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Economic and market outlook for 2018

February 23, 2018


John Carran

Written by John Carran

Senior Economist at Kiwi Wealth
John's responsibilities include monitoring economies and markets to identify both investment opportunities and risks across asset classes, regions, sectors and industries.


2017 was a great year for global share returns, with the MSCI All Countries Index gaining 24.6% in US dollar terms. Not only were share returns fantastic, but they came with very muted day-to-day or week-to-week swings.

global-shares-2017.png

Source: Factset

Over the past year, market momentum has been driven by a positive combination of globally synchronised economic growth, subdued inflation, accommodative central banks, and anticipation of tax cuts in the US.

global-manufacturing-activity.png

Source: Factset

Interest rates barely changed throughout 2017, but exhibited a fair amount of variability during the year in response to various geopolitical tensions and US political developments. This look at 2018 discusses where we see markets heading over the coming year and beyond, the possible outcomes for investment returns, and the key risks to our outlook.

Outlook

Global economy

The harmful effects of the global financial crisis are fading well into the background and positive sentiment is taking hold. Jobs are growing and unemployment is falling. Banks are likely to be less restrictive with their lending with households taking advantage to increase their spending. Decent profit expansion is likely to give businesses more scope to raise their investment, which will provide further impetus to growth.

unemployment-rate.png

 

cpi-inflation-forecasts.png

Sources: Factset and Bloomberg

Inflation

Wage and price inflation is likely to edge up globally this year. Lower unemployment in the US is likely to mean higher inflation, more so in that country than most. Upward momentum in commodity prices is likely to continue as global demand rises, which will be another positive factor for overall inflation. Offsetting these positive influences on inflation to a certain extent will be continuing spare capacity in large economies outside the US and downward price pressures from technology changes and ageing populations. For these reasons, a lift in global inflation is likely to be relatively gradual.

Global interest rates

With improving economic growth and creeping inflation, central banks will likely continue to cautiously reduce stimulus. We expect the US Federal Reserve (Fed) will hike its Funds Rate up to four times to around 2.5%. The European Central Bank (ECB) and Bank of Japan (BoJ) may signal slow reversals of their bond buying (money printing) at some stage this year, although interest rate hikes for these two major central banks may not be until early 2019.

Wholesale longer-term interest rates will also likely tick up this year. We expect the interest rate on a US 10-year government bond to rise to around 3.5% by the end of the year, which is a 100-basis point increase from the rate at the end of 2017. This is due to a combination of improving economic growth and gradually rising inflation. Although we expect global interest rates to rise over the year, they are increasing off a low base and will likely remain low compared to historical averages.

New Zealand interest rates

In New Zealand, movements in interest rates on longer-maturity bonds will likely follow the direction of those overseas, as has generally happened in the past. However, interest rates on shorter-maturities (five years and less) may stay more anchored. Although we expect the New Zealand economy to perform reasonably well as global commodity prices strengthen and local construction activity provides impetus, some recent contributors to growth and inflation are starting to abate – house prices are softening and immigration is easing off. In addition, the New Zealand dollar is likely to remain relatively stable. Therefore, there won’t be an imperative for the Reserve Bank to raise its Official Cash Rate (OCR), with perhaps one hike towards the end of the year.

Currencies

The weakening of the US dollar against other major currencies last year was a surprise to many given the strengthening in the US economy, Fed interest rate hikes, and anticipation of US tax cuts. We consider that the US dollar could further weaken against most major currencies this year as traders look beyond current conditions to future less accommodative central bank policies in Europe and Japan.

With the possibility of higher commodity prices, including for dairy, the New Zealand dollar should find reasonable support, especially against the US dollar and against the currency of our largest trading partner, the Chinese yuan. The Kiwi dollar may not be as solid against the euro and the yen, however, as economic conditions in the Eurozone and Japan improve relative to New Zealand and demand for investments in those countries rise. On average across most major currencies, the New Zealand dollar could stay relatively stable in 2018.

