Morningstar's "Perspectives" series features investment insights from third-party contributors.
After a year of strong economic and financial market performance, with volatility printing historical lows and asset valuations looking increasingly rich, investors are naturally questioning the sustainability of current trends. Are we nearing the end of the cycle? Our answer would be – not yet.
Stock markets in Japan, Europe and emerging markets have further to run
Forecasting a breakdown scenario for 2018 requires expecting either that an exogenous shock hits the global economy or that an endogenous negative feedback loop takes hold.
While clearly always possible, the former is unpredictable by nature, and unlikely in our view. It would certainly be complicated to base an asset allocation on such a premise.
As for the endogenous threat, it has to do with the very functioning of economic cycles. In a recovery, there eventually comes a point when the engine overheats. This can show up in price pressures that develop to the point of becoming counterproductive for economic actors, or investment spending that well exceeds true economic needs. Policymakers typically then press hard on the brakes – causing the engine to stall. Expansion turns into recession.
Inflation Threatens Returns
Absent signs of excesses on the inflation and investment fronts, we thus conclude that 2018 is more likely to be a year of economic continuity. Growth should remain above-trend, and broadly in line with 2017. While the business cycle does show signs of maturing in the US, at eight years old, and Japan, in Europe and emerging markets it is much younger, and, we believe, has further to run.
Crucially, financial conditions remain supportive. Even though 2018 is likely to mark a turning point in monetary policy, central banks are proceeding cautiously in their removal of ultra-loose monetary policies. Combined with macro momentum, this still ample liquidity bodes well for corporate profits over the next quarters. European earnings, in particular, have room to catch-up with the US and previous cycle highs.
That said, continuity does not mean more of the same. The cycle is moving forward, progressively reducing the slack in the global economy. So, although 2018 nominal growth should be stable relative to 2017, a trade-off between its real and inflation components is to be expected.
If inflation does indeed creep-up during the coming quarters, financial market volatility should make a comeback and developed market government bonds – an asset class that we have long strongly underweighted – come under further pressure. Our most recent move in the fixed income space has been to shift part of our allocation away from credit and towards convertible bonds and hard currency-denominated emerging market bonds, where we see better value and more upside potential.
We stand firm on our equity overweight, in view of the solid corporate profit outlook. But regional preferences are likely to matter in 2018. Valuation considerations, as well as their earlier stage in the recovery, make us favour the European and emerging markets over the US.
Commodities Demand Picks Up
Commodities are benefitting from their best demand backdrop in over a decade. Although this might fade somewhat in the new year, we like the potential diversification effect of this asset class – warranting a continued overweight.
On the currency front, in line with our expectations, US dollar strength is stalling. Going forward, we expect the euro to head higher against the greenback, and both the Swiss franc and the pound sterling to remain weak versus the single currency.
Threats Could Re-emerge
Our still constructive economic outlook for 2018 does not mean that we are not aware of the risks. On our watch list will be inflation data, financial markets’ reaction to monetary tightening and Chinese economic and debt developments. Also, after dissipating during the course of 2017, protectionist and political threats could re-emerge – notably around the Italian or US midterm elections.
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