Equity markets: The primary trend remains up, but expect a bumpy ride
Our core expectation for 2018 is that favourable fundamentals will have the upper hand over political headwinds but that the upward trend will be both volatile and less pronounced.
2018: a pivotal year in many respects
With the third-longest economic expansion in history, the second-longest bull market, and a global stock market capitalisation as a share of world GDP at around 30-year record highs, it should not be surprising if 2018 proves to be a year of transition on the following fronts.
The closing of output gaps is leading to accelerating inflationary pressure and rises in bond yields above significant resistance levels. The economic growth and earnings momentum are reaching a peak. The trend of global QE is changing while the size of G4 central bank balance sheets is decreasing slowly. Without surprise, stock price volatility has returned.
A consolidation period but nothing more
The recent decline in stock markets was long overdue given the extremes in positive sentiment, overbought conditions and the long period without a 5% setback. However, we see it as nothing more than a welcome consolidation because fundamentals remain solid. Global growth is synchronous and likely to last thanks to the rebound in capital expenditure. This provides the foundations for good earnings growth in both 2018 and 2019, thanks to operational leverage outside the US and tax cuts in the US. Share buybacks are expected to remain positive contributors to earnings per share growth. As a result, we abandoned in the middle of February our short-term neutral stance.
A need to pay more attention to entry points
Given that valuations already reflect relatively high expectations, we would not expect stock markets to progress in 2018 faster than earnings, which are expected to grow by approximately 10%. That said, we would still expect greater volatility than in recent years, because of developments such as the return of inflation, rising bond yields, moderate reversals in leading indicators (e.g. PMIs). Because upside potential is constrained and downside risks are limited, investors should no longer approach stock markets in a buy-and-hold manner but rather with a view to capitalising on volatility to buy.
What are the key risks?
Our main concern is the bond markets. If the 10-year US Treasury bond yield rises substantially above 3% in the near future, it would probably trigger another wave of selling. One reason for this is that investors with a more defensive profile would switch out of stocks and back into the security of bonds, because yields would be substantially higher than dividends. Another major source of risk is China’s economy: previously in this decade, stock markets had shivered on hard landing fears. Indeed, such fears could re-emerge as authorities target slower growth in some sectors and look for deleveraging in state-owned enterprises and local governments. We stick to our core scenario of a moderate slowdown. Other key risks are protectionism and geopolitics.
Bottom line
Although the bull market has reached a respectable age, we remain of the view that it still has further to go. Investors must accept volatility if they want to continue to participate in the uptrend.