1. There’s life in the old bull yet
It appears the reports of the US bull run’s death have been greatly exaggerated. Predicting when the US market will drop has become a favorite pastime among some investor, but Savita Subramanian, Bank of America Merrill Lynch’s chief US equity and quantitative strategist, said the average Wall Street strategist is currently telling investors to put just 55% of their wealth in equities – well below ‘euphoria’ levels that typically herald the end of a bull market.
‘We still think that there’s a way to go before we get Wall Street telling us to back up the truck on equities... and when we hit that level of maximum euphoria, that typically is the death note for a bull market,’ she said.
However, Ty Nutt, lead manager of the Delaware Value fund, was not as bullish as Subramanian on the short-term outlook, saying that it was ‘more uncertain’ given the current bull run is now the third longest on record. That said, he remains confident for the three-to-five-year outlook.
‘Over this horizon, we are cautiously optimistic about the prospects for equities,' he said, 'especially those of higher-quality companies that are trading below their long-term average valuation multiples.'
2. ‘Goldilocks’ global growth
Once the numbers have been crunched, global growth for 2017 is widely expected to have met the IMF's 3.6% forecast from October of that year. In 2018, that number is expected to rise to 3.7%.
Ethan Harris, head of global economics at Bank of America, said the market has entered 2018 with a ‘Goldilocks’ feel, adding that his team, like many other economists, expects very strong growth globally in the year ahead.
The rebound in global manufacturing has contributed in the short term, he said, and the fact that people are now paying less attention to the political and geopolitical risks that had been impacting consumer and investor behavior will also be a boon to markets in the long run.
Edward Gray, manager of the Delaware Global Value fund, noted that 2017 had been a year of marked continuity, with supportive economic data, modest inflation, benign interest rates and accommodative credit conditions. He was positive on the outlook for global growth, but added that investors should remain vigilant.
‘As we head into 2018, major stock indices continue to set records, which raises the question about the durability of the cycles underlying these gains,’ Gray said.
‘Strong equity performance in many countries and regions has been supported by a broadly improving economic backdrop, while corporate performance has generally been strong as well.’
3. Banks bounce back
Shrewd investors were eager to scoop up financial stocks in 2017, attracted by their below-book values amid a rising interest rate environment.
Bank of America’s Subramanian said financials may not have the allure of some tech stocks and do not share their high growth expectations, but the sector’s cash return profile was very attractive and financials offer the highest dividend growth of all sectors in the S&P 500.
‘[Financials] are now passing the stress test in an environment where the regulatory backdrop is flatlining and, if anything, with [Jerome] Powell as our new [Federal Reserve board] chairperson, it could actually relax over the next few years,’ she said.
Macquarie Investment Management portfolio managers Christopher Beck, Alex Ely and Francis X. Morris said tax cuts would undoubtedly boost this sector too, with rising interest rates providing further support.
‘The vast majority of loans made by small- to mid-cap banks carry a variable interest rate, so if policy rates continue to move higher, loan rates would as well,’ they said.
1. Inflation blows up
Inflation is the biggest wild card going into 2018, according to Alex Dryden, global fixed income market strategist at JP Morgan Asset Management.
Dryden was concerned that rising wage pressure both in the US and globally due to tight labor markets could lead to inflation rising above the Fed’s target level of 2%.
Brendan Murphy, manager of the Dreyfus/Standish Global Fixed Income fund, said that should inflation surprise on the upside, developed market central banks could be forced to normalize policy more quickly.
‘It is in the US that meaningful upside surprises in inflation would prove the most disruptive,’ he said.
‘Thus far, the combination of rising stocks, a flattening yield curve and a weaker dollar has seen financial conditions ease, even as the Fed has hiked rates by 100 basis points. Were inflation to become problematically high, the Fed would be forced to raise rates in the hope of tightening financial conditions and slowing growth. The asset market impact of a Fed-engineered economic slowdown would be significant.’
2. Taxing times
President Trump’s ‘largest tax cut’ in US history – a claim that has since been debunked – will undoubtedly have an impact on the US market, but what its tangible effects will prove to be is still very much up for debate.
David Kelly, chief global strategist at JP Morgan Asset Management, argued that it was important not to overestimate the impact of the corporate tax cuts.
If the $1.5 trillion tax plan had been aimed at the lower 50% of the income spectrum, Kelly said, it would have a much bigger impact on demand in the economy than one aimed primarily at corporations and small businesses.
Subramanian added that companies in challenging industries with little-to-no pricing power could well pass the tax cut on to consumers through lower prices, rather than investing it. Retailers under increased pressure from Amazon are the most likely to make this move, she said.
She added that there was no evidence
that long-term growth stands to benefit from fiscal stimulus, suggesting that the tax cut would in reality pull growth from the future into today’s environment.
3. Small caps, big risk
US small-cap stocks had a strong 2017, with the sector expected to be a clear winner from the lower US corporate tax rate.
However, as Macquarie’s Beck, Ely and Morris wondered, has this all been priced in?
‘How much of this expected relief is already factored into current valuations? The run-up following the US presidential election in late 2016 pushed small-cap valuations above 18.97 times forward earnings as of December 31, 2016. At the end of September 2017, small caps were trading at 18.95 times; meanwhile, the long-term average is 15.7 times.
‘So in absolute terms, prices aren’t exactly cheap, and any acceleration in earnings might simply justify multiples where they stand today. We would simply be “growing into the multiple”.’
Subramanian was also concerned, noting that it was a unique trait of this cycle that smaller companies have extended their leverage ratios to almost record levels.
‘If anything reverses in terms of a low interest rate and low credit spread environment, small caps are going to feel the pain before large caps,’ she said.
She added that her group is currently recommending sticking with large-cap stocks – a view also driven by the fact that the US economy is just a few years into a large-cap leadership cycle that typically lasts at least a decade.
It’s hard not to have your head turned by the dizzying rise of bitcoin in 2017. Its price went from $1,000 to a high of more than $19,500 in December, but its volatility has left many investors scratching their heads over whether to cheer it or fear it.
For Alex Healy, deputy CIO of AlphaSimplex Group, bitcoin is a case in point demonstrating the behavioral forces at work in the markets.
‘The fact that a lot of people are having a hard time explaining what’s driving it, yet the prices move, is an illustration that there can be that kind of turbulence in the market,’ he said.
Healy, a co-portfolio manager on the ASG Managed Futures Strategy fund, explained: ‘Frankly, to me, that is not surprising. We are trend-followers and we rely on that kind of pervasive force in markets – whether it’s equities, fixed income, currencies or cryptocurrencies. Whatever the asset class, we think that is a powerful force throughout the investment world.
‘In a sense, it’s not surprising, even though movement has been quite large and it has found a lot of coverage and interest from risk-seeking individuals. It’s something we see but it’s not our focus. We focus on the most liquid developing derivatives markets and futures markets around the world.’