FROM THE GLOBAL CIO OFFICE
By Candice Bangsund, Vice President and Portfolio Manager, Global Asset Allocation and François Bourdon, Global Chief Investment Officer
CAUTIOUSLY OPTIMISTIC HEADING INTO 2018
Equity Markets Could Be Ripe for Near-term Correction
As 2017 draws to a close, global equity markets have enjoyed impressive gains in the reflationary environment of synchronized global growth, robust earnings, low inflation, and still-accommodative monetary policies. However, the risk-reward proposition has faded somewhat after such a strong period of equity performance, owing mainly to stretched valuations and some worrisome signs of investor complacency. Namely, the bar for economic and earnings surprises is much higher versus last year as buoyant expectations have largely been built into prices, while subdued levels of volatility suggest that investors remain vulnerable to disappointment and appear unprepared for a negative surprise. As a result, equity markets could be ripe for a near-term correction, which warrants some profit-taking after a record year. That being said, in our view, any pullback would likely be shortlived in nature and could present some compelling trading opportunities within the cyclical bull market.
All Major Regions of the World Contributing to Global Economic Expansion
Encouragingly, the favourable conditions that have underpinned the stock market rally remain intact as we head into 2018. The global economic expansion has become increasingly entrenched, with all major regions of the world contributing positively to the acceleration. While the US economy continues to be a predominant driver, we are also seeing above-trend growth in Canada, Europe, and Japan – while developing economies are demonstrating some renewed signs of stability. In contrast, we expect the UK economy to remain vulnerable in the coming year as the stalemate in Brexit negotiations weighs on confidence and spending intentions, while the pound-induced surge in inflation erodes the purchasing power of UK consumers – a major driver of the UK economy. Reflecting this strength, the global manufacturing PMI has breached a six-year high, though we expect this proxy for the overall health of the global economy to crest and mean-revert somewhat in 2018, but remain firmly in expansion territory next year.
Central Banks Likely to Take Their Time in Paring Back Stimulative Policies
Not surprisingly, global central banks have acknowledged this economic strength and have adopted a more constructive stance in response. Specifically, the Federal Reserve has commenced the process of unwinding its $4.5 trillion balance sheet and has reiterated its plans to gradually raise interest rates over the coming year. Similarly, the Bank of Canada and the Bank of England have conveyed that emergency level interest rates are no longer required, while the European Central Bank has announced a taper to its asset purchase program beginning in January. In contrast, the Bank of Japan has vowed to continue expanding its balance sheet for the foreseeable future as the deflationary mindset in Japan continues to place a cap on prices. However, the good news is that while the economy has been strong enough to keep recession fears at bay, it has yet to generate much in the way of inflationary pressures and we see no imminent danger of overheating conditions over our 12 month horizon – allowing central banks to take their time in paring back stimulative policies and leaving the global liquidity backdrop supportive in general.
Lower Equity Returns Expected During 2018
Taken together, while we are indeed in the later stages of the economic expansion, we remain in the early stages of the central bank tightening cycle - suggesting lower, albeit still positive equity returns in the coming year.
Stronger Global Growth and Corporate Earnings Should Compensate for Rising Interest Rates
As central banks have yet to become outrightly restrictive, the global economic recovery may continue uninterrupted well into 2018. As such, the reflationary window that benefits equities at the expense of fixed income remains open at this time. While we see little value in bonds, the stronger global growth and corporate earnings trajectory should lend support to equity markets and compensate for rising interest rates in the coming year.
FIXED INCOME: UNDERWEIGHT FOR 2018
We believe that the path of least resistance for global government bond yields remains higher (and prices lower) in the environment of improving global growth, rebuilding inflationary pressures, and coordinated monetary normalization – compounded further by the prospect for expansionary fiscal policy in the US. In this environment, we maintain our underweight allocation to fixed income. Within the asset class, we would advise maintaining a short duration positioning, while also looking further up the risk spectrum towards spread product and inflation protection – both of which should thrive in the environment of negligible recession (default) risks and a revival in inflation expectations.
EQUITY: OVERWEIGHT CYCLICALLY-BIASED AND COMMODITY-LEVERED REGIONS IN 2018
As the global economic expansion lingers on, earnings growth should trend higher in accordance – lending support to equity prices over the coming year. We have a preference for the cyclically-biased and commodity-levered regions of the world (such as Canada and the Emerging Markets), while we anticipate a rotation from the defensive, interest-rate sensitive sectors of the market towards the cyclically-oriented plays (such as financials, energy, materials, industrials).
