Shock election outcomes, concerns about global protectionism and the consequences of the Brexit vote led to a general air of pessimism going into 2017, yet the markets remain sanguine in the face of myriad risks, even into 2018. Is this optimism well placed – or just complacency? Edward Russell-Walling reports.
What a difference a year makes. Twelve months ago, the outlook for 2017 was extremely unsettling, with all kinds of potential trouble on the horizon. Today, looking ahead to 2018, the landscape seems benign. Have markets become too complacent?
As the beginning of 2017, expectations for markets, trade and even geopolitical stability were riddled with concern. Donald Trump had just been elected US president, with an agenda that was idiosyncratic, to say the least, as he talked up protectionism and isolationism alongside growth. The UK had caused a collective intake of breath by voting to leave the EU. If these developments showed populism on the march, so too might impending elections around Europe which threatened to demonstrate more broadly based anti-EU sentiment.
Beating predictions
But 2017 has turned out better than anyone thought possible. Mr Trump has done less on every front, good and bad, than most expected. Continental elections passed off without any threat to the established European order – indeed, France elected a vocally pro-European president with grand plans to fix the EU.
Inflation and interest rates have stayed low. Markets, particularly in equities, have prospered, and economic growth has accelerated around the world, with all the G20 economies in positive territory. The only laggard, bottom of the G20 league with diminishing prospects, is a Brexit-bound UK.
With few inflationary pressures in view and glacial tightening of monetary policy, 2018 is shaping up rather well. Supranational forecasters agree that 2017 has been a good year for the world economy and that next year should be slightly better, though they caution against taking too much for granted.
The International Monetary Fund (IMF) put global economic growth in 2016 at 3.2%, the weakest since the financial crisis. This year’s projection is for 3.6%, rising to 3.7% in 2018. Both figures, published in October, were revised upwards by 0.1 percentage point from the IMF’s previous forecast in July.
The revision flowed from higher individual IMF forecasts for the eurozone, Japan, China, emerging Europe and Russia, where growth in the first half of 2017 was better than expected. These more than offset downward revisions for the UK – thank you, Brexit – and the US.
US recovery and slowdown
At one point, Mr Trump promised to boost US growth to 4%, though few economists took him seriously. He subsequently trimmed that to 3%, but even that has proved too ambitious. The 2017 projection by the Organisation for Economic Co-operation and Development (OECD) is 2.1%, rising to 2.4% in 2018.
Mr Trump’s tax-cutting fiscal package, now stalled in the US Congress, could boost growth slightly, along with share prices and the dollar. Most observers believe at least some parts of it will eventually be enacted in 2018. Mr Trump has threatened to withdraw unilaterally from the North American Free Trade Agreement, which would be negative for growth, though the US Chamber of Commerce has pointed out that it would hit several Trump-supporting states the hardest.
The US recovered more quickly than Europe after the financial crisis, so its business cycle is more advanced, and some people are already looking ahead to its next downturn. Capital Economics believes US gross domestic product growth will pick up from 2.1% this year to 2.5% in 2018, but believes that as consumption growth slows, the economy will grow by only 1.7% in 2019.
“We don’t see a recession in the US," says Andrew Kenningham, chief global economist at Capital Economics. “But there is a risk of a significant slowdown by 2019 and 2020. Higher interest rates are likely to have a dampening effect on household spending and employment, so growth will slow.”
Fed developments
US unemployment, which the Federal Reserve watches closely, is at its lowest level in 17 years, and the Fed finally began the very gradual process of unwinding its $4500bn balance sheet in October. It is expected to raise the federal funds rate in December, and Fed-watchers expect between two and four more hikes in 2018. Capital Economics thinks rates will be raised another four times, lifting them from the current range of 1% to 1.25% to peak at 2.5% to 2.75% in the first half of 2019.
Paul Mortimer-Lee, chief market economist and head of US economics at BNP Paribas, expects three Fed hikes in 2018, taking the range to 2.25% to 2.5% by the end of the year. “There will definitely be a downturn in the US, but it is a question of timing,” says Mr Mortimer-Lee. “If the market corrects significantly or there is a growth downturn, the Fed will back off very quickly. It doesn't want a recession.”
Fed chair Janet Yellen steps down early in 2018, to be replaced by Mr Trump's nominee, Jerome Powell. His approach to policy will be closely watched, but few expect him to rock the Yellen boat.
“Mr Powell has never dissented – he has been loyal to Ms Yellen,” says Mr Mortimer-Lee. “Will he now be a hawk or a dove? I think he will try to steer the committee from the centre.” He adds that a testing point for Mr Powell will be how he reacts when Mr Trump calls, as then-president Richard Nixon called then-Fed chairman Arthur Burns before the 1972 election, to pressure him for more expansionary policy.
