Paul O’Connor, Head of Janus Henderson’s UK-based Multi-Asset Team, reviews 2017 and discusses prospects for asset classes and regions in 2018.
What did we learn in 2017?
2017 was a remarkable year in financial markets. Despite adverse political developments in some parts of the world and the looming end of the ‘great monetary easing’, it was one of the most tranquil years historically, with equity volatility touching 50-year lows and bond market volatility hitting 30-year lows.
On the economic front, one significant feature was the positive global growth surprises – a welcome development after six years of downgrades and growth disappointments. It was notable that improving macro momentum had unusually little impact on inflation expectations, interest rate expectations and bond yields. While political developments were a distraction for investors on many occasions, they were never big enough to overwhelm these positive macro trends. 2017 reminded us that, for most of the time at least, economic fundamentals trump politics in financial markets.
Recovery: saucer-shaped, not V-shaped
We see good reason to expect positive economic momentum to continue well into 2018. The global expansion is geographically broader than at any time since 2007 and is also now broadening across sectors, with capital spending turning up after years of decline. Of course, the overhang of debt in many economies still overshadows the long-term outlook and partly explains why the recovery has been more saucer-shaped than V-shaped in recent years. It also highlights the vulnerability of the global economy to adverse shocks. Still, in the absence of any major surprises, it is quite plausible that the moderate pace of this recovery will give it an unusual longevity, compared to the faster upswings of previous cycles. That is our central case scenario.
Chart 1: Consensus world GDP growth and inflation
Source: Janus Henderson Investors, Bloomberg, as at December 2017. Notes: Red bars and dotted line represent current median consensus forecasts (which combine forecasts from different analysts). Real GDP = gross domestic product adjusted for inflation. Inflation is year-on-year % change.
Shocks aside, a more orthodox threat to the longevity of the recovery, would be a sustained upswing in inflation expectations, reviving prospects of ‘old-school’ boom, bust and recession scenarios. Given that inflation has consistently undershot expectations throughout the post-crisis recovery, this might seem a remote possibility. However, underlying inflation is creeping higher globally. Core inflation increased in 72% of developed economies during the past year – the highest percentage since 2011. At this stage, we expect the recovery in wages and prices to remain gradual, but note that any big rethink on this front could well have a significant impact on our view on the market outlook.
From US$2 trillion to zero
Market sensitivities to the inflation outlook are of course linked to the outlook for monetary policy and the speed at which normalisation proceeds. It is encouraging that markets have reacted so calmly to interest rate hikes and the ending of quantitative easing (QE; asset purchases) in the US, so far.
Still, the challenges ahead are formidable. The major central banks purchased more than US$2 trillion of assets in 2017 and that flow will gradually come to a halt by the middle of 2018. Given the unprecedented nature of these changes, it is difficult to be confident about how markets will adjust to the withdrawal of such a huge monetary stimulus. At the very least, we would expect some upward pressure on bond yields and market volatility. We take comfort from the fact that central banks will proceed very cautiously and policy will still remain very accommodative, but must recognise that they are heading into unknown territory: the risks of policy error are harder than usual to evaluate.
What is priced into markets?
On balance, our core macro view for 2018 is a constructive one, featuring a synchronised global recovery, a modest pick-up in inflation, and a gradual normalisation of monetary policy. Still, with few assets looking particularly attractive from a valuation perspective, we have to question the extent to which many of the positive features of our view are already priced into financial markets. Our enthusiasm is also tempered by the fact that bull markets in many assets are already very long by historical standards. In US equities, for example, the current bull market is now the second biggest and the second longest since the 1920s.
Our base case scenario offers little optimism for government bonds, with both the continued economic expansion and the unwinding of central bank monetary accommodation pointing to higher bond yields. The dynamics of interest rate and inflation expectations will determine the speed and scope of that move. For investors, the outlook seems asymmetric, with the most bond-friendly outcomes offering the prospect of modest returns and plausible alternative scenarios pointing towards more sizeable losses. In a recent study of seven centuries of interest rates, a Bank of England blog concluded that the evidence of eight previous periods of “’real rate depression’ is that turnarounds from such environments, when they occur, have typically been both quick and sizeable”. We remain wary and own government bonds primarily as a hedging asset rather than as a likely source of expected returns.
