Central bank dynamics will be harder to navigate

Central banks have had a dominant influence on markets for the past decade and we expect this to continue in 2018. Positioning for central bankers’ next moves will become more complex as policies start to diverge globally:

• The US Federal Reserve will likely raise rates further: we anticipate three hikes in 2018, not all of which have been priced in by the markets.
• The European Central Bank will focus on slowing its bondbuying programme while keeping policy rates unchanged.
• The Bank of Japan has begun a “stealth reduction” of its monthly asset purchases, which seems likely to continue.
• The Bank of England recently raised rates for the first time in 10 years, but concerns are rising about growth prospects as well as above-target inflation.

Protecting purchasing power will remain critical

Although the direction of monetary policy is reversing, the pace of change will be glacially slow and we expect interest rates to stay low. Consequently, financial repression will continue and protecting purchasing power will again be an important investment objective. It will be crucial for investors to understand how rising prices are impacting their income requirements, given that even relatively low levels of inflation can significantly erode purchasing power over time. Moreover, the standard inflation measures used by central banks are failing to capture real-world costs.

Beware liquidity shortfalls and volatility spikes

However careful central banks are in adjusting their monetary policies, the effects are uncertain. Of particular note is the increased risk of liquidity shortfalls and volatility spikes:

• In select asset markets, severe liquidity shortages could occur with little warning. As a result of their quantitative easing programs, the Fed, ECB and BoJ own one-third of the tradable global bond market and have effectively created liquidity out of thin air. Selling off these holdings could cause issues in the markets, including sharply higher bond yields.
• Liquidity is also being affected by concentrated flows into exchange-traded funds (ETFs) and the prevalence of highfrequency trading. These factors can stifle volatility and “herd” performance into fewer stocks.
• Overall, we expect volatility to remain relatively muted in 2018, particularly as central banks continue to err on the side of caution with respect to financial stability. Nevertheless, changing policies and any associated liquidity shortfall – real or feared – could trigger spikes in volatility. This presents risks as well as the chance to enter or add to positions. A highly valued, late-cycle market like the US could be cause for concern. ECB tapering and any further BoE rate hikes could create buying opportunities out of market volatility in the EU and UK.

Geopolitics – and plain old politics – are major risks

In our latest annual RiskMonitor survey, nearly three out of five investors said that recent political events had prompted them to enhance risk management. Geopolitics is now the top risk for investors and it will retain the potential to destabilize the global economy in 2018.

• Risks are rising in petro-states from Venezuela to Nigeria to the Middle East. Sudden tensions could trigger an oil-price spike. We note that oil remains generally underrepresented in portfolios.
• The EU’s future is not clear cut. We expect Brexit negotiations to grow more tense as the UK’s departure deadline looms. Italy’s upcoming election poses a tail-risk to European stability as the country struggles under its debt burden.
• President Donald Trump’s tax reform proposal represents a potential flashpoint ahead of mid-term elections in November. The mid-terms represent another critical moment for the Republicans and a litmus test on Mr Trump’s own popularity.
• Populist politicians with anti-globalization views are enjoying a resurgence. This could create serious longterm headwinds for economies and markets, including lower growth and higher inflation.
  

As well as keeping an eye on potential global flashpoints such as North Korea, investors will need to watch domestic political developments to gauge their potential impact on monetary and fiscal policies. Many voters resent globalization, feel squeezed by austerity and sense that inequality is rising. Politicians may be forced to respond.

Disruption will continue

We expect business disruption to continue to be an important investment theme in 2018. The market is rewarding a small group of companies that are reinventing industries and pushing traditional businesses aside. This is reflected in the concentration of stocks that are outperforming: in each of the past three years, just 60 or so stocks in the S&P 500 have outpaced the rest of the companies in the index.

Yet these disruptors are facing closer scrutiny as their size and influence attracts the attention of lawmakers and regulators:

• In the EU, tech giants have been fined for anti-competitive practices, and rigorous new data protection rules will take effect in 2018.
• The US Congress is probing the role that certain technology firms played in allegedly helping Russia influence recent elections.

It is important to note that disruption is not only driven by technology. Demographic shifts are also reshaping industries and financial markets. As high-spending babyboomers retire, the economic boost they have provided is diminishing, including in some emerging markets. Looking further ahead, ageing societies will change business dynamics. These disruptive trends highlight the importance of stock selection and the value of active management. Managers with the ability to conduct fundamental research across equity and credit markets globally can help investors take the right risks in a low-volatility environment. Active investment approaches focused on environmental, sustainability and governance (ESG) factors also allow investors to factor in other important risks and impacts.

Selectivity will be even more important

The global economy is doing reasonably well – but growth is becoming patchier. Regional differences are likely to become more pronounced. At the same time, many assets appear richly valued. Consequently, investors will need to be increasingly selective in 2018. Their expectations of active managers will increase as they seek more dynamic ways of sharing performance and fiduciary implications with their managers.

From an equity perspective, we favour Europe over the US, where the combination of reduced monetary stimulus and potentially overheated markets could turn into a major headwind if economic data lose momentum. We think yield-seeking bond investors may find some relatively attractive opportunities in sovereign debt in Asia and emerging markets.