Key Investment Themes and 2018 Outlook December 4, 2017
We offer some investment ideas and our take on financial markets for the year ahead
Author : iFAST Research Team

Key Investment Themes and 2018 Outlook

We offer some investment ideas and our take on financial markets for the year ahead

2018 Economic Outlook

Global economic expansion to accelerate

  • Building on a year of accelerating economic growth in 2017 of 3.5%, we expect global economic growth to marginally accelerate in 2018 to reach 3.6%.

  • In the US, 2017 has thus far posted a three-quarter average rate of 2.23% that is higher than its post-financial crisis average growth rate of 2.17%, this is in line with a previously expected 2.2% growth rate forecasted last year and this figure has been achieved without supportive fiscal stimulus. As monetary policy is gradually normalised, it is not expected to detract from economic growth which is expected to come in at 2.4% in 2018.

  • In Europe, the economic recovery is already widespread and entrenched as predicted in our 2017 Outlook. While monetary policy easing by the central bank will continue to provide support into 2018, many leading indicators are currently approaching or at their cyclical highs.

  • The world’s second largest economy, China, is expected to move away from a quantitative figure/number and focus on sustainable high quality growth. In place of GDP growth targets, China has set qualitative goals for the nation to achieve by 2050. Nonetheless, economic growth for China in 2018 is expected to grow at a 6.4% rate.

  • Emerging markets such as Brazil and Russia should see continued improvements in their economic fortunes following their stabilisation in 2017. Of the two, we think Brazil’s economy has more room for further improvement than its BRICS counterpart.

  • With both developed and developing economies set for growth in 2018 – we expect to see economic expansion accelerate into the New Year.

Easy monetary policy to ease off

  • In 2017, we thought that central banks had done a lot and we were unlikely to see either a hard reversal of loose monetary policies or new aggressive monetary easing.

  • For 2018, we expect the same, but, for more central banks to move towards normalisation of monetary policy given that growth rates continue to remain moderate and inflation benign. We think more central banks will abandon their asset purchase programs and shift towards raising their interest rates away from their historical lows.

  • In the US, the current stance adopted by the Federal Reserve has been a gradual normalisation in monetary policy and shrinkage of their balance sheet in lieu of a benign inflationary environment and moderate growth. Should inflationary pressures accelerate, policy-makers could normalise interest rates faster than expected. Investors are reminded to keep in mind that the Fed remains data-dependent in their approach – no policy stance is set in stone.

  • The Bank of Japan and the European Central Bank have been amongst the major central banks on an increasing easing trajectory in the past few years, but 2018 could see a directional shift in trajectory. While we think the Bank of Japan is unlikely to head towards policy normalisation in 2018, we are of the view that their European counterparts at the European Central Bank, and other Central banks across the world are likely to join the US Federal Reserve in their quest to normalise monetary policy.

Inflation to begin it’s comeback

  • Although inflation has yet to rise across many parts of the world, 2017 represented a marginal increase from 2.8% in 2016 to 2.9%.

  • While 2018’s inflation reading is expected to be around the 2.9% mark, the same as per 2017, price increases of 3.0% are currently being pencilled in for 2019.

  • The low base effect provided due to low commodity prices for most parts of 2017, and low rates of headline inflation could contribute to higher inflation prints in 2018.

Investment Themes

More Earnings Upgrades Ahead

  • As expected in 2017, we bade farewell to and saw the end of an earnings recession and said hello to strong earnings growth in 2017 across the board for the markets under our coverage.

  • After enjoying strong earnings growth in 2017 that took place after an ‘earnings recession’ in 2015 and 2016, the developed markets of US and Europe are each expected to post 10% and 9% earnings growth in 2018.

  • While earnings growth rates of 10% and 9% in 2018 are respectable, we note that revisions for both 2018 and 2019 have been in the form of downward revisions for the two regional markets, and is something worth watching closely.

  • Outside of the developed markets, earnings momentum has been fairly strong in Asia ex Japan and the Emerging markets, with positive earnings revisions being seen for both 2018 and 2019.

