Article by Matthias Busuttil
Financial markets have proven to be resilient despite the macroeconomic uncertainties and political worries in 2017. Equity markets soared to higher levels, yields on high yield and investment grade corporate bonds kept contracting versus benchmark yields while volatility diminished to muted levels throughout most of the year.
These results set a high watermark to beat in 2018. Global economies must deliver on the relatively strong growth expectations in order to sustain the positive momentum in equity markets, while any upward surprises in inflation may pose significant risks to the bond market.
With these dynamics in mind, we look at the main developments that are expected to take place in 2018 which may have a significant bearing on the direction of financial markets over the next twelve months.
Trump's Tax Reform and the US Economy
In the US, the Senate and House of Representatives have finally passed the tax reform bill which President Donald Trump has battled for since his election victory. Most notably, the new tax bill includes a cut in headline corporate income tax from 35% to 21%, a repatriation scheme on overseas profits as well as more modest tax cuts for individuals.
What this means for the economy is that companies are in a better position to step up their investments and wages whilst individuals are likely to respond with greater consumption spending. This fairly expansionary fiscal stance in an economy that is operating at full capacity is likely to support higher rates of economic growth and inflation.
European Economic Rebound
This year saw the first signs of economic improvements in the Euro area, including positive GDP growth results, modest increases in inflation, positive corporate earnings results and improving sentiment surveys. This is a most welcome development following the monetary stimulus undertaken by the European Central Bank (ECB) over the past few years.
In reaction to this, European equities as well as the currency have performed strongly throughout the year. As another wave of positive results is expected in 2018, domestically-oriented stocks may offer further upside potential since such companies are poised to benefit the most from the ongoing European recovery.
Central Banks and Benchmark Bond Yields
The US Federal Reserve and the ECB have done a great deal in communicating their plans for 2018. The Fed is expected to deliver three more rate hikes next year of 0.25% each. While no plans to adjust the current pace of balance sheet reduction have been communicated, positive developments in the labour market and improving inflationary pressures in the US will likely force the Fed to accelerate its tightening agenda.
US short-term treasury yields have risen over the last year while the long-end of the curve remained depressed as the improving economy failed to translate into an increase in inflation expectations. Going into 2018, the shift towards a mildly expansionary fiscal policy in the US argues for stronger inflation reports which would lead to a re-widening in the term premium.
The ECB, on the other hand, is expected to continue running its quantitative easing programs at least until the end of September. Policy rates are also expected to be maintained at current levels as inflation in the euro area is not projected to reach the central bank's target in 2018. However, with growing inflationary pressures in the euro area and the slow withdrawal of central bank support from the market, euro government bond yields are expected to creep higher at the longer-end of the yield curve.
Emerging Markets
A supportive growth environment in 2018 is expected to translate in another good year for emerging market (EM) equity performance. As domestic demand remains healthy, consumer-related equities are expected to be the top performing segment within this asset class.
EM corporate bonds are relatively less attractive compared to a year ago given the contraction in the yield spreads versus developed market corporate bonds. The yield carry on EM corporate bonds is expected to be the main contributor to performance for the next year, while the scope for further price gains has significantly diminished.
Cryptocurrencies
Whilst it is impossible to form an educated view on the directionality of Cryptocurrencies, given constant developments in the products and currencies available and the changing regulatory landscape, the astronomical rally in 2017 is surely worth a mention. This space is now gaining more traction, with broader parts of the population, including the less tech-savvy and elderly cohorts of society, on their toes to see what will happen with the value of the Bitcoin. Nevertheless, the mainstream investment industry is still not in a position to fully adopt these instruments due to the lack of recognition by authorities. Going forward, developments by regulatory bodies and the activity in the newly launched CME Cryptocurrency futures and other leveraged alternatives will certainly be important to follow.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.