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Key themes to chew on in 2018
MARKETS ended 2017 on a buoyant note, and that is carrying through into 2018. Strategists weigh decisively in favour of equities for the year, as renewed expectations of a more hawkish stance among central banks and inflation concerns may well dampen fixed-income performance.
But the big question must be - how long will the party last? Fund flows in early January, as tracked by EPFR Global, reflect a continuing appetite for emerging-markets equity and bond funds. Inflows into developed-market equity funds and global equity funds were also strong in the first few days of January.
The Bank of America Merrill Lynch December survey of fund managers found that the net share of investors taking out protection against a market correction had risen. Investors were split on the timing of an equity market peak: 25 per cent saw a peak in Q1; 30 per cent in Q2; and 28 per cent in the second half of the year. On fixed income, the proportion of investors saying that bond markets are overvalued rose to 83 per cent.
Strategists and fund managers here, however, are almost uniformly bullish about 2018, thanks to a Goldilocks backdrop of still-low interest rates, rising corporate profitability, globally synchronised economic growth and the expectation of renewed capital expenditure among companies. The overarching theme is risk-on; this means stay invested in equities, in particular the emerging markets and Asia ex-Japan stocks.
In fixed income, however, the outlook is more tentative. Now that growth in most parts of the world is on an even keel, central banks are widely expected to begin to tighten policy, keeping a keen eye on inflation. The US Federal Reserve, for instance, is expected to raise rates two to three times in 2018. The European Central Bank is also expected to reduce and eventually wind up its asset purchasing programme.
Strategists' preference in fixed income assets is for US high yields which is expected to rally alongside equities. There is also a strong preference for emerging market bonds.
Here are some major themes:
- Equity valuations elevated but not excessive
Global equities based on the MSCI World Index were trading at a price earnings multiple of about 20 times in mid-January, compared to their long-term average of about 18.3 times. Said UBS in its year-ahead view for 2018: "Historically, global equity valuations between 18 and 23 times have been consistent with 6 per cent subsequent six-month performance. And, much like in 2017, robust earnings growth should help push stock markets higher. More generally, investors are wise to remember that avoiding taking profits too soon is critical for long-term performance. Since 1927, the average increase in the final 12 months before the end of a bull market has been 22 per cent. Missing these periods would lower investors' long-term annualised price returns on the S&P 500 from 9.6 to just 7.2 per cent."
- Emerging markets equities
Schroders believes the outlook for emerging equities remains positive although returns are likely to be more modest. In 2017, EM equities returned over 35 per cent, thanks to attractive valuations. "We believe there is limited prospect for multiples expansion in the next 12 months. The aggregate price-to-book and price-to-earnings ratios are now slightly above their long-term averages, so the market is anticipating an ongoing returns recovery and earnings-per-share growth. We expect EPS growth of 10 to 15 per cent in the next 12 months.
"On a relative basis, valuations remain attractive. The MSCI Emerging Markets Index trades on 12.8 times forward price to earnings ratio, a discount of 24 per cent to the MSCI World Index. We continue to think there is a bias for US dollar weakness over the medium term. US dollar depreciation is highly correlated with EM equity outperformance and we believe that EM currencies, excluding the Chinese RMB, remain undervalued."
- Positive on US equities
US equities underperformed Asia and the emerging markets last year, but don't count them out. DBS chief investment officer Hou Wey Fook wrote in the bank's year-ahead report that US companies remain at the forefront of global tech innovation. "Since 2010, the S&P 500 Internet Services sub-segment has outperformed the broader index by 171 percentage points. Its outperformance over global equities is even more staggering at 236 percentage points. We believe that the world is currently at the cusp of a major wave of technological disruption, and that US companies are well-positioned to ride this upturn."
He added that the upturn in corporate earnings underpins the optimism. In the third quarter of 2017, 77 per cent of US companies reported positive earnings surprise. And, according to surveys, fund managers are currently underweight US equities , which suggests that investors may be overly cautious. The bank has picked US tech disruption as a key investment theme for the year.
DBS strategist Dylan Cheang argues that the current tech rally is backed by fundamentals. Since 2010, the US technology sector has rallied 196 per cent and this is matched by a robust 160 per cent gain in corporate earnings. The strong earnings growth explains why valuation for US tech has been kept under the lid despite its outperformances in recent years, he wrote. The key segments in this respect are robotics, the Internet of Things and artificial intelligence.
- Asia ex-Japan
Ken Peng, Asia Investment Strategist at Citi Private Bank, wrote that despite Asia's strong showing in 2017, many markets in the region are still valued much lower than developed markets. Using cyclically adjusted PEs, most major Asian equity markets remain on the lower end of the historical range, and are below their historical average.
There are a number of factors in Asia's favour. One is a weak US dollar. "There may still be periodical rebound, but we remain convinced of a weaker USD over the coming three to five years. This would be a key support to capital inflows to EM Asia and broader EM, and would suggest equity outperformance."
A second factor is that global investors remain underweight Asia, particularly North Asia. "Active investors may be slow to catch up, but benchmark weights are rising for EM Asia, particularly China. Passive inflows are likely to grow, not just in equities but also in bonds. Together, this is likely to keep portfolio inflows alive for the coming years."