Five themes that look set to shape portfolio returns in 2018

After last week’s attempts to learn key lessons from 2017, this column will now turn its attention to the year ahead. In the (unfortunate) absence of a crystal ball, no promises or guarantees can be offered, but below are five themes which investors will need to think about when it comes to portfolio strategy in 2018 and beyond.

They are:

1. Central banks and what looks like a more universal move toward tightening monetary policy
2. Whether low unemployment finally translates into faster salary increases for workers and a wider acceleration in inflation
3. The ongoing reach for yield
4. The Trump trade
5. The broader market cycle and whether the meteoric rise of Bitcoin and cryptocurrencies means we are nearer the end than we are the beginning

Each one is outlined in further detail below.

Five themes for 2018

1. Central banks and the apparent drift toward tighter policy

Although the Bank of England’s Mark Carney and European Central Bank’s Mario Draghi are firmly in position, the US Federal Reserve will have a new chair in the form of Jerome Powell come February and the Bank of Japan’s Haruhiko Kuroda sees his first term end in April. Kuroda looks likely to keep his job but Powell will be overseeing a period of change in the Fed’s Marriner S. Eccles Building in Washington, as the identity of a number of Federal Open Market Committee members is due to change in 2018.

There also seems to be a shift in the direction of monetary policy, even if the pace remains glacial.

In November the Bank of England pushed through its first interest rate increase for a decade, while Governor Kuroda gave a speech in Zurich in which he hinted that the Bank of Japan may start to relax its grip on the Tokyo bond market by no longer holding the ten-year Government bond yield at zero (though he quickly backtracked). In December the Fed raised rates for the third time this year and fifth time this cycle.

In January the ECB will taper its monthly Quantitative Easing (QE) bond scheme from €60 billion a month to €30 billion. The Bank of England is expected to eke out a second one-quarter point rate rise in 2018. And the Fed is targeting three more rate hikes and a continuation of its Quantitative Tightening scheme, whereby it begins to reduce monetary stimulus.

While the rate of change may be slow, this still represents a key test for securities markets which have feasted on record-low rates and cheap liquidity. As this column has noted many times before, it has taken an average of eight to nine rate hikes to stop the US stock market in its tracks (although the range is wide from cycle to cycle), and three more this year would take the target to eight.

Central banks’ reducing their asset holdings rather than increasing them will be a test for bonds and equities alike, especially the latter, which have benefitted from a perceived lack of alternatives when it comes to asset allocation in a low-inflation, low-yield, low-growth world.

This first graphic shows there is a possible link between the asset-buying schemes of the Bank of England, Bank of Japan, European Central Bank, Swiss National Bank and the US Federal Reserve and global stocks.

It will be interesting to see if this link persists in 2018, should the Fed stick to QT and the ECB and even the BoJ start to slow the pace of QE, although it is possible that global economic and corporate profits growth prove capable of carrying the day.

This is not to say that every central bank is raising rates or tightening policy - Brazil and Russia are still cutting borrowing costs and this divergence could be a differentiator for emerging markets in 2018, even if the Banco Central do Brasil has already taken the headline Selic rate down to a record-low of 7.00%.

Central bank bias toward tightening policy could make 2018 an interesting year for global equities

Source: Thomson Reuters Datastream, Bank of England, Bank of Japan, European Central Bank, Swiss National Bank, US Federal Reserve, FRED – St. Louis Federal Reserve database

2. Wage growth and inflation

Despite (near) multi-decade lows in the unemployment rate of 4.3%, 4.1%, 3.6% and 2.8% in the UK, US, Germany and Japan respectively, wage growth for workers remains relatively subdued at 2.5%, 2.5%, 1.2% and 0.6% for the same four countries.

Why this should be remains a matter of fierce debate. In the UK it is possible to point to auto-enrolment (meaning that workers are getting a better package but the benefits are back-end loaded and not strictly salary-related); the rise of self-employment; the development of the gig economy and job sharing; corporations being careful ahead of Brexit; and the rise of automation, as staff try not to price themselves out of a job and a robot into one.

There is also an argument that the minimum wage and living wage are having the unintended side-effect of persuading employers to offer fewer hours to offset the cost of higher hourly pay, with the result that staff are hardly better off, if at all.

Some of these themes apply internationally too and it may be that the rise of the robots and the gig economy keep wages subdued.

This appears to be the expectation of the markets, judging by the lowly rates of expectation priced in by five-year inflation expectations, which is just 1.99% in the US for example.

That is in keeping with the current Goldilocks scenario of an economy that is warm enough to help corporates increase profits but not too hot to stoke rate rises or inflation or so cool that it threatens earnings growth.

But if this scenario changes then bond and equity markets alike will have to pay attention, so investors will have to stay alert for two reasons.

First, if the economy does accelerate, then higher wages or greater investment in capacity may be needed, to the detriment of short-term margins and earnings – something which stock valuations and earnings estimates do not appear to be factoring in.

