Stock market returns this year may not as robust as 2017: Report

The stock market has gotten off to a strong start, but that doesn’t mean investors should expect a repeat of 2017, says  a global financial services firm Morgan Stanley report. 

The previous year was one of the best years historically for global equity performance. The absolute returns were remarkable in every major region last year. The S&P 500 rose 22%, the MSCI All-Country World Index gained 25% and the MSCI Emerging Markets Index soared 38%.

"Rarely have we seen such breadth across sectors," the report said. 

Though technology stocks dominated the headlines, investors didn’t need to own any tech stocks to do well last year. Bonds did well, too, even though stronger-than-expected global economic growth is typically a headwind for fixed income securities. Seven-to-10-year US Treasuries returned a little more than 2%, and US investment grade fixed income was up 6.4%.

US high yield bonds earned a 7.5% return, but their relative performance disappointed later in the year. 

"We believe we are in a classic late-cycle economy when high yield usually starts to underperform both investment grade and equities. As such, we downgraded high yield last summer close to the highs and are now removing it completely from our asset allocation recommendations."

"What should we expect in 2018? I’m not forecasting a recession, but I do think markets will be more volatile and gains won’t be as robust as some investors may expect," said Michael Wilson, chief investment officer at Morgan Stanley.

Michael Wilson said that US and non-US earnings will likely rise in 2018, the growth rate will likely peak in the first half.

Michael Wilson said he believed that financial conditions will tighten this year. Last year, many investors were pessimistic about the market, keeping cash on the sidelines that could be invested to fuel the market’s rise.

"We can no longer say that investor sentiment and positioning is muted. In fact, there are now signs we may have entered into the euphoria stage of this bull market."

This doesn’t necessarily mean the bull market is over, because this stage can last awhile. It does mean, however, that whatever potential upside is left is likely to be more speculative and thus higher risk and lower quality than what we had in 2017, the report said.

To our surprise, we hear many strategists and commentators suggesting that the risk is lower because of the tax cut, and earnings are set to go up in 2018. However, the tax situation is a “known known” at this point and one of the reasons why US equities did so well in 2017. Be wary of comments that tax reform has not yet been priced in, the report said.

Perhaps ironically, we find some comfort that our more muted outlook for 2018 seems almost as out of consensus as our bullish view was at this time last year, it said. 

Morgan Stanley Wealth Management’s Global Investment Committee, a group of seasoned market professionals who provide investment ideas to our Financial Advisors to help clients build their investment portfolios, recently made three shifts to its tactical asset allocation models for 2018.

First, they think that global markets will outperform US markets in 2018 and beyond. In particular, Europe and Japan offer lower valuations and potentially faster earnings growth. They are earlier in their economic cycles than is the US.

Also, they are no longer recommending a currency hedge for Japanese equity positions, which is a change from our long-standing recommended 50% currency hedge. 

They believe that emerging market equities will do okay in 2018 but lag behind Europe, Japan and maybe even the US in the first half.

Finally, they urge extreme caution with high yield bonds. Stocks have tended to do better than high yield late in the economic cycle and they think late-cycle dynamics have become even more evident lately. 

Look instead at short-term fixed income, such as two-year Treasurys, taxable investment-grade bonds, or high-quality municipal bonds, the report said.

While global equity and credit markets performed exceptionally well in 2017 in absolute terms, the risk-adjusted returns were even better considering the extraordinary breadth and low volatility. The biggest market correction was only 3%. That might seem surprising, given the numerous geopolitical shocks, not to mention a contentious US political climate.

To us, this just speaks to how powerful the synchronous global expansion has been and our view that the business cycle trumps politics. We also think that investors underestimated the positive impact of stronger fiscal support on equity market valuations, given still-low interest rates, said Morgan Stanley Wealth Management’s Global Investment Committee.

As monetary policy continues to normalise, financial conditions tighten and positivesurprises wane, global markets should also normalise. During the past 38 years, a correction in any given year has averaged 14%, with a median of 10%. Therefore, investors should be prepared for at least one, if not a few, 10% corrections in US and global equities in 2018.