Investors take note: the double-digit sharemarket returns of 2017 will moderate this year, explains Mark Rider.
Markets have been in the boom phase of the investment cycle for a prolonged period, and now, that phase is starting to look tired, signalling that the strongest returns of the current cycle are behind us.
ANZ’s Chief Investment Office does not expect a crash or even an abrupt disruption. We consider it more likely that ‘good times fade’ in 2018 and into 2019. From the high returns of 2017 we’ll slip into solid single-digit equity returns this year, with companies’ positive earnings – the primary driving force behind sharemarket gains – not as convincingly translating through to returns as caution rises over high share valuations and the possibility of interest rates rising faster than markets expect.
There is particular risk that US wages and inflation will lift more rapidly than currently expected by markets. With the risk to both growth and inflation now tilted firmly to the upside in 2018 and 2019, there are clear forces working against further high double-digit returns for share investors.
All up, we see it as too early to take a defensive position in our investments. As mentioned, we expect sharemarket gains to continue, but ANZ is keeping a sharp watch on the rising risk factors outlined above: the overvalued sharemarket, inflation and possible wage pressure, and their combined effect to push up interest rates.
The clock is running out
Our central case view for markets in 2018 is what we’ve termed ‘good times fade’ – and we think there’s about a 60 per cent chance this is how the year will unfold.
In this scenario we assume the investment cycle has up to 18 months to run before economic slowdown and recession risks rise. We started the year with elevated share valuations and over the course of the year we expect to see:
- wages and inflation gradually lifting
- most major central banks restraining their economic stimulus activity and looking to raise interest rates
- firmer financial conditions from the very accommodative levels at present
- less difference between short and long-term bond yields – which typically indicates investors are worried about the economic outlook.
Obviously this scenario suggests some investor caution is due, although the overall backdrop remains supportive of risk assets, such as shares, primarily due to strong economic and earnings growth.
While the immediate outlook remains supportive of growth assets, in the longer term we see need for caution.
Our investment-cycle clock (above) shows the long-term economic cycle in the US. What can be clearly seen is that the economy is now on an upswing, as it has been for several years. At its current pace it will reach the 0.5 reading in the graph within 18 months, which is the level in the previous three cycles forewarning of an approaching peak in equity markets.
While the clock now approaches levels generally consistent with markets being expensive and the economic cycle sitting in the “boom” phase, it is too early for investors to go to a defensive portfolio allocation. In short, the current signal is likely telling us to expect positive returns to shares in 2018 with downside risk rising later in the year and into 2019. Such a downturn is consistent with our ‘good times fade’ scenario.
What else could happen in 2018
But what would challenge this scenario is a more pronounced lift in US wages and inflation than we currently assume. By around the end of 2018 our indicator suggests that wages could accelerate from 2.5 per cent to around 3.5 per cent and reach more than 4 per cent by mid-2019.
The risk is that US labour-market conditions continue to tighten unabated given above-trend growth. Signs in Europe point to a similar risk there. Under this ‘inflation scare’ scenario, as well as wage growth, US inflation would accelerate (above 2.5 per cent by year end). This would lead to more rate rises than expected by the US central bank. If we add the possibility of Europe cutting its economic-stimulus program then both shares and bonds are likely to take a hit. We think there’s about a 30 per cent chance that this will eventuate in 2018.
Much less likely is a gradual slide in growth driven by a steeper decline in the Chinese economy than currently predicted. Even though inflation and interest rates remained low, such a scenario would support a more defensive position by investors in 2018 with the environment favourable for bonds but not for the Australian dollar and shares.
Our view is that central banks have time and can lift their rates gradually and this will support trend returns for growth assets in 2018 while bonds will deliver flat returns.
The leading risk to this is faster-rising inflation, which would mean that our investment-cycle clock would tick more rapidly. This would bring forward strategies to mitigate the risk associated with more rapid central-bank tightening, rates increasing and weaker share and bond markets.
In light of all this, our tactical asset allocation strategy balances the risk of the various scenarios that may unfold. From a portfolio perspective we balance these risks by holding a small “overweight” to shares, with a bias away from interest-sensitive sectors such as real-estate investment trusts and infrastructure. We hold an “underweight” to fixed income, focused in international bonds, where we see more risks of upward surprises on inflation and continue to hold our "neutral" position to the Australian dollar.
Investment return expectations in 2018 (weighted average of scenarios)
|Asset class||2017||2018 expectations|
|International shares (hedged)||20%||9%|
|International shares (unhedged)||13%||8%|
|Real assets (hedged)||11%||3%|
|Australian fixed income||4%||0%|
|International fixed income||4%||-1%|
Source: ANZ Wealth CIO
- Access the full ANZ 2018 Global Market Outlook [PDF]