Thursday 17 January 2019

Tom McCabe: 2018 is full of promise, but inflation may threaten the punch bowl

Those invested in stock markets, property and selected parts of the bond market were well rewarded in 2017, even if a resurgent euro ate into some of those returns. Photo: Reuters
Those invested in stock markets, property and selected parts of the bond market were well rewarded in 2017, even if a resurgent euro ate into some of those returns. Photo: Reuters

Tom McCabe

Christmas is probably one of the worst times of the year for investment strategists as it forces them to pin their colours to the mast for markets in the year ahead - sometimes a hazardous practice. However, this time around, most investors will approach 2018 in a good mood. Those invested in stock markets, property and selected parts of the bond market were well rewarded in 2017, even if a resurgent euro ate into some of those returns.

Furthermore, the global economy looks in its healthiest condition since this recovery began. The OECD recently noted that for the first time since 2007 all 45 of the economies it tracks were growing. Thankfully, a solid global growth pattern is again forecast for 2018, with slightly stronger US growth offsetting further slowing in China. In addition, regions which are often considered 'canaries in the coal mine' for the global economy, such as Japan, Asia and the emerging markets are performing well.

All of this indicates that another good year ahead could be in store for investors. As in 2017, asset classes like equities, property, credit and commodities should outperform cash and government bonds, assuming the recovery continues.

For some investors, one nagging concern will be that this economic and market recovery is another year older now, prompting them to look even closer at possible risks in 2018.

Generally, bull markets don't die of old age but as a result of other factors; a market crisis, a recession or sometimes an economic slowdown triggered by overly aggressive central banks.

So what are investors most concerned about for the year ahead? The topics that cropped up the most in Bloomberg stories this year present a long list of potential crisis candidates.

The most popular included 'Brexit', 'North Korea', 'emerging market crisis' and 'China debt'.

In truth, it's impossible to know how events involving North Korea will play out in 2018. It remains a clear source of market volatility for investors and supports the case for having some exposure to defensive assets like government bonds, even if the economic picture argues otherwise.

A messy Brexit could undoubtedly create difficulties for the Irish economy but the potential for it to morph into a global crisis is very limited.

We've already seen this reflected in investment markets since the referendum result - while sterling and UK bond and stock markets have been regularly buffeted by Brexit, most other investment markets carried on regardless.

An emerging market crisis or a debt crisis in China on the other hand would likely hurt global investment markets.

However, if economies continue on their current growth trajectory, these scenarios should be avoided. Emerging market growth has stabilised over the past 12 months, a clear positive from a debt-sustainability point of view.

Another key swing factor for emerging markets is the US dollar, especially given the $3.4 trillion (€2.8trn) of outstanding dollar-denominated debt there.

The dollar could have a better year in 2018, although it is unlikely to strengthen sufficiently to trigger defaults in the region.

Similarly, China's debt issues were put in the shade in 2017 as economic growth was better than expected. We expect the economy to slow a little in 2018 but not by enough to trigger a debt crisis. On top of this, profits at state-owned enterprises, which have proved to be a big driver of rising debt levels in recent years, grew strongly in 2017, meaning any corporate debt problems could stay on the long finger again in 2018.

What about the other factors that generally end bull markets and are these any more likely in 2018?

The broadening and strengthening of world economic growth through 2017 dispels the notion that a recession is around the corner. However, there are signs that we are moving towards the latter stages of this economic cycle.

Economically sensitive commodity markets are gaining momentum - for example, copper prices are up nearly 50pc since the end of 2015. Equity-market valuations also continued to climb in 2017, another trend which is also often visible late in economic cycles.

However, a key missing ingredient in this late-cycle picture is the absence of inflation. Inflation threatened to accelerate sharply in early 2017 but eased in most economies later on in the year. Despite this, investors shouldn't be complacent about inflation and the likely central bank response, given how far we are into this economic recovery.

Labour markets are tightening around the world and generally when wage inflation increases, broader inflation pressures will follow.

Furthermore, President Trump is intent on cutting US taxes at a time when arguably the economy doesn't need it - again something else that could stoke inflation.

Any step-up in inflation rates could have implications for how central banks behave. We don't believe this will end the bull market in 2018 - but it is something worth paying increased attention to next year.

If inflation rates rise sharply on the back of an improving economy, then investors should eventually expect a central bank response. Already, we have seen signs that central bank actions are becoming more synchronised - the US Fed and Bank of England hiked interest rates this year, while the European Central Bank is winding down its quantitative-easing programme.

Historically, higher interest rates have often been a cause of market downturns as central banks looked to "take away the punchbowl as the party gets going". 2018 is shaping up to be another good year for investors, thanks to the continued improvement in the world economy.

However, when it comes to risks, investors should keep a close eye on economic growth and inflation and what it means for central bank behaviour.

It could be this ghost of past downturns, rather than any crisis 'event', that unsettles investors most in 2018.

Tom McCabe is Global Investment Strategist at Bank of Ireland Investment Markets

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