2018 Year Ahead Outlook
January 2018
Watching Rates Like a Hawk
It was a remarkable year for share markets in 2017, with major markets across the globe notching returns
of around +20% for the year (for the year the US Market was up +19%, NZ Market +22%, AU Market +7%).
What was more surprising than the strong returns experienced in 2017, was the way in which they were
achieved – with what was close to an absence of volatility.
Despite the fact that markets are at high levels, we remain constructive towards shares in 2018. Our view
is that there are “real drivers” behind the market rally, with returns driven by co-ordinated global growth
& economic strength, as companies continue to experience earnings momentum. Importantly, low inflation
has meant there is still relatively accommodative monetary policy. These factors have created a breeding
ground for equity returns.
In saying that, we are aware that it is a question of “when” not “if” a market correction will occur –
particularly given we are heading into the 8th year of the bull market post the Global Financial Crisis in 2009.
Given economic growth is likely to remain solid in 2018, the factor at risk of changing in the year ahead
is an end to accommodative monetary policy. On this front we see the primary risk being higher interest
rates driven by the return of inflation or a central bank policy error. Hence our year ahead title, Watching
Rates Like a Hawk.
We point out that some of the best share market returns can be made in the late stage of a bull market
and see more opportunities in the Australian market over the NZ at the current juncture. Overall, we
remain cautiously optimistic for 2018 and continue to invest in stocks as normal, although we would not
be surprised to see a bit more of a bumpy path for share markets over the year ahead.
2017 – Record Markets Highs, Volatility Lows
Heading into 2017 we had highlighted that 2017 was setting up to be the “Year of
Politics” which markets got through relatively unscathed, apart from the odd short-
lived sell-off as markets digested the latest tweet from Donald Trump on North Korea.
One thing that stood out was the extreme calm in markets illustrated by supressed
volatility which we expand on below, which can be seen in the chart below which
shows the return of the S&P 500 index over last 3 years.
3-Year Performance of US Equity Market (S&P 500 Index)
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Strategy Group
Most major equity markets around the world are at decade or record all-time highs,
following what has been a solid year for equity market returns as shown in the table
below.
The market darlings for the year were clearly
Market
2017 Return
Technology stocks supporting the 19.4% gain in 2017
for the US market, its best since 2013. The US
US
+19.4%
Technology sector soared +36.9% in 2017, with the
Nasdaq composite posting gains in 11 of 12 months in
Australia
+7.0%
2017, a first ever for the tech-heavy index (once again
highlighting the lack of market volatility). The rally has
New Zealand +22.0%
seen the likes of Amazon CEO Jeff Bezos become the
world’s richest man (pictured below).
In terms of the impact of geopolitics for the
year, several events were digested
relatively well by the markets – with
tensions with North Korea being the key risk
to hit headlines.
There was ongoing news flow in the US
political
arena
around
the
Trump
administration which also affected investor
sentiment at the margins. However,
towards the end of 2017 the Republicans
were able to pass their promised tax reform
in the US. This impact of this should not be understated. It is estimated that tax cuts
could increase corporate earnings (profits) for US companies by around 10% for the
year ahead.
We believe there are “real drivers” behind the current market rally, with returns
driven by economic strength with co-ordinated global growth and company’s
showing solid earnings momentum.
Importantly, low inflation has meant there is still relatively accommodative
monetary policy. These factors have created a breeding ground for equity returns.
Given global economic growth is likely to remain solid in 2018, the factor at risk of
changing in the year ahead is an end to accommodative monetary policy in our view,
which we discuss in our 2018 outlook below.
Before moving on to our 2018 outlook, we would point out that we are not alone in
our optimism (in fact, given how bullish most market commentators are, it actually
makes us slightly nervous).
In its November fund manager survey, Bank of America Merrill Lynch found that
investors’ global risk appetite "noticeably" increased. A record high percentage of
investors say equities are overvalued yet cash levels are simultaneously falling, possibly
an indicator of irrational exuberance.
