/2018 – a year for active management

2018 – a year for active management

2017 saw a previously US-centric and relatively anaemic economic recovery from the financial crisis broaden out and gain vigour. The Trump presidency has so far proved to be mostly bun and no beef, while the series of European elections saw pro-European parties retain power, albeit with a stalemate in Germany. The UK was a notable exception, with economic growth lagging owing to the uncertainties of Brexit and an unexpected rise in political risk due to the poorly judged Conservative election gambit.

This broadening of economic growth has been matched by an end, or at least interruption, to the ascendancy of US equity returns. With the exception of the UK, all other major regions outperformed the US market in currency adjusted terms, partly due to starting valuations being lower and partly to improving confidence on the back of faster economic growth.

The improvement in the level and breadth of global growth is likely to continue in 2018. The US tax cuts enacted towards the end of 2017 are expected to boost US corporate earnings but also benefit growth more widely. This is unvarnished good news for general prosperity but a cool investing head may be needed at times to navigate markets that are relatively highly valued by historic standards, against a backdrop where the tailwind from low interest rates and QE liquidity is abating and, in some cases, starting to reverse. Central banks (particularly the Fed in the US) will take the opportunity of better-entrenched growth to start to raise interest rates from near zero levels, although they seem likely to do so very gradually, for fear of interrupting economic convalescence. The reduction and gradual reversal of central bank buying of bonds is a slow burn fuse that, even if it fizzles, seems likely to push bond yields higher.

The high ratings on equity markets appear rational given low interest rates but at some point this could be undermined if bond yields were to spike higher in response to either a material rise in inflation or overzealous tightening by central banks. Of the two, a rise in inflation appears the greater risk (despite the “D”flationary forces from demography, debt and (technological) disruption). A moderate rise in inflation would be a sign of economic improvement, so during 2018 there could be a divergence between markets and economies, but (in contrast to recent years) with economies doing better and markets as a whole prone to periods of profit taking in response to tighter monetary policy or inflation scares.

Markets will always fluctuate around the underlying trend set by the drivers for corporate profits and, with decent economic growth expected to continue, time should be on the side of patient equity investors. What concerns us slightly, having for some years been more optimistic than most on economies and markets, is that fewer people are sceptical or negative than a year ago, with increased complacency making markets more vulnerable to disappointment.

This makes a case for greater selectivity rather than outright defensiveness in our view. Indeed, some of the more cyclical areas (including industrials and financials) could do well, as residual scepticism melts, and emerging economies also seem likely to build on the improved relative showing in 2016-17. For contrarians, the domestically exposed stocks in the UK market have derated substantially and may now be more responsive to any glimmers of good news, having discounted much of the unpredictability of the Brexit process. It is perhaps too early for a major leap of faith in this area but it is usually more right than wrong to be a contrarian as an investor, as long as you check that the truffle on offer is not a toadstool.

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