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Blue skies in 2018
2017 has been a rewarding year for both equity and fixed income investors. But what is ahead in 2018? We ask our panel of experts for their strongest market calls.
THE BUSINESS TIMES' WEALTH ROUNDTABLE
Genevieve Cua, BT Wealth Editor, poses questions to wealth experts on their multi-asset outlook for 2018 and how to mitigate risks.
Steve Brice is chief investment strategist, Standard Chartered Private Bank. Steve is an expert on the world economy and global markets and has had more than 20 years of financial markets experience in senior positions. He is an ardent sports fan focusing on cricket, rugby and Liverpool FC.
Jasslyn Yeo is global market strategist, JPMorgan Asset Management (Singapore) Limited. Jasslyn is responsible for formulating and communicating the market outlook and investment views for Asia. She enjoys family time, reading and travelling the world in style.
Lim Leong Guan is managing director and head of Investment Platforms and Solutions, UBS Wealth Management Singapore. Leong Guan has had 27 years of industry practice. In his past roles, he has managed teams responsible for capital markets and investment products across Asia. He has developed an avid interest in cycling in recent years and is an audiophile.
Genevieve Cua: What major themes on a multiasset basis are likely to play out in 2018 and beyond? How can investors be positioned to take advantage of these themes?
Steve: As we move to close 2017 and look forward to 2018, the macroeconomic picture is one of broadening economic growth. We've seen strength on this front in developed markets and the growth differential between emerging and developed markets looks to have bottomed and could potentially widen next year.
Corporate earnings across several regions have reflected this economic strength. While we could see a bout of profit-taking given the strong run-up YTD, a multi-asset investor should maintain a reasonable allocation to equities as we enter 2018. The euro area and Asia ex-Japan present the most compelling opportunities in the equity space with strong macro momentum and improving earnings. The positive equity backdrop also suggests that a growth-focused (equity-tilted) allocation should continue to outperform a yield or income-focused multi-asset strategy as we enter the new year.
All is not lost for income investors – a moderate pickup in inflation (which is the current market expectation) suggests that a multi-asset income strategy that includes fixed income, high-dividend equity and hybrid assets (assets that contain a mix of equity and fixed income characteristics such as convertible bonds) should generate a sustainable yield of 4-5 per cent in 2018.
However, a sharp rise in inflation could create a very different outcome for the income investor. Policy tightening in response to a sharp rise in inflation would be particularly negative for fixed income and yielding assets.
While not a central scenario, income investors should be aware of the interest-rate sensitivity of their holdings and look to be agile in reducing this risk in their allocations.
Another option is to include some assets that do well in a rising rate environment – senior floating rate loans is one example.
Excessive policy tightening is one of the risk scenarios for 2018. In addition, we continue to move further along into the late stages of the economic cycle. Against this backdrop, multi-asset investors would be well-served by exploring alternative strategies in their allocations. This category of investments is useful in providing a degree of insurance when broader market momentum is challenged.
Jasslyn: The macro outlook for 2018 looks promising. The global growth cycle is expected to broaden out and extend, driven by a capital expenditure (capex) revival.
Inflation remains benign, allowing central banks to engage in gradual monetary normalisation. The withdrawal of quantitative easing is still in the early stages; financial conditions remain accommodative and risks of a recession remain low.
Against this backdrop of stronger growth, slow and steady rate rises and still ample liquidity, we expect equities to outperform fixed income. With earnings growth in the driving seat, equities can continue to deliver positive returns, despite valuations at lofty levels. Equity risk premiums still remain wide compared to history, providing some buffer against higher rates.
We recommend that investors be positioned in the cyclical sectors (in particular, technology, financials, and selected commodities and industrials) at least for the early part of 2018, as they leverage well into our macrothemes of a broadening growth upturn and gradual policy normalisation.
Fixed income, on the other hand, looks less compelling as rates move higher. We stay negative on government bonds, and neutral on corporate bonds. There is little room for credit spreads to tighten further for both investment grade and high-yield bonds, even as downgrades and default rates head lower. Coupon-clipping will be the norm, with high-yield offering some yield pick-up.
