A US recession, the return of inflation and concern that tapering might not go ahead are among the main challenges for investors to be aware of in 2018, according to Mid Wynd International Investment Trust’s Simon Edelsten. 
The manager of the four FE Crown-rated trust said 2017 has been a positive year for global equities and while he expects it to be so again in 2018, there are issues that may arise.
“The consensus is that conditions in the global economy next year will be remarkably similar to those that prevail today,” he said, a backdrop which have seen the MSCI AC World benchmark rise 13.17 per cent in 2017.
Performance of index over YTD
Source: FE Analytics
Below, the manager looks at five scenarios that could impact markets, though it should be noted that these are not predictions, merely “thought experiments”.
The first is the potential for a US recession – something that many have been predicting for some years as valuations have risen.
However, the market has continued to dumbfound detractors, grinding to new record highs throughout the year.
“Many point out that a flat yield curve often acts as an early signal of recession and the bond market in the US is currently fairly flat with three-year yields at 1.9 per cent and 10-year yields below 2.4 per cent,” Edelsten (pictured) said.
“When we talk to American banks, they tell us that companies are seldom interested in borrowing money for the long term and instead generally focus on short-term costs such as IT and automation.”
Therefore, he said the flat yield curve could be due to short-term thinking by companies, rather than the threat of a recession.
“While that could be seen as arguing that it ‘will be different this time’, things do seem different, despite the shape of the yield curve,” he added.
“Economic indicators not only show no sign of a slowdown, but actually point to an acceleration in the global economy with the OECD’s indicators of industrial and consumer confidence at their highest since 2000.”
Still, the flat yield curve in the US maybe something for investors to keep an eye on in 2018, particularly if growth begins to slow down.
Sticking with equities, another challenge is the potential for a tech bubble, as internet stocks that have grown revenues by 50 per cent this year are expected to do so again in 2018.
“History tells us that growth at that pace never continues forever. Furthermore, valuations in some stocks are now higher than when these shares were younger and so had more of their growth ahead of them,” he said.
The FANGs (Facebook, Amazon, Netflix and Google) and their Chinese counterparts were in the vanguard of 2017’s global equity boom yet there remain other interesting themes as well.
“Diverse areas such as healthcare and tourism contributed to the overall real return from our portfolios,” he said.
Indeed, while the MSCI AC World Information Technology sector shot the lights out, returning 30.74 per cent in 2017 so far, the MSCI AC World Health Care index has returned a not-to-be-sniffed-at 11.19 per cent.
Performance of indices over YTD
Source: FE Analytics
“More recently, out-of-favour sectors such as emerging market stocks have seen conditions improving. Therefore, despite the heat in some high-profile segments of the market, growth seems broadly based and covers a range of modestly valued sectors,” Edelsten said.
The third issue investors should be aware of is the potential for higher inflation, which has been muted on a global basis this year despite picking up more significantly in the UK.
“High growth often leads to inflation but Janet Yellen’s speech on vacating the chair of the Federal Reserve reflected on the enigma of persistently low inflation,” the manager said.
“Keynesian theory discusses inflation in the context of capacity: scarcity of labour allows inflationary wage demands; scarcity of goods leads to increased prices.
“On the second of these, it is hard to think of a hard commodity whose supply is particularly constrained though wage inflation has been rising a little in the US.”
In Japan, an historically inflation-free country, delivery company Yamato Transport took out a full-page advertisement in a national newspaper to apologise for raising its prices.
Japanese companies are reporting labour shortages, which in theory should create wage inflation, though offsetting this are changes in retirement arrangements, the rise of flexible working and the ability to contract services globally, which may have combined to increase the marginal supply of labour.
“All the same, the return of inflation is always on our minds as the great historic threat to our investors’ real wealth; and we try to hold a balance of investments which cope well with modestly inflation,” Edelsten said.
Fourth is the worry that the reverse of record-low interest rates and unprecedented quantitative easing measures does not come through – the opposite fear to many in the market that central banks reverse too quickly.
From 2017 to 2018, central banks shifted from accumulating huge quantities of government bonds towards a policy of allowing their stockpile to decline slowly. As the bonds they hold mature, they can choose to roll the proceeds into new bonds, or take the cash.
“This is expected to take place most vigorously in the US, where the Fed holds around $4trn worth, similar to the figure held by the ECB and by the Bank of Japan,” the manager said.
“Where the Fed leads, the other banks should be expected to follow – otherwise traders would simply borrow in one territory and leave ever-larger amounts on deposit in territories where yields are higher.”
‘Tapering’ involves taking the cash as bonds mature but economic history doesn’t give precedents for what turning these quantities of bonds into cash might mean.
While ‘classic economic theory’ would suggest this to be inflationary, no-one really knows and this is a big experiment for the markets as we head into 2018.
The final area to keep an eye on is within the emerging market space, where India could be set for a boom period following economic reforms by prime minister Narendra Modi.
While 2017 saw China growing steadily and consistently, defying the doomsters, now that wages have risen substantially, the focus is shifting to raising productivity and reducing pollution – issues that are typical of a developed economy, Edelsten said.
“The rate of change in India, however, is more compelling. In just three years, prime minister Modi has simplified the tax system, cleaned up the paper currency, part-refinanced state banks and expanded the role of electronic payments,” he added.
“He [Modi] has invested in sanitation, electrification and the gas and road networks and now seems likely to be re-elected with a stronger mandate.”
This is at a time when the population of India is on the rise, expected to surpass that of emerging market behemoth China this century.
“Many of the companies we hold as investments have seen excellent growth in demand from China, but we may now be looking for more companies that have positioned themselves well in India, a more closed economy,” he said.
Edelsten has run the £160m Mid Wynd International Investment Trust alongside Alex Illingworth and Rosanna Burcheri since it moved from Baillie Gifford to Artemis in 2014.
Since taking over, the trust has returned 88.95 per cent, beating the IT Global sector average peer’s 69.51 per cent and the MSCI AC World benchmark’s 66.08 per cent.
Performance of fund vs sector and benchmark since managers start
Source: FE Analytics
“This year was yet another year of strong real returns for our investors yet in general the valuation multiples of our holdings have not risen as their share price gains have been underwritten by rising cashflows,” the manager said.
“The notable exception – technology – has become rather more highly valued and we have taken some profits here. We have also brought balance to our portfolios by owning some financial companies, which will be beneficiaries of higher interest rates.”
The trust is 3 per cent geared and its shares are on a 2 per cent premium to net asset value, according to the latest data from the AIC. It has a yield of 1 per cent and an ongoing charge of 0.67 per cent.