2018 Outlook: the Macro view

Despite a tumultuous year marked by natural disasters, geopolitical tensions, and deep political divisions in many countries, global equity markets were able to climb the proverbial "wall of worry" to close uniformly in positive territory

Despite a tumultuous year marked by natural disasters, geopolitical tensions, and deep political divisions in many countries, global equity markets were able to climb the proverbial "wall of worry" to close uniformly in positive territory. As of writing in mid-December, the UK FTSE index and China's Shanghai composite have each rose by around 5% since New Year's Day; Germany's DAX is trading up around 15%; the US S&P 500 and Japan's Nikkei index have each tacked on about 20%; and the MSCI Emerging Market index has soared by over 30%. 

In essence, a "perfect storm" of low interest rates, improving economic outlooks, increased risk appetite, and suppressed volatility provided a tailwind to stocks across the globe last year. To mix our nautical metaphors a bit, a rising tide truly does lift all ships! 

While essentially every major stock market rose in 2017, investors will have to exercise a bit more discretion in 2018. Identifying the regions where the relative differentials in economic growth, inflation, and unemployment point to strong market performance will be a key theme in the coming year: 

United States 

At a top level, the US economy continues to perform well. Gross Domestic Product (GDP) growth is likely to come in at around 3% in Q4, with both the unemployment and inflation rates running at historically subdued levels of 4.1% and 2.2% (CPI) respectively. Many economists remain puzzled by the stubbornly low inflation rate, which hasn't ticked above 3% since 2012, despite the low (and falling) unemployment rate. 

The upshot of this economic dilemma is that US corporations have been able to book record sales without a corresponding rise in raw material or employee costs. If this trend carries over into 2018, it could be another strong year for US stock indices. From a policy perspective, the picture is a bit more mixed. Republicans on Capitol Hill appear likely to pass a large tax reform bill headlined by an across-the-board cut to the corporate tax rate. 

While the long-term merits of this bill can be debated, it's likely to lead to a short-term boost to economic growth and corporate profits. Meanwhile, the Federal Reserve has raised interest rates a total of five times from the Great Financial Crisis lows, in addition to ending its Quantitative Easing (QE) program and even starting to sell off some of its accumulated assets. 

Continued "normalization" of monetary policy could provide a small headwind for US stocks in the coming year, though the central bank is unlikely to do anything that endangers the health of the longer-term bullish trend. In sum, the US economy could see a modest acceleration in economic activity in 2018. Continued economic strength should support US stock values, though we're unlikely to see another 20% rally in the broad indices. The primary risk to our forecast would be an uptick in inflation prompting the Fed to raise interest rates aggressively in the coming year.

Source: TradingEconomics.com, Eurostat

Eurozone

Like the US, the Euro area economy expanded in 2017, but the region's economic figures remained uniformly behind those of the US. The last quarterly GDP reading from the Eurozone showed a decent 2.6% annualized growth rate, and crucially, economic growth in the Eurozone has accelerated in each of the four quarters. 

That said, the Euro area's unemployment rate remains elevated at 8.8% and inflation has spent most of the year hovering around 1.5% after a brief tick higher at the start of the year. Looking ahead, the IMF is relatively cautious on the region, predicting "only" 1.9% growth in the coming year, with relatively strong growth in Germany (1.9% growth expected in 2018)and Spain (3.2%) offset by a more subdued expansion in Italy (0.9%) and France (1.2%). 

Despite the slower forecast for economic growth, it's worth noting that European stocks are trading at a discount compared to their US rivals, so another decent year for euro area equities could still be in the cards. Compared to its US rival, the European Central Bank is in an extremely accommodative posture, with interest rates at rock bottom levels and a QE program scheduled to last through at least September. This monetary policy tailwind means the "path of least resistance" for European stocks remains to the topside. Of course, disruptions related to the ongoing Brexit negotiations could throw a wrench in our outlook for both the Eurozone as a whole and the UK in particular (see below).

Source: TradingEconomics.com, Office for National Statistics

United Kingdom 

When considering the at times contentious negotiations over Brexit and extreme uncertainty surrounding the whole affair, the relative underperformance of the UK's FTSE index this year is not particularly surprising. Unfortunately, that storm cloud could continue to hang over the country's economy in 2018 as well. 

The UK economy clocked in at a 1.5% annualized growth rate in the most recent quarter, down significantly from the 2-3% growth the country was experiencing before the Brexit vote. That said, UK citizens have seen the unemployment rate grind lower throughout the year, with the current 4.3% rate actually representing the lowest reading since the mid-1970s. Meanwhile, inflation is running a bit hotter than in other major economies at 3.1%, which limits the Bank of England's ability to cut interest rates to try to stimulate the economy. 

In sum, the UK's economic and market performance will hinge heavily on the progress in the ongoing Brexit negotiations. If the two sides are able to come to mutually beneficial agreements on sticky issues like trade, immigration, and regulation, it would provide a boost for the FTSE and the UK economy as a whole.

China

The world's second-largest single country economy continues to defy expectations and grow at a relatively rapid rate. China's most recent quarterly GDP reading showed 6.8% annualized growth, which is down slightly from previous years, but nonetheless impressive given the size of Chinese economy. Not surprisingly, this strong growth has driven the country's unemployment rate down to just 3.95% in the third quarter, and the government has also been able to keep inflation in check, with prices increasing at just a 1.7% annual rate in November. 

The Chinese government is likely to keep its growth target at "around 6.5%" in the coming year and is likely to focus on reducing the country's heavy debt load in the coming year. According to the Bank for International Settlements, China has the highest rate of non-financial corporate debt among major economies at 165% of GDP. Earlier this year, concerns about the indebtedness of the country prompted Moody's credit rating agency to downgrade China's rating for the first time in nearly 30 years. 

In our view, Beijing's policies for dealing with the country's debt is the major risk for Chinese stocks in the coming year. If policymakers continue to crack down on lenders, as they did in November, the Shanghai index could struggle in 2018, albeit at the expense of fewer long-term systematic risks. On the other hand, a more laissez-faire attitude toward the growing debt load could stoke the speculative fires and lead to strong performance in Chinese equities, at least in the short term.

Source: BIS

Japan

Japan's economy is generally growing in-line with its developed market peers, with the most recent GDP report showing 2.1% growth, but the country continues to struggle in its battle with deflation. 

Despite the unemployment rate holding steady at a 23-year low at 2.8% as of writing, Japan's annualized price growth was just 0.2% in the last quarter. The Bank of Japan has done all it can, with an ongoing QE program and its benchmark interest rate locked at -0.10%. 

That said, BOJ Governor Kuroda has dropped some subtle hints that the central bank may start to look at winding down its crisis-mode stimulus program. When it comes to Japanese markets, the Nikkei 225 index should continue to see the same tailwinds of a weak yen and supportive central bank that have driven the index consistently higher over the last 18 months.

Source: Trading Economics, Ministry of Internal Affairs and Communications

Summary

In summary, the global economy should continue the slow-but-steady growth trend that has characterized the past decade. While there are possible risks on the horizon, including US political discord, a "hard" Brexit scenario, and a reckoning for China's massive debt load, the "base case" scenario is for continued strength in global equity markets./p>

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