Our best guess about what may happen in 2018 concerning our potential investment strategy could very well be “more of the same.” To be sure, we would love to have a "performance" repeat of 2017 in the new year.
That said, 2018 looks good for our retirement and brokerage accounts, but as usual there are caveats.
Investment Outlook for the U.S.
First, the U.S. stock "bull" market is still strong. In some ways it is almost euphoric, which can be construed as a warning sign.
Plus, we have not seen a rising interest rate environment for over ten years. So we do not know how the stock markets will react if inflation picks up and the US central bank decides to aggressively raise rates to offset inflation. The bond pundits say that if the 10-year Treasury yield starts to head up to 3%, stock market investors will not like it.
For the past few years, the US stock market has been blessed with a mix of low interest rates and strong earnings growth, which in return has relied on minimal wage increases and expanding corporate margins. Inflation experts say that wage inflation is moderate, but those figures do not incorporate other "inflationary wage and benefits" factors such as health care premiums, executive stock options, etc.
But now, the era of low interest rates might be coming to an end. As signaled by the US Fed, an interest rate tightening cycle is already underway. The key indicator as to how the markets will react is still the potential reaction to the sharpness of the rise of the 10-year Treasury yield.
In addition, policy proposals by the Trump administration - such as replacing parts of Obamacare and middle-class tax increases to fund big corporate tax cuts, are probably a last-ditch attempt to squeeze even more money out of American workers, keep corporate margins high, and the stock market moving higher.
And the change at the helm of the Fed is a worry on Wall Street and the bond market, especially if we see the 2-year T-bill yield rise above the 10-year yield (an inverted yield curve).
Regardless, In the short-term, stock buybacks and foreign tax shelter repatriation facilitated by the Republican tax changes, should propel US stocks higher, at least through the late Spring.
How the US stock market party ends, with a bang or a whimper, is unknown. Absent any monetary mistakes by the Federal Reserve Board (Fed), the U.S. stock market is more likely to flatten out than to fall precipitously.
Europe has a good chance to see reasonable corporate earnings growth and correspondingly rising stock prices, especially in the small company asset class.
For one thing, the European central bank (ECB) is notably more patient in raising interest rates than the US Fed. In 2017 European economies operated below their potential, compared to the US and Asia; the EU economic “catch up” trade ought to restart a new stock market uptrend into 2018 and beyond.
Underperforming European economies, though, have led to political strife and talk of regional secessionism: the question of Scottish independence, England's Brexit, the Spanish Catalans, and even the EU hostile white nationalist movements in Poland and Hungary are disruptive problems.
These intra-EU issues have not been solved and probably stem from inefficient bureaucratic mechanisms by which transfers of money can be made from prosperous parts of the European economy to those parts of the EU that are going through harder times.
An upturn in Europe’s economic growth would ameliorate these problem, but for now, they still exist. The ECB must be careful to not squelch the recovery before it takes hold - by raising interest rate prematurely.
Outlook for Asia
Japan and China will continue to stimulate their economies. Japan could be more aggressive on this front. China, however, can also be comfortable with inflation in the 2% to 3% range.
A significant aspect of Asia’s economies over the past five or six years has been the extent to which Asia’s policymakers, in stark contrast to the U.S. and Europe, have been determined to restore labor’s share of economic growth by raising wages ahead of the rate of economic growth.
China began the trend and many other Asian countries followed suit. In 2016 and 2017 this trend might have squeezed corporate profit margins and left stock markets lagging the U.S. from a relative perspective. But it has laid the groundwork for a sustained Asian stock market rally going forward.
Wage increases allow corporations to raise prices and for workers to enjoy nominal economic benefits, even if their real (after inflation) wages are rising by a smaller amount than corporate profits.
China, which has been raising worker wages since the end of 2016, and Japan, which has been doing it since early 2013, have seen corporate profits rebound and their stock markets surge as of late.
Unlike the U.S., there is no reason to think this trend cannot continue. If it does, and if earnings growth broadens across sectors and companies, then these Asian regional environments typically favor small and mid-cap companies trading at more reasonable valuations.
Meanwhile, the premium (overvaluated asset) paid by investors for mega-cap and large cap, high-growth companies may well shrink.
In many respects the countries of ASEAN (the Asian trade pact) are even better positioned for wage inflation policies:
Thailand has a large current account surplus and low core inflation. India and Indonesia have brought down their structurally high inflation rates to moderate levels.
Policymakers have room to stimulate through both fiscal and monetary policy without severely affecting their currencies. Indonesia was able to implement a surprise rate cut without affecting the rupiah.
Elsewhere across Asia, currencies have been strong relative to the US dollar and do not believe that the dollar will be a fundamentally strong currency in 2018.
All this means that ASEAN countries can stimulate their economies and in doing so can limit any depreciation of their currencies versus the dollar.
There is a good possibility, then, that the rally in Asia will broaden out beyond China and Japan and the big tech companies.
Emerging Markets Should Favor Asia over emerging Europe and Latin America
Unless the commodities markets of Russia and Latin America take off, it may come to fruition that Asia will once again be viewed as a separate growth region from other emerging markets. Asian economies are far better-placed to see higher rates of earnings growth and more functional macroeconomic policies than either Russia or Latin America.
Consumer spending in Asia should continue to be strong. In fact, Asia’s great strength relative to other so-called emerging markets is its high savings rates. Those savings, which in the past have been used to invest in new capital stock and drive the capacity of Asia’s manufacturing sectors to produce goods, will increasingly be used as a source for Asian consumers to raise their spending and buy goods and services. This is clearly a long-term economic trend for investment.
Sizing Up Longer-Term Positives for Asia
There are also many longer-term positives for the region. The greatest of these is the continuing structural reform in Asia’s economies. We see this across the region. China is increasingly focusing on the quality of growth rather than its pace, including taking seriously issues of social welfare and environmental costs (as opposed to the the fossil fuel obsessed Trump agenda.).
Investors are also seeing increased access to China’s equity and bond markets from foreigh investors, access which already seems to be improving corporate governance. In South Korea and Japan, too, corporate governance reforms are gradually influencing management.
Also, Southeast Asia, for a long time the region’s productivity laggard, is building out its manufacturing base, with China’s help. In Asia’s most emerging frontier markets, early capitalist reforms are taking root, such as the embrace of a private economy in places like Vietnam.
Perhaps the greatest emerging markets investment opportunity is India, where a series of legal and institutional reforms over the past few years has tried to make the country’s bureaucracy more efficient: (1) to recapitalize the banks; (2) to reduce the cash economy and increase the formal economy; (3) to increase the efficacy with which state governments can use land for public infrastructure; (4) to improve the inflationary tensions and provide non-domestic investors with a more appealing set of macroeconomic conditions.
These reforms have been partially successful—and the country remains a work in progress. But India has a chance of setting in motion improvements in standards of living on a scale we have only previously witnessed in China. These reforms give us reason to be optimistic for India's future.
In the coming year, we can be optimistic, but we must also remain realistic. Many domestic and global economic variables were NOT reflected in our successful 2017 investment performance. New economic caveats arise regularly and need to be watched.
Hopefully we won't see many negative surprises in 2018 as well.
Edited for brevity and specificity from an article by the Matthews Investment Group (San Francisco, CA), December 30, 2017