More subdued share returns

Despite the somewhat rosy outlook for the global economy this year, returns from shares will probably not be as hearty as last year. An increase in valuations was a dominant driver of share gains in 2017. However, with valuations above long-term averages there is less likelihood they will continue to be the main influence on returns over coming years. Instead, further share price rises will probably rely on earnings growth.

s&p500-pricetoearnings-ratio.png

Source: Bloomberg

There are likely to be positive and negative influences on earnings this year. On the positive side, the improving global economy should lead to higher company revenues, which will help to boost earnings. Conversely, earnings will face headwinds from rising wage and borrowing costs. This will be more of an issue for the US, where the economic cycle is more advanced than other large developed countries. In Europe and in Japan, higher unemployment and greater spare production capacity will likely mean less pressure on the cost side of businesses.

Overall, our central expectation is for a moderate earnings lift, which could support similarly moderate total share returns for the year, perhaps in the 5-10% range. However, with share valuations at heightened levels, prices will be sensitive to bad news. Returns this year could be subject to more swings and roundabouts than the almost serene path last year. We discuss some of the risks that could potentially cause market disruptions in the Risks section below.

Difficult times for bonds ahead

Bond markets are likely to face more challenging conditions in 2018 than previous years. The extraordinary monetary stimulus flooding the world’s financial system is likely to be gradually removed this year. This should help push global interest rates gradually higher, therefore bringing bond prices lower. Those bonds that have very long maturities would go down most of all. While we consider there is a clear glide path in the US towards higher short-term interest rates, in New Zealand we expect perhaps one hike to the Official Cash Rate (OCR) by the end of 2018.

Narrow credit spreads (the extra yield a company investor receives over government bonds) are another challenge for fixed interest investments. These have little room to go down further, which will make it more difficult to add value from buying company bonds heading into 2018.

Nevertheless, conservatively managed fixed interest investments are likely to provide relatively stable income and experience fewer ups and downs than riskier investment, such as shares.

What should we be wary of?

Although our central scenario for the global economy and financial markets is relatively benign, there are plenty of risks to be wary of.

Higher inflation

In our view, higher inflation than currently expected is the most significant risk to continued share market gains this year. Inflation remains moderate for now, but there is little doubt that pressures are building, particularly in the US where the economy has been expanding for several years and the unemployment rate is approaching an historical low. It is possible that labour market pressures become acute, causing a spike in wages flowing on to broader price increases. This could hasten rises in borrowing costs and potentially herald an earlier end to economic expansion than currently expected. Company earnings and share prices would consequently face stronger headwinds.

China slowdown

There remain concerns about China’s high level of debt. Chinese authorities are giving a high priority to reducing the country’s debt burden and mitigating financial risks. Nevertheless, it will be a big job with bumps along the way. There is the potential for financial distress, which could severely restrict credit in China. This could cause a rapid slowdown in the world’s second largest economy, with detrimental effects for the rest of the world.

Other risks too…as always

In addition to higher inflation and a rapid slowdown in the Chinese economy there are several other risks to keep a close watch over.

Other important questions also face investors, such as how central banks react to strong economic data; whether US President Donald Trump elicits a trade war with China; will support for anti-euro parties spark a Eurozone political crisis. As always, there are innumerable unseen risks to be wary of – geopolitical conflicts, large company failures, hidden debts, natural disasters…the list goes on.

Investing in this environment

So how do we invest in this kind of environment? Our philosophy and approach remain the same.

We are active managers and are always looking out for opportunities and risks to achieve good returns while protecting customers’ capital.

Diversification is as important as ever. We don’t hold large positions in any one security or area of the market. We spread investments across regions, countries, industries, and individual companies. This helps smooth market ups and downs.

We focus on liquid shares (those that can be bought or sold quickly without affecting their value) of companies with sound balance sheets and good earnings prospects. This helps us to control portfolio risks with the aim of protecting customers’ capital.

This article reflects the personal views of the author at the date shown above. The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed, or relied on, as a recommendation to invest in a particular financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any investment decisions.

Tags: Economy

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