Five market surprises that could occur in 2018
Treasuries, the dollar, Nafta and the economies of the US and China all face uncertainty
Markets have begun the year with equities extending their record-breaking pace, while Treasuries and the dollar have come under pressure. However, despite these developments, it is worthwhile considering five out-of-consensus scenarios that could emerge in 2018.
1. Treasury yields fall
Most analysts expect US government bond yields to edge higher, with the 10-year yield ending 2018 at 2.9 per cent. Some think this is complacent, given the strong economy and the Federal Reserve’s plans to raise rates three times. Moreover, the debt-financed tax cut means investors will have to absorb $1tn of Treasuries in 2018, twice the amount last year, according to Deutsche Bank’s Torsten Slok.
But perhaps analysts are still underestimating the powerful global forces that have kept a lid on inflation in recent years. Moreover, as Mike Gitlin, head of fixed income at Capital Group, points out, “the reality is that we are closer to the end of this economic cycle than the beginning”.
It is, therefore, far from inconceivable that Treasury yields sag lower by the end of the year, once again wrongfooting fund managers and exacerbating the anguish of pension funds.
2. The dollar regains its vim
The dollar has started 2018 on the back foot, and is expected to stay there, especially versus the euro. Strategists predict the euro will end 2018 at $1.22 — roughly today’s level — while derivatives indicate investors think the euro will climb another 3 per cent against the dollar to $1.26.
But if the European Central Bank unexpectedly extends its quantitative easing programme, even as the Fed defies market expectations and lifts interest rates three times — or more — this year, then the dollar could launch a comeback. Investor positioning in the dollar is bearish, which means it would not take much to trigger a recovery.
A stronger US currency would present a headwind to emerging markets, but most of all to the US stock market. The weak dollar has been a big boost for the overseas earnings of S&P 500 companies, and a recovery could make elevated valuations look much less defensible.
3. The US enjoys an economic boom
This would be a positive surprise, but one that could ultimately carry a toxic sting in its tail. The US economy expanded an annualised 3.2 per cent in the third quarter, and that was before a big corporate tax cut.
Most analysts are still sceptical that the pace of expansion can stay above 3 per cent even with the tax cut — the median estimate of 89 economists polled by Bloomberg is for a 2.6 per cent growth rate in 2018. But there are no precedents for fiscal stimulus at a time when the economy is in such good shape, and it is possible that combined with the rising animal spirits of households and companies, the US economy enjoys a good, old-fashioned boom.
However, that could eventually be bad news for markets. Inflation above the 3 per cent level has historically proven a “toggle switch” for US bonds and equities, with losses starting to get serious above that mark, according to the Leuthold Group’s Jim Paulsen. Even if inflation remains quiescent, the Fed could decide to tighten more aggressively and knock out the low-rate support enjoyed by markets.
4. China’s economy splutters again
China steadied its economic ship last year, and perhaps most importantly, the credit binge seems to be abating. JPMorgan even reckons China’s debt-to-output ratio fell for the first time in six years in the second quarter of last year.
Yet many of the longstanding bears remain undeterred, and regulatory efforts to clamp down on parts of the vast, tangled shadow banking sector triggered a bout of market jitters in December. If that escalates into a more concerted effort that weighs on growth, it could undermine the global economic recovery that underpinned markets last year — and, in extremis, reignite the fears that triggered the last global correction in early 2016.
Even China’s banking regulator chief warned this week that a “black swan” event could threaten the country’s financial stability. “We need to focus on reducing the debt ratio of companies, restrict household leverage, strictly control cross-financial sector products, continue to dismantle shadow banking,” Guo Shuqing told a state paper.
5. Trumpian trade wars
Thus far, the Trump administration’s rhetoric around trade has remained hot air, but BlackRock chief investment strategist Richard Turnill reckons that this is the biggest danger facing markets.
The assumption has been that the US would ultimately shy away from scrapping the North American Free Trade Agreement, or escalating trade tensions with China. That is one of the main reasons why emerging markets defied expectations last year.
While Mr Turnill does not expect a trade war, the danger of one is real, he stresses. “We are most worried about the potential for a protectionist US approach to trade. This is a risk that could shake up global growth and earnings prospects — and call into question our economic outlook,” he wrote in a recent note.