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What’s ahead for the markets in 2018?

Synchronised global growth, rising corporate profits and a surprisingly smooth path to US tax reform boosted stock markets around the world in 2017. Although potentially disruptive geopolitical events such as stalled Brexit negotiations, North Korean missile launches and quirky US government leadership often captured news headlines, the overall economic backdrop continued to shine brightly throughout the year. Risk assets responded favourably to what the International Monetary Fund recently declared the most broad-based global acceleration since the start of the decade.

In 2017, the S&P 500 advanced by 19.4 per cent, making it the most lucrative year since 2013. In fact, for the first time ever the S&P delivered a positive return for every single month of the year.

Last year's surging markets added to a long string of annual gains which began on March 9, 2009. Since then, the S&P 500 has climbed by over 295 per cent while the MSCI World Stock index has increased in value by about 205 per cent.

Notably, the rising tide of asset prices was accompanied by record low volatility. Policy-induced excess liquidity though central bank programmes, such as quantitative easing, permeated financial markets and diminished market volatility as return-seeking investors bought every dip.

The CBOE Volatility Index, or Vix for short, hit numerous new all-time lows over the course of 2017 just as the major stock market averages regularly touched new highs. Pervasive low volatility suggests a high degree of investor complacency.

While equity markets cheered the global reflation scenario, fixed-income investors had a bit less to celebrate. In 2017, the US Federal Reserve hiked short term interest rates three times, as was widely expected, but the rate bumps had more of an impact on short to intermediate duration assets rather than longer-term securities' prices which held relatively firm. The Barclays Aggregate Bond Index returned about 3.4 per cent for the year, mainly reflecting interest earned and tighter credit spreads.

Since the beginning of the year, the three-month London Interbank Offered Rate (Libor) increased by 70 basis points to 1.69 per cent at year-end, while the ten-year Treasury yield persistently traded within the 2 per cent to 2.6 per cent range. As a result, the US yield curve became much flatter and the spread between the two-year and ten-year notes dropped to 52 bps, from 125 bps in January.

US government bonds yields remained pinned down by lower rates in other developed countries. Long-term US dollar bonds are relatively attractive to global fixed-income investors, comparing Treasury yields to Germany's ten-year bonds and Japan's ten-year bonds offering yields of only 42 bps and 4 bps, respectively.

Meanwhile, on the credit side corporate bond spreads ground tighter throughout the year as views on economic growth became increasingly optimistic and investors were willing to assume increasingly more company-specific risk for a lower return.

Looking forward into 2018, the Fed has maintained their forecast for three more rate hikes while the median forecast for the Federal Funds rate at year-end is 2.1 per cent. Major banks on Wall Street estimate that the ten-year Treasury yield will be trading within the 2.5 per cent to 3 per cent range next year.

Our forecast for further Fed rate hikes, rising Libor rates and a persistently flat yield curve lead us to be somewhat cautious overall on bonds at this point in the cycle, we currently favour shorter-duration securities, such as floating rate notes and carefully-selected asset-backed securities.

At the same time, we continue to consider certain corporate notes and hybrids expected to show improving fundamentals. Longer-duration hybrids combined with short-duration Libor floaters complete our ideal ‘barbell' approach' to structuring fixed-income portfolios.

In equities, America has seen some of the best relative performance among global markets for several years in a row — a good thing for our strategy. But since early last year we have been modestly reducing exposure to the richly valued US market, presently glowing in the spotlight of tax reform, and moving towards other overlooked regions.

Within the US, some rebalancing is also necessary. Regulatory relief and tax reform does give the US market a unique and powerful tailwind, but here we look to maintain and increase exposure to small and mid-cap securities which are currently paying higher taxes than the large cap multinationals already benefiting from lower marginal corporate tax brackets outside the US.

As the US continues to push through an extended mid-cycle period, other developed and emerging markets have begun to look even more intriguing by comparison. Japan, for example, appears to finally be turning the corner after many years of stagnation. Prime Minister Shinzo Abe has ushered in a new era of shareholder-friendly government policies. These ‘Abenomics' initiatives reward companies for transforming themselves into entities more focused on generating profits, rather than simply hording cash as they had been for decades.

Japan has recently experienced some of the best growth rates among the developed economies and yet trades significantly cheaper than both Europe and the US on a forward price-earnings ratio basis.

We also continue to like many emerging markets which have begun to stabilise after a tumultuous 2016. EM markets dramatically underperformed developed markets over the past decade, notwithstanding last year's encouraging gains; but we believe their recent outperformance may be the beginning of a new cycle.

In the EM space, we are particularly impressed by the growth potential of several emerging technology and e-commerce stalwarts in China, Taiwan and South Korea.

In addition to increasing international weightings, we have also been modestly tilting from ‘growth' to ‘value' stocks.

In late November, I predicted a value rotation after seeing growth stocks had outperformed value by a whopping 17 per cent since the beginning of the year (“Cheap stocks in an expensive market”, The Royal Gazette, November 22, 2017).

So far, the timing looks pretty good as value stocks have outperformed growth by more than 200 basis points since then, but I believe the trend could continue well into next year.

Within the value category, I especially like the financial sector where several constructive trends are unfolding. Higher interest rates, less regulation and lower taxes should continue to play into the hands of bank shares where valuations are still fairly reasonable compared to historic levels. I also anticipate greater merger-and-acquisition activity through the end of this decade.

Despite the lengthy run in global equities markets, further gains are possible as we expect economic momentum to continue into the New Year. However, we also see the likelihood of greater volatility as both the US Federal Reserve and the European Central Bank begin to withdraw stimulus. We therefore modestly curb our enthusiasm and emphasise selectivity across all asset classes.

Having some funds parked in shorter-duration (lower risk) assets should help investors to take advantage of potentially bigger price swings and the ongoing rotation among sectors.

Best wishes to you and yours for a happy, healthy and prosperous new year!

Bryan Dooley, CFA is the Senior Portfolio Manager and General Manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

On the up: this chart illustrates the S&P 500 Index's steady rise throughout 2017

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Published January 03, 2018 at 8:00 am (Updated January 02, 2018 at 5:56 pm)

What’s ahead for the markets in 2018?

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