Investors could be forgiven for looking ahead to 2018 with a degree of confidence. Stock market returns were strong in most parts of the world in 2017 and volatility remains low.
The global economy looks healthier than it has for some time and the world finally seems to be moving on from the great financial crisis of 2008. Against this backdrop of improved economic growth, the Federal Reserve has raised interest rates four times since late 2015. The Bank of England also followed course in November 2017 with the first interest rate hike in a decade, while governor Mark Carney indicated another two hikes may be required over the next three years to control inflation.
Of course, nothing in life is plain sailing: I expect to see some speed bumps during 2018. In the UK, these could include the Brexit negotiations, slow productivity growth and high inflation, which is denting consumer spending.
Valuations across a number of asset classes also look elevated. Quantitative easing (QE) has seen central banks in the UK, US, Japan and Europe inject trillions of cash into government bonds. This has inflated asset prices and powered the eight-year bull market that is still going strong.
As central banks embark on the challenge of unwinding QE, this will have repercussions for your investments. The bond market, in particular, could face some challenges in 2018. This is because mainstream government and corporate bond markets have been driven by low interest rates and central bank bond-buying activity. This has resulted in high prices and low yields (as the two move inversely to each other).
As rates start to rise and QE is withdrawn, I would expect to see yields going up and prices falling, which could result in capital losses. With this in mind, I suggest minimising the interest rate sensitivity of your bond allocations.
You can do this by buying a fund that invests in bonds with a short time to maturity. These ‘short duration’ bonds are less sensitive to interest rate and inflation movements, compared with those with longer maturities. AXA Sterling Credit Short Duration Bond fund is a good example. Manager Nicolas Trindade invests in high-quality corporate bonds, typically with maturities of less than five years.
Within fixed income, emerging market debt is worth considering because of the attractive yields. Investors will need to decide whether they are happy with exposure to dollar-denominated debt or local currencies. Also, whether they prefer to keep this exposure sterling-denominated via a hedged share class or not. M&G Emerging Markets Bond is my top pick in this sector, with a yield of around 4.9%, according to its 31 October factsheet.
Equity valuations broadly look elevated, but some markets appear to be attractively valued on a relative basis. Europe, for example, has seen positive economic data coming through. There are pockets of value for savvy investors. I would highlight the T Rowe Price European Smaller Companies fund or for those who like investment trusts, the Jupiter European Opportunities Trust*.
Japanese equities look cheap in comparison to other developed markets. Following Prime Minister Shinzo Abe’s landslide victory in October 2017, I’d expect to see further progress for his ambitious reform programme. Baillie Gifford Japanese and Schroder Tokyo are my top picks.
Emerging markets comfortably outperformed most developed markets in 2017, and I see no reason why this can’t continue in 2018. The good news is that emerging markets continue to look attractive on a valuation basis. The Charlemagne Magna Emerging Markets Dividend is one fund to consider in this sector. Its focus on companies that pay higher-than-average dividends means it typically has a slightly lower risk profile than its peers.
I would approach your investments with cautious optimism in 2018. The fundamentals look positive, but I would drip-feed money into the market.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Mr McDermott’s views are his own and do not constitute financial advice.
Darius McDermott is managing director at Chelsea Financial Services and FundCalibre