Investment Perspectives

5 keys to investing in 2018

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Markets soared, economies strengthened. That’s how 2017 played out nearly all around the world. What does 2018 have in store? There are likely to be shocks and surprises along the way, and also opportunities for investors. Here are some of the key investment themes for 2018, and how they may impact your investment decisions as the year unfolds.

1. Tap Into Synchronized Global Growth

After a stronger-than-expected 2017, the global economy looks set to flex its muscles again in 2018.

From Germany to Japan, generally solid data indicate that the world’s economy is experiencing a pickup in growth that is synchronized and multidimensional. With manufacturing, trade, consumer sentiment and other checkpoints mostly on the upswing, expansion is gaining traction in many of the countries driving global growth. Indeed, the synchronization of global growth has raised the possibility that the cycle can remain stronger for longer.

That may be especially true in the United States. After eight years of expansion in the U.S., investors may be concerned that the American economy is nearing the end of the cycle. Yet corporate profit growth remains healthy, tax reform could boost gross domestic product and consumer spending is relatively strong.

For most of the rest of the world, it is still early in the cycle. Europe appears to have entered a prolonged period of strength and the euro-zone economy is expected to grow nearly 2.2% in 2018, according to the International Monetary Fund (IMF).  China’s gross domestic product (GDP) accelerated for the first time in seven years in 2017, and emerging markets broadly seem set to outpace developed economies again in 2018. Japan’s economy is in its best shape in years, led by strong global demand lifting exports and corporate earnings.

Overall, the IMF expects global GDP to hit 3.9% in 2018. The organization says the global recovery now underway is the broadest in seven years, with growth picking up last year in 120 countries accounting for three-quarters of world output.

Granted, the global economy is subject to geopolitical tensions, financial stress and possible protectionist trade measures. But each of the world’s major economies is now firmly in the growth column, and that should provide companies with the potential to reap new profits, and provide investors with opportunities around the world.

2. Keep the U.S. at the Core, but Be Selective

Talk about a recovery with legs. On average since World War II, expansions of the U.S. economy have lasted 60 months. After more than 100 months, this is not your average expansion – and there may be more to come.

By many measures, the U.S. economy is gaining steam. The jobs market is solid, industrial production is healthy, wages are rising and retail sales are picking up, to name just a few. They all point to the U.S. economy continuing to grow. Why has this expansion lasted so long? The answer may be that it hasn’t overheated.

On average, the economy has expanded to 123% of its prior peak before rolling over into a recession. As 2017 ended, the economy was at about 115% of the prior peak. That’s important because recessions can be caused by excesses and imbalances that build up in the system that ultimately need to be corrected, and slower growth means they take longer to materialize. There doesn’t appear to be anything systemic, or any big imbalances that would push the U.S. economy into a recession within the next 12 to 18 months.

The strengthening economy is one reason the U.S. stock market has soared since the end of the global financial crisis. Such strength makes U.S. equities a sensible core for portfolios. But some sectors of the market may be relatively expensive, making selectivity especially important.

But not all areas of the market have reached lofty levels together. Financials recently reached its pre-recession peak after 10 years, and energy has returned to 2007 levels. These sectors may have room to run, but select companies are likely to fare better than others. Fundamental research will be key to identifying the potential winners.

From the Dow Jones Industrial Average to the Nasdaq Composite, market indexes set record after record in 2017. Although share prices for some companies may be justified, caution is warranted. Indeed, market capitalization levels around the world show the U.S. at close to an all-time high while overseas markets remain relatively low overall. Given the valuation gap between the U.S. and nearly everywhere else, it may be time to consider rebalancing portfolios toward non-U.S. markets.

3. Invest in Europe’s Recovery

Sluggish growth, political uncertainty, lagging equity returns — that’s been the story in Europe for years. Now, however, Europe is on the rebound, and there’s reason to believe the rally in the region could last well into 2018 and beyond.

There is now a growing amount of evidence — from record-high manufacturing activity to rising economic sentiment indicators — that euro-zone growth could be stronger for longer, with GDP perhaps coming close to an annualized 3% rate in the first half of 2018.

The breadth of the upturn has been striking. The German economy has long been the strongest in Europe. But countries that were previously lagging behind, principally France and Italy, have experienced dramatic changes in their economic environments over the course of the past year.

One of the most encouraging transformations has taken place in France, where the economy has turned from stagnation to boom. That’s partly due to the election of President Emmanuel Macron, a centrist, pro-European Union leader who has pledged to bring economic and political reforms to France. So far, Macron has implemented important changes — and businesses and consumers are responding positively.

It’s also worth noting that Europe’s past recoveries have been driven by net export activity, which means they’ve been vulnerable to downturns in demand in the rest of the world. This recovery, however, is being driven by impressive increases in domestic demand, as well as rising exports. In addition, there’s been an upturn in investment spending by businesses, which gives weight to the possibility that this can be a self-sustaining recovery.

What does Europe’s advance mean for investors? There’s already been a strong rally in European equity markets — the MSCI Europe Index rose about 25% in dollar terms in 2017. That performance may be hard to repeat, but given the favorable economic environment, low inflation and diminishing political risks, stocks have the potential for further gains. There also seems to be a greater emphasis on profitability and shareholder returns among European companies. Indeed, equity markets may be driven more by fundamentals, including high earnings growth, during the next 12 to 18 months.

