#Market Strategy — 15.01.2018

The 2018 stock market outlook

Roger Keller

Still new record highs on the horizon but with more market volatility

The excellent returns delivered by stock markets in 2017 have been obtained in an environment in which volatility has been extraordinarily low. Can this continue to be the case? Can equity markets continue to reach new record highs? Which are the key risks? We provide our thoughts in the comments here below.

Peak growth… peak liquidity… peak equity markets?

The economic background remains very supportive: growth will remain synchronous, broadly based and above potential. 2018 is shaping itself as the year in which global growth momentum reaches its peak for the current economic cycle. With output gaps closing, inflationary pressures should strengthen and lead central banks to further shift their policies away from their accommodative stances. The size of G4 central bank balance sheets will begin to decline in the third quarter, meaning that peak liquidity will have been surpassed. These are clearly late-cycle conditions and raise the question of whether 2018 will also be a peak year for equity markets. We believe it is too early to conclude this is going to be the case but investors will have to be open to such an eventuality.

Three reasons for staying positive

Most importantly, with a Goldilocks environment, earnings growth prospects remain solid. First of all, top-line growth will benefit not only from good volume trends but also from the return of some pricing power. Then, earnings should grow faster than sales: in the US, this will be thanks to tax cuts; elsewhere, it will be the consequence of operational leverage. For the world equity market, we see an approximately 10% expansion in earnings in 2018. The second reason for staying bullish is that the pace of monetary policy normalisation is expected to be slow. The third reason is that valuations still have room to expand before the end of the current bull market. High valuations are justified by the good visibility on global economic growth, by the low level of real yields and inflation rates that will approximate 2% on average in developed countries.

Expect higher levels of volatility

Stock markets still remain in overbought territory and complacency reigns. It is very unusual that such conditions prevail for such a length of time. Given that leading indicators such as PMI surveys and economic surprises are at or close to positive extremes, they will in all likelihood find themselves lower in coming months, which is likely to create volatility in stock markets. Indicators such as the relative strength or the moving average convergence-divergence also militate for some phases of downside pressure on stock prices. We still believe that such pressures will prove limited to movements towards the 200-day moving average, not much beyond that. We remain neutral in the short term because of these technical considerations.

What could go wrong?

Our core scenario is based on a rise of world equities in 2018 in line with the expected growth rate of earnings, which is approximately 10%. Risks on the downside would come mainly from yields rising faster than expected, either because of inflation surprises, faster tightening by central banks or investor requirements for a higher risk premia. Other key risks could be if China were to tighten and decelerate more than we envisage, if global economic indicators were to cool more significantly than we expect or because of protectionism or geopolitics. The key indicators we will follow are US ones, such as capital goods orders, inventories, housing permits, capacity utilisation, the yield curve or the unemployment rate. On the other hand, risks to the upside would come mainly from the manifestation of euphoria, as investors finally capitulate on their cautious stance since the beginning of the bull market.

Equity markets have at their disposal all the ingredients to reach new record highs. They are likely however to follow a much more volatile path than in 2017.