Most asset classes have been in a bull market since the lows hit during the financial crisis in 2009. Last year, equities in particular performed well, and as of today leading indicators continue to point to further growth, while global corporate earnings are improving worldwide. Supported by a second consecutive year of above-trend growth, we expect risk assets such as equities to outperform bonds once again in 2018. This risk-on stance should not be viewed as contrarian, given the decent economic and political visibility at the turn of the year. More importantly, we address several questions raised by investor fatigue after several years of rising asset prices. Trends in the 3 V’s - visibility, valuations and volatility - will be crucial in the coming quarters.
We expect the Goldilocks scenario of positive growth and low inflationary pressure to prevail in 2018. Although the year is likely to register somewhat less cyclical growth and more cyclical inflation, the investment environment throughout 2018 should remain favourable. Candriam’s asset allocation is positioned for above-trend expansion, due to a positive feedback loop instigated by accommodative financial conditions and supportive business and consumer sentiment. It took an unusual amount of time to see major economies (G7) closing their post-2008 output gap. If history is any guide, several quarters of positive output gap should begin now, as shown in chart 1.
Chart 1: G7 economies are just closing their post-2008 output gap
The main risk to our outlook would be an abrupt end to the Goldilocks environment. Barring an external shock, a further continued rise of the price of oil, leading to a sharp acceleration in inflation and long term bond yields could be a trigger. A sharp slowdown in growth would be another – either due to a hard landing in the Chinese economy or a fiscal or monetary policy error. Is there a risk of a policy error by one of the major central banks or have they become more predictable?
Candriam expects the equity bull market to continue for another year in 2018. The consensus on the global bond yield outlook nevertheless appears too benign. In particular, we expect central banks to continue to play an important role in the bond markets. Although the treatment of the balance sheet has been announced in a transparent and predictable manner, policy decisions by new central bankers are less certain. Overall, central bank decisions are likely to push bond yields slightly higher, but should not be an obstacle for global equity performances.
In the US, the nomination of a new Fed chair and new governors on the board should pave the way for a smooth transition from the Yellen tenure to a Powell term. The US central bank started its balance sheet reduction last October and has put the QE unwinding on “autopilot”. Regarding its funds rate, Candriam expects the Federal Reserve to stick to the dots and hike 75bps this year. As bond markets are currently not reflecting this, there is room for rising bond yields in order to avoid a yield curve inversion.
In the Eurozone, the ECB will gain particular attention in the second half, when it will start to prepare markets for the end of QE and manage interest rate hike expectations for 2019 through its forward guidance. As the ECB’s balance sheet will expand further through 2018, we do not expect a disruptive effect on equity markets as liquidity will continue to grow until Q4 2018. At that moment, another issue will emerge as Mario Draghi’s 8-year term at the helm of the ECB is coming to an end in 2019. His succession will be highly scrutinised as the next ECB president is expected to further normalise monetary policy.
Regarding Japan, we expect the Bank of Japan (BoJ) to remain the most accommodative central bank in the developed world. The next BoJ governor, should Mr. Kuroda not be re-appointed, will likely be a dove and support PM Abe’s economic programme. This could put the Japanese yen under pressure and add support to Japanese equities.
As QE fades, investors will again focus on fundamentals and equities will therefore be reliant on earnings growth, as shown in chart 2. Will corporate profits rise enough or should investors prepare for the next bubble?
Chart 2: As QE fades, equities become reliant on earnings
Equity market valuations have risen over the past year, with price-earnings ratios above their long-term averages. Clearly, valuations strongly differ from one region to another (e.g. emerging markets appear fairly valued while the US stock market valuation looks rather stretched). However, we do not detect any valuation excess nor any bubble in global equities.
In our view, a bubble corresponds to valuations which are disconnected from fundamentals. Strong earnings growth in a robust economic context, associated with decent visibility and, in the case of Europe, a decline in the political risk premium actually justify more expensive valuations than currently observed. Furthermore, low default rates and relatively sound financial statements explain most of the spread compression among credit markets.
Fortunately, consensus expectations are positive but not too optimistic for 2018 and global earnings growth targets seem achievable as the economic recovery is increasingly broad-based. After having registered double-digit earnings growth through 2017 in all major regions, consensus expectations for 2018 have been trimmed to single digit growth in the Eurozone, the UK and Japan. The US and emerging markets (respectively 16% and 13% consensus earnings growth expectations) retain the strongest progress. This leaves some upside for risk assets in 2018, driven by earnings growth. However, with volatility indices at rock-bottom levels, can an uptick be expected as geopolitical risks remain and the cyclical momentum is likely to moderate?
After the triple shock of the great financial crisis in 2008-09, the European sovereign crisis in 2011-12 and the commodity crisis in 2014-15, financial markets are finally responding to a more benign economic environment. Supported by above-trend growth and low inflationary pressure in many parts of the world, valuations have risen and volatility among equities, bonds and currencies has fallen.
Broadly speaking, it is possible to characterize 4 different volatility regimes, two in an overall contracting economy and two in an expanding environment. Since early-2016, we are in the most favourable regime for low asset class volatility, with economic expansion accelerating and spreading across many sectors. Historically, asset volatility is at its lowest level during growth acceleration phases and increases when the economy slows down, while it remains in an expansionary regime.
Candriam’s outlook for 2018 is based on a continuation of positive (but somewhat slower) growth momentum and low (but slightly increased) inflation pressure. A slowdown in momentum amid continued expansion would be a first step into a slightly higher volatility regime, as shown in chart 3.
Chart 3: The four different volatility regimes
Bond volatility, in particular, has benefitted from the post-financial crisis policy architecture and has reached levels not seen in the decades before 2008. The start of QE-blown central bank balance sheet unwinding is likely to lead to higher volatility in the fixed-income segment over the coming quarters. The good news is that history teaches us that -- barring an unexpected shock -- changes in volatility regimes are not brutal, but gradual.
The highest volatility regime is usually associated with a contracting economy. Candriam is not expecting that scenario in the foreseeable future. It is of note that once the economy starts contracting, volatility among asset classes remains high as long as the economy is not expanding again, whether it is in a contraction or recovery phase. In this environment, higher asset price volatility is an immediate result of the uncertainty faced by investors.
Candriam expects volatility to rise across asset classes in 2018 as economic momentum is likely to peak. As a result, the new regime of slightly higher volatility we are expecting should provide more performance dispersion and therefore more opportunities for active fund managers.
In a context of high economic visibility, more predictable central bank actions, solid earnings growth, no valuation excess and a slight uptick in asset class volatility, our asset allocation for 2018 favours equities over bonds. Within equities, our core investment convictions are an overweight in European small & mid-cap stocks and in Japanese and emerging market equities. Within Europe, our preference goes to EMU versus Europe ex-EMU equities. Within the fixed-income universe, we think a short duration (underweight stance) on developed market government bonds is warranted, along with a neutral positioning in credit and overweight emerging markets.