The year began with a sense of political turmoil coming from Washington. The news included President Trump’s latest confrontation with North Korea, a feud between the president and his former strategist Steve Bannon, worries about more restrictive trade measures and struggles to secure a bipartisan deal in the Senate over immigration reform.
Last year saw a range of similar domestic and political issues, but investors generally ignored the drama. So far, this year has seen a similar pattern. We don’t expect political issues to derail the bull market, but they do present ongoing risks.
Global economic growth enjoyed a strong acceleration over the past 18 months, but that pace will inevitably cool. Inflation is also likely to rise this year (especially as the jobs market continues to grow). Monetary policy is also becoming slightly tighter. All of these factors could complicate the picture for equity markets.
The good news is that global corporate earnings appear to be very strong. Revenues are growing, profits margins are stable and corporate tax cuts can be used in a variety of bottom-line-boosting ways. Corporate earnings have surprised to the upside over the past 18 months. While the pace and degree of positive surprises is likely to slow, we still expect earnings to push stock prices higher this year.
On balance, we believe the economic and policy backdrops look positive for equities and other risk assets. The major threat to financial markets is probably higher inflation. Inflation is likely to contribute to an increase in bond yields and could take the edge off of the equity rally. In this sort of environment, we expect government bond markets could experience negative overall returns while equities generate returns in the mid to high single-digit range. As such, we think it makes sense for investors to stick with overweight positions in equities, but also to expect lower returns and more volatility compared to last year.