David Kostin at Goldman Sachs, whose 2017 forecast for the S&P 500 Index of 2400
was among the lowest among strategists tracked by Bloomberg, has increased his 2018
target to 2850 from 2500, citing an expansion in profits and valuations. Further, his
forecast is for the index to reach 3000 by end of the 2019 and 3100 in 2020. If his 3-
Strategy Group
year forecast which hinges on profit growth (driven by tax reform and economic
strength) proves correct, the bull market would become the longest in history.
While we would be hesitant to state the bull-market will last another 3-years, we would
point out that some of the best returns are experienced by investors in the late stages
of a bull market.
2018 Outlook – Detailed
We are no doubt at the later stage of a long bull market, in a phase of positive and
improving economic growth that usually favours strong momentum and growth but
also higher risk investments. Valuations and investor sentiment are high, and there is
relative economic calm despite political turmoil.
Given conditions we would likely view a pullback in the market next year as
something to be expected which could likely present a buying opportunity for
investors.
However, what could make a market pullback/correction turn into the end of the bull
market? Once again, given economic growth is likely to remain solid and unlikely to
rollover in 2018, the factor at risk of changing in the year ahead (from the status quo
of a supportive environment for share market returns) is an end to accommodative
monetary policy.
On this front we see the primary risk being higher interest rates driven by the return of
inflation or a central bank policy error. While we think it is unlikely, a major policy error
from the likes of the US Federal Reserve (Fed) of European Central Bank (ECB) could
shock markets.
The world’s major central banks are currently unwinding the massive stimulus
measures (quantitative easing or “QE”) that were implemented during the global
financial crisis (GFC) to prevent financial markets from collapsing. Part of this involved
central banks expanding their balance sheets and purchasing bonds, with the
additional demand suppressing bond yields/interest rates. The Fed and ECB are now
tapering their massive balance sheets which is likely to see yields rise. The risk is a
policy error in this process, namely tapering too fast – although we do not see this as
a high probability event given the sophistication and cautious approach taken by the
Fed and ECB.
The other policy error could come
from premature interest rate
increases by central banks,
although this is once again
unlikely in our view given
“gradual” rate hikes are a
common theme in speeches from
major central bankers.
In saying that, in 2018 we see
interest rate moves particularly
by the Fed as critical to driving markets (as a “policy error” with rates rising too fast
could cause a sell-off in markets) and the market will likely react as investors adjust
their expectation around the pace of rate hikes (up and down as the pace
quickens/slows). Hence, we think the man in the image above, Jerome Powell will be
the most important person for markets in 2018.
Strategy Group
Powell is the new Fed Chair and Donald Trump’s choice to lead the Fed.
Higher interest rates are a negative for share markets, and a rapid increase in rates is
widely seen a potential catalyst for a sell-off in markets. Higher rates usually slow down
the economy (increasing the cost of borrowing) and result in tighter financial
conditions which are restrictive for business. Further, interest rates are an important
factor when determining company valuations, and higher rates result in lower
company valuations.
So, what is our rate forecast for 2018? We believe rates globally will continue to grind
higher, but not to the point where they hurt equity market returns.
The market is very widely dispersed in terms of forecasts for the 2018 interest rate
track in the US (which is an important driver for global rates). Some prominent market
strategists are forecasting four rate hikes in the US in 2018, while some are predicting
zero. The chart below shows how the US 10 Year Treasury Yield over the last 5-years
has remained supressed.
US 10 Year Yield Chart
So far, bond rates have remained relatively low, and US rate hikes have been gradual
primarily because inflation continues to surprise on the downside (The Fed aims to
control inflation by adjusting rates, and will hike to lower inflation). It is a similar story
for other major global central banks. The Bank of England recently raised interest rates
for the first time in more than 10 years and said it expected only "very gradual" further
increases over the next three years.
This has baffled the Fed and many market commentators particularly as the US labour
market looks tight with low unemployment, however this has not resulted in wage
increases (employers paying more). There are several reasons put forward for this such
as Amazon, robotics or demographics. In saying that, while the relationship between
economic slack and inflation may not be as strong as it had been in the past, most
Federal committee members believe it still exists.
