15 December 2017

Looking into 2018, one is is reminded of the old stock market admonition that “bulls make money and bears make money, but pigs are slaughtered”.  In other words, let’s not be greedy: the returns of the past year are highly unlikely to be repeated.  In an effort  to free up your time for seasonal merriment, I have adopted a pictoral approach to laying out key strategic issues for the New Year. In accordance with my belief that just a handful of good ideas (backed by  the willingness to put serious risk capital behind them) will produce portfolio outperformance, I concentrate on the key themes and risks which will drive markets in 2018: These include:

Theme 1: Aging Rally will Deliver Positive, Single-Digit returns in 2018

On a calendar basis, the current rally is aging. However, the typical end-of-cylce indicators are still not evident.  The global economic environment remains benign: synchronised global growth, low inflation, and ample global liquidity. However, stock market valuations are becoming stretched on most measures, except when compared to interest rates.  Markets will deliver positive, but single-digit returns in 2018.

Chart 1 illustrates a few key points.  First, GDP growth accelerated throughout the G7 (except the UK) and globally in 2017. Secondly, growth was more synchronised than in the past. Third, both these trends surprised markets, which had come to expect tepid GDP gains, and underperformance in Europe and Japan.  Global growth is expected to remain above trend in 2018.  It is important to note, however, that the element of surprise will be less of a factor, as markets are now more comfortable with this pattern.

Wage and price inflation – and the monetary policy tigtening which it prompts — is what ends equity market cycles.  Chart 2 illustrates a couple of key points.  First of all, global inflation remains low. Secondly, however, only the USA runs a serious risk of having inflation accelerating above targeted levels.  To be sure, unemployment has declined world-wide (fortunately), but only in the USA and UK has joblessness approached the low level of the past cycle.  Despite the risks, however, US wage gains have been modest in recent months, which will continue to limit the rise in prices.  Inflation in Europe and Japan will remain below target.  Third, Emerging Market inflation is declining , and Diverging from the USA (except Turkey).

Low inflation will allow central banks to move slowly (USA), not at all (ECB and BOJ), or cut interest rates modestly (many EM countries).

Set against this favourable backdrop, Chart 3 illustrates many measures of stock market valuation appear streched.  For example, Price/Earnings ratios are between 10% and 20% above long term average levels.

Theme 2:  US Equities — A Tale of Two Halves

Surely, after this year’s rally, markets have discounted all the good news  for US equities.  Perhaps not yet. Despite its shortcomings, the US tax reform will transform 2018 from an OK year for corporate earnings  into a bonaza: EPS will rise by some 15% next year.  Chart 4 illustrates what lies behind the post-election US rally.  Since polling day in 2016, the S&P 500 has risen 22%.  Nearly 75% of that  gain has resulted from rising corporate earnings, with the remainder emanating from an expansion in the P/E ratio (from 17 to 18X NTM forecasts). The bulk of the rally, therefore, has resulted from impressive corporate performance (part of which resulted from the tax plan), and only a small portion resulting from a reappraisal of the US outlook under President Trump.

Morgan Stanley analysed how tax reform will impact corporate earnings by sector.  With the S&P 500 likely to achieve EPS of 150, we target the market at 2,700 (18X EPS), a modest single-digit return.  As analysts, however, we focus arguably  overly on what could go wrong.  But, what would happen is President Trump is correct,  and tax reform is a panacea. With interest rates remaining historically low, there would be little reason the P/E could not expand to 20X, taking the market to 3,000!

However, a few charts indicate why the tax reform is not likely to boost US potential growth too much. First of all, weak US (and global) growth during this cycle reflects a combination of slow productivity growth and modest increases in the labour force. Chart 6 shows weak productivity gains is a global pattern — in countries with both high and low corporate taxes. Tax reform will help, but only modestly.  An aging population accounts for much of the recent decline in labour force participation, which tax cuts won’t change these demographic trends.

Chart 7 illustrates that corporate profits have little impact on wages — no trickle down!  Indeed, even though profits are at record highs, wages gains have remained modest. While low unemployment should boost wages in 2018, tax reform will  have little role to play.

US tax cuts come at a time when US fiscal dynamics are already fragile, and inflation risks are heightened.  I expect the US budget defict to widen toward 5% of GDP in the coming years, and government debt will continue to rise towards 100% of GDP! I expect cuts on entitlement spending on lower- income groups eventually to pay for corporate tax cuts.

Despite its use of forward guidance, the markets do not believe the Federal Reserve will raise interest rates three times next year.  Not only  do markets only expect  just two  hikes in 2018, but also anticipate Fed funds will peak at 2%, despite the Fed projecting a terminal rate of 2.75%.  I project the Fed will again miss its target: but this time will  hike rates 4 times in 2018!  At some point, US equities will need to adjust to this reality.  When?  Chart 8 illustrates the relationship between the US yield curve and the Russell 2000.  Typically, the stock market rally only stalls after the yield curve has been flat for awhile, and recession risks increase.  I believe the inflection point will come when the real Fed funds rate becomes positive , e.g. the second half of 2018, and coincide with political risks associated with the mid-term Congressional elections.   A Tale of two Halves: Rally fades in H2 2018!

