Financial markets began the year on a positive note, with stocks rising on the back of improving US and European economic data, talk of US tax cuts, and expectations stubbornly low inflation will see the US Federal Reserve (Fed) maintain a gradual approach to raising interest rates. Sentiment was further buoyed by stronger commodity prices, news Angela Merkel had secured a fourth term as German Chancellor and some encouraging earnings results from the likes of Netflix, Facebook and Apple; all of which exceeded analysts’ expectations. Stocks also benefited from better-than-expected Chinese growth and general optimism regarding the global growth outlook.

Limiting the early gains were ongoing tensions between the US and North Korea, and the Fed’s decision to begin unwinding its massive, post-global financial crisis balance sheet. Sentiment was also impacted by speculation the Bank of England would soon raise interest rates, Donald Trump’s failure to push through his healthcare reform bill and the decision by a number of business leaders to quit his advisory groups in protest following his controversial response to racial violence in Charlottesville, Virginia.

The positive momentum we saw in the early part of the period continued into October and November thanks to yet another round of positive US earnings results, improving US, European and Chinese economic data and further gains in commodity prices. Stocks also benefited from news Congress had finally approved Trump’s much-anticipated tax plan, Shinzo Abe’s resounding election win in Japan and the European Central Bank (ECB)’s decision to wind back its monthly bond purchases; a move seen by investors as a nod to the underlying strength of the region’s economy.

Limiting the gains was still-low inflation in the US, renewed political uncertainty in Europe—this time in Germany and Italy—and claims by North Korea that it was in possession of an intercontinental ballistic missile that put the US mainland firmly in range of its nuclear weapons.

The second half of the year began well, with stocks rising in January as investors responded positively to more encouraging US earnings results and further evidence economic activity globally was gathering momentum.

However, share markets moved sharply lower in early February as US bond yields shot to a four-year high following the release of stronger-than-expected wages data; the surprising outcome sparking fears the Fed may accelerate its rate hike agenda. Helping accentuate the decline was a rapid unwinding of so-called ‘short volatility’ trades as volatility spiked sharply higher in the wake of the release. Whilst stocks did recover somewhat toward the end of February as investors bet, the selloff was nothing more than an overdue correction following an extended period of gains, this optimism proved to be short-lived after 13 Russian nationals were indicted for allegedly interfering in the 2016 US presidential election. Share markets were also impacted by further US political uncertainty, including Trump’s sacking of his Secretary of State, Rex Tillerson, and the threat of a potential US-China trade war after Trump slapped around USD50 billion in tariffs on Chinese imports.

Markets ended the year positively thanks to yet another round of encouraging US earnings results, improving US jobs data and stronger commodity prices. Sentiment was further buoyed by news the ECB expects to leave interest rates on hold until at least midway through next year, and some encouraging Chinese economic growth; the world’s second-biggest economy expanding 6.8% in the March quarter.

Limiting the late gains were further geopolitical risks, including an escalation in US-China trade tensions, Donald Trump’s decision to quit an international deal with Iran aimed at preventing the country from acquiring nuclear weapons, and a disappointing end to the G7 Summit in Canada. Stocks were further impacted by the Fed’s decision in June to accelerate its rate hike agenda and some softer-than-expected Japanese growth data; the latter’s economy contracting 0.2% in the first quarter and ending a run of eight consecutive quarterly expansions.

Global shares

Global share markets made strong gains over the past 12 months, returning 10.8%1 in local currency terms. In unhedged Australian dollar (AUD) terms, stocks returned 15.4%2. Much of the gains were driven by a combination of still-low global interest rates, improving economic activity globally and general optimism surrounding the global growth outlook.

Stocks also benefited from improving corporate earnings and stronger commodity prices; most notably oil, which jumped 61% over the period. Limiting the gains was ever-present geopolitical uncertainty—much of it stemming from the ongoing political drama that is Donald Trump’s presidency.

