2018 IG Investments outlook

The global economy continues to expand, which should mean that the equity bull market still has legs. However, investors should pay close attention to valuation. The easy money has been made in many parts of the market and reversals, when they come, will be painful.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results

It was another strong year in 2017 for investments, with low double-digit returns across most markets generated hand-in-hand with rising global corporate profitability (up 15% in 2017), and solid economic growth.

The question everyone wants to know the answer to now is whether the bull market can continue throughout 2018.

It’s often been said that bull markets don’t die of old age, but rather they’re killed by the Federal Reserve (Fed). This one appears to be no different. As written about previously, geopolitical risk tends to be no more than a short-term nuisance for markets (offering good trading opportunities), but unless the event is very serious (e.g. sovereign default of a large economy, or a calamitous war), there is little chance of it having meaningful impact on the global economy five or ten years down the line. 

For this reason, central bank policy (which directly impacts the price and quantity of money) is the key area to watch.

After raising the benchmark lending rate in December 2017 to a target range of 1.25% to 1.5%, the Fed forecasts a further three 0.25% rate rise across 2018. However – having been let down over the past several years – the interest rate futures market is not pricing this in, factoring just a 20% probability of three hikes by year-end. Traders in London also expect a very benign UK interest rate environment, pricing in a slim 40% chance of an interest rate move from 0.5% to 0.75% by the end of 2018.

With the markets seemingly calling the central banks’ bluff, inflation data is going to be closely watched over the year ahead. If inflation rises faster than expected, central banks may be forced to raise interest rates to choke off growth, but if it remains under control then this extended period of low rates and loose monetary policy could continue for longer than expected.

That said, it’s true that headline inflation has started to move, particularly in the UK where sterling depreciation and rising commodity prices – from a low base – have filtered into the data. However this is still seen as a transitory effect; core inflation is still not especially elevated, which we can see in Chart 1.

In actual fact, core inflation has been dropping in the US, and the Eurozone continues to struggle to generate much inflation at all. As long as this state of affairs continues, interest rates should not surprise on the upside.

Chart 1: Core Inflation

Low inflation doesn’t mean you should be complacent

While the outlook is generally sunny, this doesn’t mean there aren’t pockets of overvaluation in the markets. Valuations in many areas look extended, and one way of guaranteeing low future returns is to buy an asset class that then de-rates over the coming decade. Tech stocks in 2000, and emerging markets in 2007 are prime examples. 

US equities are trading at a multi-year valuation premium relative to Europe, as written about here, which could lead to an extended period of underperformance if sentiment turns. President Trump’s tax cuts have been the latest boost to a buoyant market.

While all US sectors look quite expensive relative to Europe, it’s really the technology bull market that has driven the US indices to new highs, and this is worth keeping an eye on for more than just valuation reasons.

Chart 2: US valuations look quite rich

Facebook, Amazon, and Microsoft alone have a larger market cap ($1.75 trillion) than the whole of the German DAX ($1.4 trillion). Whether the regulators will step in to try and break the dominance of these companies remains to be seen, but it should not be ruled out. For example, Microsoft, in a decade long law suit, settled with the EU in 2013 for the rather arcane offence of not offering users a choice of different web browsers with their software. It’s fair to say that the tech giants wield rather more power nowadays, and it would be a mistake to become too complacent.

EUR High Yield – no compensation for risk

While European equities look to be better value than their US counterparts, yields for European High Yield (junk) bonds have no margin for error. In early 2012, investors had a yield cushion of 4% over US treasuries, which has since evaporated to leave US treasuries being the higher yielding market.

Come the next financial crisis, would you feel more confident holding your savings in a European car manufacturer, or the US Government?

Chart 3: US Treasuries or EUR High Yield

What about the UK?

With Brexit negotiations ongoing, it’s difficult to predict exactly what the end agreement will be, but on the balance of probabilities, a fudge that pleases neither side is the most likely of outcomes.

By 2018 the “Remainers” predicted a sharp recession for Britain, while the “Brexiteers” forecasted a boom. The reality is rather less exciting, with gross domestic product (GDP) growth forecasted around the 1.5% mark. No one truly knows whether the vote to leave the EU has done damage to the economy or not. On the one hand, the pound has fallen, which has pushed up inflation, but on the other hand, manufacturers are doing well and unemployment is at a record low.

As mentioned previously, interest rates should continue to be benign, but low rates have helped push up household borrowing back to 150% of GDP (nine out of ten new cars are bought on finance), and the Conservative minority-led government has a lot of work to do to reduce the budget deficit. Another year of muddling through would not be all that bad an outcome. 

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