It’s easy to forget that a year ago, the market was climbing a wall of worry with high expectations of a market correction following the strong rally into the end of 2016. The most prevalent media comment at the time was that the market was “fully priced”. Even before he was inaugurated, there were calls to impeach President-elect Trump and serious doubts were raised about his ability to pass his pro-growth legislative agenda through Congress. Europe was facing difficult elections in France, Germany and the Netherlands amid fears that populist parties may be successful and follow the lead of the UK and choose to exit the EU. The ever-present geo-political risks from North Korea, Iran, Syria and ISIS provided additional background noise. It’s an old adage that 9 out of 10 disasters don’t happen and in retrospect none of the concerns from a year ago had any lasting impact.
State of Play in 2018
As we move into the New Year there is a renewed sense of optimism about the health of the global economy. For the first time since the GFC, we have the prospect of a synchronized strengthening of the world’s major economies with the US the most advanced in its recovery. This is providing a very solid backdrop for corporate profits, the most important driver of share prices. Almost universally, inflation remains well contained largely due to subdued wages growth despite strong employment gains. While much attention is focused on the gradual tightening of monetary conditions in the US, the rest of the world remains awash with liquidity, a potent driver of financial asset prices since the GFC. The ECB has flagged a gradual reduction in its QE program but is a long way off increasing interest rates, while Japan’s massive QE program continues at full strength given very low bond rates and the absence of inflation risk.
A good way to think of this is that the liquidity tailwinds that have pushed equity markets along in recent years are still there, but have abated somewhat. In the US, there is additional economic stimulus from the sweeping tax cuts passed late in 2017, which will boost US GDP growth by up to 0.5%. Add to this, proposals for a major upgrade of infrastructure and large reductions in regulatory red tape are likely to further stimulate the US economy. The risk to the outlook is that if inflationary pressures start to emerge, the Fed will be forced to tap a bit harder on the monetary brakes, which will no doubt unsettle markets. Remember, bull markets don’t die of old age but eventually get killed off when Central Banks sharply increase rates to stay ahead of the inflation curve.
A bias towards growth assets such International and Australian shares paid off handsomely in 2017 as risk assets delivered a healthy premium over defensive alternatives such as government bonds, term deposits and cash. While we do not expect the same absolute performance from shares this year, we still believe their return prospects are better than for defensive assets.
Amongst share market alternatives, our preference is for international shares over Australia given a superior economic and profit growth outlook. Amongst the developed offshore markets, we have a preference for Europe on valuation grounds. Just as the monetary tailwinds for shares are moderating, the headwinds for government bonds are gradually strengthening which will further dampen bond returns in 2018. A fly in the ointment for unhedged international equities is the stubborn resilience of the $A which has entered 2018 with an unexpected head of steam. While much of this relates to a weaker $US, there’s no doubt stronger iron ore and coal prices are playing their part in supporting the local unit. Over the course of the year, as US cash rates move higher than in Australia, capital flows are likely to put downward pressure on the $A.