At the regional level, stocks in the US (12.2%3), Japan (11.3%4) and the UK (4.4%5) all posted positive returns for the year. In contrast, stocks in Europe (-1.3%6) and China (-4.2%7) were weaker; the latter even falling into a bear market toward the end of the period as trade tensions with the US rose.

Australian shares

The Australian share market also made strong gains over the year, with the S&P/ASX 300 Accumulation Index closing the period 13.2% higher. The local market benefited from a series of positive domestic earnings results, some encouraging local economic data and stronger commodity prices; the latter helping to propel major miners like BHP Billiton and Rio Tinto sharply higher.

Stocks also benefited from further Chinese growth and an uptick in domestic corporate activity, including Unibail-Rodamco’s takeover of Westfield, Tabcorp’s acquisition of rival Tatts Group and Blackstone’s play for Investa Office Fund.

Limiting the gains was persistent geopolitical uncertainty, the Fed’s decision to accelerate its rate hike agenda toward the end of the year and a series of banking scandals that ultimately led to the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.

At the sector level, energy (41.9%), information technology (33.9%) and consumer staples (30.3%) posted the biggest gains over the period. Materials (29.8%) and healthcare (26.6%) were also significantly higher for the year, while telecommunication services (-30.7%) and utilities (-0.6%) were the only sectors to record losses.

In terms of central bank activity, the Reserve Bank of Australia (RBA) left the official cash rate unchanged at a record low 1.50% throughout the period. In its latest post-meeting statement, the central bank said it expects growth to average a bit above 3.0% this year and next, employment growth to continue to improve and inflation, which remains below the RBA’s 2-3% target range, to stay low for some time; though a gradual pick-up in inflation is expected as the economy strengthens.

Meanwhile, officials acknowledged wage growth remains low and that a stronger AUD would be expected to result in a slower pick-up in economic activity and inflation than is currently forecast. Household consumption is also a concern, with household incomes growing slowly while debt levels remain high. The RBA concluded its latest meeting by saying that “taking account of the available information, the Board judged that holding the stance of monetary policy unchanged… would be consistent with sustainable growth in the economy and achieving the inflation target over time.”

Recent softer wages and inflation data, falling house prices and a moderation of RBA language have seen market expectations for any Australian rate hike in 2018 evaporate. However, we note that the Fed is still in a clear tightening phase and that inflation is strengthening once again around the world. We believe the RBA’s next move will be a rate rise.

Real estate investment trusts

Australian real estate investment trusts performed well over the past 12 months, closing the period up 13.2%8. Contributing to the gains were relatively flat bond yields, several high profile corporate deals, including Unibail-Rodamco’s takeover of Westfield and Blackstone’s bid for Investa Office Fund, and the general optimism surrounding the domestic and global growth outlooks.

Property stocks also benefited from their traditionally defensive characteristics in the face of ongoing geopolitical uncertainty and expectations the RBA is unlikely to raise interest rates any time soon.

Global REITs (6.4%9) underperformed their Australian counterparts over the year. Global REITs continued to be well supported by improving economic activity in the US and Europe, relatively low interest rates globally and the sector’s traditionally defensive characteristics. Limiting the gains was the Fed’s decision late in the period to accelerate its rate hike agenda.

Bonds and cash

International bonds made only modest gains for the year, returning 1.9%10. Major long-term global bond yields were mixed over the period; rising in the US on a combination of improving economic growth and further Fed rate hikes, while mostly falling in Europe and Japan. Yields in the UK were relatively flat. Australian bonds outperformed their global counterparts over the year, rising 3.1%11.

The yield on Australian 10-year government debt rose just three basis points over the past 12 months as improving domestic growth was offset by heightened geopolitical risks and expectations stubbornly low inflation will see local interest rates remain lower for longer. Meanwhile, both global and Australian credit markets were stronger for the year as spreads narrowed in line with improving risk appetites. In saying that, spreads did widen toward the end of the year as geopolitical risks intensified.