From a portfolio perspective, investors should not only be diversified across equities and fixed income, but also consider adding liquid alternatives (for example, relative value and hedging strategies) in order to enhance their overall risk-return mix.
Leong Guan: After eight years of expansion, some investors are concerned about a downturn. We remain overweight in global equities and underweight in high-grade bonds. Equities are likely to be supported by synchronised global growth, positive business sentiment, high employment rates as well as rising corporate earnings.
Some sophisticated investors are using structured products to adjust the risk/return trade-offs of their investments to better reflect their views.
On fixed income, we are tactically underweight euro high-yield bonds against global equities and USD high grade bonds. We still think equities provide better riskadjusted returns than credit at this stage of the business cycle.
Genevieve: A number of markets have done very well – in particular the US and more recently the emerging markets. How sustainable is the appreciation for these two markets, and do you continue to recommend exposures?
Steve: Global equities are very close to record highs and clearly, valuations are no longer cheap. However, looking at history, the performance from current price-earnings ratios (over the ensuing 12-month period) has been encouraging with positive returns 75 per cent of the time since 2001 with an average return in the high single-digits.
Add in the fact that we believe we are some way from the end of the economic cycle and we continue to favour equities into 2018.
When it comes to regional preferences, Asia ex-Japan tops our list. While we believe China is likely to pursue policies consistent with a slowdown in growth, we expect this slowdown to be modest and well-managed. Together with benign inflation pressures, this generally positive economic backdrop should support corporate earnings.
Another positive factor for the region, and for EM assets in general, is our bias for a stable to weaker USD, which should encourage capital inflows absent any significant shocks.
The euro area is our second-most preferred market.
Economic growth has been strengthening for some time and this is feeding through in rising earnings, profit margins and return on equity. We expect this trend to extend into 2018, although corporate earnings growth is expected to slow somewhat from the heady 20-plus per cent pace expected in 2017 to close to 10 per cent. There are two main risks here. First, a stronger EUR undermines the outlook for corporate earnings and, therefore, we would not hedge the FX exposure when investing in euro-area equities. Second, euro-sceptic parties win a majority in Italian elections. While we doubt even this outcome would result in a decision to leave the single currency, the election may well generate some short-term volatility in Q1.
As far as the US is concerned, we remain bullish, but it is not one of our preferred markets. Corporate earnings growth is expected to accelerate in 2018, but this acceleration is mostly due to having a lower 2017 base of comparison – US earnings growth is currently expected at around 10 per cent in 2017, whereas most other regions are running above 20 per cent. The US is the most expensive region on both price-earnings ratio and price-to-book measures, both relative to other markets and to history.
That said, even from current valuations, the probability of positive returns has historically been three in four.
Therefore, we remain constructive as we head into 2018.
Jasslyn: We are currently diversifying our overweight equity exposure across the major regions of US, eurozone, Japan and EMs/ Asia ex-Japan. It pays to be diversified as equity-market correlations have fallen significantly.
For US equities, we remain positive in the near-term.
We expect strong earnings growth, with potential corporate tax reform giving an added boost. Taking a mediumterm perspective, however, US equities look less compelling.
The US economy is in late cycle. Corporate margins are at peak levels, and are vulnerable to a squeeze as wages rise. Combined with stretched valuations, we see upside potential capped for this market.
Conversely, EMs are still in early cycle, with the EM to developed market growth differential expected to rise over the next few years. Major EM economies such as Brazil and Russia have just emerged from a recession, and are now on the mend. While China is in a slowdown phase as the economy deleverages, real GDP growth is still expected to be around 6.5 per cent in 2018.
This year, the recovery in the global trade cycle and commodity prices, as well as the weaker USD have all helped to support EM earnings. EM profit margins, however, are still running below their historical averages, therefore suggesting greater earnings potential than the US. Valuations are also less challenging when compared to the US. However, while we remain positive on EM equities from a longer-term perspective, we see some headwinds in the near-term coming from higher rates and stronger USD.
Leong Guan: We hold a neutral view on US equities but continue to see more upside with a preference for energy, financials and information technology (IT). The uptrend in corporate profits – the key driver of equity market gains – remains well-supported by solid global economic momentum, rising business and consumer confidence, and easy corporate access to capital. We continue to like US technology despite the strong year-to-date performance as we see modest improvement in IT spending by corporations and attractive valuations relative to growth.
