January 29, 2018
January is the month of Janus, the two-faced Roman god, and it’s a good time to look both ways: how was 2017 and what can be expected/hoped/feared in 2018 ?
2017 was definitely a grand cru year for equity investing: nearly all stock markets delivered double digit returns, in local currency terms that is of course. In Euro terms, it was a little harder since the relative political tranquillity meant that the common currency was never really under pressure during the past year and thus it strengthened versus nearly all major currencies.
Fears of populist victories in countries like the Netherlands didn’t come true, and in the countries where they did progress and had an impact on government building (Germany, Austria), the market didn’t seem to care that much. The big change on the European political level turned out to be the newcomer: Emmanuel Macron not only realised a complete reshuffle of the political landscape in France, but looks set to become a major force at the European level too. He might even succeed in implementing some real economic reforms in his country, where they were more than overdue.
One country that still struggles with both politics and (lack of) real reforms seems to be Italy. Nothing catastrophic in 2017, but most observers feel that in the longer run we might encounter difficulties. Not so much the rise of the Cinque Stelle movement or even the return of phoenix Silvio Berlusconi in the upcoming elections cause undue worry, but much more so the loss of productivity compared to the rest of the Eurozone: over the last decade Italy has built a gap of over 30% versus the likes of Spain, France or Germany. Quite unsustainable in the long run, especially when combined with the largest public debt within the Union at >130% of GDP (only preceded by Greece, who is “hors categorie” in this field of course).
That brings us to an area where making profits in 2017 was slightly harder than in equities: bonds.
Even if consensus had it that rates in the Eurozone will remain « lower for longer », no one will deny that the risks for rates are now on the upside. A change in ECB leadership in 2019, inflation gradually shifting higher, unemployment substantially lower and economic growth rates reaching potential: all of these factors will eventually lead to a shift in central bank policy. Whether it will be a further gradual lowering of the monthly amounts used to buy bonds, or indeed a first minor hike in short-term rates, that remains to be seen. Either way it will mean the end of Quantative Easing as we know it and might temporarily shock markets, as did the “tapering” comments in the US a couple of years ago.
But so far, so good: despite rates having a rising tendency, even euro area government bonds turned in a modest positive total return over the calendar year 2017. It is not certain that this will be the case in 2018…
In the US there seems to be a large consensus around a continued gradual rise in short-term rates (2, 3 or 4 hikes for 2018 ?), but the effects on long-term rates remain uncertain. Over the full year, that was not sufficient to unnerve markets or result in negative 2017 returns. Only very recently did markets seem to get a bit nervous around the 2.60% mark. Somewhat amazing, since a scenario with 3 or 4 hikes on the short end for the next 12 months will inevitably see long rates go well above 2.50%.
Unless the market prices in an inversed yield curve? That might give more reason for concern, since it has historically often announced the beginning of a recession. And frankly, after having witnessed a bull market soon headed into its 10th year (remember the post-global financial crisis trough was in March 2009), one shouldn’t be surprised to see some signs of fatigue or even fear popping up.
Which brings us to the 2018 part of the two-faced look on markets. There seems to be a large consensus that equities are still the place to be for decent returns in the new year. Expectations are high for European markets, that might be entitled to a catch-up with US markets since they did lose some 3 years in the post-financial crisis rebound process due to the Eurozone worries in 2011-2013.
Emerging markets are clear favourites as well. Even if the market at times seems nervous about rising US rates, these countries today look a lot better equipped to withstand the traditional downturn we saw when they had mainly debts in USD, rather than today’s sometimes enviable FX reserves.
And even Japan is on the radar for quite some observers as an attractive destination for international equity investors. Not only does the Yen really look like it should go up from here, but on top of that Abenomics are now supported by a shift in corporate governance that should benefit shareholders.
The US has fewer fans today: it’s true the markets have had quite an impressive run with new all-time highs nearly every week, which creates some fear of heights. And despite the expected (and sometimes feared) rise in interest rates just about everybody warns on USD weakness in 2018. A factor that might be detrimental for returns for non-USD based investors, especially with FX hedging becoming more expensive with the rising interest rate differential.
Maybe this should be pointed out as the major risk for 2018: consensus seems so big on a large number of assets and markets that the danger might be hidden there. What happens to all those crowded trades if all of a sudden market sentiment turns around? Maybe due to the inevitable moments of surprise and nervousness around themes like Brexit discussions, North Korea aggression, or the unknown unknowns we might encounter in 2018. Until then, the phrase that in our view best describes the attitude of most market participants is probably “rational exuberance”…
