The investment outlook for 2018

For DIY investors the obvious question is whether 2018 will live up to 2017 or whether we will see what feels like an almost inevitable and overdue correction. 80-20 Investor members will be familiar with my view that trying to predict the future is folly and fraught with dangers. You just have to go back to this time last year when I carried out a review of 2016 to see the lessons learned, one of which was the danger involved in crystal ball gazing.

As momentum investors we follow trends up (and indeed down) taking the emotion out of the investment process to increase the chances of success. The table below shows the performance of my £50,000 portfolio in 2017 versus a number of benchmarks:

Name	Year to date % return
My £50k portfolio	12.87
Average managed multi-asset fund	9.43
Passive benchmark	8.69

However there is no denying that other investors’ views and emotions do influence their decisions and investment markets and therefore to a certain degree our own returns. So it remains an interesting exercise to look at the consensus market view of what may happen in 2018, if only for curiosity. While I don’t try and predict the future the ‘smart money’ (i.e investment banks) do, partly because their clients ultimately pay them to do so. Investment banks Morgan Stanley, JP Morgan and Goldman Sachs have all just upped their predictions for equity markets. For example they now think the S&P 500, which currently sits at 2,683, will go higher with their respective end of 2018 targets ranging from 2,750 to 3,000. That's incredibly bullish.

However, there are two things to point out and that's that investment banks are notoriously poor at predicting the future, unsurprisingly. If you recall last year the consensus view was that the dollar would rally strongly and after just a few months a number of investment houses had to ditch this investment theme from their portfolios. It was a painful trade for those who pursued it for too long before ultimately abandoning and accepting that 2017 would be a terrible year for the dollar. You may take comfort in how bullish investment banks are right now but I would caution that if you make money from people investing in the stock market (as these investment banks do) then you are hardly going to predict armageddon and tell your clients to run for the hills. Yet at the time of writing stock markets remain in an uptrend, as I’ve been highlighting in my weekly newsletters, so until this trend reverses investment banks remain understandably bullish on stocks.

But let's not beat around the bush, 2017 is as good as it gets when it comes to investing in stocks. If you are banking on a repeat of 2017 next year the odds are that you will be disappointed. 2017 is likely to end up being the best year for equity returns since 2009, which was the year that the market rebounded after the financial crisis. Even if 2018 disappoints it is far easier to stomach a correction when you've made double digit returns in the previous year. Those who spent 2017 on the sidelines waiting for the stock market to crash will be pretty grumpy right now.

Investment themes for 2018?

FAANGs lose their bite?

The spectacular bull rally of 2017 was driven mostly by tech stocks and in particular the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google, now known as Alphabet). In the summer of 2017 tech stocks rebounded from a sudden sell-off after investors rushed to buy the dip. We saw a similar pattern in December but the sector rotation out of tech stocks and into financials was particularly aggressive.

The death of the tech rally has been touted for much of 2017 (and before that in fact) but the FAANG’s impressive ability to print money seems relentless which has caused investors to return in their droves after each market wobble. Valuations within the sector are at levels not seen since the dotcom bubble so the sector will be vulnerable to bouts of profit taking. If you look at the business models for the FAANGS individually there are still reasons to be optimistic

Either way in 2018 we are likely to find out whether the bull market can survive in the face of the tech bubble popping. If December is anything to go by it might be able to soldier on. The sector rotation out of tech stocks and into those sectors that looked initially most likely to benefit from Trump’s tax reforms helped support equity markets when tech stocks had a wobble. Historically sector rotation has been the lifeblood of sustained bull markets. Right now markets are betting on financials, consumer staples (which usually includes food/drinks companies as well as tobacco companies) and energy stocks being the tax reform winners but as I explain later this is subject to change.

Inflation

As we enter 2018 two key themes that will likely gain greater attention will be inflation expectations and central bank policy tightening. Both could influence whether we finally see the end to the FAANG juggernaut for the reasons laid out in my recent note. Inflation (or lack thereof) will likely get more mainstream media airtime in 2018 than it has previously. Up until now persistently low inflation has been something of an enigma, particularly in the US but also in Europe, despite the amount of money central banks have printed and historically low interest rates. Only a rise in inflation (mostly likely driven by wage growth) would allow the US Federal Reserve to raise interest rates as it hopes to in 2018. This would be bad for tech stocks as their future earnings would be worth less in real terms today, which would make them unattractive and encourages investors to take profits. It would also be bad for bonds too which fare better in low interest rate environments. While the Fed has suggested that there will be three rate hikes in 2018 the bond markets have been suggesting that investors aren't ready to believe the Fed.

Two weeks ago I speculated that perhaps Trump’s tax reforms could be the spark to ignite inflation and justify the Fed’s rate hike plans. The tax reforms have since been passed and the market has started to reconsider its consensus view on inflation. We saw a a minor wobble in bond markets (more on this later) and further signs of sector rotation in equities.

If this is a reflection of what to expect in 2018 then it could be the year where correlations between equity sectors falls further and the difference between individual stock winners and losers becomes more stark. Yet the tax reforms are so complex the market is still trying to work out which companies will benefit most and it could take until the end of the first quarter in 2018, when the next round of company reports are published, to gain any real clarity. It could mean 2018 will be tougher for broad index tracking funds thus presenting an opportunity for active funds to finally produce the returns to justify their excessive fees. Will 2018 be the year of the stock picker?