Whatever the underlying reasons for low inflation, US inflation is the key economic
metric we are watching in 2018, as higher inflation will lead to interest rate hikes in
the US given the economy looks to be in good shape in terms of employment etc.
Once again, our base case is that while there is likely to be more volatility in 2018
than 2017 (particularly as the market adjusts its interest rate track higher/lower),
markets will continue to grind higher.
Strategy Group
In terms of how to trade higher rates, we have noted in several reports that
financials, namely the Banks are likely to be the biggest winners from a backdrop of
higher rates (this because all else equal higher rates improve the NIM (net interest
margin) for banks, which is the difference between what banks have to pay for cash
deposits and what they receive from lending activities).
We also continue to believe (somewhat stubbornly) that higher rates in the US will
result in US dollar strength.
Those who have followed us will know we have been US dollar bulls for some time now,
primarily on the back of US interest rates moving higher, and the massive unwind of
stimulatory measures used to help support the economy during the global financial
crisis.
We would point out that the Federal Reserve Funds rate is now at the same level as
the RBA cash rate (the RBA cash rate has not been lower than the US Fed rate since the
year 2000). Our forecast is for the Aussie cash rate to stay flat in 2018. While we see
Australia as more of a borderline call with their economy looking brighter, we would
be very surprised if the RBNZ moved rates higher in the near term. This is key to our
forecast for a higher US dollar and lower AUD & NZD as all else equal a higher interest
rate drives demand for a currency and results in currency strength.
Given our currency view, one of our core investment themes remains investing in
stocks which will benefit from a lower currency. These include offshore earners,
exporters and stocks in currency sensitive sectors such as Tourism.
Other risk for 2018…
–
Geopolitical
In terms of other market risks, politics were a focus in 2017, and in 2018 there may be
less of an emphasis.
However, we believe US politics will still be an important area to watch for investor
sentiment, in particular the
success
of
the
Trump
administration in implementing
continued policy reform – after
the highly anticipated tax cuts
were passed.
In the US there will be mid-
term elections in 2018 and the
Republicans will be keen to
maintain the of the House of
Representatives.
The risk here is that the Republicans lose control causing a political gridlock (not to
mention impeachment attempts) and likely see the market sell-off as it results in a
more uncertain outlook in the US.
Secondly, there is a tail risk (low probability, high impact) in terms of geopolitical
tension with North Korea.
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Strategy Group
Italy also goes to the polls by May next year and protest parties (M5S and Lega Nord)
will feature prominently. The risk in Europe over the last few years has been
destabilisation with a member exiting the Eurozone, although the anti-Euro rhetoric
seems to have dialled down.
In China, Xi Jinping, has established a powerful mandate to progress economic
reform. These reforms are seen by many as overdue, with Chinese growth increasingly
debt funded. We think it likely China steps up the pace of reform in 2018 and there is
a risk that this causes a short-term slowdown in China, which will likely be felt by
Australia and NZ.
Finally, there are always unforeseen events and risks which could impact markets next
year. Another left-field area we are watching is the dramatic rise of crypto currencies
and Bitcoin.
We have generally avoided commenting on Bitcoin to date, however it will be very
interesting to watch the space in 2018. We believe that as the crypto space gets larger
and larger, it may start to have a meaningful
economic impact if it collapses. Whatever the
long-term outlook for crypto currencies,
there is little doubt that prices and investor
enthusiasm right now is creating a huge
crypto bubble with over 1000 different coins.
We think the Tweet highlighted on the left
summarises the current situation quite nicely
– referring to a crypto coin called “Dogecoin”
which was started up as a joke 2-years ago.
The founder of Dogecoin has publicly
expressed concerns, pointing out that there
have not even been any software updates
released over the last 2-years on Dogecoin.
Still, investor mania has seen the value of
Dogecoin surge to $2billion!
To summarise on risks for the current bull market. At some point either growth will
roll over or central banks will take the punchbowl away normalising monetary policy,
which will end the bull market – however we do not believe this will happen in 2018.
Outlook for New Zealand – Not Cheap, Invest Selectively
It has been all roses
for NZ investors in
recent years.
The stock market
has been on a
tremendous
run
(illustrated in the
chart on the right),
and
2017
was
another big year
for the NZX as it
had a +22% return.
