Erin Bigley-Senior Portfolio Manage
Think back to the beginning of 2017. It was full of uncertainty and concern. Yet, it ended up being a great year. Most major asset classes posted positive returns. Stocks, both US and international, had a very strong year-as did credit markets like high yield and emerging-market debt. Even conservative government bonds posted positive returns, and alternatives were on the plus side too.
What's in store for 2018? Well, the best place to start is the global economic backdrop. Global growth remains strong and continues to gain momentum. In the United States, confidence is high. Unemployment is low, consumer job numbers are strong, and corporate America has a tailwind from the recent tax cut. This leaves central banks with the comfort that they can pull back on their accommodative policies-albeit at different speeds. The Federal Reserve is going to continue to reduce its balance sheet throughout the course of the year. The ECB will end its bond purchases by the end of the year. Only the Bank of Japan is going to keep buying bonds into 2019.
The Federal Reserve will also continue to normalize short-term interest rates. What's curious is that in 2017, as they raised short-term rates, long-term rates did not move up in lockstep. In fact, the yield curve flattened. This has some investors worried: Is it a red flag? Is a recession on the horizon? It's important to note that the global economic backdrop is still strong. And the curve is flat, but not inverted. Inversion is the real red flag. And even when a curve inverts, it's typically a year or more until a recession sets in.
So, what's our outlook for the bond markets in 2018? When it comes to interest rates, we do think rates need to move higher, given stronger global growth, rising inflation and issuance of government debt. Yet there are forces that are going to put a lid on how high rates can go: global quantitative easing, as well as the general demand globally for yield. On the credit side, corporate spreads have rallied to well inside their long-term average, which means investors have to be cautious.
Given uncertainty on both sides of the fixed-income markets, investors need to be balanced. They need to have rates, because they are defensive in the event that high yield and equities sell off, but you also need to have credit to generate some income. The key is being selective and global on both sides of this mix.
Let's take a look at the opportunities in credit markets globally. In the US, we prefer securitized assets such as credit-risk transfer securities and CMBS. In Europe, we like financials. In the emerging markets, we see select opportunities in currencies, as well as government bonds, particularly in Latin America.
In interest rates, we recommend going global. When US bonds rally, as they did in 2017, global bonds tend to keep pace. But when US bonds sell off, as they may in 2018 as US interest rates rise, global bonds tend to outperform.
Now, turning to the equity markets: 2017's strong performance has many investors wondering if a correction is on the horizon. And indeed, it's been a very long time since the last market pullback, whether you look at 5%, 10% or 20% corrections. Adding to that is concern over equity market valuations. All major indices are trading with price-to-earnings valuations well above long-term averages.
However, keep this in perspective: stocks still look attractive relative to bond yields, especially when you look globally. The key is being selective and avoiding crowded trades-such as those in high-dividend-yielding stocks. Investors have been pouring into this segment of the market with a search for income. That's pushed valuations high, and it also means that dividend payers are struggling to pay those yields, paying out an increasingly high share of their earnings to meet those dividends. We think that's unsustainable. Instead, we favor companies with high profitability. And in fact, those companies with high ROEs are trading below their long-term average. We also see opportunity in small-caps. Small-cap companies should benefit from the recent tax package, more so than their large-cap peers, because they're US focused and tend to have higher tax bills. We also see more opportunity for active management in the small-cap space, since research analyst coverage is significantly lower than in large-caps. But you must be selective in small-caps. Defensive small-cap companies have seen their valuations rise; we see much better value in cyclicals.
Another year, another set of opportunities, but yet many more sources of uncertainty. The key to navigating this uncertain environment is our three key principles: Be balanced in your asset allocation between stocks and bonds, rates and credit. Be global across your entire asset allocation. And be selective in all market segments.
Happy New Year, and we'll see you next quarter.