Isabelle Mateos Y Lago Positions For 2018: Less Bullish On U.S. Stocks Than Global Ones

Summary

We remain bullish on stocks generally, given the robust global growth environment and likely continuation of historically low interest rates.

It would be prudent to expect a moderation of stock returns in 2018 compared to 2017, given how elevated valuations have become.

Markets may be underestimating inflation dynamics in the US.

Isabelle Mateos y Lago is BlackRock’s Chief Multi-Asset Strategist. As part of the BlackRock Investment Institute, she is responsible for developing and delivering thought leadership, helping shape BII’s macro views, creating actionable market views based on the insights of our investment community, and representing BlackRock’s market views across client channels and in the media globally. Ms. Mateos y Lago is a member of the Board of Bruegel, a leading European policy think tank. She is also a member of the Inspection générale des finances.

Rena Sherbill (RS): As we enter 2018, are you bullish or bearish on US stocks?

Isabelle Mateos y Lago (IML): We remain bullish on stocks generally, given the robust global growth environment and likely continuation of historically low interest rates. But we are less bullish on US stocks than global ones. We also think it would be prudent to expect a moderation of stock returns in 2018 compared to 2017, given how elevated valuations have become. Moreover, we see a low likelihood of having as favorable a ratio between positive and negative surprises in 2018.

RS: Which domestic/global issue is most likely to adversely affect US markets in the coming year?

IML: The tightening labor market is likely to start pushing up wages more than has been the case in recent years. Companies operating in a tight competitive environment may not be able to raise prices commensurately, and hence will face margin compression. More widespread price pressures on the other hand might lead to Fed to take a more aggressive normalization path.

Given the fiscal stimulus expected, we would not rule out 4 rate hikes in 2018. But the market is currently pricing in about 2. A readjustment in these expectations could prove painful to both stock and bond markets, at least temporarily. We also see potential downside risks for US markets stemming from changes in US trade policies, more specifically the risk of a protectionist turn.

RS: Do you expect the yield curve to continue flattening in 2018, and if so what impacts will that have on the equity market and the economy in general?

IML: We do expect the slope of the yield curve to remain relatively flat going forward, with both short and long rates continuing to rise. It is not unusual for the yield curve to flatten when the Central Bank normalizes policy after an accommodative phase. In this case the flattening also reflects continued high demand for safe assets globally. We do not think such flattening portends adverse developments either for the economy or markets. We do expect this rate environment to be favorable to financials and the momentum and value style factors.

RS: What do you expect to be the key driver of stock market performance in 2018?

IML: The drivers will to some extent depend on the markets. In the US, after years of strong multiple expansion, earnings will be the main catalyst, with tax cuts, and in some sectors deregulation being supportive forces. In Japan and EM, whilst earnings growth should be healthy as well given the backdrop of global synchronized expansion, there is scope for meaningful rerating. EM in addition should be supported by continued strong flows as investors increase exposure after years of underweighting the asset class.

RS: Will the transition in Federal Reserve leadership from Yellen to Powell impact equity investing sentiment? Why or why not?

IML: We do not see the transition from Yellen to Powell per se as having a meaningful impact on investor sentiment. But there are several more vacancies on the Fed board and so within a few months we could have a largely renewed board. And this largely renewed Board will need to deal with new economic conditions, including those created by the new tax bill. This creates both communication challenges and substantive ones as market participants adjust to the Fed's new reaction function, with the potential for at least temporary jitters. But we think such jitters would likely be more problematic for bond markets than for stocks, where earnings growth expectations will be what matters the most.

RS: What do you see for emerging markets in 20187?

IML: We are bullish on emerging markets, particularly on the equity side. Profitability is increasing, the macro-environment is generally much more resilient than in previous Fed normalization cycles (e.g., lower inflation, lower current account deficits, lower dollar-denominated debt) so we see EM much less vulnerable to rising interest rates and a rising dollar environment. While China will not be the tailwind it was in 2017, we see other large EM rebounding in 2018, notably India, Russia and Brazil, and others like Indonesia powering ahead thanks to positive structural reforms.

Meanwhile, the global synchronized expansion environment that we envision in our baseline is one that will generate strong demand for EM exports, enabling continued strong earnings growth. With global investors still underinvested in the asset class, we see all the stars aligned for EM to outperform in 2018.

RS: What 'surprise' do you see in the market that isn't currently getting sufficient investor attention?

IML: We think markets may be underestimating inflation dynamics in the US. Our analysis suggests that inflation will return to the Fed's target in coming quarters, allowing the Fed to continue normalizing with 3 or 4 1/3 point rate hikes in 2018. Markets currently price in a much shallower path.

RS: What's your take on cryptocurrencies, and what does the price action in Bitcoin say about the financial markets in general?

IML: Crypto-currencies have been around for some time but they have literally burst onto the mainstream market scene in 2017, with four-digit returns that have many commentators drawing parallels with the great 17th century tulip bubble. Clearly this price action is driven by speculative forces, but it is essentially impossible to determine at this stage what is the "right" price for any crypto-currency, and hence whether any price is right or wrong. There are simply too many uncertainties about their prospects - related among others to regulation, safety and volatility risk, market infrastructure - to come up with a robust valuation framework.

For that reason, we view cryptocurrencies as currently appropriate only for those prepared for the potential loss of their entire investment. However, we recognize that the technology and regulatory landscape is rapidly changing and will continue to closely monitor developments in this space and revisit our views as the market evolves.

RS: In terms of asset allocation, how are you positioned heading into the New Year?

IML: We are overweight non-US equities, neutral US equities, EM debt and US credit, and underweight sovereign bonds. We see near term upside potential for the US dollar.

RS: Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2018 and beyond?

IML: While it's always tempting to react to all the latest data releases and political news, which do drive the markets on a day to day basis, timing the market is hard to do. The best investment strategies are those that are anchored in market fundamentals; don't lose sight of long term trends and don't get distracted by the noise. We do expect a lot of the latter in 2018 as well, but also continued strong growth, continued low interest rates, and continued widespread technology-driven disruption.

On this basis, we see 2018 still as a risk-on year, with a preference for equities (especially tech and financials), appropriate diversification (using a factor lens helps), and an up-in-quality-and-liquidity bias in credit.