Jonathan Marriott – Chief Investment Officer
If there is a lesson to take forward from the last year, it is that political noise is just that. Noise. From an investment perspective, I believe that we should now focus less on politics and look at what is actually happening in the economies and markets of the world to see where we go next.
At the start of 2017, we had generally supportive economic data coming through. Interest rates in the US were expected to rise slowly and the outlook for equities was broadly positive. Concerns centred on Brexit, upcoming European elections and whether President-Elect Trump would be able to follow through with any of the promises made on the campaign trail. As we enter 2018, many of our hopes and concerns are the same. Despite the political noise, of which there was a lot, equity markets ended 2017 at, or near, their all-time highs.
Interest rates have risen in the US but in a controlled fashion without the major bond collapse that some commentators had predicted. The next stage is the gradual shrinking of the Federal Reserve's balance sheet, which will go on for a long time to come. It came as a relief to markets that Trump's nominee to replace Janet Yellen as Chairman of the Federal Reserve was considered a continuity candidate. In the UK, we have had the first rate rise in 10 years however with the expectation that the Bank of England will only make one further move per year over the course of the next two years. Economic data and company earnings have remained positive for the most part but inflation is stubbornly below target in most global economies. The exception is the UK where the post-Brexit vote devaluation is still pushing inflation higher. Brexit aside, many technological changes such as robotics, artificial intelligence and internet price comparisons, together with a more global market and ageing populations in developed markets, are likely to constrain inflation for some time to come. On the other side, low unemployment may put some upward pressure on wages. The oil price has also recovered from its lows as the Organization of the Petroleum Exporting Countries ("OPEC") production cuts hold. Inflation expectations priced into the index-linked bond market have been low and may move higher but we do not see inflation being a problem over the longer term.
On Brexit, Article 50 was officially exercised in March and finally moved the stage of negotiations to phase two. Despite this, we still have little idea as to what our final relationship with the European Union will be. The agreement in December looked like the so-called 'soft Brexit' but many within Mrs May’s own party are not going to be happy with continuing to follow EU rules. It remains hard to see the shape of a final deal and negotiations are likely to go to the last possible minute before a deal is struck. The swings in expectations are most likely to be felt in foreign exchange markets. A 'hard Brexit' could lead to a weaker UK economy and a lower pound but this would be positive for the FTSE 100 index where most of the earnings come from overseas. In 2017, the pound rallied against the US dollar but the strength of global economies and earnings growth outweighed the drag of a positive currency.
On the election front, the rise of populist parties failed to make an impact in France. Meanwhile in Germany Mrs Merkel lost ground and has been struggling to form a coalition. The emergence of Macron and victory for his new En Marche party in parliamentary elections has raised hopes of real progress on much needed structural reforms in France. In 2018, we will have an election in Italy where the anti-EU Five Star Movement has been a threat to the older establishment. The big electoral surprise of 2017 was in the UK with Mrs May calling an election with a lead of up to 20% in some polls then losing her majority. With subsequent scandals removing various cabinet members, it is surprising that she survived as Prime Minister and she possibly looks more secure at the end of the year than she had for several months. In Japan, Prime Minister Abe called an election, and fared much better, and we can look forward to more progress on his reform programme.
Trump has promised much and tweeted more but with very little delivered right until the end of the year. His travel ban on people from Muslim states was held up in the courts. His attempt to replace Obamacare floundered in Congress. The wall with Mexico has yet to be funded, let alone built. There has been little progress on his infrastructure plans. At year-end, however, he finally got his tax reform package passed, representing his first major success in Congress in his first year. This is largely positive for US companies and may add around 10% to earnings next year. The theory is that tax cuts will trickle down into more investment in the economy, better growth and ultimately, higher tax receipts. If this just increases the return to shareholders, it may prove good for Wall Street but less so for Main Street. US borrowing in the short term is likely to be higher and negotiations over the debt ceiling have just been deferred. Following the Alabama by-election for the Senate, the Republican majority was cut to only one seat, meaning that progress on Trump's other policies may be hard to come by. Mid-term elections in November are likely to make it even harder as we get to the end of 2018.
At times, terrorist attacks and disasters, both man-made and natural, came to take the headlines. The Manchester bomb, London Bridge and Westminster attacks, the Grenfell Tower fire and huge hurricane damage, amongst others, gave us pause for thought. Our sympathy goes out to the victims of these events and their families and friends who dominated our thoughts this year. The threat of terrorism never seems far away and geopolitical tensions have remained high throughout the year. The Middle East remains a source of tension. North Korea remains a danger and the military option would be a humanitarian disaster so we must hope that China can act to calm things down.
Against this background, markets soldiered on largely ignoring the political events. Improved earnings continued and firm economic data has supported this across most markets. It should be noted that while volatility measures were low last year, at times dispersion within markets has been high. We therefore favour a selective approach to equity markets going forward. We expect conditions to continue to be positive for equities in the year to come but after such a strong run, we would not be surprised to see periodic corrections in the bull market. As with last year, if we are able to look through the political noise and short-term volatility then we expect another positive year for our portfolios.