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The Bank Credit Analyst THE BANK CREDIT ANALYST Monthly forecast and analysis of the December 2017 - Vol. 69 - No. 6 global economy and financial markets SPECIAL YEAR END ISSUE OUTLOOK 2018 Policy And The Markets: On A Collision Course www.bcaresearch.com THE BANK CREDIT ANALYST Monthly forecast and analysis of the December 2017 - Vol. 69 - No. 6 global economy and financial markets SPECIAL YEAR END ISSUE OUTLOOK 2018 Policy And The Markets: On A Collision Course 2 Conclusions 49 OUTLOOK 2018: Policy And The Markets: On A Collision Course Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation. Mr. X: As always, it is a great pleasure to happen, I would worry about the potential sit down with you to discuss the economic for a sudden 1987-style crash. I remember and investment outlook. And I am thrilled that event well and it was an unpleasant to bring my daughter to the meeting. She experience. My inclination is to move right and I do not always agree on the market now to an underweight equity position. outlook and appropriate investment strategy, but even in her first year working Ms. X: Let me add that I am delighted with me she has added tremendous value to finally attend the annual BCA to our decisions and performance. As you meeting with my father. Over the years, know, I have a very conservative bias in he has talked to me at length about your my approach and this means I sometimes discussions, making me very jealous that miss out on opportunities. My daughter is I was not there. He and I do frequently more willing than me to take risks, so we disagree about the outlook so it will be make a good team. good to have BCA’s independent and objective perspective. I am happy that our investment portfolio has performed well over the past year, As my father noted, I do not always share but am puzzled by the high level of his cautious bias. When I joined the family investor complacency. I can’t understand firm in early 2017, I persuaded him to why investors do not share my concerns raise our equity exposure and that was the about by sky-high valuations, a volatile right decision. I have been in the business geopolitical environment and the long enough to know that it is dangerous considerable potential for financial to get more bullish as the market rises instability. Over the years, you have and I agree there probably is too much made me appreciate the power of easy complacency. However, I do not see an money to create financial bubbles and early end to the conditions that are driving also that market overshoots can last for a the bull market and I am inclined to stay surprisingly long time. Thus, I am fully overweight equities for a while longer. aware that we could easily have another Thus, the big debate between us is whether year of strong gains, but were that to or not we should now book profits from the 2 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH past year’s strong performance and move CHART 1 to an underweight stance in risk assets. An Impressive Bull Market Hopefully, this meeting will help us make 600 600 MSCI ALL COUNTRY INDEX* the right decision. BCA: First of all, we are delighted to see 500 500 you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating 400 400 whether to cut exposure to risk assets because that question is on the mind A great bull market, of many of our clients. We share your fueled by... 300 300 surprise about complacency – investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during 28 ACW EARNINGS 28 the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable 26 26 performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices 24 24 continue to rise, it would make sense to ...decent reduce exposure to risk assets to a neutral earnings... position over the next few months. A 22 22 blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk ACW P/E RATIO* strategy. We are not yet recommending 20 20 underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction 18 18 in the second half of 2018. 16 16 Ms. X: It seems that you are siding with ...and rising my father in terms of wanting to scale 14 multiples 14 back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, 12 © BCA Research 2017 12 I would be interested in reviewing your 2011 2012 2013 2014 2015 2016 2017 * SHOWN IN LOCAL CURRENCY TERMS. SOURCE: MSCI INC. forecasts from last year. (SEE COPYRIGHT DECLARATION). BCA RESEARCH December 2017 THE BANK CREDIT ANALYST 3 BCA: Of course. A year ago, our key expands alongside increased demand conclusions were that: and it will be critical to monitor business capital spending. A number of important regime shifts will impact the economic Lingering structural problems will and investment outlook over the prevent any growth acceleration next few years. These include the outside the U.S. The euro area and end of the era of falling inflation emerging economies are still in the and interest rates, a move away midst of a deleveraging cycle and from fiscal conservatism, a policy demographics remain a headwind for pushback against globalization, and Japan. Not many countries will follow a rise in the labor share of income the U.S. example of fiscal stimulus. at the expense of profit margins. Nevertheless, for the first time since Together with an earlier regime shift the recovery began, global growth when the Debt Supercycle ended, forecasts are likely avoid a downgrade these trends are consistent with very over the next couple of years. modest returns from financial assets China remains an unbalanced and over the next decade. fragile economy but the authorities The failure of low interest rates to have enough policy flexibility to trigger a vigorous rebound in private avoid a hard landing, at least over credit growth is consistent with our the year or two. The longer-run end-of-Debt Supercycle thesis. The outlook is more bearish unless the end point for dealing with high debt government moves away from its levels may ultimately be sharply stop-go policy approach and pursues higher inflation, but only after more supply-side reforms. the next downturn triggers a new Inflation has bottomed in the U.S., deflationary scare. but the upturn will be gradual in The potential for trade restrictions 2017 and it will stay subdued in the by the incoming U.S. administration euro area and Japan. Divergences in poses a threat to the outlook, but the monetary policy between the U.S. odds of a global trade war are low. and other developed economies will continue to build in 2017 as the Fed Time lags in implementing policy tightens and other central banks stay mean that the fiscal plans of on hold. Unlike a year ago, the Fed’s President-elect Trump will boost U.S. rate expectations look reasonable. growth in 2018 more than 2017. This raises the risk of an overheated Bond yields in the U.S. may fall economy in 2018 leading to a in the near run after their recent monetary squeeze and recession in sharp rise, but the cyclical trend is 2019. The key issue will be whether up against a backdrop of monetary the supply side of the economy tightening, fiscal stimulus and rising 4 THE BANK CREDIT ANALYST December 2017 BCA RESEARCH inflation. Yields in the euro area will planned production cuts by OPEC be held down by ongoing QE, while and some other producers will the 10-year yield will stay capped at ensure that inventories will have to zero in Japan. The secular bull mar- be drawn down in the second half ket in bonds is over although yields of 2017. Non-oil commodity prices could retest their recent lows in the will stay in a trading range after next downturn. healthy gains in 2016, but the long- run outlook is still bearish. The search for yield will remain an important investment theme, The dollar bull market should stay but rich valuations dictate only a intact over the coming year with neutral weighting in investment- the trade-weighted index rising by grade corporate bonds and a modest around 5%. Relative policy stances underweight in high-yielders. and economic trends should all stay supportive of the dollar. The The U.S. equity market is modestly outlook for the yen is especially overvalued but the conditions are gloomy.
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