Theme 3: Focus On Beneficiaries of Tax Reform

The table above highlights the beneficiaries of tax reform by sector.  Overweight small caps, financials,  capital goods, and cyclicals.  Business investment has been a weak area in this recovery in both the USA and world-wide.  Low interest rates, strong demand, and solid profitability should produce solid capex spending world-wide in 2018.

Theme 4: Stocks Outperform Bonds Again

Stocks are expensive on all measures except compared to bonds. As the equity risk premium remains above historical averages, stocks can rise even if bond yields rise towards 2.75% as expected. Once 10-year yields  approaches 3%, all bets are off!

Theme 5: Europe to be World’s Top Performer in 2018

After years of underperorming the US market, the stars are aligned for Europe to take centre stage.  Chart 1 illustrates that European GDP growth outpaces that in the rest of the G7. In addition, Chart 2 illustrates that inflation will remain below the ECB’s 2% target.  Likewise, unlike in the US where interest rates will rise more than expected, ECB policy will remain on hold throughout 2018.

Furthermore, Europe’s economic and profit cycle is a few years behind the USA.  Whereas American profit margins and corporate earnings already exceed the peak level of the last cycle, Chart 10 illustrates European earnings remain well below peak levels.  Consequently, there is much more EPS ammunition fueling Europe’s continued rally.

To be sure, reflecting lower returns on equity, European markets always trade at a discount to US counterparts.  However,  the discount is larger than normal, which seems inappropriate given Europe’s improving economic performance.  European equity returns of 10% are expected.

Theme 6: Brexit Will be Less in Focus — But UK to Underperform EU

After much (well deserved) criticism, Prime Minister Teresa May has successful navigated the United Kingdom into the second stage of talks about its future relationship with the European Union.  While many of the most thorny issues were “fudged” as usual (Northern Ireland in particular), Ms May should be commended for successfully juggling the warring members of her own Cabinet, especially gaining acceptance of a whopping divorce settlement.

Future negotiations  will become more technical, and there will be ups and dows.  Markets will focus more on fundamentals: the UK economy will underperform the EU, as will the FTSE. Chart 11, however, illustrates that sterling remains very cheap.  Downside risks have been reduced , as the likelihood of a “no deal” outcome in EU negotiations has diminished to nearly zero.

Theme 7: Asia — Coping with the Fed, Trump, and China

After this year’s huge outperformance, Asian (and emerging markets generally) markets will confront headwinds from the Fed, potential Trump trade protectionism, and China. Nevertheless, Asian and EM markets should outperform again next year, but by far less than in 2017.  As in Europe,  the EM earnings earnings cycle lags behind the USA, and EPS has more room to run.  I expect double-digit EPS gains in this sector.

Asian markets, however, never perform well when US interest rates rise and the USD appreciates: both of which are expected.  However, Chart 12 illustrates that Asian markets should have more ability to absorb these shocks this time around. US rates could rise up to 100bp beore I get too worried!

Also, Asian equities trade at a larger discount to global markets than normal.  With 13% EPS growth anticipated, Asian markets should post double-digit returns.

Asian growth has relied heavily on strong exports, reflecting accelerating global GDP growth. Asia would be vulnerable if President Trump’s protectionist rhetoric turns into policy: as American export penetration into Asian markets remains subpar.  Strenghening Asian domestic spending  will help support the Asian economy and market rally, despite Trump’s agenda. US flexibility is limited by its need to reassure its Asian partners and to gain Chinese assistance on the North Korea issue.

Concerns about Chinese debt burden receeded in 2017.  However, the debt bomb continues to  expand unimpeded, which will reduce China’s long term growth potential. Timing the sentiment shift is difficult, but high frequency data on international reserves will give clues.  After collapsing, reserves rose in 2017, but will capital flight resume?

Theme 7:  Emering Market Debt: Selected Opportunities

With real rates low in developed markets, EM debt will remain attractive, at least during H1 2018.  Fundamentals differ significantly: so be selective.  Good opportunities exist in Brazil, Mexico, Russia, and Indonesia.  Continue to avoid Turkey!

Theme 9: Political Risks — Lots, But Not too Worried (Famous Last Words)!

As usual numerous political risks exist: US mid-term elections, potential Middle East conflict, North Korea, and elections in Italy, Brazil, and Mexico. I do not expect these uncertainties to upset markets too much.  Of course, North Korea is the most dangerous.  To be sure, good options do not exist. However, while miscalculations are possible, numerous political channels remain to be explored.  I expect this issue will play out over a longer time horizon.  Normally, I would be very concerned about the prospect of a Middle East conflict in 2018.  However, the ability of American shale producers to offset potential Opec supply disruptions limits the risk to the global economy.

US Congressional elections could upset markets. If Democrats gain control of the Senate (close call, but I do not expect this outcome), the Trump Adinistration would lose any momentum gained from the tax reform victory.  Adminstration policy could become even more unpredictable: pursuing a more populist/protectionist agenda.  On the other hand, if Republicans increase their majority, President Trump will likely take another shot at repealling the ACA. Much to play for!

Likewise, the Mexican election will have important implications for local markets and NAFTA negotiations.