Volatility

The other big question mark over 2018 is whether the historic level of market calm (or maybe it’s complacency) will continue? The VIX (which is a widely accepted gauge of market fear) remains near historic lows. But what could cause a sustained increase in the VIX? Both Deutsche Bank and Bank of America recently stated that they believe the most likely catalyst is a surprise spike in inflation. The trouble with inflation is that it behaves like the genie in a bottle, impossible to control once it’s let loose. We will undoubtedly see markets slip into Goldilocks mode, not wanting too little inflation or too much but just the right amount.

Taper tantrums

A spike in inflation would likely cause investors to fear more aggressive central bank tightening around the globe. Loose monetary policy (low interest rates and QE) has fuelled the 8 year long bull market and the buy-the-dip mentality. It’s rapid removal (or tapering of QE) could be the most likely catalyst for investors to start selling bonds and even equities en masse.

It’s somewhat ironic that as we went into 2017 the consensus view was Trump’s infrastructure and tax reforms would spark higher inflation. They didn’t need to see evidence of it, just the promise of it. The Trump trade was born but then was almost as quickly replaced as the reality of Trump’s lack of progress struck home. You couldn't move for dollar bulls at the start of 2017. It was a painful trade for those that didn't change course and right now you'd be hard pushed to find a dollar bull. As we move into 2018 investors are reluctant to believe sustained inflation is coming. They need convincing to ditch those investments that have been profitable in 2017, and resurrect a version of the inflation trade.

While the tax reforms are a done deal and help to try and justify the lofty stock market valuations they appear to be mostly priced into equity markets. Stocks barely moved after the tax reforms were finalised. It may well mean that investors will start turning their attention to the likelihood of Trump’s infrastructure promises materialising.

Bond trouble

The potential for higher inflation, sparked by Trump's tax reforms, could be problematic for bond investors. Bond markets have largely held up since the tax reforms were passed but we did experience some weakness in US bond markets in the last week which spread globally. It's perhaps an early sign that investors believe trouble may lie ahead for the bond market. Inflation is bad for bonds, but in order to fund any tax cuts or infrastructure spending Trump’s government will have to borrow huge sums of money. That means flooding the market with US Treasuries which, after all, are loans to the US government at a time when the Fed is also reducing its balance sheet. The rules of supply and demand suggest that their price will fall which could drag global bond markets lower. The potential bursting of the multi-decade bond bubble is almost a perennial story and 2018 is looking to be no different. In the pursuit of low risk diversification it might be the year that Targeted return funds make up for their lacklustre performance in the bull rally of 2017 and gain popularity once again.

China tightening

Credit is likely to remain a big focus in China as the government continues to tighten financial conditions. Many investors may not realise but in response to the Fed’s December rate hike the People’s Bank of China (PBOC) mirrored it. Markets have largely ignored the recent Chinese equity weakness, which is a result of this tightening, and it’s likely to be a recurring worry in 2018. Having said that the Wall Street Journal has claimed in the last few days that people familiar with the matter inside China believe the government will soften its approach to credit tightening going forward. This would be good news for emerging market and Chinese equities which, despite their strong performance in 2017, remain attractively valued to developed market equities. In the New Year I plan to publish some new analysis on the cheapest stock markets to invest in. 2017 was a great year for growth stocks once again but with equity valuations at high levels we shouldn't be surprised if investors finally start focussing on value at a sector level and a global level.

Geopolitics

Trump’s recent visit to China probably marked the high point for US-China relations and Trump is likely to up his protectionist views and policies in 2018. Elsewhere in Asia, North Korea tensions are likely to reignite once again and Trump is only ever a tweet away from sparking a diplomatic crisis. But closer to the White House Trump is likely to face his own political problems. The tax reforms are hugely unpopular among the electorate and polls suggest that the Republicans will struggle in next November's midterm elections. Even before that the US has to solve the problem of its debt ceiling in January, failure to do so will force the government to be shut down due to lack of funding. In fact political risks will likely surface globally once more (I've not even got around to mentioning Brexit yet). To help give you a steer of key dates for political and central bank events below I have included a useful 2018 timeline produced by Credit Suisse. Just click on the image to view it in full.

Currency moves

If 2017 and the dollar taught us anything it was how currency moves are difficult to predict and how trends can unravel quickly. Yet for UK investors the strength of the pound has a crucial impact on their investment returns and will continue to do so in 2018. A strong pound is bad news for the FTSE 100 and our overseas fund holdings. Any profits made abroad are eroded when they are converted back if sterling is strengthening. So where could the pound end up in 2018?

I will leave you with some research from Hargreaves Lansdown compiled by asking a panel of economists, fund managers and analysts for their 2018 predictions. On the pound versus the euro Hargreaves said:

The consensus prediction is for GBP/EUR to find little fresh impetus for any significant move higher over the first six months of the year, with 77% of respondents forecasting GBP/EUR to end the first half of the year in the current range of 1.10-1.15.

Or in other words the pound is likely to remain exactly where it is versus the euro. On the pound versus the dollar their panel favour:

sterling to register modest gains against the US dollar (into the $1.35-1.40 range) by the end of the first half of 2018. Overall, our survey respondents point to sterling having a more difficult second half of the year.

Sterling is currently at $1.335 so make of that what you will.