Walking a tightrope in 2018

Global growth was pronounced and widespread in 2017. After years of disappointment, levels of business investment rose. Unemployment fell in developed markets, while wage inflation pressures remained largely absent. Meanwhile, emerging market fears dissipated as capital outflows reversed and growth stabilised.

Buoyed by stronger growth and low discount rates, asset prices were strong across the board. Almost all equity markets delivered double-digit returns. In the bond market, tighter credit spreads accompanied stable government bond yields.

As we enter 2018, the question on investors' minds is clear: will the bull market continue?

Firing on all cylinders or moving late cycle?

We expect the economy to continue firing on all cylinders in 2018, supported by easier bank lending conditions and US tax cuts.

While the near-term risks appear balanced, the picture is less clear as we move deeper into the year.

We expect the economy to continue firing on all cylinders in 2018, supported by easier bank lending conditions and US tax cuts. While the near-term risks appear balanced, the picture is less clear as we move deeper into the year.

After almost nine years of uninterrupted equity market gains, there is a case to be made that it is time for a reversal of fortunes. Although an extended run of strong returns is not always reason to believe a correction is imminent, increasing recruitment difficulties and manufacturing utilisation are evidence of diminishing slack. Unless growth slows, core inflation is likely to rise, which in turn will put pressure on corporate margins and the discount rates applied to future cashflows.

Timing any corrections is difficult but crucial, as market returns may stay strong until just before the inflection point. The risk of a correction will materially increase when we see the economy move to late cycle. As a result, investors need to be particularly wary of nascent recession risks, taking into account the typical 6-12 month lead of markets over the economic cycle.

With this in mind, we are focused on several emerging threats and potential triggers, which – combined with structural headwinds such as debt and demographics – could undermine global growth in the year ahead.

1. Evolving Political Risks

Political risks are evolving, not disappearing. While the populist politics we saw in 2016 and 2017 had little impact on markets, we remain wary of potentially disruptive political developments such as a protectionist agenda in the US, conflict in Asia or the Middle East, and elections in Latin America.

However, the biggest political risk in 2018 could be what is not even on the calendar. In 2017, China's leadership prioritised 'stability at all costs' ahead of October's National Congress. This could mean a greater focus on tackling the structural challenges of high debt, environmental dilapidation and slowing trend growth. Such a pivot would imply downside risks in the near term.

Net of redemptions and QE, government bond supply is set to soar in 2018

Net of redemptions and QE, government bond supply is set to soar in 2018

Source: Morgan Stanley, LGIM estimates

2. Badly timed US fiscal stimulus

If inflation rises, the Federal Reserve (Fed) could raise interest rates faster than expected in the next two years. However, there are three scenarios that could keep inflation low again in 2018. First, disappointing US growth could take the heat out of the labour market. That being said, growth looks strong and there are few signs it will slow. In fact, with Congress likely to deliver stimulus worth close to 1% of GDP in 2018, this fiscal boost risks overheating the economy at this stage in the cycle.

Second, an improvement in productivity would prevent unit labour costs from rising, even as wage growth climbs. If technological progress and greater retail competition keep inflation down, this should help solve the productivity puzzle. Third, rising wage pressure could lead to a margin squeeze if firms are unable to pass on higher costs, bringing the cycle to an earlier end.

Markets will have to adjust to the policy priorities and communication style of Jerome Powell as the new chair of the Fed. Asset prices could well be shaken up, as markets have become used to the gradualism and transparency of the old regime. Considerable turnover on the committee could lead to a fundamentally different perspective on the monetary policy outlook.

3. Brexit blues in the UK

In stark contrast to the Eurozone, the UK economy slowed during 2017. Real incomes were squeezed as the Brexit-induced fall in sterling began to bite, while the housing market also cooled. A drag on business investment, Brexit uncertainty is likely to persist through 2018. While a transition deal is likely, there is still a risk of no agreement or outcomes that could lead to an early general election.

After November's hike in interest rates and combined with current economic uncertainty, the rate of future hikes is unlikely to speed up. But with the turn in the interest rate cycle, the international value of the pound is likely to find some support from the Bank of England.

4. China: The elephant in the room

Global manufacturing picked up steam in 2017, supported by a recovery in world trade growth and positive domestic demand in several emerging markets. We therefore remain optimistic about the prospects for emerging market debt where global trade is supportive.

China is the elephant in the room. Industrial activity appears to be slowing as the growth rates of various monetary aggregates diminishes, which – alongside the recent increases in Chinese domestic interest rates –is consistent with the authorities trying to take the heat out of rapid credit growth.

So far it appears controlled. Capital outflow and currency pressures have eased. Given the alarming increase in China's debt in recent years, the authorities' attempt to reduce leverage could be a positive development for the medium term. But there are risks the economy could slow more than expected in the near term as funding becomes increasingly scarce.

Preparing for a market correction

The conditions driving recent impressive equity market gains could stay in place this year. However, the market has priced in this optimism, implying greater vulnerability to disappointment.

Investors looking to adopt a prudent strategy can do so in three ways. The most active way is to stay long equities but keep the finger on the trigger to reduce risk in response to more late cycle signals. A more systemic way is to gradually lower equity exposure as we go deeper into 2018. Finally, investors could add appropriate hedges to their portfolios – for instance, going long inflation, the US dollar and Japanese yen in portfolios that are also long market risk.

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