This week TAMIM Managing Director Darren Katz takes a look at the year that was and what is to come in 2018. Exuberance is back and asset prices (well most of them) are moving higher. So what should you be aware of in the next year and what are the risks you need to protect against.
We spent 2017 disagreeing with investors about their perceived worries regarding equity markets primarily due to geo-political and sometimes economic concerns. Starting with the US elections in November 2016 and the election of Trump to the US Presidency through to the French and Italian elections. North Korea also created significant angst when they started testing missiles over Japan and Kim Jong Un and Trump started arguing over who had the biggest big red button. Despite all of this 2017 was a year of strong returns across most asset classes and markets except cash. The old adage of cash being king certainly did not hold in 2017 and those that panicked themselves out of being invested missed out on positive portfolio returns.
The best performing asset class in 2017 was emerging market equities with a 31% return followed by developed market equity at 19.1%. The Australian share market - represented by the S&P/ASX 200 Accumulation index - increased by 11.8%. Interestingly, in a similar fashion to 2016, the majority of 2017’s returns were generated in the last 3 months of the year. The traditionally strong REIT sector disappointed at 5.1%.
With the new year upon us, we felt it was time to update our views on financial markets. With most risk assets generating strong returns in 2017, there is a strong belief that the end of this buoyant economic cycle is close but this is still a good time to be long risk. With most measurements of volatility telling us that volatility was low in 2017, we should expect more volatility in 2018 and we therefore need to be focused on liquidity and remaining diversified across our investment portfolios.
Last year the globe focused on the rise of populism with a number of shock political outcomes. 2018 does not hold the same risks, there is still some hangover from the 2017 populist party however. Germany is still trying to form a coalition government with a weakened Merkel led Christian Democrat party working with the German Social Democrat party on a solution. If this fails there will be new elections in April. Italian elections must be held by May. We are more used to a fragile Italian government though and this poses less risk to the market. Brexit does pose some concern with the triggering of Article 50 in March 2017 we are almost half way through the 2-year official deadline to complete the process. Australia may also face a 2018 election given the fragility of the coalition majority highlighted by the recent dual citizenship farce. To add to the above we have Janet Yellen leaving the Fed on February second.
Geopolitical events will continue to come, go and cause short term angst but in the medium to longer term economic reality always rules and we should look to these short-term events as opportunities for us to buy or even sell assets at opportunistic price levels.
Despite strong global growth, inflation has remained subdued which is a little puzzling. We believe this is primarily driven by low wage growth. While we are not sure if low wage growth is as a result of the battle scars from the GFC or maybe ongoing technological disruption to the workforce. Over time inflation will continue to normalise globally, but disinflation due to technology will continue to cap the upside to inflation and therefore the risks.
Interest rates will also continue to normalise but this will still occur a lot slower than anyone expects and while the Fed is raising rates, the ECB, BOJ and BOE are all at different points in their cycles. The ECB will continue with its Quantitative easing program through 2018 albeit on a reduced basis. It is important to remember that it has promised not to raise rates until it has ended its support program. The Fed will start to reduce its balance sheet at the start of this year but again this will be very gradual. It looks like we might start to reverse net central bank asset purchases by mid 2019 as can be seen in the chart below. With yield curves in different regions impacting other regions, we may be in a scenario where yield curves do not predict recessionary environments. Given we are looking at potential inversion of the US yield curve this will be important to remember.
Stocks are more positively skewed towards economic growth than Fixed Income and, with a continued strong outlook for economic growth in 2018, we believe that investors should remain exposed to equities.
Global PE ratios are above historic norms (see chart below), consumer confidence, employment and business sentiment all remain strong. If we face a rebound in productivity then this should be a strong indication that the environment for equities is positive. High PEs hide the reality that this increase has not been across all sectors. Rather, as an example, in the US it has been skewed to specific segments of the market such as IT/technology where tech stocks are in a secular uptrend. Increased earnings expectations do not seem to be out of kilter with reality and there is also the potential boost to the US economy from the tax reform package.
A key risk of high valuations across US equities is that an earnings recession could trigger a sharp correction leading to a global sell off. It is important to remember that although high valuations do not trigger corrections, deteriorating fundamentals do.
2017 has been the best year for Eurozone earnings growth since 2010. Pleasingly this has been driven by earnings growth (illustrated by the green segments in the next chart) rather than by multiple expansion. Future earnings growth is also being revised higher.
In Japan, as Robert Swift noted on a number of occasions last year, we have seen that corporate earnings are improving coupled with strong improvements to corporate governance. Valuations remain at or below averages with fundamentals and earnings still lifting - we favour Japanese equities.
Back home, there has been a pick-up in government infrastructure investment which is positive however household debt remains a major issue. The largest drawdown in the ASX200 in 2017 was 5% (this has only happened twice in the last 24 years). On average this is normally around the 12% mark. We should expect to see a pick up in volatility through 2018. With our market remaining skewed towards financial services and banks, a significant slowdown in this segment or a significantly more hawkish RBA could see our economy stall significantly.
The stronger earnings growth has resulted in high PE Australian stocks performing well in 2017, pushing them close to their 2016 highs. The dispersion of performance between high PE and low PE stocks increased in the last year, making growth stocks susceptible to a sell off. We currently favour an active approach to Australian equities with our portfolio having had a large exposure to the strongly performing IT sector. While we have reduced our investment to this segment marginally this is largely due to stretched valuations. We are interested in infrastructure as a sector and have been investing in businesses exposed to government infrastructure projects. We are also starting to get more interested in resources as long-term secular demand for commodities is starting to reappear with the Chinese One Belt One Road project ramping up. Incidentally, stronger resources prices, in particular iron ore, will continue to keep the Australian dollar strong versus the US dollar.
Government debt is expensive globally and we believe this looks worse due to the expectations of a rising yield environment (even though we think the rises will be slower then everyone expects). Corporate bonds are not much more appealing as credit spreads have tightened with the long search for yield forcing more investors into this segment of the bond market. With the risk of capital loss high in traditional fixed investment markets, TAMIM continues to look at the private lending market for a source of income in client portfolios. We have invested into pool of private loans and see the ability to continue to deliver strong returns north of 8% on a net basis going forward over the next couple of years.
Construction is booming and on a per capita basis Australia has 14.6x the number of cranes operating as does North America. This is a positive signal for economic growth, it does however also signal an overheated property market.
It must be remembered that the property market should be looked at by segment (be it residential, commercial, office or retail) and also geographically. We have made comment on numerous occasions that we believe the Brisbane CBD residential apartment market is overheated and will see significant price falls. This has already occurred in some instances - specifically Melbourne (Docklands) and Perth. TAMIM continues to see resilience in most segments of the property market and we believe that, while low rates continue to be met with the provision of credit, property prices will remain stable. We are firm believers in paying the right price when purchasing an asset and we will continue to search for attractively priced property assets to offer our clients.
2018 will remain a good environment to be invested in risk assets. Investors should remain nimble with portfolio liquidity being important. Higher levels of diversification in this high valuation environment are also important. We need to watch wage inflation globally as well as locally as any up tick there will be an early warning signal of a return to higher inflation rates. We also need to monitor asset price inflation closely with many global financial and economic organisations becoming increasing uncomfortable about the long-term problems accommodative monetary policy is causing. A key risk to the system would be an overly hawkish Fed or even worse RBA but we don’t see this as the major threat .The risk of exiting investments too soon and being under invested are the bigger concerns heading into 2018.
Markets & Commentary
At TAMIM we are committed to educating investors on how best to manage their retirement futures.
Sign up to receive our weekly newsletter:
TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.