The global economy is on a stronger footing and we see that it will continue to be supported by a combination of strong growth and low inflation in 2018. While structural factors such as the impact of technology remains important, cyclical forces suggest that inflation will begin to catch up with the strength of economic activity in 2018.

Our macro settings point to a reflationary environment driven by a global trade boom that results in a stronger growth and inflation as the upswing pushes commodity prices higher. Also, with the US fiscal reflation, the country experiences a fiscal boost, incorporating deeper tax cuts and increased infrastructure spending, driving inflation higher, which is concentrated in the US.

While the global economy is anticipated to continue its growth path unabated in 2018 with central banks set to normalise their monetary policies, room for volatility, driven by short-term interest rate movements cannot be ruled out. Hence, while hoping for a relatively smooth year of positive returns in the financial markets, it is essential to take into consideration potential upsets that could arise from macro data failing to meet expectations, unexpected policy changes, political noises and geopolitical tensions.

We expect upwards pressure on long-term government bond yields of between 5 and 45 basis points depending on the country, while we foresee opportunities in equity markets supported by the economic cycle that has more room to run. This means earnings visibility, which had underpinned the equity market returns in 2017, should continue in 2018, provided earnings growth maintains the momentum with focus on online, innovation, technology and energy sectors. As for the movement of currencies, the key drivers will depend on local factors.

A. Global economy is on a stronger footing

• We see the combination of strong growth and low inflation will continue in 2018. While structural factors such as the impact of technology remains important, cyclical forces suggest that inflation will begin to catch up with the strength of economic activity in 2018.

• Global growth is across the board and not just being a US-centric growth. Advanced economies are now in a “sweet spot”, with the outlook on developing Asia and emerging markets positive. We project a global growth of 3.6% in 2018 from 3.4% in 2017, the fastest since 2011. (See Table 1)

• For advanced economies, our 2018 US GDP outlook is 2.5% while the euro region’s GDP is 2.3% and Japan 1.8%. Meanwhile, developing Asia is poised to grow by 4.9% in 2018 with the Chinese GDP at 6.4% and India at 7.0%. We project Malaysia’s GDP at 5.5% in 2018. (See Table 1)

• Our macro settings point to a reflationary environment driven by a global trade boom that results in a stronger growth and inflation as the upswing pushes commodity prices higher. Also, with the US fiscal reflation, the country experiences a fiscal boost, incorporating deeper tax cuts and increased infrastructure spending, driving inflation higher, which is concentrated in the US.

• A firmer inflation outlook in 2018 reinforced by stable oil and commodity prices as reflected by the pick-up in producer price inflation around the world supports a further tightening of monetary policy. The US Federal Reserve (Fed), with its fiscal policy providing an extra boost to growth, should see three rate hikes in 2018 to 2.25% and one or two rate hikes in 2019 to 2.50% – 2.75% from 1.5% in 2017.

• Elsewhere, the European Central Bank (ECB) and Bank of Japan (BoJ) are moving their respective monetary policies towards a tighter direction. The ECB should end its quantitative easing (QE) in September 2018 and institute a rate hike in 2019. The BoJ will continue the yield curve control (YCC) and we can expect the BoJ to raise the 10-year government bond yield target. It will be a turning point towards a tighter policy.

• Meanwhile, rate tightening is envisaged in many economies in Asian ex-Japan (AxJ) including Malaysia. We anticipate Bank Negara will likely raise rate 1-2 times in 2018 by 25 basis points from the current 3.00% overnight policy rate (OPR). The OPR is poised to normalise at 3.50%.

B. Short-term volatility still in the picture

• While the global economy is anticipated to continue its growth path in 2018 with central banks set to normalise their monetary policies, room for volatility driven by the short-term interest rate movements cannot be ruled out.

• Hence, while hoping for a relatively smooth year of positive returns in the financial markets, it is essential to take into consideration potential upsets that could arise from macro data failing to meet expectations, unexpected policy changes, political noises and geopolitical tensions.

• Asymmetry or unanticipated shocks could come from the central banks as they navigate towards a new global liquidity pattern. A runaway inflation scare will send interest rate expectation significantly high. Adverse surprises from below expectation macro data could result in a sharp spike in the Volatility Index which is extremely low now, suggesting strong complacency amongst the investors.

• A deflationary environment is still possible, though the probability is low. It can happen if the current cyclical upswing eases and the global growth weakens due to the overshooting of the US Fed in its tightening monetary policy, euro running out of ammunition, China debt crisis, deteriorating demographics and geopolitical risks. A sharp tightening of the financial conditions can add upwards pressure on bond yields which can lead to a deflationary environment.

• We should also take into account that markets have had a strong couple of years and valuations are tight. At the same time, risks abound. Geopolitical risks including North Korea, terrorism, Brexit and unpredictable political developments in Europe and the US make for an uncomfortable investing environment.

