Global stock markets had plenty to cheer in 2017, with most major international indices advancing around 20 per cent. Will the current mood of "rational exuberance", as Goldman Sachs and Barclays term it, persist into 2018? Or should investors be cautious given stocks are far from cheap following a nine-year bull market?
One might think the mood is getting a little too exuberant, given not one of the nine major Wall Street strategists recently surveyed by Bloomberg forecast a decline in 2018. On the other hand, few strategists are forecasting a repeat of 2017's strong gains: the S&P 500 is likely to advance by a relatively modest 7 per cent in 2018, according to consensus forecasts.
In reality, however, precise forecasts should be taken with a pinch of salt. This time last year, the consensus was the S&P 500 would gain around 5 per cent in 2017. Instead, the index hit its year-end target by February and was more than 20 per cent higher before 2017 was over.
Wall Street strategists have a reputation for being perma-bulls, but this is only half true. Yes, they rarely predict annual declines, but they also tend to play it safe, usually predicting single-digit percentage gains.
However, stocks tend to swing about wildly. Big returns and painful losses are extremely common in stock markets, but few strategists ever dare to make such predictions.
Goldilocks market
If there is value in perusing strategists’ forecasts, it is that they are revealing of investors’ current expectations and beliefs. Right now, the consensus is that, although equities appear expensive, synchronised global growth and rising corporate profits will continue to lift stocks.
A record number of fund managers believe the ideal Goldilocks market – not too hot and not too cold, with above-average growth and below-average inflation – will persist, according to a recent Merrill Lynch monthly fund manager survey. That scenario will result in elevated risk-taking in the face of high valuations.
That stance is echoed by Goldman Sachs. In a report entitled “Rational Exuberance”, Goldman admits most valuation metrics indicate the median S&P 500 stock has hardly ever been as expensive is it is today. Nevertheless, stocks usually overshoot fair value in bull markets, and the benign economic environment means Goldman expects stocks to advance up to 10 per cent this year.
The term “rational exuberance” is also used by Barclays, which expects 2018 to be a “continuation of the ‘Goldilocks’ economic environment to which markets have become accustomed”.
Although global equities “seem fully priced”, strong global growth – Barclays expects the global economy to grow 4 per cent, more if US tax reforms deliver – should favour risky assets.
Markets outside the US where there is "greater scope for cyclical recoveries in corporate earnings" represent the best bet, with European stocks especially "compelling", it says. Citigroup, too, is bullish, saying 2017 saw the "first year of synchronised global profit growth since 2010" and to "expect something similar in 2018".
There is also general agreement among strategists that this is a late-cycle rally, given the US bull market is now almost nine years old. That’s the second-longest in history, and roughly twice as long as the 2003-07 advance that preceded the global financial crisis.
However, strategists are more divided on what this means for investors. Some are cautious. Merrill Lynch's Michael Hartnett, very bullish in 2017, says the air is "getting thinner" and predicts a "big top" in the first half of 2018; Ned Davis Research says the bull market is in the "very late innings"; Jeremy Siegel, usually a very bullish observer, expects "one more push" to new highs but says stocks are "clearly near to a top", resulting in lower returns and more volatility in 2018; Morgan Stanley expects below-average annual returns of around 4 per cent; fund giant Vanguard says returns over the next five years will be modest and cautions there is a 70 per cent chance of a double-digit correction at some stage of 2018.
A market ‘melt-up’?
However, market history indicates the biggest returns often occur in the latter stages of bull markets. BMO Capital Markets, for example, notes bull markets tend to enjoy gains of more than 20 per cent in their final year as elevated sentiment drives valuations higher.
“You’re seeing more people jumping in because they fear they are missing out on the bull market”, says Ed Yardeni of Yardeni Research. One of Wall Street’s biggest bulls, Yardeni expects stocks to rise around 17 per cent in 2018, saying there might well be a near-term “melt-up” in stocks.
Even Merrill Lynch's Savita Subramanian, who is cautious in her outlook, admits positive sentiment and momentum may yet result in 2018 being a "year of euphoria".
Citigroup's Robert Buckland, too, reckons we have yet to see the heady sentiment that typically marks market tops, saying the long rally "feels like the most miserable bull market of my 30-year investment career". Buckland notes global equities have seen net inflows of $120 billion over the last three years, compared to $275 billion in the three years prior to 2007's major peak, suggesting stocks are unlikely to top out in 2018.
Merril's Michael Hartnett, however, is more concerned by what he sees as increasingly elevated sentiment and valuations. Hartnett is "macro bullish" but "market bearish", pointing to worrying signs of "bubble-like behaviour" – soaring cryptocurrency prices, record art prices, European speculative-grade bonds falling below US treasury bonds, Argentina issuing a 100-year bond, and "exponential" Nasdaq growth.
“The end of the Icarus trade [a central bank-enabled high-flying bull market with investors chasing growth and high-yielding assets] could give way to an aggressive downgrade in risk assets once peaks in profits, policy and positioning become excessive”, says Hartnett, who says strong returns in the early months of 2018 may be followed by a “sobering flash crash a la 1987, 1994 and 1998”.
Schwab’s Jeffrey Kleintop is more sanguine. Global stocks trade on 21.3 times earnings; that’s higher than normal, says Kleintop, but this may not matter just yet. Since 1969, MSCI World Index annual returns have ranged from losses of 5 per cent to gains of 45 per cent following periods of similarly high valuations. The average return has been 17.5 per cent, suggesting highly-valued stock markets tend to continue rising.
Downside catalysts
For the bull market to be derailed, then, a catalyst other than valuation is needed. Political volatility represents one potential banana skin. Market were “bizarrely unreactive to anything political or geopolitical” in 2017, notes JPMorgan, shrugging off President Donald Trump’s unpredictable behaviours and elevated tensions on the Korean peninsula.
It remains to be seen if this nonchalance will persist in 2018. The ongoing investigation into the Trump administration's Russian connections, US midterm elections, and uncertainty over taxes and regulation are all potential sources of volatility.
Still, political sell-offs tend to be short-lived affairs. Interest rate policy is more likely to be a source of tension. Futures trading suggests markets expect two US rate rises in 2018, with inflation and volatility expected to remain low. However, a recent Bloomberg survey of 41 economists found three rate hikes are likely, while JPMorgan forecasts four hikes.
“It’s going to be quite challenging for central banks to get the balance right on how much to do,” says Investec, which bills 2018 as a “pretty key year for normalisation”. Merrill’s Michael Hartnett goes further, saying inflation is likely to be the “big story of the year” due to US tax cuts driving higher-than-expected inflation and economic growth.
What if Hartnett is wrong? What if inflation remains low in 2018 and the “era of excess liquidity” continues? In that event, he says, stocks are likely to continue flying high as the Icarus trade continues, potentially resulting in a bubble that might not pop until 2019.
