2018 is likely to be a departure from 2017 insofar as we expect returns to be lower and market conditions to be more volatile. Why is that the case? Firstly, equity and bond valuations are stretched in major markets. Secondly, we don’t see a lot of momentum left in the US, although there are better prospects in Europe and the emerging markets. Moreover, the changing macroeconomic backdrop should bring new challenges in the form of credit tightening in China, as well as policy adjustment in the west. From that perspective, markets are unlikely to enjoy the benign conditions of 2017 over the next 12 months.
Monetary policy in the west will be characterised by further normalisation, with a likely package of tax cuts in the US. The Federal Reserve will raise interest rates next year at least three, perhaps even four, times. The ECB has already announced that it will begin to taper its balance sheet purchases. The Bank of England and the Bank of Canada have already raised interest rates so in a broad sense, we are now transitioning to some adjustments in monetary policy in advanced economies. One hopes that they will be normal and not disruptive. However, if inflation accelerates, then the pace of tightening will as well.
In China, policy is also being adjusted after a period of rapid credit growth that has underpinned property markets and fixed asset investment. The Chinese authorities are already beginning to curb off balance sheet financing, which will probably also lead to some slowing of Chinese growth in 2018.
The biggest risks of the moment are thought to be in the realm of politics and geopolitics. We are currently facing a number of uncertainties, including Brexit, the completion of the tax reform bill, mid-term elections in the US as well as tensions in the Korean peninsula and elsewhere.
However, lurking in the background, there are two challenges that we have not had to confront for some time. First, global growth might slow. As discussed, this is most likely in China, where credit growth is being tightened. It is also important to note that global growth surprise indices are at very high levels – levels where they typically peak and then begin to decline. That is partly because expectations cannot keep up with the pace of growth, but it is also entirely possible that we’ll see genuine disappointments in that space.
And then finally, the risk of inflation, which is currently not on anyone’s radar screen. Markets seem to be complacent to the risk that inflation could accelerate but with output gaps closed in North America, Western Europe and in Japan, there is a chance that inflation will accelerate, which could pose significant challenges across all asset classes.
2018 is likely to mark a departure in portfolio positioning for all investors and we are marking changes to our portfolios as well. In recent years, it has benefitted to be long equities to enjoy the broad based recoveries we have seen across different equity markets, but also to have the comfort of declining bond yields as part of a 60:40 portfolio.
However, we think that genuine diversification is the real story for 2018. This means taking some equity risk where earnings potential resides, for example in emerging markets, Western Europe and parts of the Japanese equity market but otherwise trying to build alongside those equity exposures alternative forms of returns that are not correlated with either equity or fixed income movements. This is mostly in the area of relative value positions and in some carry positions in specialised areas of credit. In our view, genuine diversification in portfolios will be fundamental in 2018, something that has not been accomplished in most portfolios for a number of years.