Risk is usually the result of a very high degree of confidence among market participants in one particular outcome.
Five global risks for investors in 2018 are: geopolitics, chasing returns, private investment boom, return of inflation, and natural disasters.
Having a well-balanced, diversified portfolio and being prepared with a plan in the event of an unexpected outcome is a key to successful investing.
A global recession would be a big risk for stocks. While the global economic cycle is aging, we don’t foresee a global recession taking place in 2018—although that risk may rise in 2019.
What are the big risks for investors in 2018? The biggest risks in any year aren’t usually from out of left field (although that sometimes happens), they are often hiding in plain sight. As goes one of my favorite quotes: “It ain’t what you don’t know that gets you in trouble, it’s what you know for sure that just ain’t so.”
Risk is usually the result of a very high degree of confidence among market participants in one particular outcome that either doesn’t end up happening or suddenly appears a lot less likely to happen. So, from that perspective, here are five global risks for investors in 2018, in no particular order:
- Chasing returns
- Private investment boom
- Return of inflation
- Natural disasters
We spent much of 2017 dismissing the market risk posed by geopolitics, but the impact it poses may change in 2018. Entering 2017 many investors were intensely focused on geopolitics after the Brexit vote and the U.S. election, but the acceleration in global growth outweighed any potentially negative impact from either trade disputes or military threats. The opposite could happen in 2018. The economic backdrop may become more vulnerable as 2018 progresses because sentiment is largely dismissive of geopolitics having any impact on markets.. These factors could combine to make geopolitics more impactful, particularly as the year matures.
2) Chasing returns
Consistently predicting what markets will do is hard, if not impossible. Predicting investor behavior, on the other hand, can be surprisingly simple. Without the aid of advice, investors often tend to chase returns. The rolling five-year return has most closely mirrored investors’ buying and selling of stock funds (mutual funds and exchange-traded funds combined), as you can see in the chart below. In our 2017 outlook, we pointed to the turnaround in the five year return for global stocks as a clear signal of the rebound in net buying of equities that took place last year. In 2018, that trend may reverse.
Might investors’ buying spree end in 2018?
Global stock market performance measured by MSCI All Country World Index.
Source: Charles Schwab, Investment Company Institute, Bloomberg, data as of 1/6/2018.
While no one knows exactly what the global stock market will do in 2018, as each month passes the five year return drops off months from 2013—a year when global stocks returned +23%. That is a high hurdle for 2018 to maintain to keep the five year return from falling. If stocks underperform 2013’s gain, which seems likely, the five-year return (the blue line in the chart) will fall and so may the pace of buying by investors (the orange line). The past three times those two lines have trended down coincided with the three bear market declines of 20% or more during the past decade.
3) Private investment boom
From a surprise perspective, years that ended in “8” haven’t been very good to investors in recent decades.
- In 1998, hedge fund Long-Term Capital Management applied too much leverage to low spreads in emerging market debt resulting in a bailout and bear market.
- In 2008, banks applied too much leverage to low spreads in subprime debt resulting in a bailout and a bear market.
In 2018, we may not see a repeat of the curse of the “8”s since it seems that the chase for yield hasn’t led investors to focus on returns from low-spread securities magnified by high leverage as much as in past cycles.
So where has the chase for yield led? One place has been in private assets. A few years ago, investors were said to have adopted the mantra of “TINA” or “There Is No Alternative” and bought publically-traded stocks. Investors in more recent years could be said to have adopted “AINT” or “Any Investment Not Traded.” During this cycle the chase for yield has caused investors to increasingly turn to exploiting the spread between public and private assets, known as the liquidity premium, fueling a boom in private assets that aren’t traded in public markets such as private equity, private debt, commercial real estate, and direct lending.
Fortunately, there is a big difference that may make a potential downturn in these assets less risky for the overall economy and markets: there is less leverage employed by the buyers of these assets who are generally long-term investors that include individuals, endowments, insurance companies and pension funds. That may mean a downturn in these assets may have less of a negative ripple effect on financial institutions and public markets than we saw in 1998 or 2008 when highly-leveraged banks and hedge funds were major owners of the depreciating assets. Still, a downturn with no liquidity in private assets could mean forced selling of publically traded stocks or bonds, making it a risk worth watching in 2018.
4) Inflation surprise
Market prices continue to reflect a low risk that interest rates will increase enough to trigger a recession in the near future. Yet, global demand may finally start to exceed capacity for the world economy in 2018 as the world’s output gap turns from negative to positive, as you can see in the chart below. The shift from excess supply to excess demand may lead to a rise in inflation just as it did the last time the gap turned positive in 2004.
The output gap is finally closing
Source: Charles Schwab, Organization for Economic Cooperation and Development data and 2018 forecast as of 12/8/2017.
Yet, few expect any uptick in inflation next year. The economist and market consensus is that inflation will remain the same as in 2017. In fact, to use the U.S. as an example, of the 74 economists tracked by Bloomberg only five expect even a half of a percentage point rise in inflation in 2018. Keep in mind that inflation usually moves by more than percentage point a year and has moved by at least a half a percentage point in 15 of the past 20 years. So given the very high degree of confidence among market participants and economists in there being no change, inflation has the potential to surprise in 2018.
While some rise in inflation seems likely and may be welcomed in the stock market and help lift corporate earnings, the risk is that inflation surprises more significantly and forces central bankers to raise interest rates more quickly than anyone is expecting—this is what has ended many past economic and market cycles.
5) Natural disasters
While every year has its share of natural disasters, 2017 saw an extraordinary number of them. The raging fires in California and the strongest ever Atlantic hurricane hitting Ireland followed the succession of hurricanes and typhoons slamming into U.S. and Asian shores, while Mexico was hit by devastating earthquakes and a series of landslides brought destruction in Asia and Latin America. 2017 ranked as the most costly year ever for natural disasters.
Rising trend in inflation-adjusted annual cost of natural disasters
Inflation adjusted via country-specific consumer price index and consideration for exchange rate fluctuations between local currency and US dollars.
2017 estimate includes only AccuWeather estimates of $290 billion for Hurricane Harvey and Irma and $85 billion for the California fires.
Source: Charles Schwab, Insurance Information Institute as of 10/15/2017.
While disasters tend to spur economic growth despite the widespread destruction they leave behind (see Fires, Hurricanes, and Earthquakes: What Disasters Mean For Markets), an increasing wave of disasters may mean the repeated costs of rebuilding start to outweigh the boost to growth. That could lead to a change to the muted way markets have historically reacted to disasters. An above average Atlantic hurricane season is predicted for 2018 by the first of the major forecasters (Tropical Storm Risk Consortium of the University College London) to provide an outlook.
Whether or not these particular surprises come to pass, a new year almost always brings surprises of one form or another. Having a well-balanced, diversified portfolio and being prepared with a plan in the event of an unexpected outcome is a key to successful investing.