Reasons to be cheerful: What to expect from markets in 2018

First, the political risks that fixated investors a year ago largely failed to materialise. President Trump did not start a trade war with China on his first day in office, and voters in Europe did not follow the path of the UK and reject the European Union.

Second, as political risk faded the economic sun shone.

Growth surprised on the upside as the world economy enjoyed a synchronised upswing and international trade revived. For the first time in six years economists did not have to apologise for their growth forecasts.

Investors are set to register double digit returns from equities in 2017 with some markets seeing gains of more than 20 per cent.

Volatility has been exceptionally low and the index of large cap US stocks, the S&P 500, has enjoyed its longest unbroken run of monthly gains since January 2007.

An excellent year, but such returns will cause pension schemes to ask whether this is as good as it gets? Can the combination of factors that delivered such performance in 2017 be repeated in 2018? And if not, will new drivers emerge?

Expectations are set high

As we head into 2018, the growth picture remains strong. Business is confident and leading indicators signal robust growth ahead.

Consequently, corporate earnings should continue to improve and support risk assets, particularly those exposed to the cycle.

However, there are a few key differences with 2017. Expectations have risen and consequently the scope for positive surprises is less.

Moreover, next year is likely to see a gradual pick-up in inflation and even some acceleration in wages as labour markets tighten further.

The environment will be more reflationary and consequently central banks will be looking to withdraw stimulus, with the US Federal Reserve set to hike rates three times in 2018.

Interest rate increases are not necessarily bad for risk assets if they are accompanied by stronger growth, as we saw in 2017.

Next year’s rate rises in the US will continue the process of normalising real rates and markets may well take them in their stride.

However, to the extent that they are accompanied by greater concerns over inflation, investors will start to discount the end of the expansion.

Europe anticipates end of QE

Policy rates in the Eurozone are not expected to change in 2018, but here the focus will be on the central bank’s withdrawal from quantitative easing.

The European Central Bank’s asset purchase programme is set to halve from €60bn to €30bn per month from January and we expect it will end in September.

Relative to the asset markets affected, the ECB’s programme has been more significant than that of the Fed, as can be seen by the prevalence of negative five-year bond yields in core countries such as Germany, France and the Netherlands.

As growth remains robust and the ECB begins to end QE markets will look for an increase in policy rates, thus pushing bond yields higher across the Eurozone.

Such a move will be felt most keenly in the indebted periphery, which has been such a beneficiary of low rates. Meanwhile, political risk will return to the region with a general election in Italy likely to be held in March.

Japan could outperform Brexit Britain

From this perspective, investors seeking the ‘Goldilocks’ environment of 2017 will have to look beyond the US and Europe.

Japan still looks attractive with monetary policy expected to stay on hold, while political risk is minimal following Abe’s victory in the recent general election.

To some extent emerging markets also fit the bill, with inflation and interest rates likely to be falling next year.

As for the UK, growth prospects remain hampered by Brexit and the political situation still appears volatile. As the next phase of negotiations begin optimists may point to hopes of a softer Brexit.

However, while encouraging for domestic companies, UK institutions need to watch out for the effects on their portfolios of a subsequent rise in the pound.

Keith Wade is chief economist at investment managers Schroders.