  • Asia ex Japan and Emerging markets are expected to deliver strong earnings growth and positive earnings revisions in 2018. The likes of China, Korea, Singapore and Taiwan are the bright spots in the region while IT and financial sectors are expected to be the major contributors to the earnings upgrades.

Stocks to head higher, but expect volatility

  • An environment of accelerating economic growth, alongside modest inflation and still easy monetary policy by central banks should continue to be a positive for earnings, and hence, stocks.

  • While we expected some volatility in 2017, it actually turned out to be amongst the lowest on record for many markets. We do not think that a repeat of such an environment is to be expected by investors.

  • For Asian equities, the turnaround in the earnings revision cycle should continue to be a key catalyst for the cyclical markets. The North Asian markets are expected to do most of the heavy-lifting yet again to allow the Asian benchmark index to head to new highs.

  • With other Central Banks likely to join the US in its continued normalisation of monetary policy, excess liquidity in the financial system could be expected to fall, which might lead to relatively higher levels of volatility. Volatility levels have been historically low over the past few years (thanks to the monetary policies of the various major central banks) and a return to a normalised volatility regime in the US in 2018 and beyond should not catch investors unaware.

Asia's exports growth remain robust

  • We expect the global economy to accelerate, and that this round of economic expansion is still a long way to go given the back of thriving consumption and expanding private investment. In particular, the economies in Japan and Eurozone are still in the early stage of recovery while the US economy continues to grow at a solid pace.

  • With this favourable trading environment, we believe Asia’s exports growth (in values) momentum will remain robust in 2018 following a strong rebound this year. Exports volumes in the region are expected to remain on a strong uptrend as they closely follow the demand in advanced economies. Prices of exports will no longer be a drag, thanks to a stabilising domestic CPI and international commodity prices.

  • The strong demand for semiconductors is another factor to driver the Asian export growth. The region’s tech product exporting countries especially Korea and Taiwan will continue to benefit from increasing facilities investment reflected in the rise of machinery for semiconductor production and the strong export demand due to new smartphone launches from global manufacturers.

RMB - the trend of appreciation has just begun

  • Expectations of RMB depreciation have changed after Chinese macroeconomic data such as current account balance, exports growth and FX reserves have seen improvements.

  • The RMB has been returned to the trend of appreciation against the USD especially after the People’s Bank of China (PBOC) introduced the counter-cyclical-factor into the quotation mechanism of the central parity rate.

  • Interest rate differentials will be another driving force of the appreciation as we expect the onshore interest rates (both short- and long-term) to rise further amidst the financial deleveraging campaign.

  • Despite this, we do not expect the Chinese currency to appreciate too rapidly as the Chinese government would like to see a more solid recovery on exports. We believe the RMB’s strength is fundamentally supported and the trend of appreciation has just begun. We expect the USDCNY rate to hit 6.45 in 2018 and more two-way volatility of the trading band.

Temper your return expectations

  • Returns for developed markets like the US and Europe over the past few years have outpaced the rate of earnings growth, with valuations having already more than normalised to fair levels and beyond, that see it trading at premiums to our estimates of their fair values.

  • For the US, a negative rate of return for investors is what we currently forecast over both a two year and three year timeframe, which beckons us to rate it “2.0 Stars – Unattractive” and advise investors to underweight the region in their allocation.

  • For Europe, while we maintain a “2.5 Stars – Neutral” rating on the market, we note that returns are expected to be modest on both an absolute basis, as well as relative to historical rates of return and what other markets are offering us.

  • In any case, high double digit returns for either US or European would be stretching their respective valuations further into already expensive territory.

  • If it’s strong double digit returns investors seek, the Asian and Emerging market equity markets should continue to be their focus in 2018 as it was in 2017.

  • In the fixed income space, continued low yields mean return expectations remain low.