4. Capture the Potential of Emerging Markets

Emerging markets seem to thrive on synchronized global growth. They boomed from 2003 to 2007, and countries from Asia to Latin America may be reaching new levels of development during the current worldwide economic advance. The MSCI Emerging Markets Index gained 37% in 2017.

Some investors may consider that too far, too fast. But due to the evolution and maturation of emerging markets, developing countries around the world may have room to run as they assume a greater role in the global economy.

For example, emerging markets have shifted from old industries to high tech, or from smokestacks to smartphones. Back in 2008, energy and materials stocks dominated the MSCI Emerging Markets Index with a 38% combined weighting — and many of those firms were state-owned enterprises that were more susceptible to infrastructure-driven booms and busts. In 2017, however, those sectors accounted for only about 14% of the index.

Information technology now is the largest sector in the index, accounting for 28% in 2017. And because of the accelerating usage of mobile phones and greater internet penetration, Chinese technology-related firms are now the biggest companies by market value in emerging markets. This “tech-tonic” shift over the past decade has also come with a decrease in volatility as cyclical, commodity-oriented companies are no longer index heavyweights.

Now, with a background of improving global growth and potentially higher export volumes, the rally may have more upside. The IMF estimates GDP growth in emerging markets will be 4.9% in 2018, up from 4.7% last year and headed for an estimated 5% in 2019. Brazil and Russia, for example, are expanding after several years of contraction. China’s economy has proved to be more resilient than some thought possible and is growing at its fastest pace in years. Growth there has been supported by sustained stimulus measures, robust home sales and steady consumer spending. In India, political stability and reforms have helped modernize the country’s economy. The MSCI India Index gained 37% in 2017.

For investors, an improving global economy and dollar weakness can be tailwinds for emerging markets companies in a broad range of industries, from information technology to consumer goods to financials to commodities exporters.

Among those are companies that represent a relatively new phenomenon — the emergence of multinational companies in developing countries. Consulting firm McKinsey & Co. predicts that, by 2025, 46% of all Fortune Global 500 companies will come from emerging markets, mostly China. In 2000, it was a mere 5% of the list.

In all, emerging economies are home to thousands of multinationals (companies with net sales of more than $1 billion). In nearly every industry, these companies are playing an increasingly important role, and some of them are taking their place among the most powerful companies in the world. Indeed, select companies present a significant opportunity to invest in the evolution of emerging markets.


5. Rates are Rising, But Don’t Bail on Bonds

The U.S. Federal Reserve raised interest rates three times in 2017 to a range between 1.25% and 1.5%. The Fed has also announced the start of a gradual shrinking of its $4.5 trillion balance sheet, which was swollen by massive purchases of Treasury bonds and mortgage-backed securities in the aftermath of the 2007–2009 financial crisis and recession.

The rate hikes have made some bond investors nervous. But the Fed’s moves have been well telegraphed, and widely anticipated by the market. In the past, that’s made all the difference. History shows that as long as hikes don’t catch the market by surprise, such as the hikes that began in 1994, they can have a relatively modest impact on long-term yields.

Even if rates rise more than expected, as long as they rise gradually, bonds may be able to absorb the associated price declines. That’s because price changes are only one part of bond returns. Income is the other critical component, and when interest rates rise, the portfolio’s income can increase. In short, price declines can be moderated by interest income. Moreover, as lower yield bonds mature, investment professionals can take advantage of higher rates when redeploying the proceeds by investing in bonds with a higher yield.

Still, as the Fed continues on a path of gradually raising interest rates, many investors are moving to cash, short-term bonds and floating-rate securities. But the view that bonds have to suffer losses when short-term rates rise is a misconception. Looking at the most recent seven periods of interest rate hikes, including the current period, investment-grade (BBB/Baa and above) bonds have generally delivered positive returns.

If rate hikes are gradual, interest earned by bonds can overcome the price impact to deliver a positive return. Indeed, since the Fed began on its current course of rate hikes, the index has gained nearly 6%, even as the fed funds target has risen by 100 basis points. The Fed has signaled that it will maintain a gradual pace in raising rates and tightening monetary policy. Against this backdrop, interest rates will likely remain range-bound.

Looking ahead, the Fed is expected to raise rates several times in 2018, but long-term rates may not rise meaningfully. In fact, in this environment, it’s possible rates will stay “lower for longer,” and history suggests that could be the case. Investors who take a broadly diversified approach in their fixed income allocation and avoid excessive credit risk shouldn’t feel a dramatic impact from Fed policy.

Bonds play a variety of roles in a diversified portfolio, including providing income and capital preservation. They also help mitigate volatility. When equities get volatile, bonds typically perform better and provide balance to a portfolio. The rate increases now underway should not change that fundamental relationship.

Any reference to a company, product or service does not constitute endorsement or recommendation for purchase and should not be considered investment advice.

American Funds are intended only for persons eligible to purchase U.S.-registered mutual funds.
 

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