The panel’s principal worries for 2017 failed to materialise, leaving them optimistic about prospects for 2018.
A strong finish to 2017 lifted equities around the world to new all-time peaks. On Wall Street the Dow Jones Industrial index gained 25 per cent, while the NASDAQ Composite index totted up a 28 per cent rise. The MSCI index of global stocks tracking shares in nearly 50 countries also closed the year at an all-time high. The FTSE All World index had its biggest increase – 22 per cent – since 2009, following 14 straight months of gains.
Even the unloved UK market scaled new peaks in the year-end buying flourish. Japanese markets remain a long way from their stratospheric highs of the late 1980s, but from September onwards a rush of foreign buying pushed the market nearly 20 per cent higher. After this dizzying ascent across the board, our panel of asset allocators are pausing for breath and have begun this year on a more cautious note.
Realistic on risk
‘After such a good year, you are always tempted to take a bit of profit,’ admits Keith Wade at Schroders. ‘We do feel inclined to take some risk off the table. Very few people think the markets will be as good this year as they were in the last.’
Schroders highlights three areas of potential risk for investors in the year ahead: the return of inflation, the end of the great quantitative easing experiment and a number of political issues in the UK (Brexit), Europe (Angela Merkel’s future) and the US (possible gridlock in Washington after mid-term elections).
Richard Dunbar at Standard Life Aberdeen agrees: ‘Expectations of returns for equities in 2018 have to be reined in after the strong performance last year.’ Rob Burdett at F&C Investments, meanwhile, thinks there is further to go this year: ‘It was a good year for investors in 2017 – better than most would have predicted. Even so, I still don’t think we have reached a point of irrational exuberance.’
However, he warns: ‘Markets are getting a little more tired as they advance, so we have to be a bit more wary and more discerning about where we invest. One warning sign is that companies who fail to meet their targets and issue profit warnings are really being hammered by the market.’
Our latest panel scorecard, assessing the first quarter of 2018, clearly shows a tendency to trim overweight positions in equities. There is even clearer evidence of caution in the outlook for property, commodities and corporate bonds – three sectors offering risk assets that diversify away from equities.
Alan Higgins at Coutts is lowering his property score from 6 to 5. This means none of the panel is now overweight property. The average score in property three years ago was 7. Now it is down to 4.4. Equally, no one is overweight in corporate bonds any more: Higgins, Burdett and Wade all reduced their scores this time around. Finally, neutral positions are increasingly favoured in commodities. Wade has cut his score for the sector from 7 to 5 on evidence of slower growth in China, which might affect industrial metal prices. ‘Also, energy sector prices have done so well lately,’ he adds.
Overall, in six of the 10 categories covered – European equities, emerging market equities, global bonds, global corporate bonds, property and commodities – average scores have been tweaked lower. This is not to imply that our panel has suddenly lost faith in this long-running recovery in equities, or lost their preference for risk assets over government bonds. Indeed, one panel member, Chris Wyllie at Connor Broadley, has kept all his scores unchanged.
That perfect blend of low inflation and moderate synchronised growth spreading across the global economy – the so-called Goldilocks scenario – still prevails and provides the bullish background for corporate earnings growth, the ultimate source of stock market strength. Significantly, average scores for both UK and US equities are now slightly higher.
‘The outlook is still supportive of risk assets,’ says Higgins. ‘Nothing is signalling a recession in the US or elsewhere within the next 18 months to two years, and the Trump tax cuts will boost the US further.’ Chris Wyllie agrees. ‘The growth fundamentals still look very good,’ he says, ‘and, if anything, we are seeing signs of further acceleration in the US. The US seems to be taking over the growth momentum from Europe.’ Indeed, the Trump tax cuts have prompted Wade to raise his US growth forecast for this year from 2 to 2.5 per cent.
Wary of optimism
The overriding mood remains optimistic. Dunbar says: ‘If you look back 18 months or so, we had a litany of worries about the future of the euro, low growth in Europe, a US slowdown and problems in China. None of that came to pass. Instead, we have Goldilocks.’
Yes, but will Goldilocks last much longer? Probably not, the panel seems to think. Dunbar himself thinks the current benign environment will certainly be tested this year. Higgins agrees: He says: ‘The market is a bit complacent about inflation risks for 2018 in the US, where unemployment is now down to 4 per cent. I don’t think inflation is going to spike upwards, but you don’t need to see much of a rise for the US Federal Reserve to raise interest rates by more than the market is expecting.’
