Resolutions, geopolitical issues, the US$ and the oil price

Welcome to 2018. Global equity markets have celebrated with a bang, apparently without a care in the world. If it was just that simple. I remain cautious and my New Year resolutions are:

• Preserve capital;
• Reduce risk; and
• Be satisfied with lower risk adjusted total returns.

It’s bleeding obvious equity markets will close higher in 2018. Consensus forecasts overwhelmingly agree. The reasons abundantly clear, even the blind can see - synchronised global economic growth, accommodative monetary policy, corporate earnings growth, strong commodity prices and recently legislated cuts in U.S. taxation. But markets do not necessarily follow in the path of the obvious, hence my New Year resolutions.

What is also bleedingly obvious is U.S. markets are highly unlikely to continue to surge at the rate of the opening week of 2018, where the S&P 500 and the Nasdaq Composite jumped by 2.6% and 3.4% respectively in the first four days. It is as if a new era has dawned. It hasn’t. The economic and market cycles are as old as humanity as is greed, speculation and fear. Believing “This time it’s different”, is likely to prove costly. Continue to be aware, vigilant and prudent.

Recall, Joseph in the Book of Genesis predicting seven years of famine after the seven years of plenty and urging Pharaoh, the king of Egypt, to store food from the bounteous crops in readiness for the famine. The famine came. Egypt survived by drawing on the reserves of prudently stored produce. Today’s investment scenario is little different, so harvest some of the gains from the years of plenty and prudently store them for the inevitable onset of leaner times. Don’t let the fear of missing out overtake valuation as your investment mantra on a whim.

I reiterate my thoughts in Forecast 2018 regarding the risks associated with the pending clash of U.S. monetary and fiscal policy. Despite three interest rate hikes in 2017, the current federal funds rate range of 1.25%-1.50% is out of step with economic fundamentals, before fiscal stimulus works through the economy. The interest rate setting still reflects an ‘emergency’ and the U.S. economy is well past any emergency that requires the current level of accommodation from monetary policy. Citigroup’s chief economist Willem Buiter says, “The stimulus is completely unwarranted. The Fed may have to shed its pacifist, dovish cloak and become much more aggressive, and could easily ‘murder’ the expansion.”

While global synchronised economic growth is touted, it appears to be a northern hemisphere phenomenon. The economies of the southern hemisphere including Brazil, South Africa and Australia are all struggling.

As with any other year, in 2018 Australia’s GDP growth will require the cooperation of the household sector via household consumption. Elevated everyday cost of living expenses and sluggish wages growth make cooperation increasingly difficult. Household disposable income has declined over the past two years as gas and electricity prices have escalated. As house prices peak and start to decline, the psychologically important wealth effect is bruised and will affect consumption behaviour.

Households are likely to become more conservative and rein in consumption, which will affect the contribution of the most important component of the country’s GDP growth. The peaking of the east coast residential building boom also means the construction industry’s contribution to economic growth will subside. Without significant state and federal government infrastructure investment, Australia’s GDP growth would be languishing. The private sector still lags, despite the hype over business investment.

Should wages growth rebound, it is more likely households will opt to pay down debt rather than lift consumption. While official interest rates are unlikely to move for most of 2018, there is always a chance banks could introduce an out of cycle increase. However, the pending royal commission may lessen the chance, at least in 2018. But households are increasingly mindful the next move in interest rates will be up and the extended honeymoon of record low mortgage rates will end.

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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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