As 2017 has progressed, investors have increasingly built consensus around the view that we are in a “Goldilocks” environment. 
Put simply, this means that economic conditions are neither “too hot” nor “too cold” to undermine global economic growth or force central banks to accelerate the pace of policy tightening. As a result, equities have been able to rise substantially without a sustained rise in bond yields.
The low volatility in equity markets has been striking. We are in the midst of one of only three periods (along with 1949-50 and 1935-36) when the US market has delivered positive returns in twelve successive months. In the past, the S&P 500 index has never generated positive performance for each of the first ten months of a calendar year. At the moment, this is also the longest period without a 5 per cent correction in US equities for over 20 years.
Clearly, the “Goldilocks” environment has been unusually positive for equities and emerging markets have been a prime beneficiary, rising more than 25 per cent so far in 2017. The pricing conditions were fostered by coordinated central bank stimulus in response to the crisis period of 2015-16.
Stimulative policy has remained in place in 2017 as inflation data has been surprisingly weak in key developed markets. The result has been synchronised economic growth and a weaker US dollar, which are very supportive conditions for emerging market performance.
Despite the strong economic growth and positive returns from emerging markets, small caps have significantly underperformed.
The market has been led higher by large-cap technology stocks such as Alibaba, Tencent and Samsung. These stocks have benefited from investors’ appetite for growth stocks and their large index weightings mean they have been further supported by ETF flows into emerging markets.
Entering 2018, the main question is the sustainability of current market conditions. Key central banks have surprised markets this autumn with reasonably hawkish statements.
Interest rates are now rising in the US, UK and Canada, and the European Central Bank is tapering its asset purchase programme.
The US economy is leading this economic cycle and low levels of unemployment are at levels historically associated with a pick-up in inflation.
Should inflation materially improve in 2018, we expect investors to price more aggressive hikes in interest rates, leading to a stronger US dollar. This would represent a profound change in pricing conditions that we would expect to have a substantial impact on emerging market equities.
A stronger US dollar may initially weaken flows into emerging markets due to its impact on debt servicing and terms of trade. We believe that investors will need to be much more discriminating with their exposure in 2018 and we are focusing on countries that can benefit from structural reforms.
India remains an attractive long-term investment and we believe that the Ocean Dial Gateway to India Fund is well positioned to capitalise on the country’s prospects. We also believe that small caps can start to outperform if global economic growth stays strong, as we expect.
Within Asia, we are emphasising funds with a higher exposure to smaller companies, such as Waverton South East Asia Fund.
One of the key risks to global equities is central bank policy error. This is heightened by a change of leadership within the Federal Reserve. Should the central bank hike rates too fast, it could derail economic growth and undermine stock markets. Emerging markets would be especially vulnerable in this scenario and so we are closely monitoring developments in US monetary policy.
Anthony McDonald is a senior investment analyst at City Financial. The views expressed above are his own and should not be taken as investment advice.