C. Improving global fundamentals to support Asian local bonds

• With the central banks set to normalise their monetary policies, we may see volatility driven by the short-term interest rate movements. Hence, investors in fixed income will need to look beyond beta to meet their return requirements. It is becoming imperative to yield higher returns from fixed income portfolios via asset allocation or security selection, while managing the risks ahead.

• Improving global fundamentals will continue to support investment flows into Asian local bonds. It should favour countries with strong fundamentals and room for growth potential. We like markets with positive fundamentals and reform momentum like India.

• Despite a narrowing of liquidity surplus going forward, the pricing-in of incremental rate hikes by the US Fed and an absence of policy cut by the Reserve Bank of India can add upwards pressure on the 10-year government bond yields by 10-15 basis points in 2018. (See Table 2)

• Positive cyclical outlook for China is supportive of growth despite the US trade protectionism being a risk. China central bank’s monetary policy will continue to be neutral with a tightening bias although its fiscal policy will remain supportive with the launch of multiple large-scale infrastructure projects. While the risk of a debt-inspired collapse on the economy is there, chances of it happening is unlikely. We feel the rise in yields does provide opportunities to add long-term bonds. The Chinese bond market tends to deliver high nominal and real income, and benefit from stronger global growth and capital expenditure. Also, we expect the RMB to remain stable against the USD. 10-year government bond yields should gain around 5–10 basis points in 2018. (See Table 2)

• Indonesia and Malaysia are expected to ride on the stronger global growth and commodity-sensitive and long-term valuations with some caution on the domestic noises.

• For Malaysia, we expect the local bond yields to hold up to the pressure of US Fed rate hikes, more so with BNM’s hawkish tone. We feel the current MGS levels have already partially priced in a potential rate hike for the long-end of the yield curve. As for the short-end of the yield curve, we anticipate investors to eventually account for the probabilities in. A positive GDP growth outlook, improving business sentiment, supportive government policies and regulations and the firmer ringgit would continue to drive the demand for local bonds, moderating the potential rise in yields with some concern on the coming GE14. We project the 10-year MGS yields to rise around 10 basis points in 2018. (See Table 2)

• Meanwhile, the demand for Malaysian government securities (MGS) that are long-dated will remain resilient, supported by players like pension funds and insurers. Gross issuance of MGS and Government Investment Issue (GII) in the 11 months of 2017 is at RM102.4bil while the corporate side gross issuance is RM111.2bil and corporate bond issuance at RM190.1bil at end-November, all surpassing expectations of RM100bil-RM110bil for 2017 MGS and GII bonds and RM105bil-RM115bil for corporate bonds. With several infrastructure projects expected to kick off in 2018 as announced in Budget 2018 where the funding requirements are up to RM1.0 trillion, we expect a large proportion of this to be funded via the bond markets over the next few years. (See Table 3)

• In the US, with the expectations of gradual adjustment in the monetary policy, yield hunting will remain strong. Treasury Inflation-Protected Securities (TIPS) will remain attractive for the long run due to cheap valuations amid a more stable oil price and a still below target inflation. In our view, a key factor that will influence the 2018 long-term yields will be the number of short-term interest rate hikes envisaged over a longer period. Much will also depend on the fiscal policy i.e. deficit-fuelled programmes that raise the Treasury supply which is currently being envisaged to be broadly funded with short-maturity Treasuries rather than long-maturity bonds. We project the long-term rates to gain around 15-20 basis points in 2018. (See Table 2)

• As for the Euro region, it is now more self-sustained with a broad-based growth driven by domestic and external demand. Politics will likely remain on the forefront, with Italian elections slated for no later than May 2018. Also, the Germans are risking another election. Since we are not expecting any rate hike before 2019, the government bonds will continue to move sideways for most of 2018. We foresee long-term government bond yields to rise by 40-45 basis points in 2018. Alternatives to core government bonds such as corporate debt, high-yield, and European periphery bonds should remain well supported. (See Table 2)

D. Opportunities in equity markets

• The synchronized global expansion in 2017 is poised to continue unimpeded in 2018 supported by broader-based growth. It suggests to us that the economic cycle has more room to run. This means the trend of positive economic and earnings visibility which supported the equity market returns in 2017 should continue in 2018, provided earnings growth maintains momentum.

• In this environment of modestly rising interest rates and fuller valuations, opportunities exist for stock markets to lead global equities in 2018. The economic risk is seen more favourable to equities supported by rising profitability that will boost returns over credit given tight spreads, low yields and a maturing cycle.

• Earnings in the US have recovered strongly and are now higher than their prior peaks. Still, earnings momentum is poised to stay strong in 2018 supported by the corporate tax cuts that could provide an extra leg up for earnings. The focus should be on momentum and value factors, financials, technology, and dividend players.

• In the case of Europe, sustained above-trend economic expansion with steady earnings outlook will support cyclicals. Corporate results will remain the centre of attention.

• For Japan, the drivers are improving global growth, more shareholder-friendly corporate behaviour and solid earnings on the back of a stable yen outlook. While the BoJ policy and domestic investor buying are seen as supportive, the concern will be on a stronger yen.