Cash returned 1.8%12 over the past 12 months, underperforming all the other major asset classes.

Australian dollar

The AUD ended the year lower, thanks in part to several Fed rate hikes, heightened geopolitical risks and expectations still-soft inflation and wages data will force the RBA to keep interest rates on hold for longer. The currency was also impacted by the yield differential between Australian and US government bonds turning negative for the first time since June 2000. Limiting the decline were stronger commodity prices, encouraging domestic earnings results and some upbeat rhetoric from RBA officials regarding the domestic growth outlook. The AUD also benefited from stable Chinese growth and improving economic activity globally.

The AUD fell 5.7% against the euro, 5.0% against the Japanese yen, 4.7% against the British pound and 3.9% against the US dollar (USD). Meanwhile, the broader Australian Trade-Weighted Index13 closed the period down 4.4%.

Where to from here?

We expect volatility to continue through 2018 as investors contend with US policy agenda, potential further US rate hikes, potential normalisation of monetary policy outside the US and ever-present geopolitical risks.

Relative to the US, we still believe other developed markets represent better value. Despite the slowdown in early 2018, we remain upbeat on the health of European economies; though caution is warranted given rising near-term political risks. Emerging markets assets have weakened recently from a stronger USD, but corporate earnings and economic growth are still resilient. In saying that, geopolitical risks remain along with the threat of tighter US monetary policy and a potential trade war between the US and China. We still believe emerging markets represent superior value relative to their developed peers on a longer time horizon.

Our base case is for the Fed to raise interest rates a total of three to four times in 2018. We feel bonds remain expensive and may face headwinds in the form of potential rising inflation and higher US yields, especially given that the US labour market is tight. Any selloff in bonds could be amplified if the Fed decides to raise rates at a faster pace than expected, and if global central banks shift away from their accommodative monetary policy stances.

We hold an unfavourable view on high-yield debt, as valuations have become stretched given the compression in credit spreads to near-historical lows. Conversely, we favour local currency emerging markets debt, with fundamentals remaining strong.

In terms of currencies, the USD has staged a recovery, driven by interest rate differentials between the US and the rest of the G10. We hold a neutral view on the USD, and believe its recent rebound is technical rather than structural in nature. We continue to hold a preference for the Japanese yen, given the solid economic data flow from Japan, including strong external demand and a tightening labour market. The yen is also attractive from a ‘safe haven’ perspective, as it is the currency most negatively correlated with global equity returns. Meanwhile, the future direction of the AUD is likely to continue to be influenced by movements in commodity prices together with any potential shift in the RBA’s stance on monetary policy.

Overall, we expect global growth to remain modestly positive through 2018, with downside risks of further market selloffs as markets continue to adjust to potentially higher levels of interest rates and changes to monetary and fiscal policy, especially in the US.

1 Global shares measured by the MSCI World ex Australia Net Accumulation Index in LC
2 Global shares measured by the MSCI World ex Australia Net Accumulation Index in AUD
3 US shares measured by the S&P 500 Index
4 Japanese shares measured by the TOPIX Index
5 UK shares measured by the FTSE 100 Index
6 European shares measured by the Dow Jones EuroStoxx 50 Index
7 Chinese shares measured by the Shanghai Shenzhen CSI 300 Index
8 Australian REITs measured by the S&P/ASX 300 Property Accumulation Index
9 Global REITs measured by the FTSE EPRA/NAREIT Developed Real Estate Index Net TRI (hedged to AUD)
10 Global bonds measured by the Barclays Global Aggregate Bond Index (hedged to AUD)
11 Australian bonds measured by the Bloomberg AusBond Composite 0+ Year Index
12Cash measured by the Bloomberg AusBond Bank Bill Index
13 The trade-weighted index for the AUD is an indicator of movements in the average value of the AUD against the currencies of our trading partners.