Author: Stephanie Baxter, Deputy Editor at Professional Pensions
This article originally appeared on https://www.professionalpensions.com/professional-pensions/feature/3022582/will-2018-be-a-turning-point-for-markets
After a year of stellar growth and stubbornly high valuations, asset bubbles may forming that could lead to market corrections. Stephanie Baxter looks at what 2018 has in store
It has been yet another challenging and eventful year for pension scheme investors. Geopolitical risks emanating from North Korea, Brexit, and European elections dominated the agenda but did not feed into the financial markets. In fact, despite concerns these risks would shock markets, 2017 has actually turned out to be a pretty positive year globally.
End of cycle?
Global economic conditions are at their most favourable point of the past decade. This provides a so-called ‘goldilocks’ scenario for equities, which have had a great year with strong macroeconomic data and double-digit earnings growth.
The question on every investor’s lips is whether stellar global growth will continue into 2018, and if equities will stay on this upward path.
Meanwhile, global central banks are signalling a slow, steady process toward interest rate normalisation, which may soon start to impact markets and investor behaviour. Could 2018 spark the start of the end of the bond market’s longest bull-run?
A survey of institutional investors by Natixis Investment Managers in September/October found 76% are concerned that depressed low rates have created asset bubbles, while 64% cited rate rises as their top portfolio worry for 2018 as it could trigger a correction in fixed income values.
NN Investment Partners chief investment officer Valentijn van Nieuwenhuijzen is optimistic about 2018. He says: “This year we saw the best economic conditions we’ve had over the past decade, not only because growth is at healthy levels, and global growth is at the upper end of where it has been in recent years, but especially because it’s so broad-based across regions – the US, Europe, Japan, but also the emerging world. It has also been well-supported by different sectors in the economy. Until 2016 consumer demand drove global growth, but clearly we’re now seeing business spending coming in, which we were missing in recent years.”
He believes 2018 will be another fairly healthy growth year, and that it is too early for this current cycle to end.
“Although I expect some increase in US inflation, it’s not yet a situation in the global economy where we’ll see broad-based bottle necks putting pressure on inflation. This recovery can run for another two to three years before that happens on a broader scale. Then you’ll get more questions about the end of the cycle and potential for recession, but it’s too early to see that for 2018.”
As such, equities are his preferred asset class for 2018, expecting double-digit earnings growth. He also believes low inflation numbers will prevent any rapid tightening of monetary policy.
But others believe we are soon heading for a correction in the equity markets, such as star fund manager Neil Woodford who has warned there are “many lights flashing red”.
As Redington head of equities Nick Samuels says: “This year saw the relentless march of the US equity market in particular, reaching highs on a regular basis, and valuations not far off record highs, only aside from the tech bubble. There’s a quite narrow leadership of those areas too.
“Active managers generally have been struggling as they can’t justify having those at such high weights in portfolios at those sort of valuations. This gets people worried and is pretty nosebleed stuff, as everyone remembers what happened in 2000 when there was a market crash and everyone lost money.”
Despite geopolitical risks and very high uncertainty, there has been a surprisingly low level of market volatility, which has raised concerns of investors being complacent.
This is a bizarre and pretty unique environment, says Kempen Capital Management head of investment strategy Nikesh Patel: “Despite some momentous political upsets both over whole of 2017 and latter part of 2016, markets have really just sailed through them all and been pretty sanguine. It’s really been asset managers preparing for these events and then realising that actually they had no impact on the market in the end.”
For example, take the recent German elections – where the very unexpected outcome that Angela Merkel would not be able to form a government had little impact on global markets.
Five years ago such an outcome would have been an absolute earthquake through financial markets, says Patel.
Of course there are more geopolitical risks to come in 2018, not least from North Korea and Brexit, which could shake things up and bring back volatility.
But Van Nieuwenhuijzen says there needs to be more than political surprises or a surprise election results before the economy gets derailed, and that the chance of the economy being so weak that it will be derailed is “very small”.
Whether volatility increases will likely be determined by what happens to inflation levels.
“Business cycles like this don’t die because of time – they either get killed by central banks deciding to tighten or by excesses in financial markets, which are both linked to inflation,” says Patel. “The canary in the coalmine is inflation, and this will be the signal as to whether volatility will start to increase.”
He thinks the markets are generally under-pricing inflation risk at the moment.
“At the moment central banks can stay easy but as soon as wages start to pick up we think markets will start to price inflation much more aggressively, which will lead to normalisation in volatility rather than a spike.
“We think it’ll be a steady 2018 where we prefer equities to credit, and still prefer credit to bonds, so it will still be a risk-on environment in 2018. That’s positive for all those pension funds that are still exposed to risky assets.”
There are likely to be bouts of volatility around events such as further rate hikes from the US Federal Reserve and the Bank of England (BoE).
“This doesn’t bode well for fixed income and government bonds, and there will be more fragility in other bond assets”, says van Nieuwenhuijzen.
Sustained growth and further rate rises should put upward cyclical pressure on yields globally. However, the structural supports for bond markets that have kept yields lower for longer are still in play such as low productivity growth and high demand for government bonds.
Punter Southall principal Danny Vassiliades also points out the BoE’s rate rise plans could be scuppered by factors such as Brexit: “Given we’ve just had a base rate, it’s tempting to think will be succession of rises in the near future, but the big risk is the UK economy stalls, maybe because of Brexit or something else, and then the case for further rate rises just falls away. So the markets might react to that.”
However, research firm Capital Economics predicts the BoE will tighten policy by more than markets anticipate as the UK economy weathers Brexit uncertainty and higher inflation a bit better than is widely anticipated. It anticipates three UK rate rises in 2018, and this will help push up gilts yields, which recently jumped on the news of the agreement of payments to the EU. It projects the 10-year gilt yield will rise slightly from 1.3% as of 5 December to around 2.0%.
Opportunities to be found
Despite some expectations that the market rallies will come to a close in 2018, most believe that the current fundamentals will continue – at least for a short while.
One of the big challenges has been finding opportunities when most assets look very expensive.
Orbis’s Brocklebank argues there are still some opportunities to be found in equities, however.
“We’re seeing something akin to a supercluster – there’s a strong bifurcation in the equity market where significant proportions of the market are unattractive but other areas are attractive. Overall, while markets on average don’t look particularly good value, the spread of valuations within the market does offer good opportunity – not as extreme as it was 18 months ago but still looks very attractive to us.”
Schemes uncomfortable about investing in equity are looking elsewhere to get similar levels of return without taking extra risk, says Redington’s Samuels.
For example, risk premia strategies, which invest in styles such as value and momentum that do not necessarily correlate to a bull or bear market. Redington has put £2bn into smart beta on behalf of its clients in the past 18 months, and expects allocation to rise in 2018.
“There are still some interesting parts of the illiquid space, particularly in the more complex world of credit, where there’s still potentially a bit of premium to harvest,” he adds.
At the heart of all this is the need for schemes to be realistic about the absolute level of returns they can expect going forward.
“After double digit returns in the past, there needs to be a complete change in mind-set that investment managers promising returns of RPI plus 5% are being incredibly optimistic in these economic conditions,” says Vassiliades. “We’re telling clients they’ll do well to get 3.5%, 4% absolute in these kinds of markets, which isn’t the most welcome news.”
While too early to say, the current market cycle could continue into 2018 with equities performing well, and planned UK rate rises falling through. However, pension funds should watch out for the emergence and correction of asset bubbles, alongside interest rate hikes and increased volatility.