• Looking at Asia ex-Japan (AxJ), drivers will be economic reforms, improving corporate fundamentals, valuations and better-than-expected growth in the developed world. But the risks include a sharp rise in the US dollar, trade tensions and elections. India, China and selected Asean markets like Malaysia would benefit in 2018. The key concern is that a faster-than-expected Chinese slowdown would pose risks to the entire region.

• Malaysia’s equity market is expected to stay strong in 2018 supported by a strong flow of deals, healthy GDP outlook, firmer commodity prices and a stronger ringgit against the USD. Initial public offerings (IPO) are poised to come from energy, infrastructure, financial services and consumer sectors. In 2018, one can expect several significant IPOs including Bank Islam, Edra Global Energy and potentially, foreign insurers in Malaysia. (See Table 3)

• Besides in Malaysia, capital is expected to be raised through equity placements and right issues as the equity market continues to gain momentum. Furthermore, growth will come strongly from the mid-corporate segment. Adverse noises from geopolitical risks and the upcoming general election will be temporary.

• In the meantime, the Malaysian debt market will remain positive given the various funding requirements for infrastructure projects that are due to be rolled out. It will be financed through the debt capital market, sukuk issuances, or project financing and loan syndication. Corporate bond issuance should be around RM90bil – RM100bil in 2018.

• Also, in 2018 one can witness corporates looking to strengthen their core businesses. Hence, there is room for acquisitions in similar businesses or divestment of activities deemed non-core. Opportunities are expected to come from across all sectors but in particular will be consumer (food and beverage), real estate, banking and insurance, construction and infrastructure, oil & gas industry and e-commerce sectors. There could be an increase in M&A interest in the SME space. (See Table 4)

E. Online, innovation, technology and energy are key sectors going forward

• One of the key sector focus will be on the “online” disruption. Strong growth in social media and online platforms has come at the expense of growth in other industries. It has become a threat to players in the retail, traditional banking, distribution and media space. Apart from compressing earnings, the new technology is expected to further disrupt traditional businesses, forcing the latter to forgo near-term profits to innovate and stay competitive, failing which they will be swept away.

• Hence, innovation will be our focus. For companies to ensure sustainable growth over the long term, they need to focus on innovation. Those who innovate successfully will be in a better position to take advantage of the changes and will be rewarded by investors. Hence, the focus should be on companies that are well-managed with a culture of supporting ongoing innovation, performance and accountability irrespective of the economic cycle. As such, the emphasis should be on a global basis given that in a globalised world, there are always opportunities at the company level rather than region or sector.

• The technology sector has been a star performer in 2017. We believe the development and adoption of new technologies is changing the business model for nearly every industry, from retail to energy production. This sector is eating many sectors in a significant manner and has long-term growth opportunities. Although valuations are not cheap, the sector is expected to generate stable and sustained earnings growth.

• Finally, transformation in the energy and automotive industries going forward. The combination of competitive renewable energy, better battery storage costs and growing electrically-powered vehicles is appearing to forge a viable path towards de-carbonisation of energy and transportation. Although the transition is not expected to be linear, it will be good to avoid the losers and search for winners.

F. Local factors will be key drivers of currencies

• The positive global GDP outlook in 2018 implies that prospects for a pickup in investment are getting brighter despite some levels of pronounced risk. Looking at the currency markets, we believe local factors will be key drivers in 2018. In particular, the centre of focus will be around investment as business confidence, corporate profitability, manufacturing performance and capex are on the rise, providing a better feel of the business cycle and investment trend.

• The direction of the EUR/USD in 2018 will likely be dominated by normalization of the conventional policy with the ECB expected to end QE by September 2018, and the timing of interest rate hikes to start in 2019 by 25-50 basis points.

• The GBP/USD will very much depend on the outcome of the Brexit negotiations apart from the potential incoming macro data and the direction of the monetary policy. (See Table 5)

• The JPY will be influenced by yield spreads against the USD where the Fed is poised to raise rates three times in 2018. It will add some downwards pressure on the yen besides expecting the BOJ to maintain its current accommodative monetary policy that should see continuous capital outflow. However, the risk aversion momentum should mitigate the downside risk. (See Table 5)

• Looking at the yuan, while the concern is on the debt level of the corporate sector, the ongoing reforms to ensure stable growth plus measures to curb shadow banking should bode well for the Chinese yuan and it may strengthen slightly against the USD in 2018. (See Table 5)

• In the case of the MYR, improving macro fundamentals and fiscal position, healthy consumer and business sentiments, improving fiscal position plus an extremely low default risk, a potential normalisation of the policy rate paves the way for the currency to further catch up in 2018. Besides, with an undervalued MYR – our fundamental analysis shows a fair value of 3.95 while the real effective exchange rate presents a fair value of 3.76 – implies there is still plenty of room for this laggard currency to gain momentum. (See Table 6)

Source: AmInvest Research - 3 Jan 2018