The Bulls & The Three Red Flags
What is in store for Economies and Markets in 2018?
Around this time of year, many analysts and fund managers are giving their views. The last time the market consensus was as optimistic as today was shortly before the financial crisis started unfolding. Now, as then, we see a groundswell of optimism: the probability of equities being higher by the end of 2018 is 61%, and that shares will beat bonds is 70%. There is only a 27% chance of a global recession. They are not worried about the prospect of the Federal Reserve pushing up interest rates.
There are some red flags within the consensus view.
The first is that investors expect volatility (as measured by the Vix index of US stock volatility) to rise next year. 2017 was the calmest year on record despite all the angst in the political world. You can explain this by fundamentals: we have had positive surprises on growth from Asia and Europe, with the US economy nicely humming along. You can also explain this by speculative behavior: a lot of investors are betting on low volatility through ETFs. It is hard to see how volatility could be as low in 2018 as it has been in 2017. This implies that when volatility finally starts to rise, people are going to get hurt. Usually, equities struggle with rising volatility.
The second red flag is that the measures taken by the central banks to reduce their quantitative easing will be benign. If the leading central banks hold by their announced plans, 2018 will be the year that their balance sheets will begin to decline. If this happens, it is a good sign as the economy will continue to grow as everybody hopes but it will be harder for risky assets to continue to perform.
China is a case in point. China has tightened its monetary policy by raising interest rates and reducing money growth; given the normal lags, this will have its main impact in 2018. Signs have already emerged in the form of house prices in Beijing and Shanghai which were lower in October than they were a year ago. The resulting slowdown is not dramatic: growth of 6.1% rather than the expected 6.7%. Still that would drag down global growth to 3.3% from 3.5%.
By all measures and despite some red flags, 2018 is still set to be the year of fastest economic global growth since before the financial crisis. It will surpass 2017 which was already very good. Momentum is building up across the world economy and people are going to feel very good. Unemployment is going to fall further people will be more optimistic and will be taking more risks. American and European companies have stepped up their capital spending given the signs of stronger global growth. Signs of overheating and inflationary pressure will not (yet) start to emerge in 2018 as productivity increases. We are likely to be in a phase of strong, sustainable growth and that bodes well for a positive market performance.
We will continue to watch the market developments and recommend good companies to invest in. Stay tuned and have a successful and prosperous 2018.
Switzerland, December 28th, 2017