We prefer companies that are benefiting from the secular shift to cloud-based computing, increasing spending on security and those without significant reliance on legacy revenues.
We also take a neutral view on EM equities. EM economic activity and manufacturing sentiment are improving but geopolitical tensions, potential trade friction, and the rising US dollar present downside risks.
Our most preferred EM markets are China, Indonesia, Thailand, Russia and Turkey. China remains a bright spot and we continue to favour Chinese equities. We do not see the recent 19th Party Congress emphasis on reforms as a cost to stability and see opportunities in new-economy IT and consumer sectors and USD bonds issued by high-quality SOEs.
Genevieve: What risks are you most mindful of for 2018 and what steps might you take to mitigate them in portfolios?
Steve: The number one risk for us is the outlook for inflation. The overwhelming consensus is that inflation will pick up, but only modestly. While this is a headwind for bond markets, it is unlikely to undermine the outlook for equity markets, in our opinion.
However, a sharp rise in inflation would be a very different scenario. In this environment, central banks would be forced to focus on controlling inflation rather than supporting growth. Historically, economic cycles are brought to an end by either an external shock – eg a sharp rise in oil prices – or by central banks tightening monetary policy in response to higher inflation. We only attach a 10 per cent probability to such a scenario, but with output gaps suggesting limited – if any – excess capacity, this is something we need to pay close attention to.
For investors, a sharp rise in inflation is a challenging scenario to protect against. The usual candidates would be physical assets, such as gold and real estate. Historically, gold has held its value in real terms over very long periods of time. However, in normal times, the correlation between inflation and gold is very low and is why we continue to recommend that any allocation to gold should be limited to 2-5 per cent.
Real estate is another option to protect against a potential rise in inflation. However, most real estate investors rely on mortgages to fund their investments.
Rising interest rates would increase funding costs, potentially to the point where investors become forced sellers. We believe it is critical to minimise this risk, especially at this point in the cycle.
This leaves two potential areas for investors to consider when protecting against a sharp rise in inflation.
The first is cash. While cash would suffer in real terms from any pick-up in inflation, this should ultimately be countered by rising interest rates. Meanwhile, having cash on the sidelines would be useful if asset markets correct significantly as this could then be used to add to equities and bonds at much lower levels.
The second area to consider is global macro strategies. These strategies can go long or short different asset classes. Their true value often comes in periods of significant stress when positive trends reverse. These strategies have underperformed in recent years, but a limited allocation (5-10 per cent) could be used as an insurance policy.
Jasslyn: One key risk to watch out for in 2018 is the return of risk premia. As central banks move towards monetary normalisation, the rising tide of quantitative easing (QE) liquidity that has lifted all boats will start to fade. Investors may suddenly wake up and realise that they have not been adequately compensated for the risk they are taking, and this could cause a sharp market correction across all asset classes.
We believe that fixed income looks particularly vulnerable. We point out that 2018 will the first year in four years where supply is expected to exceed the demand of global government bonds, as the Fed engages in quantitative tightening (QT) and the ECB does a soft taper.
This could lead to a surge in bond yields, and cause a sell-off in government bonds. Corporate bonds may also be adversely impacted, given that credit spreads for both investment grade and high-yield bonds are already trading near historical hights.
Another key risk is on the inflation trajectory, where there are both upside and downside risks. On one hand, inflation could suddenly accelerate, with the US economy operating at full capacity, and fiscal stimulus adding fuel to fire. If the Fed responds by increasing the pace of rate hikes, this could spook markets. On the other hand, inflation could stay weaker than expected, with capex aiding productivity growth and constraining unit labour costs. If the Fed ignores this and continues to tighten, this could result in a policy mistake, and spook markets as well. The new Fed chair, Jay Powell, adds another element of uncertainty. Other risks include the political uncertainty surrounding the Catalonia turmoil in Spain, the Italian election and the North Korean crisis.
Consequently, investors should still hold safe-haven assets (eg gold, government bonds) as part of their diversified portfolio. We highlight that risk management is very important. The current low-volatility environment will not last, and investors should consider buying downside protection, especially now when the cost of protection is cheaper.
