Outlook 2018: Equities.

Last year, the surge in equity markets and corporate profitability came as a surprise to many. While risk exist, there seems to be no obvious reason why 2018 should not see more of the same.

Equity markets and corporate profitability increased in sync in 2017, and we expect this trend to continue in 2018. While some analysts are concerned about complacency among investors, there are many good reasons why the equity boom has further to run.

Economic growth is buoyant in all major parts of the world, helping push corporate earnings higher in a way not seen since before the global financial crisis.

Thinking about the global economy as it runs through a cyclical pattern, we appear to be early to mid-cycle (although different economies are at different stages). This matters for the UK equity market because of the high proportion of stocks that have a global earnings footprint. While this is a supportive phase of the economic cycle for such stocks, at the same time the domestic (UK) economic environment is being challenged by uncertainties related to Brexit.

In Europe, the ECB’s asset purchasing program has succeeded, despite the expectations of many, in stabilising once-troubled economies and improving overall fundamentals. On the other side of the Atlantic, hopes remain high for the effectiveness of the administration’s tax reform plan.

Across the Pacific, Japanese equity markets have been lifted by the Bank of Japan’s ongoing monetary expansion and a renewed electoral mandate for the policy’s architect, Prime Minister Shinzo Abe. And emerging markets are thriving, too, thanks to rising global demand, stability in China and rebounding commodity prices.

True, market bears insist valuations are too high to be sustainable and that earnings growth could fail to materialise. Countering that view, bulls point to ongoing growth in market share by highly valued technology companies, attractive risk premiums, and an upbeat mood among households and boardrooms.

In this “Goldilocks” environment of subdued inflation and buoyant growth, we see no evidence that market optimism is overblown. Investors are focusing on critical factors such as earnings, which underpin surging tech stocks today in a way they did not during the late 1990s dotcom boom-and-bust cycle.

Fundamentals remain exceptionally strong: Companies around the world are sitting on huge piles of cash and – apart from Chinese state-owned companies – possess solid balance sheets, rather than relying on nearly free borrowing. Capital investment is increasing in the US, Europe and Japan, suggesting the next major step in the bull market may be deployment of capital surpluses to invest and make acquisitions – including, in the US, a surge in share buybacks financed by the repatriation of overseas funds.

Despite last year’s stock market growth equity investors still have plenty of cash on the side lines awaiting good opportunities. For now at least there are a few good alternatives for high returns.

At the start of 2017, investors were worried about a series of elections looming in major countries, lacklustre growth and weakening earnings prospects. Instead the year brought greater political stability, a sharp upturn in growth and a brightening earnings outlook that pushed several Eurozone equity markets to record highs – despite concerns about a messy Brexit, populism and separatism.

Earnings prospects remain impressive amid accelerating profitability and monetary support from the ECB’s bond purchases, benefiting in particular cyclical stocks, from banks to industrials.

Wall Street continues to outshine other markets in terms of absolute and historical valuation levels, and a successful tax reform package could lift the annualised rate of growth close to 3%. Equity markets are increasingly dominated by tech behemoths like the so-called FANG quartet (Facebook, Amazon, Netflix and Google/Alphabet). The sector now makes up nearly a quarter of the S&P 500’s market capitalisation, a share that seems set to increase.

Last autumn’s stellar Tokyo Stock Exchange performance reinstated Japan as a market powerhouse. The combination of still-low valuations, improving economic growth driven both by domestic demand and exports and ongoing monetary easing by the Bank of Japan, makes it currently the most attractive of the four main regions for equities.

Following Prime Minster Abe’s new electoral mandate in October, the continuation of his pro-growth, anti-deflation strategy seems assured for now. Corporate cash piles are likely to be channelled into M&A activity further boosting the market.

Emerging markets including China are also benefiting from increasing demand in the developed world and at home. China’s pockets seem to have been deep enough to ward off the much-feared “hard landing” while political stability has been underlined by the 19th Communist Party Congress.

Commodity exporters should continue to benefit as resource prices, from base metals to energy, continue to recover. Like Brazil, many emerging market countries are taking steps to reduce domestic and international debt levels, while India’s infrastructure plans demonstrate an increased focus on pro-growth policies.

Can such stability last? Volatility indices were at historical lows for much of 2017, and drawdowns were limited and brief as investors seized buying opportunities. But sectors, styles, themes and stock-picking are becoming more important to extract alpha in a low-volatility environment.

Moving forward, we continue to prefer cyclical sectors over defensive ones, and favour value and small caps stocks, especially in Europe, as well as technology on a longer-term basis, with capital expenditure set to be a top theme in 2018.

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