Sunday 18 November 2018

Earnings growth helped 2017 report card - now investors can look to new year with justified optimism

Inflation is expected to remain at current levels. Photo: PA
Inflation is expected to remain at current levels. Photo: PA

Bernard Swords

The end of the year is report card time for investors - when we look back to see how the year turned out versus our expectations 12 months ago. It's also when we look forward to the year ahead as we formulate and adjust our investments strategies.

Let's start with our high marks. Bond markets turned out pretty close to what we expected. Goodbody forecast returns of 1-2pc from the euro area bond market and currently it is 1.5pc.

Positioning went well for us, too. Corporate debt outperformed sovereigns, while shorter-dated debt did better than longer-dated, so we got a healthy extra return over the 1.5pc.

Equities on the other hand turned out far stronger than we anticipated - and we were relatively optimistic.

We thought investors would get a 10pc total return (in local currency terms) from equities, but it is currently running at 16pc. The euro area performed well, as did emerging markets, which did equally well.

Earnings growth: the story of the year

The unusual strength in earnings growth has driven this surprising result in equity markets. Much of it has been due to stronger economic growth across all major regions of the world - a synchronised expansion that we have not seen since 2010. Another contributor was a better margin out-turn, which is always a difficult figure to predict.

One feature that helped equity markets was the lack of valuation compression. We thought at the start of the year that, with the Fed beginning to start tightening, monetary policy would put upward pressure on US longer dated interest rates and, hence, push down equity valuations.

This did not happen as the US bond market moved quickly to price where interest rates would peak. The market was also supported by flows from the euro area and Japan, where quantitative easing (QE) continues.

Starting the watch on 2018

As we look ahead to next year, let us examine the fundamental background. The global economy is ending 2017 on a strong note. Barring some weather impacts, this looks set to continue into the early part of next year. Currently, consensus forecasts are for a slightly higher growth rate next year (3.6pc), which does not seem unreasonable at this stage.

Inflation is also expected to remain at current levels. The impact of rising energy prices will be waning and the cyclical pressure that should be there due to continued tightening in labour markets is being offset by structural forces in some key areas. Hence, a steady inflation rate does look achievable.

If this turns out to be the case - inflation little changed and real growth holding at a respectable level - then we are likely to see monetary policy changes similar to what has happened in 2017.

The Federal Reserve should gradually increase interest rates and modestly reduce its balance sheet; the ECB and Bank of Japan should move towards neutral QE, but maintain interest rates close to the zero level.

So, although there will be the spectre of less monetary support in 2018, the reduction is likely to be on a scale and at a pace that won't disturb financial markets.

At the start of 2017 we focused on political uncertainty. This will be significantly reduced in 2018. It appears we will have some agreement on a fiscal package in the US and, in the euro area, the only elections on the horizon are in Italy where the euro-sceptic parties have been losing support.

Although the feared volatility never arrived in 2017, nothing on the horizon warrants particular caution in 2018.

More of the same on the way

There will be support again for bond markets as central banks move very gradually, QE continues and inflationary pressure remains subdued.

The potential returns are likely to be low - we expect 1pc from the euro area bond market - but it will be better than deposit rates and there is some scope for corporate debt sovereign spreads to tighten further. Goodbody continues to favour corporate debt globally and high yield in the euro area.

For equities, we expect another reasonable result. Nominal economic growth in 2018 is expected to be similar to 2017, but we do not think that earnings growth of 15pc will be repeated.

This year's figure was flattered by a strong recovery in profits from the energy and mining sectors, which will not happen again in 2018.

Excluding these factors, earnings growth would have been 11pc in 2017. The consensus forecasts earnings growth in 2018 is 10pc.

This might be a little bit high, as it is difficult to see margins improve at the same rate for 2018. But 8pc growth looks entirely reasonable.

While the Fed may be tightening policy, its pace and degree are not likely to be disruptive.

If we look at past tightening cycles, the worst time for equity and bond markets was when the Fed changed tack - not 12-24 months after it did so. Hence, despite high absolute valuation levels for equity markets, we do not foresee deterioration here.

Against interest rates and bond markets, equity valuations seem reasonable. We do not expect longer-dated bond yields to be materially different to where they are at present.

So, we expect another good year for financial markets. The global economy is healthy and inflation pressures remain subdued, so we see only modest changes in monetary policy in 2018.

Taxation changes in the US will give a one-off boost to earnings in the US and keep the profits going into 2019.

Political impediments are significantly lower in 2018 with only one election to focus our minds.

We have been increasing our exposure to equity markets through 2017 and we will continue to do this in the early part of 2018.

Bernard Swords is Chief Investment Officer, Goodbody

Sunday Independent

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