Whilst there were many potential concerns for investors at the start of 2017, it turned out that many of the worst fears failed to materialise and it was the favourable economic and corporate situation that dominated asset markets. For the first time since the financial crisis all of the 45 largest economies are seeing growth and this synchronised healthy global growth environment looks set to continue at least through 2018.
There are some concerns that 2017 conditions were as good as it gets for investors, with good growth, strong corporate profits, subdued inflation and supportive central bank policies, but any changes to these conditions are only likely to be gradual. After such a long period of economic expansion we need to be mindful that we could be approaching the latter stages of the cycle and be alert for signs of a slowdown or potential recession.
The all important US economy remains in good shape and the passage of tax reforms has further bolstered growth forecasts. European confidence is growing, with the European Central Bank seeing a “continued robust and increasingly self-sustaining economic expansion”. This is enabling the ECB to reduce their crisis-era monetary stimulus programme faster than expected. Although some political risks have passed, there remain potential problems to overcome in Spain and Italy.
The main drivers of global growth continue to be the emerging markets, with positive contributions coming from all areas now that Brazil and Russia have returned to growth. China remains the dominant emerging economy and although there continue to be some longer term concerns over their growing debt levels the economy appears to be set on a healthy but gently slowing growth course.
The UK economy is not experiencing the upswing seen elsewhere, with growth expected to remain at a somewhat subdued 1.5% in 2018. UK inflation has also risen sharply following the post-EU referendum decline in sterling and this is hurting consumer spending power given that wage growth has remained around 2%. Inflation should moderate in 2018 and provide some relief to consumers and further signs of a softer form of Brexit would reassure investors who remain wary of the UK, but much uncertainty remains over the eventual outcome. As the domestic political situation remains challenging, the prospect of a potential hard left UK government may become more of a focus for investors as the year progresses.
So the priority for investors should remain on the economic and corporate environment, key factors to watch will also be the activity of central banks and any political issues that could potentially endanger the growth outlook. The exceptional levels of central bank monetary policy support seen since the financial crisis have aided the economic recovery and undoubtedly also boosted asset prices in many areas. With central banks now showing increased confidence in the global recovery we are seeing growing evidence of monetary policy normalisation via interest rate rises and reduced quantitative easing (QE). Central banks are well aware of the risks that policy changes could cause for asset markets, so are likely to progress slowly. Any signs of inflation may hasten their speed of change, but most forecasters expect the inflation outlook to remain benign.
Bond markets have enjoyed a very long period of gains as yields have moved ever lower, leaving valuations stretched. Structural factors such as demographics, high debt levels and the impact of technology have suppressed inflation and helped justify low interest rates and bond yields. The exact impact of QE on bond yields is hard to determine, but the gradual normalisation of monetary policy is likely to put some upward pressure on yields. With very little income support for government bonds returns could easily be eroded by capital losses. The robust growth environment should continue to subdue default levels, so the superior income from corporate bonds provides some additional support relative to gilts.
2017 was a strong year for global corporate earnings and further double digit gains are forecast for 2018. Although this growth is good for equities, the strong equity gains in recent years have left most valuation measures at above average levels so markets would be vulnerable if a slowdown did occur. In the UK, the equity dividend yield remains an important source of income that still compares favourably to the income levels seen from bonds and cash deposits.
Whilst the UK domestic economy is providing challenges for some UK businesses, the equity market derives the majority of its revenues from outside the UK and is also enjoying a period of rising corporate earnings. The UK market is home to some world-class companies and valuations are low compared to many other markets, so the period of underperformance could reverse if investor confidence returns.
Another area where valuations are also still relatively cheap despite their recent outperformance are the emerging markets. Superior economic growth, improving corporate earnings and their evolution away from commodity related earnings towards higher quality growth areas such as technology has encouraged investors to increase their exposure.
Commercial property investor sentiment has improved somewhat after the initial post EU referendum dip. Returns are expected to be primarily driven by rental income, with limited prospects for further capital growth. Valuations look full against long term property averages although yields of around 5% continue to look relatively attractive compared to many other asset classes.
The gradual normalisation of monetary policy around the world is currently expected to include a small number of gentle UK interest rate increases in coming years, but rates will remain very low by historic standards and higher inflation has left cash deposits struggling to offer anywhere near real returns for savers.
In summary, the current healthy global economic and corporate situation looks set to continue through 2018. The extended period of healthy market returns has left most asset classes relatively highly valued and a potential period of more modest returns with volatility above the current extremely subdued levels is likely.
With bond valuations looking especially poor value, equities and commercial property still offer the best medium to long term prospects for returns ahead of cash and inflation and our portfolios remain tilted towards those assets where possible.
As always, investors must be prepared for some periods of volatility by ensuring their overall investment portfolio is well diversified.
Please remember that past performance is not a reliable indicator of future results. The value of investments and the level of income received from them can fall as well as rise, and is not guaranteed.
You may not get back the amount of your original investment.