Outlook for 2018
LSD: is this the economic drug that will keep the financial market outlook constructive in 2018?
We enter the new year with valuations on equity markets high, and bond yields still relatively low, despite ongoing voices of concern and frequent predictions talking of imminent stock market collapse or bond market reversal. It was Paul Samuelson, the first American to win the Nobel Prize for Economics, who once said that stock markets have predicted nine of the last five recessions. This phrase has been adapted and used many times since to highlight that markets can frequently get it wrong. But likewise, how many times can it be that imminent market collapse is predicted by those who analyse the financial outlook?
At some stage, of course, a stopped clock is right. If you keep saying something is going to happen it will. But naturally a stopped clock is no use at telling the time.
The point is not to dismiss these siren voices. After all, valuations on a whole range of instruments are high, so high that if there were a major correction it would likely surprise no-one. Instead, the first key message is that we enter 2018 with market valuations – on equities, bonds and many other financial instruments – at levels that suggest we should be asking whether markets are pricing properly for risk.
Recently, on Our Views, we outlined some of those risks: economic, financial and geopolitical. That is the health warning. Of course, the lesson from the past is that steady saving and investing is the best long-run approach: when it comes to the stock market it is time in the market not timing the market that delivers rewards. For bonds, meanwhile, the bull market of the last quarter century has been built on low inflation. Which leads us onto the ‘L’ in our LSD: liquidity.
‘L’ is for liquidity
Liquidity is ample as we enter 2018. Central bank monetary policy has been accommodative since the financial crisis. It has helped feed asset price inflation. The question for 2018 is whether it will feed more widespread inflation. Tighter labour markets in the UK, US and some other economies, plus greater job creation on the Continent, suggests higher wage inflation is possible. And, if so, this might incentivise firms to boost profit margins by raising prices, driving up domestic cost pressures, here and overseas. For the moment, inflation expectations remain muted, and in the UK we remain of the view that inflation will decelerate during 2018.
The question then is whether liquidity conditions can be tightened without damaging growth or spooking financial markets. Central banks are at different stages of their exit process, led by the US tightening, with the UK far behind and the euro area and Japan even further back. The likelihood is that 2018 will see the Federal Reserve and Bank of England normalise further – perhaps three interest rate hikes in the US and two in the UK, although even this is not guaranteed. But the European Central Bank and Bank of Japan will still add liquidity, the spillover of which will help global markets.
‘S’ is for synchronisation
The second half of 2016 saw a synchronised pick-up in the world economy that became more evident during 2017 and looks set to become more entrenched in 2018. We expect solid global growth in 2018. This will boost global trade, and UK exports, too.
Even emerging economies, led by China, are recovering. This macro-backdrop is positive. But as we have outlined before, it is some of the longer-term drivers that are particularly exciting: the fourth industrial revolution, China’s Belt Road initiative and the ability for the UK to reposition itself in this changing environment. These trends should be positive for investment.
‘D’ is for debt dynamics
The aftermath of the financial crisis was characterised across western economies by deleveraging, as firms and people reduced debt, and by an increase in public sector debt. In the UK, the accumulation of UK public sector debt peaked with a budget deficit of £152.5 billion in 2009/10, and has slowed since, to £45.7 billion in 2016-17 and is likely to be around that level again in 2017-18.
Provided nominal GDP (growth plus inflation) sees steady growth, and government borrowing yields stay low, then it is possible for the debt figures to surprise on the positive side in the year ahead. A worry, though, is what may happen to household borrowing. Household debt, which includes mortgage and unsecured debt, has been creeping up in recent years, and is expected to reach 150% of GDP by 2023, although it is still below the 160% it reached back in 2008.
So, two different trends to watch on the debt outlook: the budget deficit trending in the right direction, and the sensitivity of personal borrowing if interest rates rise.
‘D’ is also for dollar
While debt was the ‘D’ to focus on from a UK perspective, for the global economy attention will likely be on a different ‘D’: the dollar. At the start of the Fed’s interest rate tightening cycle, financial markets were worried that the strength of the dollar could hit emerging economies – where many corporates had borrowed in dollars – and thus impact global growth. This fear did not materialise. Now, with oil prices firmer, the trend for the dollar will have a bearing on the global inflation outlook. As the Fed hikes rates further in 2018, the dollar may show some resilience.
Sterling, too, has been edging up versus the dollar as more extreme fears over the Brexit process have eased. It is the latter that weighs over sterling in the year ahead. But there is every likelihood the UK will agree a deal with the EU and if the government holds its nerve this will include a favourable deal for The City based on equivalence that will be of mutual benefit to the UK and the EU.
The impact for the UK
So what then does this mean for the UK? The consensus for growth is centred around 1.5%, with the official Office for Budget Responsibility view being that after 1.5% in 2017 the economy will slow to 1.4% in 2018 and 1.3% in 2019. Such forecasts are credible, but we are more positive.
Consumption should be boosted by higher real incomes, exports by the stronger world economy, but uncertainty may restrain investment growth. Growth could be closer to 2%. Inflation should decelerate from 3.1% now towards 2% by the end of 2018. The Bank of England should move interest rates gradually. I think they should err on the side of caution, not tightening prematurely but even so, it still makes sense to factor in two quarter point rate hikes in 2018.
