Q1 2018 Market Outlook:
Be Prepared for the Unexpected

Although the underlying economy in the US and Europe remains strong, recent price declines and increased volatility in the equity market suggest that mitigating downside risk through diversification will remain an investor priority through 2018.

2017 will be remembered as a great year for financial market performance

Amid record low volatility, global equity markets swelled to record highs: the US finished up 22%, Europe 15% and the UK 13%, all in local currency terms. Robust equity performance was not limited to developed economies, as emerging market equity gains eclipsed both the US and Europe. Global credit markets were also robust, as high demand resulted in record issuance, moderated volatility, and lower yields for both corporate and sovereign borrowers.

What does this performance suggest for developed markets in 2018?

We begin 2018 with a vigorous and strengthening economic backdrop in the US and Europe that provides support for the financial markets to continue 2017 trends.

In the US, high levels of positive investor sentiment are justified by rising GDP, increased corporate earnings, and low unemployment. Moreover, an expansionary fiscal stance and deregulation focus will encourage further economic development. In Europe, both consumer and business confidence are at multi-year highs as corporate profits continue to increase. Upwardly revised GDP estimates, improving growth prospects and positive employment data suggest a cyclical upswing is well underway. Although the underlying economy in the US and Europe remains strong, recent price declines and increased volatility in the equity market suggest that mitigating downside risk through diversification will remain an investor priority through 2018.

The State of Play: Credit and Equity Markets in 2018

Corporate credit instrument spreads are extremely compressed against government bonds of similar duration. Indeed, in late 2017 yields on European high yield bonds fell below that of US Treasuries. With little room for further yield declines, credit returns in 2018 may be driven more by income than by further spread compression. An increase in rates through inflation or central bank policy may dampen borrower demand; however, deregulation, increased capital expenditures, and the hunt for yield all help create an environment for a robust credit market.

After a historic run-up in prices, equity market valuations are not cheap. With strong future economic performance already priced in, investors expecting upcoming stock increases to match recent levels may be disappointed. As valuation multiples are currently stretched, the primary driver of equity valuation in 2018 may be earnings growth rather than further price expansion. Earnings growth is primed to increase through greater capital expenditures, tax law changes, and deregulation. These positive market drivers may be moderated by recent increases in equity market volatility and the resulting higher risk premiums.

Linking the Macro Economy and the Financial Market

The key question for 2018 is how investors will earn adequate yields while moderating risk exposure. The answer will stem from a combination of monetary and fiscal policy, inflation expectations, capital expenditures, and aggregated investor risk – return tradeoffs. With that in mind, the below US market drivers bear close watching in 2018:

Central Bank Actions Harmonize and Become Less Accommodative

The Fed and ECB have both communicated what central bank actions the markets can expect in 2018. The Fed expects to increase rates – three hikes up to 2.1% are expected this year – as it reduces its balance sheet, continuing the normalization process. The ECB expects to begin normalization of its own balance sheet expansion late in the year and is not expected to raise rates. Should Eurozone economic performance prove robust, the ECB may revisit its plans to increase interest rates. Although the trend should be gradual, central banks have been clear about their intention to move away from easy monetary policy.

Conclusion: By the end of 2018, central bank policy makers intend to make monetary policy less accommodative than it is today, as normalization is gradually implemented.

Expansionary US Fiscal Policy and Tax Law Effects Could Boost GDP

Late 2017 saw a significant change in the US tax code with the passage of the Tax Cuts and Jobs Act. The headline changes are generally considered expansionary, with lower tax rates, immediate deduction of investment spending, and repatriation expected to increase GDP and, through increased capital investment, enhance worker productivity.

Tax reform is not the only policy tailwind. Deregulation efforts are likely to encourage investment spending, which should provide a further economic boost. Indeed, consensus GDP numbers are 2.9 percent for 2018 v 2.3 percent for 2017.

Conclusion: An expansionary fiscal stance and fewer regulations should provide a boost to GDP.

Will Inflation Make a Comeback?

Inflation, a key determinant of bond yields and central bank action, has been persistently below the Fed’s two-percent target since 2012. Although structural drivers of disinflation will persist for the foreseeable future, e.g., the “gig” economy, increased automation, etc., at the same time, short-term offsetting factors signal a potential rise in inflation in 2018. The first factor is that labor market tightness in the US could lead to wage inflation. Next, is that the US is pursuing an expansionary fiscal policy during a time of full economic capacity. Finally, an increase in commodity prices could upset inflation expectations, which are now anchored at historically relatively low levels.

Conclusion: After years of absence, inflation may be ready for a comeback, with concomitant effects for the credit markets.

Capital Expenditures Increases Drive Growth Through Increased Earnings

After four years of declining year-over-year global corporate capital expenditures, the trend finally reversed in 2017. Going forward, expansionary fiscal policy and a favorable tax environment will encourage this increase in capex to continue. Cash rich US companies may finally shift from financialization methods of stock growth, i.e., buybacks and dividends, to income growth measures, i.e., capex and R&D. Fueled by high business confidence and low interest rates, along with the structural incentives of low excess capacity and a tight labor market, companies have strong incentives to prioritize capital investment in 2018.

Conclusion: Short term structural incentives to renew capital stock could have long term GDP effects through productivity enhancements.

The Global Struggle for Yield Continues

The overriding theme in global credit markets in 2017 was yield compression. High investor demand across credit sectors kept valuations high and intensified the hunt for yield. Vanishing risk premiums resulted in investors earning sovereign-like yields for taking on corporate-like risks.

Rising rates due to central bank action and an increase in inflation should act as a boost to yield and encourage spread decompression. Moreover, the rate of central bank normalization will be an important factor in how quickly rates will rise. Nevertheless, investors without an underwriting edge or who can’t drive transactions terms will find yield and safety to be mutually exclusive desires to satisfy.

Conclusion: The hunt for yield will be most successful for parties with expertise in credit underwriting and with access to proprietary transaction flow.

Be Prepared for the Unexpected

2017 proved to be a banner year for investors and the economy continues to move in the right direction in 2018 as a result of certain political and economic tailwinds. Notwithstanding these seemingly favorable market conditions, it is critically important, now more than ever, to be prepared for the unexpected. Placing all your eggs, or at least most of your eggs, in one basket does not seem to be the prudent option in an evolving and richly priced market. As you think about the market and investing in 2018 and beyond, constructing a balanced portfolio that is appropriately diversified across equities, traditional fixed income and alternatives will likely continue to be the best way to be prepared for the unexpected and successfully perform under most market conditions.

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