2018 Outlook: More strong returns likely but it could be a bumpy ride

2017 might have been a politically turbulent year, with geo-political tensions such as Brexit and North Korea dominating the headlines. But for markets, 2017 was actually an outstanding 12 months, characterised by strong performance and low volatility.

The FTSE 100 reached all-time highs on numerous occasions and finished the year with yet another record close. New all-time levels were also reached on markets in the US, South Korea, India and Germany.

There is a synchronised economic recovery taking place that is likely to continue in many of the world’s major regions and this should provide a platform for respectable returns. Indeed, in 2018 we could well see more stock market records; the consensus is that global growth will hit 3.5%-4% this year, with most G7 economies predicted to expand by over 2%. The US market should be boosted by President Trump’s recent business-friendly tax package and this should mean continuing strong profits growth, which is supportive for equities.

In addition, real-time growth indicators such as Purchasing Managers’ Indices (PMIs) generally point to stronger global growth and, all things being equal, this should underpin another year of respectable returns.

A note of caution, however, would be that 2017 was almost as good as it gets on the markets, so there is now more room for disappointment than in previous years. We are beginning to see some monetary policy divergence, which may unsettle some investors, and there are a few other areas that could produce a curve ball into the markets.

Why 2018 could be more volatile
While inflation in the US is still low, it is rising, and we are likely to see more rate hikes in 2018, which may cause some nervousness. Rising interest rates and currently high equity valuations provide cause for caution, but interest rates would have to rise significantly before investors felt their assets would be better off in cash or bonds than equities.

That seems very unlikely for the foreseeable future but a few upside surprises to inflation could cause a few jitters.

Interestingly, however, research by Brewin Dolphin shows that the correlation between interest rates and equity performance may have been overplayed. Our data suggests that, in fact, the extraordinary growth in global M1 money supply in the latest cycle shows a stronger correlation with market outperformance than the level of interest rates.

Crucially, one of the main drivers of this is China.

The China effect
M1 money supply essentially refers to liquid cash and this is generally created by the combined actions of policymakers and banks. Although the developed world’s central banks have been infamous for the stimulus they have imparted, more recently China has been the most aggressive chaser of growth.

During the financial crisis, Chinese banks embarked on a lending spree to sustain its economic growth. But our research shows that, in 2016, China’s policy was even looser, resulting in a glut of M1 money entering the global economy. As a combined result, total debt to companies and individuals in China has risen from $6 trillion during the financial crisis to around $28 trillion at the end of last year.

That took its debt from 140% of GDP to 260% of GDP over the same period and makes China’s companies the most highly leveraged in the world.

Another consequence of this lending was to boost the amount of cash in the global economy; in the latest market cycle, China has contributed nearly half the M1 money supply growth in the world. The Eurozone is responsible for most of the rest with the US barely contributing. This means that China is now a bigger contributor to global GDP and money supply growth than it has ever been, meaning it has a proportionately greater influence on global markets.

China slowdown and other things to watch…
After winning re-election, President Xi Jinping has said he wants to address China’s huge debt, so we expect China to continue raising interest rates and introducing capital controls to stop money leaving the country. Not only might this slow the Chinese economy, it should reduce its contribution to M1 money supply this year, which in turn would mean less money available for investment in global equities. That is a recipe for volatility and potential market corrections.

Also in the mix are concerns about Brexit, which could easily unsettle markets (although they said that about 2017 too), and possibly a slowdown in the US, although strong corporate profits and Trump’s pro-business agenda could extend the US bull run still further.

With all this in mind, investors should be optimistic for 2018, but prepared for a few more bumps in the road along the way.

As Brexit matures, US rates continue to rise and the world sees a possible tightening of liquidity through the money supply, it may be that the investing “highway” feels a little less like the smooth tarmac of 2017 and more like driving off-road as this cycle hits its peak.

The real challenge for investors after an environment of very low volatility is that they may be unnerved as it “normalises”. More volatility means more opportunity for active investors with strong nerves. If one region or asset class goes down in value, other regions and assets rise, and we are expertly positioned to take advantage of these investment opportunities as they appear.