Can investors continue to profit from global risk assets?
Many asset markets made strong gains in 2017: emerging markets were the best performing stock market last year and economic growth is set to be well ahead of developed markets for the year ahead. China grew by about 6.6% last year while India grew by 7%.
The Eurozone also shifted from weak growth and deflation in 2016 to recovery and stronger growth in 2017, and analysts believe it has scope for recovery to broaden in 2018. In the US, shale recovery, tax stimulus and stronger productivity points to GDP growth of between 2.5% and 3%. However, the UK has lagged as Brexit negotiations and lower GDP have dampened its prospects.
Overall, Karen Ward, chief market strategist at J.P. Morgan Asset Management says the backdrop remains strong for global risk assets as long as inflation remains subdued and central banks don’t move too fast to ‘normalisation’ of interest rates.
But 2018 marks 10 years of global expansion which is “quite lengthy by historical standards”, according to Ward, and investors are rightly nervous given the rule of thumb of a recession every decade.
“The length of recovery raises questions in people’s minds. We have seen extraordinary gains in equity prices last year and in the last couple of weeks alone. We’re getting questions from our clients asking whether they should cash in,” she says.
Ward says what makes this cycle different is the synchronised nature of growth seen last year. Historically, there tend to be “pockets of strength” such as in the States or China but this period of synchronised growth has been a comforting aspect for investors as it is broadening out by both sector and geography.
However, she adds that the pace in 2018 is expected to be broadly the same as 2017, “though may be a bit lower” as “the scope to beat it is that much harder”, she says.
Further room for growth?
The next question investors should ask is whether there is room for economies to grow.
“Unemployment is still high in Europe so growth is just a bit easier. If you want to expand, there are workers knocking around so there’s more scope for growth in Europe. In the States and the UK, the unemployment rate is pretty low so it’s a bit trickier as we’re not awash with spare resource.
“But the cycle can go on for longer. If we don’t get more people but get more out of them there will be a revival in productivity. Productivity recovery has been appalling due to a lack of investment, capital and technology as companies were scarred after the crisis. But investment is starting to pick up as the scars of recession are starting to fade which should lead to higher GDP and better productivity. This backdrop should sustain the pace of growth seen last year.”
Ward adds: “It’s reasonable, sensible and rational to be optimistic still about growth in 2018 even though it was really good last year.”
The impact on stock markets
But what does this mean for stock markets? The problem is that even if economic growth is sustained, stock market valuations are expensive and don’t allow much room for higher returns.
Darius McDermott, managing director of Chelsea Financial Services, says we’re probably in the last stages of the bull market, but there is no immediate catalyst for stock market weakness.
“Given how high stock markets are, a significant correction or even a bear market really wouldn’t surprise me – we’ve been in a bull market for almost nine years, after all. That said, there doesn’t seem to be any particular reason that markets should wobble right now.
“Economic and corporate earnings growth are doing well at the moment and global growth is co-ordinated for the first time in over a decade. Barring a sudden global slowdown, 2018 should be ok for investors.”
He adds that in the UK, inflation isn’t high enough to cripple the majority of households, GDP figures are solid and there don’t seem to be any imminent signs of a recession rearing its head.
Equity valuations have reached very high levels, McDermott says: “While markets could continue to go up, I always have at the back of my mind that the higher the price you pay in the first place, the less chance you have of making money, which means investors need to have realistic expectations about returns.
“It is a fool’s game to try to time the market and, while we see reasons for optimism, we still believe it pays to tread carefully at the moment and remain selective. When it comes to equities, we prefer European, Japanese and emerging markets,” he says.
Adrian Lowcock, investment director at Architas, agrees markets aren’t cheap at the moment but he says they’re not in bubble territory just yet, though some areas are close.
“Stock markets have been incredibly stable through 2017 with nothing causing a sell-off, even rising tensions with North Korea. However markets do not go up in a smooth line and corrections are part of investing.”
He says that a correction of 10% is “long overdue” but that in itself isn’t enough for one to happen.
“All we know is that a correction of 5%, 10% and 20% are all likely to happen at some point and therefore it is wise to be prepared for it. But also it’s not wise to try and anticipate a correction as the last legs of a bull market are often the most profitable and trying to time corrections can be damaging to long-term investment returns,” he adds.
Are valuations as expensive as people think?
However, Mike Bell, global market strategist at J.P. Morgan argues that valuations haven’t changed much since the start of 2017 in Europe, the UK and Japan as earnings have grown strongly.
“It is only emerging markets and the US which have seen valuations creep higher as share prices rose by more than earnings expectations. With emerging market valuations starting from a low base, only US valuations look somewhat expensive compared with their long-run average,” he says.
Bell adds that while starting valuations dictate a significant part of long-term returns, historically, they’ve not been a good predictor of returns over the next year. Stocks should be going up due to a healthy labour market and a better indicator is to look at jobless claim counts which tend to move up before the unemployment rate shifts.
“In 2000 when the jobless claim count started to rise, that was the point at which equity investors sniffed trouble on the horizon – this was the beginning of the bear market. If the labour market is healthy, it keeps investors on the table as they’re afraid of missing out on late cycle returns which have nearly always been strong.”
He explains that the S&P 500 in the final wrung of the bull market has never delivered less than 15% so “investors are rightly concerned about the opportunity cost of taking money out too early”.