The media is now awash with predictions for markets in 2018 from economists, strategists and fund managers. Whilst many are thoughtful, there are just as many that are generated by thought bubbles or influenced by commission arrangements.
Our approach is to present our view of the future from a solid analysis of the present. There is no better way to capture this context than through the charts that are presented by the Reserve Bank of Australia – most recently updated in early January. These charts don’t make predictions, but they do give us a factual snapshot of the present and present trends, both recent and longer, which are worthy of analysis.
The World Economy
Let’s begin with the world economic environment and highlight some critical influences for 2018.
The IMF has helped us with our thought process by estimating that the Trump tax cuts in the US will lift projected world growth by about 0.25% in each of the next two years.

Figure 1. World GDP (annual % change)
Source. IMF
The setting of cash rates by Central Banks remains a critical factor for markets in 2018. Whilst the US Federal Reserve (Fed) has moved rates higher from 2016, it is at a snail’s pace compared to past cycles. Meanwhile, the European and Japanese Central Banks are continuing to hold cash rates below zero and are therefore checking the pace of likely adjustment by the Fed. The RBA is also caught with cash rates set at 1.5%. We believe the RBA is unlikely to move without a lead from offshore central banks.

Figure 2. Policy interest rates
Source. Central Banks
Low cash rates do influence – but they do not dictate – the outlook for longer term bond yields. Of more significance is the monetary policy – particularly QE programs – set by central banks. While the Fed is decreasing its rate of purchasing of US government bonds in 2018, there is no such suggestion from European or Japanese central banks.
While increases in US bond yields are expected in 2018 (lower bond prices), these increases across the rate curve will be met by capital fleeing the oppressively low yields in Europe and Japan.  The Australian bond market will respond at a similar pace to the US bond market and therefore bonds will remain relatively weak and a poor performing asset class in 2018.

Figure 3. 10-year Government Bond Yields
Source. Thomson Reuters
Central bankers claim to be setting monetary policy based on their notional targets for inflation – currently at about 2% per annum. The chart below confirms that inflation has reappeared and deflationary risks have abated. Today, there is no logical reason to hold cash rates below zero, with GDP growth and inflation appearing. However, that is where we expect cash rates will stay until inflation sits for many months above 2% across the world.

Figure 4. Headline Inflation – Advanced Economies
Source. RBA; Thomson Reuters
Sustained low interest rates and negative real yields (below inflation rates) are supportive of economic growth across the world. Thus, synchronised growth is occurring across developed and developing economies. The outlook is for more of the same in 2018 with no aggressive monetary policy adjustments likely to be adopted.

Figure 5. GDP Growth – World
Source. ABS; CEIC Data; RBA; Thomson Reuters
The outlook for inflation remains benign, with energy prices remaining relatively weak and wages growth muted. The costs of production and distribution remain under control. Indeed, as world trade becomes freer (ex the US) with trade barriers coming down, it is hard to imagine a significant spike in inflation. In Europe, unemployment remains high (even though it has declined significantly over the last 4 years) and this ensures that there is little chance of a labour cost blow out.

Figure 6. Labour Markets – Advanced Economies
Source. ECB; Eurostat; RBA; Thomson Reuters
Then we have the enduring influence of both Chinese economic growth and the maintenance of a relatively weak Chinese currency in the face of dynamic economic growth and burgeoning trade surpluses with the world. The IMF has maintained its growth projections of 6.5% per annum average for China in 2018 and 2019. In USD terms, China’s growth is twice that of the Euro Zone, even though the latter is 25% bigger.

Figure 7. Overview of World Economic Outlook Projections
Source. Thomson Reuters
The Chinese currency continues to track the USD and while there has been a slight revaluation of the Renminbi since President Trump’s election, the Chinese are benefiting from the recent devaluation against the euro, yen and $A. A weak Renminbi represents further downward pressure on world inflation.

Figure 8. Chinese Renminbi
Source. BIS; Bloomberg; RBA

The Australian Economy

The latest national accounts show that the Australian economy remains fairly solid (not strong) in the face of declining mining investment and slowing residential construction. The chart below shows that government expenditure (public demand) remains a substantial support for growth. It also shows that the surge in commodity prices and export volumes in 2017 has been offset by large increases in imports. In our view, the recent revaluation of the $A is the result of sharp weakness in the USD driven by political leadership issues rather than economic factors. While currency forecasting has suddenly become more difficult, we suspect that the $A will see 75 US cents again in 2018.

