As every sports fan knows, strategy must be path-dependent. Think about football – the version we Americans insist on calling soccer. If you’re a goal down with a quarter of the game to go, you will end the game on the attack. Go two up in the first half, and while you might substitute a centre forward for a fullback, you’d still seek to ride your momentum. Only once you’ve knocked in a third would you “park the bus” on the goal line, as my UK colleagues put it.
As we move into 2018 we are two goals to the good, with synchronised global growth and a big US tax overhaul. It may already be opportune to bring on short-duration fixed income and low-volatility hedged strategies as a substitute for some corporate credit. But economic and market momentum is still with us, and we think we can press for a third goal before half-time with inflation-sensitive assets.
As we approach the midpoint of the year, volatility, rising interest rates, a late-cycle slowdown and potential political risks could come back at us, looking for equalisers; at this point, it could be a good time to use continued market momentum to shift, gradually, to a more defensive formation.
Global equities, as measured by the MSCI World Index, enjoyed high double-digit returns through 2017.
Against this background, equities are now no longer cheap, but neither are they terribly rich. Even if they were, rich or full valuations do not cause market corrections in themselves. Markets respond to catalysts.
When it comes to immediate downside risks, there are signs of late-cycle behaviour, from disappearing high yield bond covenants to the rise and subsequent fall of bitcoin, but the overwhelming catalysts moving into 2018 are momentum from synchronised global growth, the benign inflation and monetary-policy background, and pro-growth policies such as tax reform in the U.S.
However, things could change through the second half of 2018.
First, we expect inflation to reappear, which may encourage central banks to hike interest rates more quickly than the market currently anticipates. At the same time, balance-sheet reduction will be gathering pace at the Federal Reserve and the European Central Bank will be advanced in its asset-purchase tapering. Risk premia may have to adjust especially quickly in Europe.
Then there is the likelihood of further slowing in China’s economy. That is likely to have knock-on effects on commodity prices and other growth drivers in emerging markets, and to soften the global synchronised cycle later in 2018.
Among the more predictable political risks, 2018 brings potentially eventful elections in Brazil, Italy and the US markets will start to look at opinion polls in late summer for any signs that the Democrats might regain a majority in either house of Congress in November’s midterm elections, which could tie the current administration’s hands for the remainder of its term.
In the meantime, there are the Italian elections in March, Robert Mueller’s special counsel investigation in the US, and of course the Brexit negotiations.
Essentially, 2018 is expected to be a game of two halves, and that makes it a challenge to articulate a consistent 12-month outlook. The expectation is that strong positive economic and market momentum can persist into the first half. Should the first half play out as anticipated, it would be opportune to begin using such continued momentum to adopt a more defensive stance later in the year while remaining ready to act should risks manifest themselves sooner rather than later.
However, there are a few areas of elevated downside risk to avoid, as well as some areas of potential value. We retain an ‘above normal’ outlook for global equity returns, with a preference for non-US over US equities, and emerging equities over developed.
While we are ‘neutral’ on China, the emerging world will still be a beneficiary of synchronised global growth. We favour US small caps over large caps, and value stocks over growth.
In fixed income we lean toward high yield over investment grade. While we still prefer corporate bonds over governments, corporate credit is one place where we have already adopted a more cautious view. The pricing of corporate credit risk is outpacing the fundamentals of corporate earnings. There are other places to get income, albeit with varying degrees of risk. One such place might be emerging markets debt, where inflows continue to be steady and positive.
Overall however, our view is not defensive. We respect the momentum currently driving both the fundamentals of the economy, and the pricing of financial risk assets, and express that in our positive views on non-US equities, US small caps, cyclical value stocks and shorter-duration strategies. We also anticipate a turnaround in the inflation story. We do think the newfound return potential of cash can help investors manage portfolio beta down slightly, and we are also mindful of the asymmetrical downside risks building in credit.
Ten for 2018
The heads of each of Neuberger Berman’s investment platforms identified the key themes they anticipate will guide investment decisions in 2018. These 10 themes are summarised below.
Macro: Global inflection point nears
- “Goldilocks” gives way to something more complicated
Though the strength of global economic momentum is undeniable, a consequence of factors — including tightening central bank policy, plateauing economic growth and rising market volatility — suggests that conditions are unlikely to remain “just right” for all of 2018.
- Both monetary and fiscal policy are in motion globally
As major central banks wind down unprecedented levels of monetary stimulus, their efforts are being met — and potentially complicated — by expansionary scale policy and reform initiatives taking root in a number of countries.
Risks: Clouds gather as the year progresses
- Geopolitical climate remains unsettled
Elections this year in Italy, Mexico, Brazil and the US — in addition to ongoing disrupters such as North Korea, special investigations and Brexit — could upset the current order.
- China accelerates structural reforms
An emboldened Xi will be more aggressive in reducing leverage and re-orienting China’s economy toward more sustainable, high-quality development, to the potential detriment of near-term growth.
Fixed income: The chase continues
- No end to the search for yield
Biased higher but still low, long-term interest rates continue to send investors into less-familiar corners of the fixed income markets in the hunt for yield, with high valuations leaving little cushion to absorb a volatility shock.
- Credit drivers begin to change
Continued low default rates suggest global credit spreads likely will be impacted less by fundamentals and more by technical developments such as hedging costs, LDI-related flows and regulatory changes.
Equities: Two-way markets return
- Market momentum could present opportunities to reduce beta exposure
Strong earnings growth could fuel equities in early 2018, providing investors with chances to trim holdings in high-valuation stocks and redeploy into more attractive risk-adjusted exposures.
- Active management positioned to shine
Market dynamics continue to shift in favour of active management, which could extend the comeback mounted by stock pickers in the past year after a period of underperformance.
Alternatives: Finding opportunities amid high valuations
- Low-vol strategies for a more volatile world
Market-neutral and relative-value hedge funds may help investors earn returns with lower volatility.
- Sharpen quality focus in private assets
Given high private equity valuations, investors can help mitigate risk by targeting experienced private equity sponsors with a history of adding operational value or by moving up the capital structure to first-lien private debt.