The 4th Quarter of 2017 was another quarter of growth for the markets once again coupled with extremely low volatility. 2017 was a year that saw the Dow continue to record 87 new record closing highs since the election in November of 2016. The world economy has reached an unusual state of stability. Just about every country is seeing positive growth, but no country is seeing that growth booming out of control. Inflation has been firmly in "goldilocks" territory, meaning not "too hot" and not "too cold". The past year turned out to be more bullish than we anticipated, and the magnitude of asset returns surprised many. Many firms predicted a year ago a "sideways market". For instance, Vanguard had a "modest outlook" for the US and "positive but muted" and "guarded" globally. Both Goldman Sachs and Credit Suisse estimated in January 2017 the S&P would close out 2017 at 2300 (essentially flat as it started the year at 2275). The S&P closed the year at 2673.
Many of the events that people worried about in early 2017 - including the election of a far-right government in France and aggressive U.S. trade policy - didn't materialize. The MSCI ACWI closed at a record high 61 times, and 30-day realized volatility of the S&P 500 Index hit its lowest level since the early 1960s. Other surprises: Inflation fell and long-term bond yields were flat even as the economy improved, while cryptocurrencies posted huge returns.
Looking forward to 2018, here are some thoughts from Russell Investments that we agree with which highlights things to consider and look for to play out in the coming year (the full outlook from Russell Investments is accessible by clicking here):
The belief is that global growth momentum is likely to persist into 2018, pushing up equity markets over the first part of the year. Japan, Europe and emerging markets are likely to outperform the U.S. Similarly, the euro, Japanese yen, British pound and emerging market currencies may offer investors more potential upside in 2018 than the U.S. dollar.
The strategists also believe that the timing of the next U.S. recession will be a critical issue for the global economy in 2018 as this almost always results in an equity bear market.
The U.S. still dominates global markets and is further advanced in its cycle than other economies, which means that most scenarios for 2018 are likely to be driven by the U.S. By next April, this will be the second-oldest U.S. economic expansion on record. The Business Cycle Index (BCI) model puts the probability of a U.S. recession in the next 12 months at around 25%, a high, but not alarming, percentage given the age of the expansion. This probability, however, could easily rise through the year, if, as we expect, the Fed tightens another three times in 2018.
Further out, they see the risk of a recession in 2019 if additional policy tightening by the Fed causes the yield curve to become inverted. They believe the 10-year U.S. Treasury yield could rise towards its fair value before declining in the latter half of 2018 as recession fears grow.
In contrast to the U.S., the Eurozone is amid a mid-cycle renaissance and at the early stage of its exit from a very loose monetary policy, which the strategists believe may keep core Eurozone bond rates range bound through 2018. They also expect another strong year for the Asia Pacific region, buoyed by an accommodative policy at the Bank of Japan, although re-emergent wage and price inflation may cause the Reserve Bank of Australia to raise rates twice in 2018.
Key global market outlook highlights include:
U.S. equities could push higher before facing headwinds later in 2018
Three U.S. Federal Reserve rate hikes expected
Recession fears likely to rise as U.S. yield curve continues to flatten
Europe, Japan and emerging markets expected to outperform U.S.
In addition, credit and equity markets tend to price in recessions around 6-12 months ahead of time. Given all this uncertainty, we believe it's best to look at various scenarios for 2018, rather than focus on one story. We think there are three plausible scenarios, with the central scenario the most likely:
Equity markets face increasing headwinds later in the year. Japan, Europe and emerging markets (EM) outperform the U.S. in what could be a relatively flat year for global equities.
Growth and earnings are stronger in Europe, Japan and emerging markets.
The U.S. 10-year Treasury yield approaches its fair value of 2.7% before declining as recession odds grow. The yield curve flattens and potentially inverts by year-end.
Upside scenario: blow-out rally
Fed is dovish and tightens by less than expected. Growth is ok and inflation doesn't rise much.
USD is weak. Emerging markets do very well.
Euphoria takes hold and investors leverage into the market.
Downside scenario: Fed mistake triggers a 2018 recession
Fed overtightens into a sluggish economy.
R-star (the real rate consistent with full employment/neutral real rate) turns out to be much lower than expected.
Markets hit turbulence in early 2018.
Euphoria: Still to come?
There's an old saying that bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria. The phase we have yet to encounter this time is euphoria. This is when we would see the blow-out rally scenario.
, from our investment decision-making process of cycle, value and sentiment, provides the main guide to this scenario. It currently seems complacent and overbought, but not euphoric. One of the best indicators is that margin debt has yet to take off. According to the New York Stock Exchange (NYSE), margin debt grew by just 15% in the year through October 2017. Looking through this NYSE data, it often grows by more than 40% in the year before a major market peak, as overconfident investors borrow to gain market exposure.
Could a Fed mistake bring markets down?
Bull markets don't have to end in euphoria. As another market saying holds, they can be killed by the Fed. One of the key recession-risk issues is working out when Fed policy becomes restrictive. It's entirely plausible that a couple more Fed funds rate hikes could turn policy restrictive.
We will be monitoring the yield curve closely. This is one of the key inputs into the BCI model. The yield curve has inverted before every recession over the last 50 years. The spread between yields on 10-year and 2-year Treasuries has narrowed from 140 basis points, when the Fed started tightening at the end of 2015, to 60 basis points in late November.
Our 2018 annual outlook overview is very U.S.-centric. It's worth asking whether there are any global factors that could trigger a global bear market. The main candidate for a non-U.S. shock is China. We're not expecting a China-sparked crisis, but high debt levels are a risk and outgoing People's Bank of China governor Zhou Xiaochuan recently warned about the risk of a "Minsky moment"
(a Minsky Moment refers to a sudden collapse of asset prices after a long period of growth, sparked by debt or currency pressures. The theory is named after economist Hyman Minsky)
The recent Communist Party National Congress entrenched the power of President Xi Jinping, giving him the authority to pursue his reform agenda in his second five-year term. Near the top of his list is deflating the debt bubble. Chinese central bankers have many more levers than their counterparts in developed markets, so the likelihood is they will be able to engineer a gradual deleveraging. But tightening credit in a high debt economy is a fraught exercise. China's monthly money and credit growth statistics will bear close watching for signs of a sharper-than-expected slowdown.
In sum, we're not especially bullish or bearish about the year ahead. 2017 delivered better returns than most industry analysts expected, but the cycle is old and the U.S. Federal Reserve (Fed) is about to step up the pace of rate hikes. Our 2018 outlook view in one sentence? Equity markets may push higher over the first part of the year, before facing headwinds later in 2018, as markets factor in rising risks of a 2019 recession.
The views in this 2018 Global Market Outlook are subject to change at any time based upon market or other conditions and are current as of the date on the cover. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
Keep in mind that, like all investing, multi-asset investing does not assure a profit or protect against loss.