Investors should expect more of the same in 2018, as many of the factors that drove risk assets higher this year remain in force. Still, 2017’s returns will be difficult to top for many asset classes, and investors should keep a wary eye out for unexpected inflation and geopolitical risks.
Much went right for investors in 2017. Economic growth strengthened across both developed and emerging markets, low inflation allowed central banks to remain largely accommodating, and political risks were generally contained. Earnings staged a strong recovery, growing by more than 20% year-over-year in emerging markets, Japan, and the United Kingdom, and a still-respectable 10% or more in the Eurozone and United States. The result was a festive 17.5% return year-to-date through December 8 for developed markets stocks in local currency terms, and an even merrier 26.5% return for emerging markets equities.
Looking ahead to next year, developed markets equities have the potential to deliver a second straight year of healthy gains. Reasonably valued markets like Japan and the Eurozone offer the best prospects, with 2018 earnings forecasts setting a low bar. Japanese and Eurozone earnings are expected to grow around 3% and 6%, respectively, versus around 12% in the United States. Top decile valuations for US stocks leave little margin for disappointment, though proposed corporate tax cuts offer at least some upside. Still, US margins look more stretched than peers, and there are few obvious candidates to take the baton should high-flying tech stocks stumble.
Emerging markets stocks are positioned for another productive year in 2018. Steady economic progress should support robust earnings growth, and valuations, though richer than one year ago, are not a headwind. Investors should keep a watch on technology stocks—after a massive 50% return in 2017, IT is now the largest sector in the MSCI Emerging Markets Index.
Credit markets offer slimmer pickings in 2018 given low yields and central banks that are gradually withdrawing stimulus. Longer-duration assets like investment-grade bonds and USD-denominated emerging markets debt would be especially susceptible to higher inflation and rising rates, though higher-beta credit like high yield might also suffer given worries about debt affordability. Proposed tax reform could throw some of these borrowers a curveball by capping interest deductibility, yet other proposed measures (e.g., lowering corporate tax rates and immediate expensing of capex for several years) will at least partially offset the impact. Investors will be well served by looking at more attractively valued structured credit and niche opportunities in private markets.
One surprise of 2017 was that oil-related assets did not deliver higher returns. Spot prices rose as markets moved closer to balancing, OPEC and several non-OPEC countries extended their supply cuts, and metrics such as free cash flow and leverage levels improved for producers. Ongoing discipline by these companies, paired with reasonable valuations, should set the stage for a more rewarding 2018, especially if global growth continues to translate into stronger demand.
Overall, we remain constructive on prospects for risk assets in 2018 given ongoing strength in macro and micro data, as well as reasonable valuations in most equity markets. This said, the party cannot go on forever, and we are closely watching central banks for signs they might remove the punch bowl faster than markets anticipate. With markets very complacent, and the consensus citing so few risks on the horizon, it may not take much to see volatility pick up. Investors can prepare for the morning after by maintaining diversified portfolios and ensuring adequate liquidity is on hand.
Read Outlook 2018: Stick Around for Dessert for more of our views on developed and emerging markets equities, credit, real assets, sovereign bonds, and currencies, as well as the advice of our chief investment strategist.