Good times fade away on markets

From the high returns of 2017 we’ll slip into solid single-digit equity returns this year, with positive company 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.

" The strongest returns of the current cycle are now behind us.” 

There is particular risk US wages and inflation will lift more rapidly than currently expected by markets – and indeed that fear was the trigger this week. 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 but we are 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.

Clock 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; and
• 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.

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Our investment-cycle clock shows the long-term economic cycle in the US. What can be seen is the economy is on an upswing - and has been for several years.

At its current pace, it will reach the 0.5 reading in the graph, a level forewarning a peak in equity markets within 18 months – this has happened in the previous three cycles.

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?

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 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 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 this will eventuate in 2018.

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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.

Time

Our view is 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 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.

Mark Rider is Chief Investment Officer at ANZ