Hike or no, the US dollar looks set on a downward path for now. ”The dollar downtrend should resume against most currencies for the next 18 months, because the US is further along in the cycle,” says Ajay Rajadhyaksha, head of macro research at Barclays. This favours non-US equities.
Eurozone surprises on upside
If Fed policy is heavily influenced by employment numbers, the European Central Bank (ECB) is fixated on inflation. And, disappointingly, for some, 2017 has been the year when inflation did not return, seeing rising employment and growth but surprisingly weak wage pressures on both sides of the Atlantic.
At the start of 2017, eurozone growth was predicted to be 1.4%. In fact, it may be half as good again, at 2.1% (in 2016 it was 1.8%), falling to 1.9% in 2018 (according to both the OECD and the IMF). And yet inflation remains lower than expected, at 1.4% in the year to October, much the same level as in the US.
“The economy has really been doing well, globally and in the eurozone in particular,” says Luigi Speranza, head of European economics at BNP Paribas. “What is key in the eurozone is that this is a domestic-led recovery, and not just in Germany. France and Spain are doing well, and Italy is doing exceptionally well relative to its trend.”
European growth is being supported by employment and consumption, global growth and exports, wealth effects (helped by market performance) and, importantly, a pick-up in business investment. “There has been a long period of underinvestment,” says Mr Speranza. “So now there’s a need for a catch-up.”
ECB policy matters
Underlying all this is the accommodative stance of the ECB and its quantitative easing (QE) programme, an approach only now about to be gradually relaxed. “It’s very important what the ECB is doing,” says Mr Speranza. “It is taking a very cautious approach, and we will continue to have easy monetary policy for a long time. The improvement in the economy has not yet got us to [the ECB’s inflation target of] 2%, so the job is not done.”
The ECB, whose main interest rate is 0%, will halve monthly bond purchases from January 2018 while extending the QE programme to September, or possibly beyond. It says it will not raise rates until after it has stopped asset purchases, suggesting that no rate rise should be expected until 2019. Mario Draghi’s term as ECB president ends in October 2019, and some believe he will feel obliged to hike rates before then. They say if he leaves it for his successor, it will look like regime change rather than continuity.
Neville Hill, head of European economics at Credit Suisse, suspects 2018 could be a year of two halves. In the first half, ECB tightening will seem a long way away. But with growth and rising inflation, and interest rate markets starting to sell off, impending tightening could prick the euphoria of equity and credit markets. “There is a clear risk of a market correction,” says Mr Hill.
The immediate future looks less lively in Japan, where there are no expectations for short-term interest rate changes, and the Bank of Japan looks likely to maintain its target of about 0%.
Equities optimism
Corrections aside, the environment in 2018 should be supportive of risk assets in general, and of equities in particular. After a dismal 2016, especially for initial public offers (IPOs), equities have had a resurgent year in 2017. Hopes are that this will continue into next year, particularly in Europe and possibly in Japan. In the US, however, where wage pressures may eventually start weighing on profits, equities could flatline.
“We believe that this equity market can sustain its rally into 2018,” says Phil Drury, head of Europe, the Middle East and Africa (EMEA) capital markets origination at Citi. “Recent earnings figures show that companies are performing well. Private equity is raising record funds, and institutional investors are relatively flush with cash, so buying sources are competing for equity ownership.”
There is a “strong” pipeline of IPOs into 2018, according to Mr Drury. He adds that, as interest rates rise over the next 12 to 24 months, total income funds will switch out of debt capital markets (DCM) into equity capital markets, further underpinning the latter.
In DCM, credit spreads and bond yields are close to all-time lows. Corporates have not exactly been over-active, given relatively low levels of investment and the carry cost of holding liquidity on the balance sheet, though some have taken the opportunity to issue longer. Participants expect a business-like, rather than a dramatic, year in 2018.
“We expect that corporate activity will be steady,” says Morven Jones, head of DCM origination, EMEA, at Nomura. “The direction of travel for spreads must be wider, but how fast is more difficult to tell. There is still a strong technical bid for bonds.”
Sovereign, supranational and agency issuance volumes will be broadly similar to the current year, if a touch lower for sovereigns, Mr Jones believes. For financial institutions, he expects increased activity driven by the gradual withdrawal of central bank liquidity support, and an uptick in loss-absorbing regulatory capital issuance.
The QE taper effect
The ECB’s QE taper will have a meaningful effect on the market, and nowhere more so than in corporate bonds, according to William Weaver, head of DCM, EMEA, at Citi. “What happens to the corporate purchase programme will be critical,” he says.
