2017 was even better than expected for the global economy. Investors will have performed positively on most asset classes (US equities, emerging equities, European equities, sovereign bonds, investment grade and high yield credit, real estate, commodities, etc.). The growth momentum is still there and the outlook remains favourable for 2018 (global GDP growth is expected at 3.7% in 2018 compared to 3.6% in 2017) despite main central bank monetary policies being a little less accommodating, the aggregate balance sheets of the latter should start deflating from the end of the year.
The US economy will remain in the spotlight with, in the coming months, the effects of the corporate tax cut and the new infrastructure spending plan. These elements will undoubtedly have a positive impact on economic growth, but a negative one on public deficit. Inflation could also rise in this environment, which will justify further Fed hikes (Fed funds are expected at 2.25% by the end 2018 against 1.5% today).
Europe should still experience fairly robust growth (above 2%). The monetary policy of the ECB remains accommodative and many political risks have disappeared; however, the consequences of Brexit, the Italian elections and the separatist pressures of Catalonia will remain a threat.
Japan should continue to benefit from global growth and the ultra-accommodative policy of the Bank of Japan.
Is it still too early to get out of equity markets?
In the current environment, with no sign of a recession or a growth rate slowdown, a positive investment approach for risky assets can be maintained; at least during the first half of this year, although 2018 could see the return of volatility for all asset classes.
Stocks performed very well in 2017 and it can be increasingly tempting to get out from equities due to their high level, rising valuations and changing monetary conditions. Nevertheless, historically equities have tended to perform well in the latter stages of economic cycle expansion.
US stocks are certainly the most expensive of all, in relative as well as in absolute terms, but many investors think, like Janet Yellen in her last speech as President of the Fed, that “the fact that their valuation is high and in the top of their historical range does not mean that they are necessarily overvalued. ”
In this environment, it will be necessary to be particularly selective while remaining sufficiently diversified. It will indeed be important to choose themes with lower valuations or high potential growth that will benefit from the current dynamics and choose the most appropriate underlying assets. For example, investments in robotics, biotechnologies, companies that introduce or benefit from disruptive business models, emerging market equities (which benefit from stronger economic growth and lower valuation than developed countries), Eurozone banking stocks and European small and mid cap companies are all attractive options. Finally, the historically low level of volatility of equity indices can be used to hedge cheaply (purchase of Put options) or to expose themselves with limited risk to equity markets (Call purchases).
Bond markets in 2018
Interest rates and credit spreads are historically low, and do not compensate investors for the risks taken. The recent “Steinhoff” debacle perfectly illustrates the asymmetry existing between the expectation of return and the risk of loss.
We could probably talk about overvaluation or even bond bubble (with some negative yields). Current interest rates are still very low, making the bond selection process much more difficult. As a result, it is preferable to favor diversified, flexible investment strategies with no benchmarks (investing outside the benchmarks).
Subordinated financial debt in Europe, MBS in the United States, Cat Bonds, emerging debt and “Loans” may also constitute investment opportunities with an acceptable return / risk ratio.
In this context of low interest rates, absolute return strategies are also a good alternative to traditional bond investment. But here too, you have to be very selective and well diversified.
Currency allocation is an important part of portfolio construction; it is a source of risk and performance in its own right.
In the short term, the Dollar could appreciate (especially against the Euro) because of the good economic news in the United States as well as interest rate and growth differentials. However, within the next 12 months, the EURUSD should climb (weakening of the dollar) towards 1.25 (which is its theoretical equilibrium value). The divergence between monetary policies should, decrease over time because of the dynamics of European growth.
Two Scandinavian currencies can be good diversification opportunities: SEK and NOK. The EUR / NOK has peaked since 2010. Sweden’s economy and inflation rate are recovering at the same pace or higher than those in the Euro area. For this reason, the Swedish central bank will probably adopt monetary policy measures at least as hawkish as those of the ECB, which should lead to the appreciation of the SEK over the next 12 months. The fundamentals of the Norwegian economy are strong and a stabilization or increase in oil prices will provide sustainable growth prospects for the country and its currency.
An exposure to commodities including gold (and precious commodities), gold mines and oil infrastructure, can also be incorporated into a diversified portfolio for the following reasons:
- they are correlated with inflation;
- they have very little correlation with traditional asset classes (equities, bonds and credit);
- they are behind the stock market.
Despite their high market valuation, the economic growth that will continue in 2018 should benefit equities (especially in the first half of the year) but to a lesser extent when compared with 2017. Nevertheless, 2018 should also see the return of volatility, the rise of inflation, higher interest rates with geopolitical risks still hovering over our heads. It will therefore be necessary to be selective, well diversified and to have a flexible approach. Investors can be cautiously optimistic for this new year 2018!