It’s been a vintage year for equity investors. Outside the UK, which has had other things on its mind, stock markets have delivered fantastic returns. Buoyed by reasonable earnings growth as the world enjoyed a synchronised recovery, investors were happy to bring forward 2018’s returns into last year.
The bull market since 2009 has been long and strong. In duration, it has only been exceeded by the 1990s in the post-war period. The drivers of the nine-year bull market - particularly higher valuation multiples - are, however, largely played out.
That is the bad news. Offsetting this is the fact that there is little reason to expect a bear market in 2018. To believe that will happen, you have to think we are on the brink of a recession or that inflation is poised to return with a vengeance, pushing interest rates up much faster than either investors or the Fed currently forecast. Neither of these looks particularly likely although inflation, as I discuss elsewhere, is a genuine tail risk.
Putting money to work in the stock market makes sense only if you think the potential reward outweighs the possible risks. With the S&P 500 having reached the 2,700 mark that has looked like a sensible target for some time, the market as a whole may go up a little from here. But, having risen four-fold in ten years, there’s a real chance that it retreats by rather more. The risk and reward is, therefore, asymmetrical.
If volatility remains low then another few percentage points of capital plus dividend income might look alright in a context where cash and bonds offer such paltry returns. If, as I expect, volatility comes back next year, as investors respond to central banks delivering on their promised tightening of policy, then the rewards may look a bit more marginal.
This, of course, is at the aggregate market level. It is a good reason to be suspicious of the siren call of low-cost market trackers that guarantee to deliver you market returns minus fees. It is an equally good reason to roll up your sleeves and go to the effort of identifying that minority of fund managers who have the ability to deliver market-beating returns.
The 30-year collapse in real interest rates has provided a tailwind for equities. The rising tide has taken away the need to pick winners and avoid losers. Just turning up has been enough. This won’t be the case next year and probably for many years to come. In more ways than one, the New Year is a good time to get active again.
Bull markets compared: how much longer?
Source: Thomson Reuters Datastream, as at 31.12.17
Past performance is not a reliable indicator of future returns. When investing in overseas markets, changes in currency exchange rates may also affect the value an investment.
Select 50 pick: In a sideways-moving market where active investment is rewarded, we prefer stock-picking funds like Jeremy Podger’s Fidelity Global Special Situations.
Oil continues to be the most widely-watched and important commodity. As we move into 2018, the outlook is balanced and the base case must be for crude to stay within its current trading band between $60 and $70 a barrel.
The reasons to expect further rises in the price this year include the continuing discipline of OPEC and its partners, notably Russia. They have extended production curbs until the end of 2018, albeit with a review in the middle of the year. This confirms Saudi Arabia’s new-found desire to put a floor under the oil price while it pushes through far-reaching reforms at home and faces off against its regional rival Iran. The days when it thought it could quickly price US Shale out of the market are long gone. On the supply front, it’s worth bearing in mind that disruptions due to war and weather are unusually low at the moment. There is a view that the rate at which output falls away in Shale wells in North America may have been underestimated too.
The other main driver of the oil price is end-user demand. Here, too, the pressure looks like being to the upside as the global synchronised recovery remains on track. Half of oil demand comes from the developed countries in the OECD and growth here is firm.
Offsetting these positive factors is the ever-present risk that a much higher price of oil will encourage more Shale production. This source of new potential supply will continue to put a ceiling on the oil price. The days of $100 oil are long gone and the market looks in reasonable balance.
Oil in focus
Source: Thomson Reuters Datastream, as at 31.12.17
Past performance is not a reliable indicator of future returns.
Returns for fixed income investors were good again as yields across the bond spectrum ended the year a bit lower than they started. While markets were braced for a year of tightening, the real story was the unexpected failure of inflation to respond to the synchronised pick up in global growth.
Economists are having to re-assess the models which have served them well in the past, rules of thumb like the Phillips Curve which illustrates the trade-off between inflation and employment. With unemployment at historically very low levels, inflation should really be picking up faster than it is. This is a real conundrum for policy-makers, but maybe it shouldn’t be. It simply reflects the ongoing headwinds for growth and inflation of too much debt and an ageing population that’s dropping out of the workforce and into retirement.
The danger posed by the inflation puzzle is that central banks keep policy looser for longer and tolerate above-target inflation, even at the risk of stoking up imbalances in the system. We are already seeing debt at historically high levels and risk-taking by companies is increasing.
Whether this is a problem further down the track or not, it probably means that 2018 will be another year of low interest rates. This is particularly likely in Europe, where inflation is notably absent, and the UK, where Brexit continues to cast a shadow. Only in the US are we likely to see a sustained tightening.
The bigger worry for fixed-income investors is in corporate debt, where valuations have become stretched as the difference between the yields on company and government bonds has narrowed. High-yield bonds look particularly vulnerable because the reward for rising default risks is uncomfortably low.
As in the equity market, the late stage of the economic cycle is a time to focus on picking the right securities. This is more important than trying to squeeze a little more income out of your bond portfolio.
Select 50 pick: Ian Spreadbury is a very experienced and cautious bond manager. He has two funds on the Select 50, Fidelity MoneyBuilder Income and Fidelity Strategic Bond.
Important information: Please be aware that the price of bonds is influenced by movements in interest rates, changes in the credit rating of bond issuers, and other factors such as inflation and market dynamics. In general, as interest rates rise the price of a bond will fall. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between corporate issuers.
The commercial property cycle has, like its bond counterpart, gone on for longer than the sceptics feared. Real estate is still a source of attractive and high-quality yields and so property has a place in any well-diversified multi-asset portfolio.
However, while 2018 will see many of the tailwinds for the asset class continue, we are, by definition, one year closer to the end of the cycle than we were a year ago. This is not a time to throw caution to the wind, as some real estate investors seem to be. This is rather a time to lock into sustainable income and to de-risk a portfolio.
There are a few ways to do this. First, it is worth noting a key difference between bonds and property. With bonds, an investor gets paid for taking the risk of holding bonds for longer. With real estate, it is the opposite. Short leases are considered riskier (because of the potential for an empty building) and so investors pay less (and get a higher yield).
The frothiest part of the property market is high quality and long leases. Here yields are now as low as 3% or less. There is no room for error at this level, or even much income to pay for depreciation, obsolescence and other ongoing costs. So, counter-intuitive as it may sound, shorter leases with higher yields are worth focusing on today.
Another way to de-risk a portfolio is to shun leverage. Debts are cheap but late in the cycle is a good time to reduce not increase borrowings. Finally, look for contrarian ideas. The UK is out of favour with real estate investors because of Brexit fears. Arguably, this is now in the price.
Shorter leases offer higher yields
Source: Fidelity. Real Estate data is based on Fidelity International’s proprietary deals database, over the 12 months to 19.10.17
Select 50 pick: The illiquid nature of the property market can make it difficult to move in and out of a real estate investment. For that reason, the Select 50 suggests a property equity fund, the iShares Global Property Securities Equity Index. Invested in listed stocks, it is correlated to the equity market but provides access to property’s income.
Important information: Some funds in the property sector invest in property and land. These can be difficult to sell so you may not be able to cash in this investment when you want to. There may be long delays in acting on your instructions to sell your investment. The value of property is generally a matter of a valuer's opinion rather than fact.