Leong Guan: The best defence against market volatility and uncertainties is diversification. We continue to strongly advocate diversification across asset classes, geographies and sectors.
We assess the probability of a recession in the next six months to be low. While bonds are unlikely to be safe havens as they were in the past due to historically low yields, they remain an important part of a well-diversified portfolio. Together with alternative investments such as hedge funds, they help to reduce the reliance on any one asset class. Hedge funds are typically good risk diversifiers at the current stage of the cycle. A rising interest rate environment, increase in dispersion and the decline in correlations in recent months tend to benefit hedge funds.
Genevieve: Currencies have been a major source of return (or loss). What major trends/ themes in this respect do you expect in 2018, in particular for the US dollar, euro and Asian currencies?
Steve: We believe keeping a focus on the US dollar will be key to the currency market outlook and the impact currency markets have on different asset classes. While it is tempting to focus on the drivers behind other individual currencies, 2017 year-to-date has illustrated the point that change in the USD outlook has been key to moves in major currency pairs rather than the other way round. We do not believe 2018 will be any different.
One likely key theme for FX markets in 2018 will be the lack of significant support from real interest rates or monetary policy for the US dollar. While the Fed is likely to continue raising rates gradually, real interest rates may not rise should inflation continue to creep higher alongside.
The fact that the Fed is rising rates is also likely to be less of a surprise to markets. US tax reform remains a potential surprise, but history shows past periods of earnings repatriation into the US have not had a significant positive impact on the currency.
In our opinion, this backdrop remains potentially most supportive for the euro. The currency has taken a breather over the past two months, as we expected, but we believe support is likely to re-emerge as the direction of travel for the ECB remains towards tighter policy. We believe this will be a key second theme in currency markets.
Closer to home, the Singapore dollar has been a great example of how many Asian currencies continue to be driven by broad trends in the US dollar. As a third theme, we expect this trend to extend into 2018, with the lack of support for the US dollar likely translating into gains for the Singapore dollar (and, indeed, the broader Asian currency universe).
Finally, we believe this currency outlook has greater implications for bond markets than equities. While continued support for the euro may create some concerns about the impact on equity markets, we believe the currency and equity markets will continue to balance each other out from an international investor's perspective.
The impact may potentially be greatest for local currency bonds across EM where the currency outlook is usually the main driver of returns. Here, we continue to look for opportunities should the US dollar rebound temporarily.
Jasslyn: The US dollar has weakened significantly this year on the back of weaker-than-expected US inflation numbers and global monetary convergence. Market expectations of a more benign Fed rate hike trajectory and a more hawkish European Central Bank (ECB) narrowed interest rate differentials, which helped to drive the dollar lower.
For 2018, we see the US dollar largely in consolidation mode, with risks to the upside. Markets will likely need to re-price in more rate hikes from the Fed as inflation grinds higher and fiscal stimulus builds expectations for a more hawkish Fed, which is dollar supportive. Additionally, tax reform is expected to encourage corporate repatriation flows back to the US, providing some support for the dollar as well.
The ECB is expected to be dovish in its communication, adhering to its soft taper path, with inflation staying below its 2 per cent target. Speculative long positions in the EUR are looking stretched, which will limit EUR upside. Conversely, the Bank of Japan (BoJ) will likely keep its policy unchanged until early 2019, in support of a weaker yen.
Asian central banks, in general, will be moving towards monetary normalisation. However, it will be a very gradual pace, given benign inflationary pressures. We see more muted performance for Asian FX, with US rates expected to move higher and inflows into Asian equities to slow.
Leong Guan: We remain long-term bullish on the EUR/ USD, lifting our six- and 12-month forecast to 1.22 and 1.25 respectively while keeping our three-month forecast at 1.18. In the short term, we see the pair consolidating after a soft tapering announcement by the ECB at its October meeting while the US dollar remains well supported with hopes pinned on US tax reforms. In the longer term, the economic environment in 2018 will likely be characterised by synchronised growth across the globe and the USD may depreciate in such an environment despite the Fed hiking rates. Further, the euro will likely be well-supported by the strength in the European economy. w