Coming off strong increases in 2017, still-rising indexes have become a big story in global markets. The big, hanging question is: can their run continue?
James Norman, President of Legg Mason affiliate QS Investors, foresees a broad investment landscape with ample growth opportunities in developed and developing countries. Which sectors will lead the way in 2018, and beyond, is a question – and reason for diversification.
“We would not expect the rally to slow down much,” he said. “Before a strong 2017, emerging markets (NYSE:EM) had underperformed developed markets – particularly the U.S. – to an extent not seen since the 1990s, when we had the Asian financial crisis. Certainly, emerging markets are in a much different place than they were back in the ‘90s. We have gone through this period over multiple years of emerging markets underperforming. It's time to have a little mean reversion.”
“Global markets have had a great year. Over the next one to three years, that outperformance can continue. Valuations are more attractive. Growth is very attractive. The growth rate within EMs is almost twice that in developed markets. We think they will continue to outperform.”
Brandywine Global fixed income portfolio manager Jack P. McIntyre sounded similar themes.
“I'm not sure we are running on all cylinders, but out of six, we are running on five,” he said. “It's sort of broad based, so even the developed world is contributing. I don't think that's going to change, there is enough forward momentum. We do not have huge global inventories. If we did, I’d get more nervous. People are always looking for a reason to say, ‘things are going to slow down.’ I don’t see the real money – the leverage guys – all positioned for risk assets and EM.”
“There are always risks, such as protectionism,” Mr. McIntyre observed. “If China does a policy mistake, slows down too much and does not address it, that's a risk. I don't think it's enough to derail the momentum of positive global growth. Without a lot of inflation pressures, it will keep the U.S. Federal Reserve (Fed) going slowly in terms of removing monetary stimulus. Same with the European Central Bank and Bank of Japan. When you look at global monetary policy, it's not quite as simulative as it has been – but it's certainly nowhere towards being very restrictive, yet.”
Sentiments for continuing growth were echoed by Mark S. Lindbloom, a fixed income portfolio manager with Legg Mason affiliate Western Asset Management.
“Our outlook is fairly constructive for 2018, given the fundamentals, central bank policies and inflation,” Mr. Lindbloom said. “A couple of tales could surprise the markets. One would be that growth is much better, we are made great again, and The Fed has to react more aggressively than we all expected. We will have a new Fed Chairman; we don't know exactly how he will respond to that sort of pressure. And we do not know how responsive the markets and world economies will be to higher interest rates. This may be a new world, with nominal growth and inflation.”
“The other tale, also of concern, is growth will be much weaker as we go through 2018 than expected. Not a high probability, but let’s say that as The Fed starts to raise interest rates in December and beyond – they are calling for three during 2018, while the markets are calling for one to two – that the economy responds much more quickly than we think.”
“The third are the impacts – intended and unintended – on U.S. tax reform legislation,” Mr. Lindbloom said. “We are thinking that will go through in early 2018. What are the potential negative impacts we might see from that package? Something to watch very, very carefully.”
Jeffrey Schulze, an investment strategist with Legg Mason affiliate ClearBridge Investments, echoed many of the same concerns. Yet the outlook for inflation drew specific attention.
“This pulse of global growth is going to be hard to go against,” Mr. Schulze said. “We have the lowest number of countries ever in a recession. The one thing that can spoil the party is inflation. If you do see a firming up and inflation moving higher in the U.S. and Europe, both central banks will have to act a little bit more aggressively than what's currently priced in. If that is the case, obviously fixed income markets will re-price, and equity markets will re-price as well.”
“An area of a concern is Europe, and what the ECB is likely to do with quantitative easing (QE). When they did their QE program, The Fed never bought all the issuance that was coming out of the U.S. Treasury. The ECB bought seven times that issuance over the last 12 months. Starting the taper and moving out of the markets may have more outsized effects than expected.”
While Legg Mason believes there is reason for optimism, it must be tempered with caution.
“Let’s not forget that $8 trillion of bonds worldwide are negatively yielding now,” Mr. Schulze said. “You are actually paying for the privilege to own those bonds, roughly 17 percent of the global bonds out there. A rerating of those bonds could cause a little bit of a market ripple.”
While many global bond sectors have wallowed, equities have soared. Can they continue to rise?
“Returns in the last year have been exceedingly strong,” Mr. Norman said. “You're not going to see replication of those very strong returns, the second-longest expansion in U.S. history. You see valuations going up, not only in the U.S. and other markets, but on a cyclically adjusted basis: we are at the highest point ever, except for just before the technology bubble. We have exceeded 1987 in terms of cyclically-adjusted price/earnings ratios, when we had the crash.”
“People have become very complacent,” Mr. Norman emphasized. “I don't think it's necessarily going to be new news that causes markets to go down; it's going to be peoples’ perceptions of that news, and the behavior around that, if people become concerned. Yes, things look very positive, but there's certainly a lot of things that could derail that, and a lot could be behavioral.”
Read more of Legg Mason affiliates' "New Year's Resolutions" as we enter 2018.
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