Five themes from 2017 that could influence 2018

There can be no denying 2017 was an eventful year and making money was not entirely straightforward, even allowing for Bitcoin’s surge into the stratosphere. Bonds generally struggled, commodities were mixed and equities provided the best returns, albeit with very wide performance gaps between the best and the worst geographies, sectors and stocks.

Elections in the Netherlands, France and Germany failed to derail European stocks, even as the Brexit negotiations appeared to weigh on UK equities, and higher interest rates in the US and UK and a slightly less loose monetary policy in Europe still seemed to leave plenty of liquidity in the tank with which to drive stock valuations higher.

Economic growth held up, tensions between America and North Korea escalated, China did not disappoint and inflation confounded central bankers and economists alike by remaining subdued.

A year of modest growth and moderate inflation saw quality and momentum prove to be the dominant stock market themes, as value’s day in the sun in 2016 proved to be brief. However, as 2017 ended, cyclical value (and also income in the form of defensive value) began to outperform as tech, biotech and consumer staples lost some favour, weighed down perhaps by lofty valuations.

The secret now for investors is to see what lessons can be taken from 2017 and applied to 2018, to help them protect wealth and seek positive returns while managing risk most effectively.

The scores on the doors

Just to reaffirm how 2017 panned out, here are a few means of keeping score.

First, by asset class, equities led the way.

Equities did best of the major asset classes in 2017

Source: Thomson Reuters Datastream. Total returns in sterling terms.

After spending 2012-2015 in the doghouse, Emerging Markets outperformed their Developed counterparts for the second year in a row.

Emerging markets added to 2016’s outperformance in 2017

Source: Thomson Reuters Datastream. Total returns in sterling terms.

This is also reflected in the key regional performance trends, where Asia took charge. Even the pound’s second-half rally was not enough to dampen the appeal of overseas assets and the UK underperformed for the second year in a row for good measure.

Asia did best and the UK fared relatively poorly in 2017

Source: Thomson Reuters Datastream. Total returns in sterling terms.

By sector, Technology dominated, which is hardly surprising when you consider a fascinating statistic from fund management giant M&G that Facebook, Apple, Amazon, Netflix and Google added $1.4 trillion in market capitalisation between them in 2017. Defensives, value sectors and bond-proxies Telecoms, Consumer Staples and also Energy found the going a lot tougher.

Technology dominated sector performance in 2017

Source: Thomson Reuters Datastream. Total returns in sterling terms.

Five key lessons to learn

Looking at that deluge of data, the following five events and trends from last year look to offer the most important lessons for the 12 months ahead.

Growth expectations rose

The so-called Trump, or reflation, trade remains powerful all year, while China’s ability to consistently deliver annual GDP growth in the 6-7% range provided welcome reassurance that another key cylinder in the economic engine was still firing. In addition, Europe surprised on the upside as even Italy reached the dizzying heights of 1.5% GDP growth in the third quarter.

This all helped to stoke strong performance from equities which handily outpaced bonds on the global stage in sterling, total return terms, as can be seen from this chart, which divides the price of a global equity tracker by that of a global bond tracker. The equity tracker clearly rose faster throughout 2017.

Equities handily outperformed bonds in 2017

Source: Thomson Reuters Datastream

Lesson one: The inflation narrative is gaining pace, although bond markets’ failure to actually fall out of bed would suggest that fixed-income experts remain concerned about the potentially deflationary influence of too much debt, poor demographics in the West and the price-crushing powers of the internet. If inflation does pop its cork in 2018, that would be bad news for bonds, if history is any guide, and potentially help cyclical and value plays, although too much inflation could force central banks to tighten policy more quickly than expected – so stock markets need to be careful what they wish for.

Momentum beat value and quality and income

This can be clearly seen in the rampant performance of technology stocks within equities in 2017 and the failure of cyclical value plays to maintain 2016’s strong relative showing. The surge in cryptocurrencies was an even more extreme example of the power of momentum jockeys, although sector trends within the calmer waters of the UK equity market were similarly clear.

Momentum sectors took charge in the UK in 2017

Source: Thomson Reuters Datastream.