Strategy Group
Overall market valuations are expensive (see figure below), and strength in the NZ
market has been backed up by solid economic growth. However, looking forward the
majority of economic forecasters expect economic growth to slow in 2018. There is
also uncertainty around policy implemented by the new Labour-led government.
Given the starting point, we would be very surprised to see anywhere near a +22%
return repeated for the NZX in 2018.
Valuations Historically High – Price to Earnngs Multiple of NZ Market
Further, the local NZ market is sensitive to rising interest rates. An attraction of the
NZ market is its high dividend yield compared to other markets. In the years post the
GFC, low interest rates means that money globally has flown out of cash and bonds,
and into high dividend yield stocks, particularly in generally stable dividend paying
sectors such as Utilities, Property stocks, and Telecommunications. This has been called
the “yield trade”.
In 2018, if rates rise as they are expected to, the yield trade will become relatively less
attractive, and there is likely to be outflows out of yield trade stocks back into fixed
income investments. Hence, we would be wary of investing heavily into these sectors,
with NZ power generator stocks (Mercury, Contact, etc) being an example of a sector
at risk.
We would caveat our comments above by saying that as always, we still see
opportunities on the NZX (although we are cautious around the level of the market as
a whole). Stock Pickers should become more selective as the Bull Market ages and we
continue to focus investing in stocks with thematic tailwinds and solid fundamentals.
Outlook for Australia – Turning a Corner
Thanks to a surge late in 2017, the ASX 200 index crossed the key 6000 level for the
first time in almost a decade. Although unlike several major global markets, remains
below its pre-GFC peak driven by the mining boom.
We generally see more investment opportunities in the ASX over the NZX at the
current juncture, and expect the ASX market as a whole to likely outperform the NZX
in 2018.
The ASX is not as expensive in terms of market valuations relative to the NZX, and
Australia is in a "sweet spot", where a mild cyclical economic growth uplift should
support company earnings, but won’t be enough to spark any aggressive policy
tightening from the Reserve Bank. RBA governor Philip Lowe seems to indicating next
move in interest rates is likely to be up but there was no case "for a near-term
adjustment in monetary policy".
Interestingly, Australian business profit conditions have been reported as being
considerably above average in recent times reflecting improved confidence, however
this has not yet been
reflected in ASX listed
company
earnings
forecasts as shown in the
chart (see right).
Across sectors, the largest
improvement has been in
mining, but construction
and manufacturing have
both also picked up. The
weak spot in Australia has
been the retail sector.
This suggests there may be
room for earnings forecast
upgrades in 2018, and combined with relatively attractive valuations versus markets
such as the US and NZ, we think Australian shares may well be a better investment in
2018 than other more expensive markets.
As with NZ we continue to prefer stocks which fit our key investment themes.
Team’s Top Picks for 2018:
We thought we would end our year ahead with some stock picks!
We took a survey of our analyst team for their top stock picks in AU/NZ/US for the year
ahead, and came back with the following results:
(note that you can read our full reports on the stocks below on our website)
NZX Picks
ASX Picks
US Picks
We hope everyone has a prosperous year of investing in 2018!
Stock ratings
Given the dynamic nature of share prices ’s rating can become out of sync with the projected total return as the share price moves. The rating
must only be viewed as valid with respect to projected total return at the time of rating or target price changes.
Individual stock ratings are determined by the projected total return on a stock. ’s analysts project a 6 to 12-month target share price for each
stock. The capital gain or loss implied by the 6 or 12-month target share price, along with the analyst’s projected prospective dividend yield, generates
the analyst’s projected total return for a given stock.
Based on a current 6 to 12- month view of total share-holder return (percentage change in share price from current price to projected target price plus
projected dividend yield), we recommend the following:
BUY: Based on a current 6 to 12-month view of total share-holder return, we recommend that investors buy the stock
SELL: Based on a current 6 to 12-month view of total share-holder return, we recommend that investors sell the stock
HOLD: We take a neutral view on the stock 6 to 12-months out and, based on this time horizon, do not recommend either a Buy or Sell
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