Forecast 2018: Will it be a Dog of a year for financial markets?

As the year closes, our 2017 bull case targets for the S&P500 and the S&P/ASX200 of 2,600 and 6,000 have been met. Momentum is still positive and is likely to take global equities markets higher in the near term.

Without forecasting closing year index levels, we believe the U.S. and Australian equity markets will close 2018 at a lower level than the exit level of 2017. The magnitude and cause of a market correction is difficult to predict. Investors are currently oblivious to an exogenous factor but there is abundant fertile ground in which one can sprout.

In 2017 global equities markets, led by the U.S., enjoyed a Trumping time. In 2018, they may well suffer a Thumping. Risk assets have enjoyed an extremely favourable environment. Excess liquidity, low interest rates and a high level of complacency have driven risk asset values to high, and in many cases, very stretched levels. U.S. markets have been supported by significant growth in passive investments led by value agnostic exchange traded funds and a record level of share buybacks.

While the synchronisation in global economic growth is a positive there is little synchronisation in the monetary policies of global central banks. The U.S. Federal Reserve is tightening. While the presses of the European Central Bank and the Bank of Japan are still printing, albeit at a slower rate, they are still adding liquidity to their respective systems. The Bank of China is slowing credit growth which will have implications on China’s economic growth in 2018 and beyond.

2018 will see the clash of monetary and fiscal policy on a major scale. The clash of the largest U.S. monetary tightening process in history with equally the largest ill-timed non-wartime fiscal stimulus.

As the U.S. Federal Reserve embarks on a five to six-year monetary policy tightening journey to normalise its balance sheet and interest rates, the U.S government is on the brink of major tax reform which could add US$1.4trn plus to the deficit in addition to a promised US$1trn boost to infrastructure spending over 10 years. As GDP growth accelerates, fiscal policy should be moderating, not expanding. This clash will potentially make the task of the new Chairman of the U.S. Federal Reserve Jerome Powell and the Federal Open Market Committee (FOMC) more difficult.

Record U.S. margin debt cannot be ignored. It currently stands at over US$580bn and is at a record level relative to U.S. GDP at 2.9%, higher than both the peaks prior to the collapse of the 2000 dot.com boom and the GFC. Nor can the rapid build up of funds in open-ended equity exchange traded funds (ETFs). Equity ETFs will attract over US$300bn in 2017, with November end totals at US$294bn. This is more than the whole ETF industry, which boasts funds over US$3.4trn, has ever previously attracted in one year.

With major U.S. market indices making new records over 60 times in 2017, it is little wonder the flow of funds has reached current levels. The fear-of-missing-out (FOMO), high levels of complacency/low volatility and low costs have combined to drive ETF exuberance.

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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