Don’t underestimate the value of active management

  • Following strong returns for both stock and bond markets over the past few years, investors have gravitated towards passively-managed investments such as Exchange Traded Funds (ETFs), with Morningstar data suggesting that passive mutual funds in the US have continued to see inflows on a one-year basis while actively managed funds have continued to see net redemptions. With bond yields at still low levels and selected equity markets trading at premiums, we think actively-managed investments are more appropriate, with active stock-pickers able to shun more expensive stocks in favour of more attractive ones, while an era of rising interest rates coupled with historically-low rates means credit selection, currency expertise and a more flexible positioning should aid in driving fixed income strategy returns to a greater degree going forward.

  • While ETFs have their benefits such as taking advantage of intraday volatility to capture low prices and avoiding the potential of underperformance by an active fund manager, strong active management is likely to provide investors with stronger returns over the long term.

What should investors do?

Overweight equities vis-à-vis bonds

  • Similar to our decision last year, the house view is for an overweight equities-bonds allocation for the year ahead.

  • Earnings forecasts are strong and are factoring in strong economic growth which in-turn is based on many leading indicators that are either currently approaching or at their cyclical highs.

  • Asian and EM equity markets continue to have the potential for higher returns. Strong earnings growth amidst positive earnings revisions will aid in delivering a higher total return for Asian and EMs.

  • Comparatively, Asian and EM equity markets have material room for valuations to mean-revert and provide outsized gains than their developed market peers. Healthy earnings growth and stable dividends will aid in delivering a higher total return for Asian and EMs.

  • We are projecting returns of close to 30% by the end of 2019 for both Asia ex Japan and the Global Emerging Markets.

  • Given some of the risks facing bonds in 2017 with interest rates yet to normalise, the dangers of rising bond yields should see investors be on the defensive for fixed income.

Continue to favour Asia ex-Japan equities

  • For the first time since 2011, 2017 saw positive earnings revisions throughout the year for Asian equities as a whole, and we believe this trend is likely to continue moving into 2018.

  • Following on from our call in 2017, we believe that Asian equities remain the most attractive equity region for investors with the recovery in the earnings revisions cycle for Asia ex-Japan equities continuing to be a key catalyst for future returns. Despite posting a strong year-to-date return of 30.5% in USD terms (as of end October 2017), we forecast returns of close to 37% by the end of 2019 for Asia ex Japan equities.

  • Similar to 2017, Asian equity returns are expected to be driven by cyclical markets with strong earnings growth in 2018. The likes of China, Korea, Singapore and Taiwan continue to be the bright spots for the region and continue to be amongst our highest rated markets.

  • Assuming a continuation of strong earnings growth within Asia, we mark down our target valuation for MSCI Asia-ex-Japan market at 14.5X PE and expected CAGR earnings growth rate to be 16.8%, which transfers to a target index level of 950 by end of 2019, 37% higher than the level on 5 Dec 2017.

Developed markets still necessary for portfolio diversification, Go underweight

  • Our forecasted returns for developed markets like the US and Europe have fallen for 2018 on the back of downward-revisions to earnings growth as well as higher forecasted contractions in the valuation multiples. The main detractor of their potential upside for both markets are the likelihood of a contraction in valuation multiples, which could be reset via a correction in the stock market.

  • For 2018, we still expect the European markets to deliver low single-digit returns for investors and continue to advocate an allocation (albeit underweight) to developed markets for portfolio diversification purposes,

  • For US equities, with forecasted returns in negative territory for 2018, the usage of alternative strategies in addition to lowering one’s exposure to the world’s largest stock market could be considered.

China remains cheap despite its strong performance

  • The economic growth model in China is changing, with a move away from a hard number to a focus on sustainable high quality growth.

  • We believe that People’s Bank of China’s monetary policy in 2018 will be neutral with an aim to stabilise market liquidity whilst dealing with regulatory issues and deleveraging as they seek to rein in debt levels and property prices in select cities.