Corporate bonds have been a rewarding asset class to own during the era of QE, delivering solid returns with little volatility. While they have served us well in our multi-asset portfolios throughout this period, we have been reducing weightings into the rally in the latter months of 2017 against the backdrop of lower yields, lower credit spreads, and deteriorating quality of bond issuance. We would still expect positive returns from corporate bonds, if the economy evolves as we anticipate, but feel that the risk-return characteristics of the asset class have deteriorated and we would be inclined to reduce weightings into any further strength.
Sticking with stocks – but not ‘all in’
Once again, we enter the year with equities our preferred asset class. While the ending of QE will be a challenge for all financial markets, equities at least offer solid earnings growth as an offset. Relative valuations remain attractive, compared to cash, government bonds, and corporate debt. However, given the maturity of the bull market, absolute valuations that are far from cheap, and emerging evidence of investor complacency, we do not think that this is the time to be ‘all-in’. Looking ahead we expect lower returns and higher volatility compared to 2017, a year with barely a market drawdown. We think it is sensible that we start the year keeping some firepower in reserve, so that we have some cash to put to work if any dips do materialise.
Regionally, we still prefer the eurozone to the US for its medium-term catch-up potential and for valuation reasons. We like Japan because it offers exposure to a set of characteristics that are scarce in other markets, such as corporate reform, political stability, and accommodative monetary policy. We also like these markets because they are more cyclical than many other developed markets, so typically perform well when global growth is improving and bond yields are rising. We tactically reduced our overweight in emerging market equites in the latter half of 2017, to lock in some strong performance and to reflect our shorter-term concerns about macroeconomic momentum in China.
In equities, getting the style exposure (such as value or growth) right has been at least as important as getting the country positions right in recent years. While the outperformance of growth over value in the post-crisis environment was largely supported by fundamentals, 2017 saw a valuation shift that, to us, leaves value stocks looking relatively more attractive as we enter 2018. Continued growth, higher inflation, and higher bond yields, may help resuscitate investor confidence in value stocks, after a pretty difficult year for the style.
Chart 2: Global value has underperformed growth as bond yields fell
Source: Datastream, Janus Henderson Investors as at December 2017. Notes: MSCI World Value and MSCI World Growth indices are total return indices and rebased as at the end of 2009. Bond yield is the JP Morgan Global Government Bond Index redemption yield.
Asymmetric risk = the risk an investor faces when the gain made from the move of an underlying asset in one direction is significantly different from the loss incurred from its move in the opposite direction.
Boom and bust = a boom and bust cycle is a process of economic expansion and contraction that occurs repeatedly.
Bond yields: these move inversely to bond prices. Upward pressure on yields would therefore mean downward pressures on prices.
Bull market = a financial market in which the prices of securities are rising, especially over a long time. The opposite of a bear market.
Credit spread = the difference in the yield of corporate bonds over equivalent government bonds.
Gross domestic product (GDP) = the value of all finished goods and services produced by a country, within a specific time period (usually quarterly or annually). It is usually expressed as a percentage comparison to a previous time period, and is a broad measure of a country’s overall economic activity
Growth investing = growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
Inflation = the rate at which the prices of goods and services are rising in an economy. The Consumer Prices Index (CPI) and Retail Price Index (RPI) are two common measures. ‘Core inflation’ eliminates products – usually those in the energy and food sectors – that can have temporary price shocks.
Recoveries: a saucer-shaped recovery is a type of economic recession and recovery that resembles a shallow ‘U’ shape when charted (economic measures that may be charted include employment, GDP and industrial output). By contrast, a V-shaped recovery chart has steeper sides.
The great monetary easing = the period in recent financial history characterised by central banks purchasing assets on the open market in order to lower interest rates and increase the money supply.
Value investing = a type of style investing. Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase.
Volatility = the rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility.
These are the manager’s views at the time of writing on 5 December 2017 and should not be construed as investment advice. The opinions expressed do not necessarily reflect the views of others at Janus Henderson.