Inflation meanwhile remains elusive, prompting many to call for the demise of the Phillips curve (an empirical model that postulates a trade-off between unemployment and inflation). Here we beg to differ with consensus: although price pressures have yet to flare up, we do not consider inflation to be dead. With GDP growth now exceeding potential across the globe, excess capacity is fast disappearing. Not to mention the impact of higher oil prices – a trend that we expect will continue in 2018.
What then of the outlook for equity markets? Continued strong earnings growth, even if at a slower pace, will clearly be supportive, arguing for further upside to the rally during the first part of the year at least. Earnings surprises could be particularly strong in Europe, where some estimates are now putting fourth quarter 2017 GDP growth around 4% (on an annualised basis).
But rich valuations, especially in the US, and the very low level of volatility do make us uneasy. As we wrote a couple of months ago, volatility is no longer just an outside measure of risk. It has become a critical input for many investors’ asset allocation decisions, when not a variable upon which they make direct bets. Short volatility positioning is currently extreme, meaning that if/when something – such as an inflation surprise – triggers a reversal, the scramble to cover positions will likely cause not just a reversion to the mean but quite possibly an overshoot of volatility. In turn, the equity risk premium would be reassessed, turning systematic buying into systematic selling, all the more so since passively managed funds have gained such prominence.
In the bond space, meanwhile, the picture remains grim with little to no yield on offer, and the prospect of gradually rising interest rates (falling bond prices) as central banks normalise policies. Needless to say, a pick-up in inflation would only make matters worse.
So, as this new year dawns, we confirm our short duration portfolio positioning and relative preference for equities over bonds. We are even considering adding to equity exposure to take advantage of the probable near-term upside – while carefully monitoring the risk. Within equities, our thematic convictions have not changed: shale producers stand to benefit from supportive oil supply-demand fundamentals, with room for stock prices to catch-up, and the outlook for the bulk shipping industry continues to be buoyed by the global economy.
Reflecting on 2017 performance
Before offering some more thoughts about the coming year, let us reflect on how financial markets – and our portfolios – performed in 2017.
Equity markets certainly had a strong year. Measured in euro terms, the MSCI World index posted an 8% gain, led by emerging markets which rose 21%. The European and Japanese indices gained 11% and 9% respectively, while North America lagged slightly at 7%.
But while equities cheered, bond markets suffered, losing 6% in aggregate (still in euro terms). US bonds lost 9%, while Eurobonds returned only a meagre 0.7%.
As such, a globally diversified balanced portfolio (split equally between stocks and bonds) returned ca. 1% in 2017, while its defensive counterpart (25% stocks, 75% bonds) lost some 2.5%. Focussing solely on European markets generated better results, with a near 6% gain for a balanced benchmarked portfolio and ca. 3% for a defensive one.
The performance of our balanced model portfolio stood near the lower end of this range – a disappointment relative to our expectations. The fault lies not with our global scenario and asset allocation, but with three specific factors: significant dollar depreciation, persistently low volatility and energy stocks lagging the oil price.
The greenback’s 15% drop versus the euro proved the single largest drag on our 2017 performance. Foreign currencies (mostly the US dollar) exposure cost us about 4%. That said, this performance is not lost forever, to the extent that we have not exited our dollar positions. If the Eurodollar trend reverses in 2018, as we argue in more detail below, some of the lost 2017 performance stands to be recovered during the coming months.
Volatility, too, caught us wrong-footed last year. Little did we expect it to drop further, from what was already a historical low at the onset of 2017. So, rather than serving as a portfolio buffer, our exposure to volatility cost us money.
It is in energy that our frustration is probably the greatest. Indeed, the fundamental thesis that we had laid out for global oil supply, demand and inventories in 2017 played out almost exactly – fuelling a 12% upmove in the WTI oil price. But not only was that performance eaten away by the afore-mentioned dollar depreciation, the stock prices of shale oil companies also lagged crude for much of the year, only making up some ground in the closing months.
Not the time to give up on the dollar
Source : Bloomberg
2017 taught us to no longer rely on the range-bound currencies paradigm that we used to attribute to some form of unspoken agreement between major central banks. Having sustained (unrealised) losses on our US dollar-labelled holdings, and with hedging now pricey, it is thus critical to assess the 2018 prospects for the greenback.
For three main reasons, we would argue that, during the first part of the year at least, the likely path for the dollar is up. First, despite the already advanced stage of the cycle, US growth stands to accelerate in 2018. The tax legislation just enacted by the Congress should add some 0.2-0.3% to GDP growth, also taking into account accelerating infrastructure spending. Even though Europe is also on a roll, the pick-up in US growth should provide relative support for the greenback.
Then, there is the possibility that this additional stimulus to an already fully-employed economy causes inflation to finally edge higher, forcing the Federal Reserve to deliver more than its three anticipated rate hikes. This would accentuate the US interest rate differential versus Europe, bolstering the dollar, particularly since the European Central Bank (ECB) has committed to keeping its own rates put until after the end of its asset purchase program. With the Italian general election scheduled for March 4, promising a split result and months of political gerrymandering in order to form a government, the ECB appears unlikely to renege on its pledge.
Finally, the repatriation of foreign corporate profits, also encouraged by the recent tax bill, should imply buying pressure on the dollar. Admittedly, there are no figures as regards the currency breakdown of such profits. But it would seem fair to assume that a good proportion is held in the currencies in which they were generated, if only for natural business hedging reasons. Note also that if foreign profit repatriation does indeed prove consequent, chances are high that this money will mainly be spent on stock buybacks – adding to the near-term positive case for equity markets.