Lesson two: If the narrative regarding a global synchronised recovery holds firm in 2018, investors will have less reason to pay a premium rating for tech and biotech stocks or quality growth names like consumer staples plays and more opportunity to buy cyclical growth for much lower prices. There were some signs of this shift in the fourth quarter and they need to be watched, although the bond market’s reticence and determination not to panic suggests the Trump trade has yet to convince everyone.

The pound and Brexit dominated in the UK

Despite Prime Minister Theresa May’s autumn intervention in Florence and her December breakthrough in Brussels on the issue of the putative divorce bill, there is a long way to go in the Brexit negotiations. The key issue of trade is now on the table, the Irish question has yet to be concluded to the satisfaction of everyone and the EU’s members will have to vote on any eventual deal (and the UK’s MPs seem to want their say in Parliament too, at some stage).

There is much work to do and companies could be forgiven for waiting before they commit to capital investment or hiring decisions. The pound looks undervalued on a purchasing power parity basis so that should at least help exports but it is hard to see why growth should markedly accelerate in 2018 from the modest levels we have seen of late.

The pound began to regain some ground in late 2017

Source: Thomson Reuters Datastream

Lesson three: The debate over a “hard” or “soft” Brexit is still raging. Talk of the former has so far pressured sterling and favoured holding assets priced in currencies other than the pound or domestically-quoted firms that operate mainly overseas. Within the UK, the result is a split market, with overseas plays looking expensive after strong performance and domestic plays looking unloved and cheap but possibly lacking a catalyst to stoke fresh interest in them. Any unexpected change in direction for sterling could perhaps prompt a reappraisal, although this column said exactly the same a year ago and it made no difference at all.

Volatility was subdued as headline indices almost fell asleep

The FTSE 100 rose or fell by more than 1% in a day on just 16 occasions in 2017, the lowest figures since the 18 occasions of 2005. This will have helped soothe the nerves of any clients who were edgy about their equity exposure and it may have been no coincidence that stocks did best of all of the major asset classes this year.

Daily movements of 1% or greater in the FTSE 100 were very rare in 2017

Source: Thomson Reuters Datastream

However, for all that the UK’s headline index did little, there was plenty of violence at the stock level. Nine FTSE 100 stocks showed a one-day drop of least 10% (a tenth was demoted from the index in the autumn) and the range between the best and worst performers in the benchmark was massive – from NMC Health up 107% to Centrica down 36%.

This gathering movement below the surface suggests that investors need to be prepared for a few more ripples up top in 2018 and beyond – an environment which could give active managers another chance to shine.

Lesson four: Looking back 12 years, volatility then increased (52 occasions in 2006, 92 in 2007) before all hell broke loose in 2008. It seems unlikely that everything can remain as still as a millpond for ever, although if the previous cycle is any guide then a rise in volatility could be a warning that the good times are about to end and a tactically risk-averse shift may be appropriate, with a final crescendo the signal that it is time to start becoming more aggressive again.

Central banks once more stood centre stage in 2017

It is possible to argue that stock markets were narcoleptic because they remained drugged by cheap money from central banks. The Swiss National Bank (bizarrely now a huge shareholder in Apple, amongst others) and the Bank of Japan kept loosening policy at full tilt via their Quantitative Easing (QE) programmes and although the European Central Bank began to taper its QE scheme and reduce the amount of monetary stimulus it left interest rates unchanged at zero. The Bank of England made no move to taper QE either.

Even if correlation is not causation there does seem to have been a relationship between central bank asset-buying programmes and perky equity markets, as zero interest rate policies and depressed bond yields persuaded (or obliged) investors to take more risk in search of better returns from their cash.

Central bank policies could be seen to have influenced global stock markets

Source: Thomson Reuters Datastream

Lesson five: If 2017 saw central banks acting largely in concert, 2018 may do the same, but not quite in the same way. The US Federal Reserve has already pushed through five interest rate increases this cycle and targeted three more for 2018. The Bank of England has raised rates for the first time in a decade, the European Central Bank is tapering QE and even Japan has dropped hints that it may take a less stimulative stance next year. This could be the biggest test of all for asset prices in 2018 if policy is tightened across the board, even if this happens only slowly.

Russ Mould, Investment Director