COMMODITIES: POSITIVE OUTLOOK FOR OIL IN 2018
Oil: We remain bullish on oil prices heading into 2018. Notably, the synchronous global expansion should continue to bolster demand, while on the supply-side, inventory levels have stabilized and even receded towards more normal levels, with OPEC members agreeing to an extension to production curbs past March 2018 – all of which should help crude markets achieve a better balance in the coming year.
Copper: Copper prices should remain well-supported by the stronger global growth backdrop and the corresponding rise in demand that comes with it, while dwindling inventories and a weaker greenback should also place a floor under prices.
Gold: We remain neutral on gold due to the opposing forces in play. On the one hand, prices will remain vulnerable to the stronger US growth trajectory and as the corresponding revival in inflation accelerates the pace of monetary policy normalization in the US. On the other hand, escalating geopolitical uncertainties should help to place a floor under prices.
CURRENCIES: BEARISH OUTLOOK FOR THE US DOLLAR
US dollar: The convergence of global growth prospects and central bank normalization supports an allocation towards non- US dollar currencies. Specifically, the synchronized global expansion should be bearish for the US dollar as ex-FOMC central banks begin to normalize in response to stronger global growth, compounded further by increased inflows into foreign markets.
Canadian dollar: While the Canadian dollar could indeed take a breather as the Federal Reserve prepares to raise interest rates several more times through 2018, we expect the Canadian dollar to remain well-supported over the coming year - particularly if our call for higher crude prices comes to fruition.
Euro: We expect the euro to strengthen modestly over the coming year as the economic recovery becomes increasingly self-sustaining and as inflation gathers pace in response, allowing the European Central Bank to continue unwinding its ultraaccommodative monetary stance - while the softer greenback should also lend support.
Sterling: We have a neutral positioning on the pound. On the one hand, the pound remains historically cheap and should be supported by broad based weakness in the US dollar – though the uncertain economic backdrop in the UK could weigh on the pound in 2018, particularly as the implications of Brexit become increasingly clear.
RISKS TO THE OUTLOOK: PREDOMINATELY GEOPOLITICAL IN NATURE
A Rise in Trade Protectionism
Recent trends towards populism and protectionism could bring about tremendous political upheaval and a corresponding crisis in confidence – disrupting the global economy and financial markets alike. In the US, renewed pressure to make good on his campaign promises ahead of the midterm elections could see President Trump’s rhetoric on protectionism translate into action, particularly due to his ability to act unilaterally on the foreign policy front. Namely, any sudden breakdown of NAFTA negotiations or US-China relations remain front and center from a risk perspective. If anti-trade rhetoric in the US becomes a reality and results in tariffs being imposed on economies such as China, Canada, and Mexico - retaliatory measures could ignite a global trade war.
With the twice-a-decade National Party Congress now behind us, we will be watchful on how aggressively President Xi pursues economic reform and at what expense to the growth outlook. After consolidating his power, an increasingly assertive and wide spread stance towards financial sector reforms to crack down on excesses could pose considerable risks to both economic growth and financial stability.
Escalating Geopolitical Tensions
Tensions between the US and North Korea remain elevated, while turmoil in the Middle East lingers on – both of which could negatively impact consumer and business sentiment and undercut both the global economy and financial markets alike.
Emerging Market Instability
Emerging market economies are most vulnerable to a faster pace of interest rate increases in the US and a corresponding resurgence in the US dollar. The sharp decline in foreign direct investment, repayment of US-denominated debt, and potential capital outflows could result in major contagion and a corresponding flight to quality trade, further exacerbating USD strength and a broad-based tightening of financial market conditions. Furthermore, excessive and rising debt burdens in China leave the economy vulnerable at a time when growth is already slowing, rekindling fears of a hard landing in the world’s second largest economy.
In Europe, while anti-euro parties were unable to gain significant ground in France and the Netherlands, the potential for a rise in euro skeptic movements prevails in Italy (where support for the euro remains low), which risks throwing the region into political disarray at the same inopportune time when the fallout of Brexit remains highly uncertain.
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