Wade is already flagging higher inflation this year and warning: ‘In 2017 inflation remained quiescent and growth was good, but this year the cyclical forces at work will be strong enough to push up the rate of inflation and give the Fed something to do.’ He has already pencilled in three moderate Federal Reserve interest rate rises for this year, but some economists think there will be four. ‘We have to be wary,’ Wade stresses. ‘Our analysis shows that when inflation begins to pick up, markets begin to flatline.’
The trickiest decision panel members have to face is where to position themselves on Wall Street – clearly still easily the most powerful and influential force in world markets. It is hard to find any consensus among the panel members.
Wyllie has plumped for a neutral weighting. ‘My score of 5 reflects on the one hand our discomfort with valuations, which are hard to justify. On the other hand, the fundamentals remain good, with the US economy accelerating.’ He admits the strength of US equities in 2017 wrong-footed many investors who flocked to Europe instead, and accepts that the US may continue to confound experts on the upside. ‘It is hard to be overweight the US because it is so pricey,’ he argues, ‘but it is risky to be underweight as well.’
Wade is more positive. He keeps his score at 6 again, to reflect the US’s improved growth prospects but also its strong bias towards high-growth technology stocks. Dunbar has raised his US score from 4 to 5, but he will ‘tilt the portfolio away from expensively rated big tech stocks such as Facebook, Google, Amazon and Netflix’.
If, as Wyllie says, it is risky to be underweight in the US when it is soaring away, it is more than a little embarrassing for a fund manager. Burdett is now the only panel member prepared to put up with that embarrassment. He keeps his score at 4. ‘I accept that the US is continuing to deliver on corporate earnings growth, but I still find the valuations challenging.’ With his cash score at 8, Burdett stands ready to act on any Wall Street setback. ‘At the moment it does feel prudent to have a strong cash position,’ he says.
Emerging market strength
Emerging markets remain the most favoured sector in equities, with Japan almost as popular. Remarkably, the recent strength of the emerging market sector has prompted only one panel member, Alex Higgins, to lower his score. He comes down from 7 to 6. He has been selling into the rise since last summer. Back in August he had a score of 8. ‘These markets have had a great run,’ he says.
Schroders calculates that the sector’s average return last year was around 30 per cent. That’s hard to sustain, maybe, but other panel members such as Burdett are happy to stay well overweight with what Burdett describes as ‘so much positive noise coming out of markets in Asia’. Wyllie, meanwhile, says: ‘[Emerging markets] still have mileage but are no longer a buy on valuation. But with broad global growth in prospect, it does not feel right to be out of this sector.’
Burdett remains an enthusiast for Japan and has sustained an overweight position for some time. It paid off dramatically in the final weeks of 2017, with the Nikkei 225 index ending the year 20 per cent higher. Foreign investors began supporting the market again after the snap election in October returned prime minister Shinzo Abe to power amid growing evidence of widening profit margins. Burdett says Japan is ‘a story of good valuation at a time when it is hard to find good value anywhere else at the moment’. Even here, though, Burdett cannot resist taking some profit after the strong gains of the past few months, and he has lowered his score from 8 to 7.
Dunbar is also taking profits in Japan, knocking back his score from 6 to 5. But Wyllie and Higgins think there is more to come, and both stick at 7. According to Wyllie, the strong surge ahead of Christmas was ‘a case of the bears capitulating at last’. Wade looks to be a latecomer to the party, raising his score from neutral to another 7.
In European equities, Dunbar is concerned that Europe has become too fashionable with investors. ‘A year ago it was out of favour. Now sentiment seems universally positive – usually time to tread warily.’ He remains overweight, though at 6.
Wyllie also has his concerns but stays overweight on the same score. ‘The fundamentals may look good, with the EU and the UK having traded places in terms of economic growth,’ he says. ‘Consumers in Europe are not clapped out the way they are in the UK.’ However, he believes a testing moment will come when the European Central Bank stops printing money. ‘Then we will find out where interest rates should be.’
Wade is already predicting that to happen by the end of this year, and that is reason enough for him to take some profits, lowering his score from 6 to neutral. Meanwhile, political uncertainties are returning over the difficulties in forming a German coalition government, the pending Italian election and the crisis in Catalonia. This is enough to persuade Burdett to shave a point off his score from 6 to 5.
But Higgins still prefers Europe and Japan to the US and insists that ‘not much has happened to change our view’. Even very weak eurozone economies such as Greece and Italy are in a much better place than they were two years ago, he claims.
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