The ECB plans to halve monthly purchases from €60bn to €30bn. Today, its monthly quota includes €7bn of corporate bonds. “In the new world, does it scale down corporate purchases pro rata? We think it will keep buying at the rate of €7bn a month,” says Mr Weaver. “Corporate QE will continue for a good nine months, putting the ECB in a position where it owns nearly one-quarter of the eligible pool. That will be very supportive for credit spreads.”
The view from the credit rating agencies is positive. Moody’s expects European speculative-grade corporates’ default rate to stay below 2% in 2018, for example. Philipp Lotter, co-head of EMEA corporate finance at Moody’s, notes that at the end of 2013, 28% of the sovereigns rated by the agency were on 'negative' outlook. “Today that figure is down to 16%,” he says. “In 2013, 67% of the corporate finance sectors we covered had a 'stable' outlook, but today it's 72%.”
Likewise, the number of banks in Moody’s rated universe that failed in 2017 is the lowest since 2007, according to Frederic Drevon, the agency’s co-head of global banking. “The cost of credit for institutions is at an all-time low. Things can only go the other way, and a slight deterioration in credit quality is to be expected going forward,” he says.
While the US banking sector remains stronger than its European counterpart, Europe’s banks are going in the right direction, Mr Drevon adds. Credit Suisse’s Mr Hill agrees. “Some say the eurozone is doomed because there are so many bad loans on banks' balance sheets,” he says. “But they forget how helpful a vigorous economy and low interest rates are for bad loans. Non-performing loans are down in the past year, and the financial system in Europe continues to heal from the damage done in the financial and euro crises.”
Formerly, Fed tightening and the winding down of QE might have prompted an outflow of capital from emerging markets but Capital Economics’ Mr Kenningham doubts this will happen this time around. “Emerging markets are better organised, with floating exchange rates and less external debt. We are optimistic about emerging markets as an asset class and optimistic about their growth,” he says.
Moody’s shares that optimism in an upbeat 2018 Outlook on global credit conditions, saying: “Growth-focused economic policies in China, stable commodity prices and trade recovery will support growth in emerging markets.”
BRICs enjoy stability
Brazil and Russia have come out of recession and are more likely to grow in a stable, if not rapid, fashion. While many have shaved their forecasts for India, due to one-off effects of demonetisation and a new sales tax, they still expect 7%-plus economic growth in 2018.
Having picked up a touch from 6.7% in 2016 to 6.8% in 2017 (IMF estimates), China’s growth is expected to slow in 2018, perhaps to 6.5% – the same rate as emerging and developing Asia as a whole. There is a lot of debt in the system but, since much of it is owed by state-owned enterprises to state-owned banks, it will not threaten growth. The Chinese authorities are managing the slowdown with care and China is unlikely to be a source of volatility in 2018.
In May 2018, Chinese mainland shares begin their staggered inclusion in MSCI indices, which will attract more foreign capital. “Access is now dramatically improved via Hong Kong-Shanghai Stock Connect,” says Rakesh Patel, HSBC’s global head of advisory. “We think the MSCI inclusion will attract $10bn in initial inflows, and $500bn over time.”
Subsiding fears of a Chinese hard landing have been positive for commodities, particularly industrial metals. Commodities have benefited from a weaker US dollar, while stronger demand has given oil prices a lift. However, the latter are now restrained by what Mr Kenningham calls a “thermostat”.
The Organization of the Petroleum Exporting Countries has shown that it can cut production and stimulate prices when they get too low, while price rises are checked by prompt increases in shale oil production. Capital Economics forecasts that a barrel of Brent oil will cost $55 by the end of 2018, compared with $60-plus towards the end of 2017.
A puzzling calm
As ever, risks remain. Moody’s warns that newly rated companies have the most aggressive capital structures since 2011, with very high initial leverage and weak cashflow generation in 2017. Meanwhile, geopolitical shocks can always upset the apple cart, with potential trouble spots including the Middle East, North Korean, Spain and now, perhaps, even Germany. Yet markets recovered very quickly from bad news in all these places, and Spanish bonds barely moved during the Catalonia referendum crisis.
Why are investors so sanguine? “It’s baffling everyone,” admits HSBC’s Mr Patel. “Perhaps the longest bull market in recent history and low interest rates have led to some complacency. This has also led to massive inflows into passive strategies, because investors are buying into the fact that the bull market may continue.”
Finally, there is Brexit, and the risk that the UK’s EU-departure negotiations will fail. The OECD believes associated uncertainties will slow UK growth from 1.6% this year to only 1% in 2018. “Brexit will rumble on,” says one London-based banker. “Sterling is where market sentiment is most clearly seen but, frankly, people have stopped predicting. We’ll just have to wait and see.”
