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Investors are very optimistic. But two analysts think they may be ignoring a
big risk
WHAT is in store for economies and markets in 2018? Around this time of year, a
large number of analysts and fund managers are giving their views. Among the
most interesting and thoughtful approaches can be found at Absolute Strategy
Research (ASR), an independent group founded by David Bowers and Ian Harnett.
ASR adds extra depth to its analysis by contrasting its own views with those of
the consensus. To do so, the group polled 229 asset allocators, managing around
$6trn of assets, for their views on the outlook for economies and markets. They
found a groundswell of optimism; the probability of equities being higher by
the end of 2018 was 61%, and that shares will beat bonds is 70%. The allocators
think there is only a 27% chance of a global recession. And they are not
worried about the prospect of the Federal Reserve pushing up interest rates.
There are some disconnects within the consensus view. The first is that
investors expect volatility (as measured by the Vix) to rise next year.
Usually, equities struggle in such circumstances. The second disconnect is
between their views on the business cycle and those on the stockmarket; since
last year, their optimism about the former has reduced while their bullishness
about the latter has increased. A third disconnect is between their views on
high-yield or junk bonds and equities. Normally, the two asset classes perform
well at the same time. But investors are unenthusiastic about junk, preferring
the debt issued by emerging market governments.
Messrs Bowers and Harnett think investors may be caught out by a slowdown in
China. They are not forecasting anything dramatic; growth of 6.1% rather than
the expected 6.7%. But that will drag down global growth to 3.3% from 3.5%. In
addition, interest rates may rise a bit faster in America than investors
expect. David Bowers says it is the second derivative that often drives
markets not the change, but the change in the rate of change.
ASR points to the tightening of monetary policy that has occurred in China this
year in the form of higher interest rates and slower money growth; given the
normal lags, this will have its main impact in 2018. Signs have already emerged
in the form of house prices in Beijing and Shanghai which were lower in October
than they were a year ago. American and European companies have stepped up
their capital spending given the signs of stronger global growth but they may
be disappointed by the outcome in 2018.
The other big worry is longer-term. The long era of quantitative easing (QE)
has caused investors to look at asset classes in a different way. They have
been deprived of their traditional source of portfolio income; government bond
yields have been driven down to historic lows and have been locked away on
central-bank balance sheets. Equities have been used as a source of income
instead, with companies generating cash in the form of dividends and share
buy-backs. And investors have sought to juice up their portfolios with
alternative assets such as private equity. But these assets are illiquid, and
backed by a lot of debt. So there may be a nasty shock in the next crisis when
investors try to realise those illiquid assets.