Please remember that when investing your capital is at risk.
We enter the new year with valuations on equity markets high, and bond yields still relatively low, despite ongoing voices of concern and frequent predictions talking of imminent stock market collapse or bond market reversal. It was Paul Samuelson, the first American to win the Nobel Prize for Economics, who once said that stock markets have predicted nine of the last five recessions. This phrase has been adapted and used many times since to highlight that markets can frequently get it wrong. But likewise, how many times can it be that imminent market collapse is predicted by those who analyse the financial outlook?
At some stage, of course, a stopped clock is right. If you keep saying something is going to happen it will. But naturally a stopped clock is no use at telling the time.
The point is not to dismiss these siren voices. After all, valuations on a whole range of instruments are high, so high that if there were a major correction it would likely surprise no-one. Instead, the first key message is that we enter 2018 with market valuations – on equities, bonds and many other financial instruments – at levels that suggest we should be asking whether markets are pricing properly for risk.
Recently, on Our Views, we outlined some of those risks: economic, financial and geopolitical. That is the health warning. Of course, the lesson from the past is that steady saving and investing is the best long-run approach: when it comes to the stock market it is time in the market not timing the market that delivers rewards. For bonds, meanwhile, the bull market of the last quarter century has been built on low inflation. Which leads us onto the ‘L’ in our LSD: liquidity.
‘L’ is for liquidity
Liquidity is ample as we enter 2018. Central bank monetary policy has been accommodative since the financial crisis. It has helped feed asset price inflation. The question for 2018 is whether it will feed more widespread inflation. Tighter labour markets in the UK, US and some other economies, plus greater job creation on the Continent, suggests higher wage inflation is possible. And, if so, this might incentivise firms to boost profit margins by raising prices, driving up domestic cost pressures, here and overseas. For the moment, inflation expectations remain muted, and in the UK we remain of the view that inflation will decelerate during 2018.
The question then is whether liquidity conditions can be tightened without damaging growth or spooking financial markets. Central banks are at different stages of their exit process, led by the US tightening, with the UK far behind and the euro area and Japan even further back. The likelihood is that 2018 will see the Federal Reserve and Bank of England normalise further – perhaps three interest rate hikes in the US and two in the UK, although even this is not guaranteed. But the European Central Bank and Bank of Japan will still add liquidity, the spillover of which will help global markets.
‘S’ is for synchronisation
The second half of 2016 saw a synchronised pick-up in the world economy that became more evident during 2017 and looks set to become more entrenched in 2018. We expect solid global growth in 2018. This will boost global trade, and UK exports, too.
Even emerging economies, led by China, are recovering. This macro-backdrop is positive. But as we have outlined before, it is some of the longer-term drivers that are particularly exciting: the fourth industrial revolution, China’s Belt Road initiative and the ability for the UK to reposition itself in this changing environment. These trends should be positive for investment.
‘D’ is for debt dynamics
The aftermath of the financial crisis was characterised across western economies by deleveraging, as firms and people reduced debt, and by an increase in public sector debt. In the UK, the accumulation of UK public sector debt peaked with a budget deficit of £152.5 billion in 2009/10, and has slowed since, to £45.7 billion in 2016-17 and is likely to be around that level again in 2017-18.
Provided nominal GDP (growth plus inflation) sees steady growth, and government borrowing yields stay low, then it is possible for the debt figures to surprise on the positive side in the year ahead. A worry, though, is what may happen to household borrowing. Household debt, which includes mortgage and unsecured debt, has been creeping up in recent years, and is expected to reach 150% of GDP by 2023, although it is still below the 160% it reached back in 2008.
So, two different trends to watch on the debt outlook: the budget deficit trending in the right direction, and the sensitivity of personal borrowing if interest rates rise.
‘D’ is also for dollar
While debt was the ‘D’ to focus on from a UK perspective, for the global economy attention will likely be on a different ‘D’: the dollar. At the start of the Fed’s interest rate tightening cycle, financial markets were worried that the strength of the dollar could hit emerging economies – where many corporates had borrowed in dollars – and thus impact global growth. This fear did not materialise. Now, with oil prices firmer, the trend for the dollar will have a bearing on the global inflation outlook. As the Fed hikes rates further in 2018, the dollar may show some resilience.
Sterling, too, has been edging up versus the dollar as more extreme fears over the Brexit process have eased. It is the latter that weighs over sterling in the year ahead. But there is every likelihood the UK will agree a deal with the EU and if the government holds its nerve this will include a favourable deal for The City based on equivalence that will be of mutual benefit to the UK and the EU.
The impact for the UK
So what then does this mean for the UK? The consensus for growth is centred around 1.5%, with the official Office for Budget Responsibility view being that after 1.5% in 2017 the economy will slow to 1.4% in 2018 and 1.3% in 2019. Such forecasts are credible, but we are more positive.
Consumption should be boosted by higher real incomes, exports by the stronger world economy, but uncertainty may restrain investment growth. Growth could be closer to 2%. Inflation should decelerate from 3.1% now towards 2% by the end of 2018. The Bank of England should move interest rates gradually. I think they should err on the side of caution, not tightening prematurely but even so, it still makes sense to factor in two quarter point rate hikes in 2018.
Please remember that when investing your capital is at risk.
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