Business Eye CI spoke with Chris Colclough
Head of Portfolio Management, at Guernsey’s Canaccord Genuity Wealth (International) Ltd for his expert commentary on possible 2018 surprises
“There are known knowns. There are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. There are things we do not know we don’t know.”
Donald Rumsfeld
Markets are very good at pricing in ‘known knowns’. In fact, it is often not a good strategy to invest on the back of them, and known knowns by their nature provide very few surprises. Markets are less good at pricing in known unknowns; too often the speculation entailed in looking at them leads to extremes of valuation. Known unknowns often generate surprises but it is the unknown unknowns that provide the greatest scope for serious dislocation.
In this article we look at six possible surprises for 2018. All are known unknowns, because if we knew the unknown unknowns, they would be known.
Nice surprise one: Brexit works out
It is a highly consensus investment position (and one we happen to share) that the uncertainties surrounding the Brexit negotiations are bad for UK assets and for sterling. However, in this surprise, imagine coming to the end of 2018 and finding that the UK and the EU have reached a mutually beneficial agreement on Brexit, that:
- Entails minimal disruption to UK trade
- Allows the UK to retain access to the single market, but with much reduced financial contributions to European projects
- Gives the UK freedom to negotiate trade deals with the rest of the world
- Rekindles industrial and consumer confidence
- Leads to a spurt in growth, so the UK once again tops the G7 economic growth tables.
The results? A surge in sterling, a rally in Gilts, falling inflation, better real earnings, and for the stock market, modest growth, only constrained by the amount of overseas earnings in the FTSE 100. International investors flock back to UK stocks and bonds and UK assets are the strongest performers among all developed markets.
Nice surprise two: nothing goes wrong in the world economy – more Goldilocks
The bull market from the depths of 2009 is long in the tooth; including dividends, the S&P 500 index in the US is up 18% so far in 2017, after rises of 12% in 2016, 1% in 2015, 14% in 2014, 32% in 2013 and 16% in 2012. Since the end of 2011, US equities have risen by 135% on this basis. In the UK, government bonds have returned 25% over the same period, and UK corporate bonds 55%. Except for gold, everything has gone up. It can’t last, can it?
In this surprise, that’s exactly what happens. Currently expected earnings growth of 12% in the US for 2018 expands significantly further with the benefits of tax reform; company profits increase strongly in Europe; central banks act extremely cautiously in raising interest rates and/or reducing Quantitative Easing (QE); global economic growth remains robust and inflation very tame.
This translates not into the measured, cautious optimism with which investors like us view the world at the moment, but an environment yet again of strong, double-digit returns in equities, solid mid-single digit returns from bonds and a further expansion of valuations. We may get scared where this leaves us by the end of the year, but the journey, though a white-knuckle ride at times, leaves us breathless and flushed with excitement by December 2018.
Nice surprise three: Trump gets stuff done
The first year of Donald Trump’s presidency has been a disappointment, even despite Congress finally approving his sweeping tax reforms at the end of 2017. Otherwise, his administration has been long on hot air and short of legislative action. Many now write off ‘the Donald’ as a loud-mouthed braggadocio, full of ill-considered and offensive bluster.
But in this surprise, things turn out very differently in 2018. The stock market loves the tax reform and the surge in investment, and rallies strongly, even as interest rates rise, and average hourly earnings begin to climb more quickly as well. North Korea suspends its nuclear arms programme and becomes more integrated into the world economy. A resurgent Trump propels his party to shock success in the mid-terms and lays the foundation for a second term presidency. The world is seldom so pleasant, and to provide balance we’ve suggested three darker surprises below.
Nasty surprise one: inflation comes back to haunt us
This surprise would see the depressing effects of technology on price levels dissipate in the face of very low unemployment and the emergence of significant skills shortages. As inflation moved past central bank tolerance levels, the current expectation of slow and gradual monetary tightening would be comprehensively broken. Authorities across the globe would remove QE and increase interest rates much more aggressively than markets expect. Bond prices would fall, and equity valuations, which are priced for a low inflation environment, would contract.
At the same time, company profits would come under pressure from rising wages and raw materials costs, creating lower valuations as well as lower profits on which to base the valuations. This would prompt a sharp contraction in shares across the world, rapidly denting confidence. The smug complacency of the Goldilocks economy is shattered, just as it was in 2008, only this time central banks don’t have anything like the firepower they had then to combat it.
Nasty surprise two: populism comes back with a vengeance and bad things happen
Despite scoring his first (and only) major legislative victory in 2017 with the Tax Cuts and Jobs Act, President Trump continues to fall short on his other existing plans to reform healthcare, infrastructure, housing and welfare. As a result, faced by an electoral disaster in the mid-term elections, he withdraws from the North American Free Trade Agreement (NAFTA), starts building the wall to keep Mexico out and implements protectionist policies against China. At the same time, he ramps up tensions against North Korea, prompting significantly heightened geopolitical risk.
Russia takes advantage of a European Union distracted by Brexit and in its presidential election year tries to repeat the successful annexation of the Crimea by fomenting unrest and revolt in the Baltic states. The hope engendered by the election of President Macron evaporates in the face of a resurgent populist movement in Italy. In Britain, Theresa May’s government collapses because of a compromise forced upon it by the EU during the Brexit negotiations on the border between Northern Ireland and the South, which results in the DUP withdrawing support. In the ensuing general election, Jeremy Corbyn wins on a mandate of uncosted promises.
In this nasty surprise, politics becomes the driving force to risk aversion. Risk assets would sell off aggressively, and safe havens, such as gold, the dollar, US Treasuries and the Swiss franc would rise on pure fear. The euro would fall and sterling plummet. Most equities would be crushed, although the collapse of sterling would mitigate the worst effects for UK investors. This would be scant consolation in the face of much higher personal taxation from the new Labour government.
Nasty surprise three: an attack on the new technological world order
We all now know that the wonderful utility that social network, search engine and internet media companies provide comes at a cost. The new economy giants evade taxation, facilitate fake news, corrupt the democratic process, invade the privacy of citizens and destroy countless thousands of jobs through unfair competition. Companies such as Facebook, Google/ Alphabet, Netflix, Amazon and the like have been the primary drivers of the equity bull market, becoming the largest companies in the world in the process.
In this nasty surprise, the old-world order fights back. Google and Amazon are investigated by the US Department of Justice anti-trust authorities with a view to breaking them up. Facebook is caught up in investigations on its role in recent elections. Advertisers begin to leave the social networks, eroding their earnings. Meanwhile, on the advice of Bill Gates amongst others, Congress implements legislation that taxes industrial robots as factors of production. Governments the world over find ways to tax internet retailing, damaging the ability of companies like Amazon to disrupt seemingly limitless areas of commerce. The use of Artificial Intelligence is strictly regulated. In China, the Communist Party takes effective control of the internet giants there, like Baidu, Tencent or Alibaba. Increasingly these companies become instruments of state control, just as in George Orwell’s 1984. The result is a collapse in the share prices of the FAANGs (Facebook, Amazon, Apple, Netflix and Google/Alphabet). With technology now 20% of the wider US market, this leads to a severe market correction.
How can I prepare for surprises in 2018?
Like most known unknowns and all unknown unknowns, the only certainty now is that whatever causes it, the correction, when it comes, will be a surprise. Indeed, we have had so long without a spike in volatility and a significant market downturn that in many ways the biggest surprise next year will be if we don’t finally get one.
The good news is that our experts are continually exploring and analysing the markets to spot what’s happening long before it affects investments. They’ll help you prepare for the unexpected so you don’t have to worry about known, or even unknown unknowns.
