2018 outlook: Exploiting opportunities in a rising yield environment
• Global growth, supported across sectors and regions, is expected to stabilise at healthy levels in 2018 • Our research on drivers of market behaviour points at a still favourable environment for relatively risky assets • Equities are our preferred asset class, supported by a benign macro and earnings outlook as well as positive behavioural dynamics • We like Japan, emerging markets and Eurozone equities, while we prefer cyclical exposure based on strong macro data and moderately rising bond yields • Fixed Income assets are challenged by rising interest rates and tight valuations; a flexible allocation towards shorter duration and growth exposure is advised
Global economic conditions are at their most favourable point of at least the last 10 years. Since the end of last year, global growth has embarked on an ascending path following two years of slowing momentum. In a sense, it was the nexus between accelerating earnings growth, rising business confidence and rising capital expenditure (capex) which pushed global growth towards the top end of the range seen since the global financial crisis.
Valentijn van Nieuwenhuijzen, Chief Investment Officer at NN Investment Partners: “A burning question is of course whether we will break the growth ceiling in 2018. To start with the “bad” news: we think we will not. A sustained breakthrough will rest on the aforementioned nexus becoming stronger. While earnings growth will remain at double-digit levels, it is likely to slow down driven by the view that, for now, the cyclical rebound in productivity growth has mostly run its course while pricing power will not surge ahead. At the same, time we should see a moderate increase in wage growth, especially in the US and Japan. The slowdown in earnings growth goes hand in hand with a stabilisation in business confidence which suggests that corporate spending momentum should remain robust, but is not likely to accelerate.
The good news is that growth is unlikely to falter. Growth is firing on more cylinders than at any time since 2008. This certainly is the case across sectors but also across countries, which probably explains why global trade has rebounded so strongly over the past year and why emerging markets have been able to join the party. Moreover, both consumer demand and capex are rising strongly while the risks to fiscal policy are on the side of easing, which suggests that growth is also supported across demand components.
While the real side of the economy is powering ahead, the nominal side remains puzzling. Wage and price inflation keep lingering and productivity growth remains muted. These two pillars will be key swing factors in 2018 and need to resurrect in order to push nominal growth through the ceiling – and to fuel a continuation of the uptrend in growth oriented assets like equities. The lowflation/low productivity puzzle demands for a higher-than-usual uncertainty premium and is at the same time the core reason for a market ecology that has high absolute valuations (and low expected returns) in combination with still attractive relative valuations.
Fears of excessive market valuation are understandable, but basing one’s investment approach too much on fear may lead to opportunity losses that eventually erode one’s return potential. Our research on drivers of market behaviour suggests that we have certainly not entered a negative territory for risky assets. Metrics on sentiment, investor emotion, herding behaviour, liquidity conditions and positioning help us to reach this conclusion, but the simplest explanation is that there are still no clear signs of exuberance or excessive optimism in markets’.
Equities are NN IP’s preferred asset class for 2018. The fundamental backdrop for equity markets is the best we have seen in years, with strong macroeconomic data and double-digit earnings growth both this and next year. At the same time, the low inflation numbers will prevent any rapid tightening of monetary policy.
Patrick Moonen, Principal Strategist Multi Asset at NN Investment Partners: “The conditions for equities come close to a Goldilocks-like environment. Next to the benign fundamental picture, market dynamics have improved substantially in the past few months. Momentum is strong, while positioning is increasing but not yet stretched. Investors are optimistic but far from euphoric, as evidenced by several sentiment indicators.
An important question obviously is whether equity markets will continue the uptrend seen since early 2016. Many observers point at stretched valuations, but we think valuation is not an impediment for further rises. True, price-earnings ratios are high, but not extreme if we take into account their current point in the earnings cycle. Relative to fixed income instruments, equity valuations are in line with, or more attractive than, historical averages. This is especially the case for the Eurozone and Japan.
The relatively high equity risk premium is one of the reasons why Japan is our preferred equity market. In addition, the election victory of Prime Minister Abe substantially reduced political uncertainty. This should ensure a continuation of Abenomics and accommodative monetary policy. We also like emerging market (EM) equities. Earnings prospects are strong, valuations are attractive, and most EMs are supported by favourable financial conditions. However, shifting Fed expectations and a stronger dollar, combined with a consensus overweight positioning, are the main risks to EM equities. Furthermore, we prefer the Eurozone to the US because of its more attractive valuation and greater cyclical sensitivity.
In sectors, we also have a preference for cyclical exposure. This strategy is supported by three elements: strong macro data, higher bond yields following gradually tighter monetary policy, and stable to rising commodity prices. The energy and materials sectors obviously benefit from the latter, while financials is our preferred sector given its low valuation, good earnings outlook and positive correlation with bond yields. As we expect a moderate rise in bond yields, financials should outperform the search-for-yield sectors like utilities and telecoms.”
The outlook for fixed income markets looks rather challenging at first sight. Monetary policy normalisation is on its way and as a result we are moving from a search-for-yield to a reflation environment. This is a challenge for fixed income assets which in the past couple of years have benefited massively from search-for-yield flows.
Pieter Jansen, Senior Strategist Multi Asset at NN Investment Partners: “The pace of monetary policy normalisation and of the rise in bond yields will to a large extent determine the correction risk for fixed income spread products, like (high yield) corporate bonds and emerging market debt. We expect both to keep developing in a particularly gradual fashion. Still, given the turning point in the monetary policy direction, tight valuations and weak liquidity, the risk of a temporary, moderate spread widening is material. Significant spread widening usually only happens in a risk-off environment and, given the positive fundamental backdrop, we do not expect this.
As the pace of monetary policy adjustment will greatly depend on the evolution of growth and inflation data, a dynamic approach to fixed income investing is prudent. In a moderate growth environment we would likely see a continuation of the search for yield, with ongoing inflows into most spread categories although the potential for significant spread tightening is low. In a more positive growth and rising bond yield scenario, investors may shift from low risk, long duration exposure to short duration assets while seeking spread compensation from higher risk assets. Low correlation to US Treasuries, exposure to growth, and floating rate coupons are preferred characteristics in such a scenario. Examples of these can be found in asset classes like convertible bonds, alternative credit, or emerging market debt.”
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