Don’t ring the bell yet – Market Outlook 2018

From

Stanley Yeo

Despite the recent market volatility, don’t believe the rally that began in 2009 is over.  However, this rally is one of the longest and largest on record, pushing valuations to expensive levels, especially in the US.

“These valuations mean that the five to ten year outlook for equities is less positive than it has been in a while.  However, over the next 12 months, economic strength should support corporate profit growth, providing support for equities”, says Stanley Yeo, Deputy Chief Investment Officer and Portfolio Manager Strategy and International Equities at IOOF Investments.

“Although we believe equities have started to become expensive, especially in the US, sentiment does not appear to be at the euphoric levels that signal the end of the bull market.”

It is important to focus on the fundamentals. The global economy is currently growing at its fastest pace since the financial crisis.

Mr Yeo stated, “We expect this strength to continue into 2018, with the recovery eventually being brought down by tighter monetary policy at some point over the next few years.  Stronger capital investment and productivity growth should support economic activity overall, although productivity growth in the developed world is unlikely to return to the levels seen in previous decades and has been an area of disappointment.

“We remain optimistic about both emerging market economic growth and emerging market equities and debt.  In contrast to the developed economies, where growth has been ongoing for several years, the recovery in emerging economies and markets remains in its infancy.

“It will be many years before most emerging market economies face capacity constraints, and we thus see the scope for strong economic growth, higher corporate earnings and positive equity market returns to continue for some time. With emerging market growth at last starting to pick up and likely to persist, we forecast that emerging market profits will rise over the next few years, which should continue to attract investors.

“In 2018, we expect bond yields to rise more materially as the Federal Reserve (Fed) continues to raise interest rates and global quantitative easing (QE) is slowly replaced by quantitative tightening. We believe we are at the early stage of a multi-year exit from QE and zero or negative interest rates in the developed world, which will put pressure on returns of government bonds.”

Exceptionally loose monetary policy has, at last, led to what appears to be a self-sustaining and self-reinforcing expansion that will slowly lead to monetary policy being normalised.  The process of normalisation is most advanced in the US, which has already started to reduce the size of its balance sheet and raise interest rates.

Mr Yeo further commented, “The biggest risk to financial markets is if the Fed raises rates more aggressively than expected.  If the Fed does so because of economic strength, then the impact on equities and other risk assets may be modest.

“However, if the Fed does so because it is concerned about higher inflation, then this could be more of a challenge to asset prices.”

Various remaining geopolitical risks are difficult to quantify, such as the risks of a trade war involving the US or a further escalation in tensions between the US and North Korea.

In concluding, Mr Yeo said, “In summary, we are in a late cycle – but the last year of a bull run can be profitable, and we don’t expect a recession in 2018.

“As such, we remain positive on risk assets, but may turn more defensive if the Fed tightens more than expected.”

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