak to trough correction of nearly 12 per cent.
Consolidation and corrective periods usually last between one and three months. It will take some time to clear the overbought conditions and excessive optimism.
The main reason why we believe that we are not currently facing a bear market but rather a period of consolidation is that global economic conditions remain strong.
The world economy seems to be firing on all cylinders, and particularly encouraging is the recovery in capital expenditure, which points to a continuation in the current economic expansion for some time. The earnings outlook is therefore promising, for 2018.
The main constraint on equities is valuations, particularly as bond yields are rising. Still, 2018 should be a year of positive returns compared with 2017, which we forecast in a range of 10 per cent.
With regards to fixed income, global bond yields surged in January on the back of solid macro data, higher inflation expectations in the US and central banks' hawkish tone. This is in line with expected higher growth and higher inflation in 2018 in the US.
FOUR RATE INCREASES
Consequently, we expect four rate increases from the Fed in 2018 and higher yields, especially at the back-end of the curve. Our 12-month targets are 3.25 per cent for the 10-year Treasury and 1.25 per cent for the 10-year German Bund.
We remain underweight on government bonds and maintain a defensive position on corporate bonds with short duration investment grade bonds, floating rate bonds, unconstrained bond strategies, and local EM (emerging markets) currency debt.
In summary, in order to avoid being bitten in the Year of the Dog, investors will need to be more nimble, tactical, and opportunistic given the late cycle nature of global equity markets. A dog will always be your best friend, but you might need to keep it on a shorter leash.
- The writer is chief investment officer Asia, BNP Paribas Wealth Management