Figure 9. Contributions to GDP Growth
Source. ABS; RBA
An analysis of the state breakups below shows that a slight slowing in SE Australian growth (residential investment) has been partially offset by the recovery that has commenced in WA. We believe that in time, this recovery will result in an improvement in WA property prices and reward investors that made counter-cyclical purchases when the WA economy plummeted following the resources boom.

Figure 10. State Final Demand, year-ended growth
Source. ABS; RBA
Like the rest of the developed world, Australian consumer price inflation is tracking at historic low levels of circa 2%.

Figure 11. Consumer Price Inflation
Source. ABS; RBA
This supports our contention that the RBA does not need to act independently of overseas central banks and lift cash rates anytime soon.

Figure 12. Australian Cash Rate
Source. RBA
Low cash rates support the Australian household sector to pay down debt. The following chart shows that historic low interest rates have not stimulated consumption. Rather they have seen a reduction in the net savings ratio and therefore a push to repay high mortgage debt.

Figure 13. Household Income and Consumption
Source. ABS; RBA
However, the average Australian household has never been wealthier with the value of property and financial assets lifting at a much faster rate than debt over the last eight years.

Figure 14. Household Wealth and Liabilities
Source. ABS; RBA
While wealth is a positive influence, there is a discernible negative influence over weak consumption activity caused by low wages growth. Since 2012, Australia has endured the lowest level of sustained wages growth recorded in the last twenty-five years.

Figure 15. Unit Labour Costs Growth, non-farm, year-ended
Source. ABS; RBA
It is our view that a reasonable level of wages growth will occur in 2018. The following table highlights the dramatic lift in employment in Australia. However, the growth is focused within the “household services” segment, suggesting services jobs incorporating tourism, aged care, healthcare, entertainment and catering (restaurants and cafes). In addition, there has been a solid lift in construction jobs offsetting the decline in mining.

Figure 16. Employment Growth by Industry, since February 2012
Source. ABS
Record production and export volumes of iron ore continue to have a positive influence on Australia’s export performance and economic growth. The projected growth in China by the IMF suggests that demand for basic materials will be maintained in China and therefore iron ore prices will be dictated by supply (appearing in abundance across the world).

Figure 17. Bulk Commodity Exports, quarterly
Source. ABS; RBA
Household wealth creation, government expenditure growth and favourable export markets ensure reasonable business conditions. Of course, low interest rates remain a positive influence for reported company profits. Company leverage remains moderate and the low cost of debt has played a large part in driving profit growth. This will continue through 2018.

Figure 18. Business Finances
Source. ABS; APRA; RBA
While Australian company profits will continue to grow in 2018, the bulk of this will come from commodity or resources companies. Overall, the earnings per share of the Australian market is forecast to grow this year (about 6% above 2017) – but it is still marginally below the market EPS of 2006/07. Australian companies continue to generate poor returns on capital and the Australian equity market has limited upside without a surge in equity asset speculation across the world.

Figure 19. Forecast Earnings per Share, MSCI Australia
Source. Thomson Reuters
This is most clearly shown by the major banks which represent 30% of the Australian share market. The final chart shows that while Australian banks remain highly profitable, we believe they will continue to struggle to grow both earnings and EPS at the same rate as the broader market.

Figure 20. Australian Bank Profits
Source. APRA; RBA
Our banks remain well capitalised under sustained supervisory pressure from APRA. The capital buffer that has been built up over the past few years provides a safety cushion in the case of a mortgage market downturn. However, the increased capital dilutes earnings per share growth as return on equity continues to drift lower.

Figure 21. Capital Ratios, consolidated global operations of locally incorporated ADIs
Source. APRA
While global equity markets are excessively buoyant at present, we do acknowledge that world economic growth will be sustained by continued supportive monetary settings. This remains the basis for our view that positive returns from equities and property assets should occur in 2018. It may not be quite as exuberant as 2017, and it is likely to be more volatile than 2017, but the economic support is simply too great at present to ignore.
That is not to say that we are happy to close our eyes and follow momentum; we will not blindly buy excessively priced shares unless they exhibit high-quality characteristics. In our view, high quality is in more abundance in US equity markets than it is in Australia.
So, the dilemma continues for investors. Economies are growing and freer trade with a very low cost of debt ensures economic activity should sustain itself in 2018 (and indeed 2019). However, there continues to be an excessive level of monetary support underpinning the world’s growth; and while it must end, there is no likelihood that 2018 will see it happen. Indeed, markets are driven by foreseeable events and the likelihood of monetary policy unwinding in Japan and Europe in 2019 is still an unlikely scenario.
At Clime, we remain alert to the risks of the unwinding of support for asset markets. From an asset preservation perspective, we will endeavour to be early and not late if the outlook outlined above changes.