Second, faster wage growth could also persuade central banks to act more quickly to tighten policy and turn off the liquidity taps. This does look unlikely now but it is the sort of negative surprise that could hit sentiment hard.

Wage growth is still subdued despite low unemployment in major developed economies

Source: Office for National Statistics, US Bureau of Labor Statistics, Bank of Japan

3. The reach for yield

Bond yields generally remain depressed (some $11 trillion of bonds worldwide still come with negative yields, according to the Financial Times newspaper) and central bank QE schemes have ground down the premium, or spread, on offer from sub-investment grade (junk) and investment grade corporate and government bonds relative to US Treasuries, UK Gilts and German bunds.

If interest rates do rise then bond prices could fall by a degree which more than offsets the financial gain offered by the coupons. A very subdued inflationary environment is needed to keep bonds safe at this level, although global debts, weak demographics in the west and the price-crushing powers of the internet mean this is by no means impossible.

Investors need to be aware of duration risk (and how sensitive individual bond holdings or their preferred active or passive bond funds are to movements in interest rates).

Even if bond yields remain low, income-seekers still have a problem, one where the most tempting solution is to turn to equities. After all, the prospective yield on the FTSE 100 is 4.3% for 2018, according to consensus forecasts, a figure which easily outstrips cash or the 1.16% yield available on the 10-year Gilt.

Yet care is needed. Several high-profile income stocks came a cropper in 2017, notably Pearson and Provident Financial, even if the oil majors BP and Shell confounded the doubters by holding their mighty dividend payments once more.

Investors must therefore look carefully at the stocks which feature in the top-ten lists of their preferred equity income funds, especially as just four sectors – banks, insurers, consumer staples and consumer discretionary – are forecast to generate the vast bulk of UK dividend growth for 2018, while oils are a big chunk of the total pot.

The higher oil goes, the safer the dividends of Shell and BP become, and thus the safer the yield of the FTSE 100 in some ways, although higher oil would represent a cost to consumers and corporates alike in other sectors, so even that scenario is not a zero-sum game.

Banks, insurers, consumer staples and consumer discretionary are forecast to dominate FTSE 100 dividend growth in 2018

Source: Digital Look, consensus analysts’ forecasts

4. The Trump trade

Markets continue to warm to the reflationary potential of the fiscal-spending, tax-cutting and regulation-slashing programme outlined by US President-Elect Donald and rising US share prices represent the clearest sign of enthusiasm for the proposed tax reform programme.

Estimates suggest that US corporate earnings per share could benefit by between six and ten percentage points, depending upon which estimates you use – although this does beg the question of whether the smart gains seen in the Dow Jones Industrials, S&P 500, NASDAQ Composite and Russell 2000 indices already factor in this boost, given they have risen at a faster rate than that since President Trump won the November 2016 Presidential Election.

For the moment, however, the analogies with President Reagan’s first term (1981-84) are providing the market with a powerful narrative. ‘The Gipper’ also cut taxes, increased defence spending and preached deregulation to such powerful effect that US GDP growth soared to 8% year-on-year and stocks boomed, but even the most ardent bulls of US stocks must note that Reagan inherited a far more propitious set of circumstances than Trump.

When Reagan took charge, interest rates and inflation were falling, Government debt was low (and left room for manoeuvre) and stocks were cheap after a torrid bear market.

Under Trump, rates and inflation seem to be slowly creeping higher, debt is already reaching uncomfortable levels and stocks are at nosebleed valuation levels, according to Professor Robert Shiller’s cyclically-adjusted price earnings (CAPE) ration, after a nine-year bull market.

CAPE is a poor near-term market timing tool but history suggests it has the potential to be fair predictor of returns from US stocks on a 10-year view and if that pattern holds up then investors may choose to assess their US exposure and ensure they feel the risk-reward ratio is appropriate, given historically-high valuation and also the manner in which Japan, the UK and emerging markets appear to be trading on multiples which are less demanding relative to their history.

The Shiller CAPE ratio has a terrible near-term record of forecasting US stock markets but a potentially decent long-term one

Source: www.econ.yale.edu/~shiller/data/ie_data.xls, Thomson Reuters Datastream

5. The market cycle

Fund management legend Sir John Templeton once asserted that “Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria.”

Investors may therefore be tempted to check their portfolios and asset allocations, to see where, if anywhere, they have exposure to unloved (and potentially cheap) and overloved (and potentially expensive) assets.

The issue of valuation remains a subjective one, but this column receives plenty of feedback during the year and the table below is based on both its assessment of valuation relative to history and also the number of questions and comments received about given topics.

Areas where little or no interest has been shown feature in the “pessimism” and “scepticism” boxes.

Those topics which stirred considerable correspondence feature in the sections marked “optimism” and “euphoria,” with a valuation overlay applied for good measure.

It will be interesting to see if the most popular, momentum-driven areas remain as popular in 2018 or whether the more contrarian, value-driven options come to the fore.

Asset class performance leaned toward momentum and away from value options in 2017

Source: AJ Bell

Russ Mould, AJ Bell Investment Director