  • Despite delivering year-to-date stellar returns of 38.9% in local currency terms (as of end October 2017), Chinese equities continue to remain the single market that provides investors with the highest expected returns over the next 1-2 years. Valuations are very undemanding at this juncture despite the performance in 2017; China equities trade at just 11.1X 2017 earnings (as of end October 2017), a fair distance away from the 13X fair PE we attribute to the market. On our estimates, the China equity market is on track to deliver a 23% annualised return by end-2019, driven primarily by both an expansion of the market’s valuation multiple as well as strong earnings growth.

HSI to hit 40,000 by end 2019

  • In the upcoming two years, we believe the Chinese IT and financial sector will be the growth engine behind HSI index, potentially driving it to hit 40,000 be end-2019.

  • The increasing demand for protection amid higher disposing income constantly boost Chinese insurance companies' earnings, overall sector profile may also shifts somewhat towards IT section as insurance provider invest heavily into "InsurTech", we may therefore see an increase in growth rate and the associated valuation for these insurance providers in coming years.

  • As for Chinese banking, we are now convinced that the ongoing expansion in Net Interest Margin and improving asset qualities may trigger a structural re-rating for the sector, earnings improvement and valuation expansion could co-exist in coming years, thus boosting their share price.

  • Tencent remains to be a driving force for HSI index, we are convinced that the company could maintain its' growth rate in gaming section thanks to the active acquisition of popular games released by external parties, while the active expansion on content generation and further monetisation on payment service are also potential earnings driver later on.

  • With above mentioned catalysts on earnings and valuation, we have a higher earnings forecast for HSI index compared to market consensus (12.5% vs 9.5%, CAGR in 2 years), couple with an optimistic valuation target of 14.0X PE ratio, our target for HSI will be 40,000 by end of year 2019.

Japan – the dark horse for 2018

  • Foreign investors have been fickle with their attitudes towards Japan. Japanese equities have seen investors flock to invest upon Shinzo Abe's initial rise to power, and then shun it upon losing faith in Abenomics.

  • However, the current picture that we see in Japan is one that looks similar to that between 2013 and 2015, which resulted in Japanese equities delivering sizeable cumulative returns. Much like the mentioned period, we see positive revisions to corporate earnings and improvements in both corporate as well as economist sentiment.

  • Arguably the two period hold different growth catalysts, the previous growth come mainly from the sharp depreciation in the Japanese Yen, while current growth looks anchored on the current global economic recovery and a consistent demand for machinery from China and ASEAN region. Despite the difference in originations, we think the similar improvement in earnings and sentiment are worth their salt.

  • Understandably, a forecasted annualised return of 7% does not appear to be overtly attractive compared to what the market delivered through in late 2016, but a potential annualised 7% gain remains extremely attractive within the developed market space, where the US is forecasted to deliver negative returns and Europe equities are expected to see a paltry 2.4% annualised return.

  • We believe Japan’s macro environment shall strengthen further in the upcoming quarters, earnings for industrial and consumption related companies are likely to continue to deliver strong growth, setting the foundation for the market to go higher, given that valuations are still not demanding by historical standard.

Seek out safer bonds for capital preservation in fixed income

  • While interest rates in the US are still on its up-cycle, the current stance adopted by the Federal Reserve has been a gradual normalisation in monetary policy due to a benign inflationary environment and moderate growth. Should inflationary pressures accelerate, policy-makers could normalise interest rates faster than expected which could lead to volatility in bond yields in 2018.

  • While there is currently a lack of opportunities in the fixed income space that are attractive from a risk-return basis, we maintain that fixed income remains an integral and relevant part of an investor’s portfolio, and should be seen as a portfolio stabiliser.

  • Given that yields on safer fixed income instruments like G7 sovereign bonds remain unattractive at this juncture (and are also expected to be hurt more should the Fed hike rates quicker-than-anticipated) despite having risen recently, investors might think that the riskier segments of fixed income are more attractive. However, in the current environment, we prefer the safer segments of fixed income such as short duration bonds over credit spreads such as high yield and emerging market debt due to the risk of rising risk-free rates which will send yields rising for credit spread related instruments.

  • While our long-standing preference for short duration bond does not offer yield hungry investors a mouth-watering return, we believe the segment is best placed to offer investors capital preservation.

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