What's next for investors in 2018?


The correction in global equities is stoking fears of a prolonged selloff putting an end to one of the longest, most profitable bull runs in history. While recent volatility is expected to continue, global economic growth continues to support solid corporate earnings that could spur asset prices higher over the next few months.

Here are the key elements that we expect will drive markets through the remainder of 2018 and help guide a disciplined approach to investing.

Fundamentals are supportive of market growth

  • The reemergence of volatility represents a return to more normal conditions.
  • Better global growth is contributing to a healthier earnings backdrop that should remain an important tailwind for stocks.
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The influence of “unpredictable” government on financial markets

  • Central banks across major markets are facing a myriad of challenges caused by late-cycle effects and overhanging trade disputes.
  • A trade war could derail economic activity and upset stock markets.

Where we are finding global opportunities

  • Emerging markets are growing at twice the rate of developed markets and trade at a significant discount.
  • The need to improve existing infrastructure and build more of it has become a major priority in both developed and developing nations.
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Fundamentals are supportive of market growth

Volatility is returning to global equity markets following an unprecedented period of calm; and more ups and downs in share prices are likely ahead. But these types of swings are not uncommon and may represent a return to more normal market conditions in an environment backed by strong fundamentals and still supportive of global equities.

10-year trailing market volatility, as represented by the CBOE Volatility Index (VIX)
Source: Bloomberg, February 2018
Source: Bloomberg, February 2018



After some lean times following the financial crisis, economies in many parts of the world have found firmer footing of late and have been expanding at a more coordinated pace.  Canada, the U.S. and Europe have all seen an uptick in their respective GDP data in recent years, even Japan has recorded eight straight quarters of positive growth. Global manufacturing activity, meanwhile, is near its highest level since 2011, according to recent Purchasing Manufacturing Index (PMI) data for January. In the past, this leading indicator has peaked an average of 15 months prior to the beginning of a recession, suggesting an economic downturn is far from imminent. 

Better global economic growth is contributing to a healthier earnings backdrop that should remain an important tailwind for stocks. The most recently reported quarterly earnings season for S&P 500 constituents has been exceptionally strong with the largest number of “beats” since data collection began in 2000.

All of this leads us to believe that the current cycle has room to run. We recognize that elevated levels of growth can become increasingly difficult to improve upon; however, leading to some downside risk as economic data inevitably disappoints in the future.

For bond investors, the current environment offers less certainty. Higher rates are a risk for government bonds, but the high yield category does not appear to be a point of major concern. Interest coverage and leverage ratios are mostly in check, and although spreads have widened significantly of late, higher rates do not necessarily spell the end of a market cycle and could prove to be only a pause before cycle peaks are eventually reached in the months to come.

The influence of “unpredictable” government on financial markets

One of the biggest challenges facing investors today is the potential for interest rates to rise too fast as central banks transition to less accommodative policies in an effort to keep global growth in check. So far, these efforts have had a relatively benign impact but risk remains of a policy misstep that could derail economic activity and upset stock markets.

The U.S. Federal Reserve’s next moves are of particular interest to financial markets. The Fed has raised interest rates six times in a little over two years. but is expected to continue their tightening trend through 2018 if solid economic conditions persist. While interest rates are still at historically low levels, an inflation scare, as evidenced in February 2018, could trigger a market downturn, given elevated bond yields and confidence levels.

Source: Board of Governors of the Federal Reserve System (US), February 2018
Source: Board of Governors of the Federal Reserve System (US), February 2018

 

The Fed’s decision making is complicated by the Trump administration’s more aggressive fiscal policy and its ongoing talks with key international trade partners. While recently passed tax reform may help support financial markets in the near-term, it could lead to an overheated economy and inflationary pressures. At the same time, as NAFTA negotiations go unresolved, fear of potential disruption in North American markets increases.

The Bank of Canada also appears hung up on trade with its nearest neighbours. A pull-out from NAFTA by the U.S. would likely send the Canadian dollar lower in the short-term and add stress to Canadian consumers. Considering all parties lose to some extent in a trade war, we remain hopeful for a fair deal. However, with Mexican elections upcoming in July, an eventual resolution could be pushed towards the end of the year or even into 2019.

The European Central Bank, meanwhile, faces the difficult task of prescribing one set of monetary rules for multiple economies at several different stages of growth. Overall, conditions appear relatively stable, though the central bank has yet to fully wrap up easing measures and Brexit negotiations continue to weigh on sentiment. In contrast, the Bank of Japan appears committed to asset purchases until sustained inflation catches up and has shown no incentive to change policy they believe is working.

Where we are finding global opportunities

We believe some of the best investment ideas are found beyond Canada’s borders and favour portfolios that are diversified broadly across various asset classes, sectors and geographies.  This includes selective exposure to U.S., European and Japanese equities, as well as emerging markets where opportunities are bolstered by attractive valuations and economic growth rates that are twice that of developed markets.

No longer just a commodity play, China, India, and other Asia Pacific nations are becoming more well-rounded economies with tech hubs driven by a young and growing middle class. That has given rise to some of the world’s biggest and most profitable internet companies such as Alibaba Group Holding Limited and Tencent Holdings Limited.

Market cap representation of key sectors* in the MSCI Emerging Markets Index
Source: MSCI, Thomson Reuters Datastream, HSBC calculations as of October 2017
Source: MSCI, Thomson Reuters Datastream, HSBC calculations as of October 2017

*excludes sectors where representation is below 5% in both 2007 and 2017. Real Estate (0% in 2007, 3% in 2017), Utilities (3%, 3%) and Health Care (2%, 2%) are not shown on the chart

 

Market cap of commodities and IT sectors in EM relative to EM aggregate
Source: MSCI, Thomson Reuters Datastream, HSBC calculations, October 2017
Source: MSCI, Thomson Reuters Datastream, HSBC calculations, October 2017

 

In addition to this preference for global exposure, we view Infrastructure as an asset class worth consideration. As the result of growing urbanization, aging populations and climate change, the need to improve existing infrastructure and build more of it has become a major priority in both developed and developing nations.

Many of the world’s biggest institutional investors and pension plans already allocate a growing percentage of their portfolios to owning infrastructure. In large part, this is because of the potential these real assets have to generate steady income and cash flow over the long term, in addition to natural diversification benefits.

Retail investors have been slower to the take, but have growing access to the diversification and benefits of this high growth area by investing in global equity securities of issuers in the construction industry and related sectors including telecom, utilities, energy and transportation.

 

All information is in Canadian dollars unless stated otherwise.
Commentaries contained herein are provided as a general source of information based on information available as of February 27, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice.
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Publication date: March 16, 2018.