Financial market forecast: markets to watch in 2018

1. The pound

The pound (GBP) sits on a knife-edge heading into 2018, with questions surrounding Britain’s future relationship with the EU continuing to influence the markets. Brexit negotiations are not due to conclude until October 2018 but, if the recent impasse is anything to go by, that date could easily be pushed back.

If the rhetoric from either side suggests Britain is heading for a ‘cliff edge’, or agreeing to unfavourable terms, sterling is likely to fall heavily against other major currencies. And, if a ‘no deal’ scenario materialises, the pound might even be pushed to an all-time low against the euro (EUR).

Of course, sterling could strengthen if the pace of negotiations picks up, and the market might even turn bullish if the terms look favourable. With so much at stake, the pound is our analysts’ number one market to watch in 2018.

2. Western stock markets

Western stock markets have seen a multi-year rally. Prices of the S&P 500, Dow Jones, FTSE 100 and DAX indices have risen since 2009, driven by corporate buy-backs, strengthening global economies, and central bank policies.

But some analysts and traders argue that the stocks are overvalued, with price-earnings (P/E) ratios in many of these markets way above historic averages. Some are now suggesting that a credit event, major fraud, interest rate hike, or new regulation could see major adjustments in 2018. Others believe that the markets will continue to rise, due to a favourable economic outlook.

So, will the multi-year rally continue, or is the oft-predicted crash going to happen?

3. The US volatility index

With uncertainty surrounding global stock markets, the year ahead promises to be interesting for the volatility index (VIX). This measures expectations for S&P 500 volatility over the coming 30 days, based on an analysis of call and put option prices.

Our analysts have outlined three scenarios for the VIX next year:

1. The smooth transition (probability 45%): companies on the S&P 500 deliver sustained earnings growth. The VIX remains low, in the 9-15% range.
2. The stealth inflation shock (probability 35%): inflation rises faster than the Federal Reserve (Fed) expects, and bond yields increase. The VIX rises to the 18-20% range.
3. The ‘black swan’ event (probability 20%): an unexpected economic event creates a deflationary environment. The VIX spikes to over 30%

You can read more about these scenarios in our thematic playbook for 2018.

4. The US dollar

The year ahead could see the US dollar (USD) rise significantly, as a result of changing monetary policy and Trumponomics.

The Fed is widely expected to raise interest rates two or three times in 2018, in response to falling unemployment and increased consumer spending. So, we could be seeing interest rates of 2% or more by 2019, which would likely increase demand for dollars.

The effects of these rises could be amplified if President Donald Trump is able to pass the tax cuts he has proposed. Republicans claim these will increase employment and boost spending across the economy so, if passed, we might see the markets price in some additional Fed funds rate hikes.

However, the tax reform bill still needs to be approved by the Senate and reconciled with an alternative version that passed through the House. It therefore remains to be seen what form the final bill will take and how the markets will react.

So, will 2018 make USD great again?

5. Japanese yen and stocks

Haruhiko Kuroda’s term as governor of Bank of Japan (BoJ) comes to an end in April 2018, and Prime Minister Shinzō Abe has yet to announce whether he will be reappointed or replaced, making it an interesting time for the Japanese yen (JPY) and Nikkei 225.

Kuroda is widely credited with implementing monetary policies – including an innovative quantitative easing package – that returned Japan to inflation by reducing the value of the yen, and gave Japanese stocks a much-needed boost. His policies have closely followed the economic policies devised and advocated by the prime minister (‘abenomics’), so he is widely expected to hold on to his seat.

But, if he were to be replaced by someone more hawkish, our analysts would expect to see some major price adjustments. Japanese stocks could tumble, and the yen might appreciate.

6. Chinese stocks

China’s economy continued to grow in 2017, along with concerns about its sovereign debt level. Will we finally see a slowdown in 2018?

Chinese economic growth has been largely debt-fuelled since 2010, with state-owned enterprises and local governments able to take out massive loans to fund domestic and international investment. Debt now totals approximately 250% of gross domestic product (GDP), and much of that debt is expected to turn bad, causing S&P to cut China’s sovereign debt rating from A+ to AA- in September. To tackle the problem, President Xi Jinping is beginning to rein in cheap credit, which could hit Chinese stocks.

However, the Chinese government is still aiming to double GDP by 2020 (compared to 2010 levels), and critics say credit growth is still too fast. A worst case scenario could see the Chinese ‘debt bubble’ burst, causing a financial crash, though some believe this is unlikely given the vast majority of debt is held by state-controlled entities.

One thing’s for certain, President Jinping’s next moves will be watched by analysts and traders globally.

7. Oil

The oil price is already at a two-year high, but its rise looks set to continue in 2018 – provided supply and demand factors shape up as expected.

These drivers can be difficult to predict, but US shale oil production seems to be stabilising, and recent rhetoric from the Organisation of Petroleum Exporting Countries (OPEC) and Russia suggest that they will maintain production cuts into late 2018 at the very least.

While supply looks as though it will stabilise, global demand seems to be on the rise. Both the International Energy Administration (IEA) and OPEC recently revised their demand forecasts upwards, which suggests prices will increase in the year to come.

Of course, nothing is guaranteed. Historically, it has not been uncommon for OPEC countries to exceed their production quotas, and any economic downturn (particularly in China) could radically reduce demand. So, it remains to be seen what will happen to the oil price in 2018.

8. Cryptocurrencies

The use of cryptocurrencies is likely to expand over the next year but, with potential hard forks and regulation on the horizon, volatility appears set to continue.

Demand for cryptocurrencies is likely to rise in 2018, as their popularity with consumers increases and major banks, including HSBC, UBS and Barclays, begin to test blockchain technology. The number of decentralised apps (dapps) available on the Ethereum network is also likely to rise, which may cause ether's price to surge.

However, any rise in price is unlikely to be linear. Ethereum’s constantinople fork is expected next year, and a bitoin fork could also be on the cards, with any uncertainty surrounding these updates likely to have a negative effect on short-term prices. And any security breach (e.g. a hacked blockchain or wallet service) could have devastating long-term consequences.

Several countries are also in the process of introducing regulation to limit retail investors’ exposure to cryptocurrencies. China recently outlawed trading cryptocurrencies on exchanges and banned initial coin offerings (ICO), and Russia is preparing to introduce similar regulation. Some say this will severely curb demand for cryptocurrencies, while others suggest the decentralised nature of cryptos will limit the effects of this regulation.