2017 was one for the record books. The global economy blazed a path of financial glory, with many of the world’s equity markets setting new highs. Closer to home, surging corporate profits and buoyant trade powered the region’s markets to their greatest gains in eight years. The benchmark MSCI Asia ex-Japan Index, for example, rose 39 per cent last year, outperforming the S&P 500 - for the first time since 2012 - by 20 per cent.
With 2017 now behind us, the question on investors’ minds is how much of the bull market will extend into 2018.
With macro fundamentals broadly intact, the global economy is expected to have another solid year; UBS forecasts 3.9 per cent global economic growth this year, up slightly from last year. But this may not necessarily translate into significantly higher asset prices, like it did last year, as monetary, political and technological context are all changing, among others. And each will require investors to adapt.
First, the good news: Global economic performance last year was the best since 2011. Growth accelerated to around 3.8 per cent from 3.1 per cent in 2016, thanks to multiple regions recording strong growth; 2017 was only the seventh year in the past three decades that every economy in the Group of 20 grew. While periods of high economic growth often sow the seeds of their own demise, there is little evidence of an impending recession.
Past recessions have been caused by oil price shocks, overly tight monetary policies, sharp cuts in government spending or financial/credit crises. But this year, oil prices are likely to move sideways; central banks are still likely to err on the side of caution; governments are expected to keep net spending as a proportion of gross domestic product broadly unchanged; and leverage does not appear to be a particular threat.
So barring unexpected external shocks, such as an armed conflict between the United States and North Korea, or a major flare-up in the Middle East, the global economy should keep on humming throughout the year. This solid economic backdrop, together with hearty earnings growth - we see Asian earnings growth at 11 per cent this year, after a 19 per cent rise last year - should continue to support global equity markets this year. Neither global nor Asian equities are at levels that have historically presaged weak performance, and some re-ratings of Asian stocks are likely as earnings growth broadens into lagging sectors and regions.
Nonetheless, the investment context is changing and investors should be prepared for a more challenging year.
ASIAN INFLATION AND INTEREST RATE CYCLES - A TURNING POINT
The global economy has finally turned Asia’s way, yielding benevolent conditions. Asia’s economic growth rate last year not only beat expectations, but also set solid foundations for this year. Now with the region settling into steady economic expansion, further change is inevitable.
Greater profitability, lower real interest rates (nominal rates minus inflation), robust bank balance sheets, rising capability utilisation, and favourable government policies like China’s Belt and Road Initiative are jump-starting investment. Asian investment growth should accelerate from 5 per cent last year to 8 per cent to 9 per cent this year, thus supporting the next phase in the region’s growth recovery, especially in South-east Asia and India.
But 2018 should also mark the gradual comeback of inflation in the region. We expect headline consumer prices to increase by 0.5 per cent to 1 per cent this year, thereby, piquing the attention of Asia’s central banks. Already, the Bank of Korea recently raised its policy interest rate for the first time in six years, making South Korea the first big Asian country to tighten monetary policy since 2014. Still, any tightening bias among Asian central banks will probably be quite gradual, as signs of overheating remain absent at present.
That is, while solid economic growth remains supportive of asset prices, Asian investors should prep their portfolios for the return of inflation, tighter monetary policies and, hence, higher volatility. As higher interest rates typically boost net interest margins, the financial sector should benefit from greater client activity, higher loan demand and improving credit quality.
IS DISRUPTION A BOON OR BANE?
Much of the equity performance last year can be attributed to the technology sector. In the third quarter, for example, tech firms accounted for 23 per cent of the S&P 500 earnings, up by 5 percentage points in three years. The sector is now the largest in the MSCI Emerging Market and China indices, and its weighting in the MSCI Asia ex-Japan Index shot up from 18.7 per cent in June 2013 to 31.7 per cent in June last year at the expense of most other sectors.
Asia’s innovation story too is poised to surge ahead this year (and beyond) and help the region re-rate by spurring more sustainable earnings growth. Bloomberg’s average innovation score for Asia rose from 66.5 in 2013 to 78.3 in 2016, nearly the same score as the top five developed markets, and Chinese R&D spending is set to outstrip that of the US and the European Union combined by 2020, according to UBS forecasts. Already, this rapidly narrowing innovation gap is accelerating Asia’s shift from old to new economy, with the region now home to global leaders in industries beyond electronics, including environmental technology, automation, new materials, pharmaceuticals and medtech.
This disruption is having significant repercussions across the economic spectrum on start-ups and incumbents, and this trend has only just begun. For example, last year, stocks in the US food retail sector fell by 11 per cent in the week that Amazon said it would purchase Whole Foods. Investors should thus avoid concentrating on firms or industries threatened by disruption and instead focus on technology leaders in emerging areas like digital data, automation and robotics, and smart mobility. Companies in the old economy embracing innovations could also flourish.
STAY INVESTED IN 2018
Despite the challenges, investors should remain invested or risk missing out on another vibrant year for the financial markets.
Since 1927, the average increase in the final 12 months before the end of a bull market has been 22 per cent. Missing these periods would lower investors’ long-term annualised price returns on the S&P 500 from 9.6 per cent to 7.2 per cent. Rather, diversification across regions, securities and sectors remains the best way to profit from the rotating economic cycle while protecting from potential shocks.
•The writer is the Asia-Pacific regional head at the chief investment office of UBS Wealth Management.
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