Markets are famously idiosyncratic. One of their quirks is how forward-thinking they can be and that, in some respects, the year is almost over by the time you reach July.
Companies know how things are shaping up and, barring an improbable turn in fortunes, management can say with a high degree of certainty whether current year profits will be met or not. So by the time the summer holidays arrive, the focus is squarely on next year’s plans.
Investors, too, start to turn their attention to the following year long before the current one is over. Earnings forecasts for “Year 2” (“Year 1” being the current year) begin to firm up around the middle of the year and conversations about the macro outlook also start to gravitate towards it.
It is important to navigate this transition from one forecasting period to another, otherwise you are increasingly looking in the rear view mirror. With this in mind, I have set out five themes that might help define 2018. Some are already at work in markets, while others are more controversial and may or may not kick in throughout the coming year.
Theme one: The end of quantitative easing
How will rolling back QE affect markets? At the moment, there are lots of reports on the mechanics of how the central banks will do it but little about the impact on market sentiment and asset prices.
Central banks have swallowed up huge quantities of government bond issuance over the last five years. Investors have looked elsewhere to replace this exposure, often investing across borders. The system may react badly when domestic government bond issuance comes back on line, with Bank of America suggesting a substantial re-pricing of bonds and/or equities will be required to create a sustainable equilibrium. Currency adjustments may also be the order of the day.
Theme two: Rising recession risk
Most economists say there will not be a recession in 2018. It is fashionable to think economists are always wrong but, in fact, they are usually right: they invariably say there will not be a recession and normally there is not one.
Every once in a while, though, their reliable forecasting rubric – “next year will be the same as last year”- lets them down. 2018 could be one of those years. The current expansion is one of the longest on record and there are some signs demand for consumer durables and housing is beginning to wane a little. Tightening monetary policy against this background only increases the risk of a downturn. This is a key risk for equity markets in 2018.
Theme three: Brexit
The UK decision to get off the EU merry-go-round increasingly looks like a costly one over the short to medium term. Real incomes are down and inflation is rising. The economy is slowing and, for the moment at least, the risks are to downside.
Both main parties support a hard Brexit but that does not mean Brexit is a slam dunk. The Conservatives are in the final act of a quarter century split over Europe, while Labour’s European ambiguity allowed them to appeal to both working class Brexiters and metropolitan Europhiles. Brexit is vulnerable in today’s febrile atmosphere and a change of mind is not impossible. This would be very good for UK asset prices, especially equities and the currency.
Theme four: US leadership crisis
After the initial flurry of Trump trades, markets have downplayed the importance of the new President. Plenty of headlines, not much price action, has been the story recently. But Trump’s temperament has been shown to be wanting and he has not faced a significant crisis yet.
At some point that will change and investors may start to demand higher risk premia to compensate them for the unpredictability of the mercurial President.
Theme five: Capital versus labour – a looming confrontation
Trouble has been brewing between these two since the financial crisis and 2018 might be the year when things finally hot up. Capital has had a good ride since 2008. Limited creative destruction during the crisis helped preserve capital intact and favourable policies since then have supported asset prices.
Labour has not had it so easy: witness rising insecure employment and stagnant wages. Elections in the US, UK and even France suggest populations may not be happy to stick with status quo. Pressure will build on politicians to rebalance between capital and labour, and between generations.
Higher bond yields may be the price we all pay. If that produces pain for the corporate sector, it (counterintuitively) may allow growth to finally pick up, as bankruptcies create space for fitter companies to grow. Markets really are idiosyncratic, if not perverse.
Bill McQuaker is portfolio manager on Fidelity’s Multi Asset Open funds