Our eight themed tips for 2018 have been selected at a time when there are some very contradictory influences at work on markets. All seems good on the economic front, with the world experiencing a rare period of synchronised growth. What’s more, whatever the long-term wisdom of President Trump’s tax cut, the immediate implications for the important US stock market look positive – whether it be a case of companies recycling higher post-tax profits into share buybacks, which seems a likely course based on recent history, or the more economically-virtuous outcome of increased investment in growth. However, it’s somewhat ironic that these buoyant conditions have helped to embolden players in the world’s two largest economies to embark on policies that could cause serious problems for our aged bull market.
In the US the Federal Reserve seems serious about raising rates. The US tax cut will only provide further encouragement. What’s more, while wage inflation has been notable by its absence over recent years, it would be rash to rule out the tight labour market finally delivering stronger wage growth in 2018.
While US investors in 2018 may have cause to reflect on the mantra ‘don’t fight the Fed’, in the world’s second-largest economy, China, it could be said to be a case of ‘don’t prank the People’s Bank’. Having strengthened his grip on power last year, Chinese premier Xi Jinping seems set on slowing the rate of lending growth. While the machinations of monetary tightening are less transparent than the process under way in the US, the intent looks clear. The key worry for watchers of the Fed and People’s Bank of China is that these institutions may have waited too long to act and that dangerous asset bubbles exist here, there and everywhere. The concern is that by buying ‘safe’ bonds at any price, central banks have set an artificially low benchmark against which other assets are now valued as investors have been forced to make ever riskier investments to generate anywhere near decent returns.
Such fears are particularly pertinent for value-orientated investors, especially those looking to the US. Indeed, while the S&P 500’s forward price-earnings (PE) ratio may not look obscenely expensive compared with its history, the picture gets more worrying when one considers that this high valuation is being applied to stocks at a time when corporate profit margins are towards the top of the long-term range. Margins normally revert to mean over an economic cycle, although some noteworthy investors, such as GMO’s Jeremy Grantham, have this year argued that margins may have reached a permanently higher plateau. However, if history repeats, it is worth noting that cyclically adjusted valuation measures, such as the Shiller PE, point to equities being hugely expensive, with only the dot-com boom competing. While tax cuts could provide a boost to post-tax margins, the prospect of wage rises and an increase in the cost of debt are reasons to think operating margins could start to ‘revert to mean’ in 2018.
Meanwhile, signs of overcomplacency, ranging from record low readings of the Vix ‘fear gauge’ index to the behaviour of Bitcoin are also reasons to be circumspect.
Against the backdrop of high valuations internationally, the UK stands out as offering some decent pockets of value. The many resources companies that are listed in the UK are still recovering from the rout that ended the so-called ‘super cycle’. One of these stocks, Ferrexpo (FXPO), is our Recovery Tip of the Year. It not only stands to benefit from a reinvigorated balance sheet and improving cash flows, but the environmental benefits for steel producers from the pellets it produces. International Tip of the Year Atlas Copco (SWD:ATCO) should also benefit from a more robust outlook for the resources sector, given plans to spin out its mining business. Its exposure to global industrial demand means it should also be a beneficiary of the current healthy global economy.
Meanwhile, stocks with a domestic focus have been battered by Brexit-related uncertainty. Often at times of great uncertainty the market veers on the side of excessive pessimism and we hope that will prove to be the case for our Income Tip of the Year Marston’s (MARS). What’s more, cost inflation related to sterling weakness should be less of a factor for stocks such as Marston’s as 2018 progresses because comparisons will increasingly be made against periods affected by the same issue. Growth Tip of the Year JD Sports (JD.) has also seen its shares weaken due to Brexit-related issues. However, overseas growth looks exciting, exclusive product deals with ‘cool’ brands provide a competitive advantage and we think a trend of broker upgrades could be re-established in 2018 and prompt a re-rating.
Contrarian Tip of the Year Babcock International (BAB) has also been brushed with Brexit-related fears. A drop in the half-year order book has sparked concern that government decision making is slowing. What’s more, a significant negative movement in working capital in the first half has set off alarm bells that the group could be set to go the same way as outsourcing peers, such as Serco, Capita, Mitie and Carillion. However, we feel Babcock boasts some key differences. If the group can dispel investors’ concerns in 2018 and meet earnings forecasts then the shares represent exceptional value.
Momentum is a major factor in markets, so our Tips of the Year also try to latch on to some current trends. Our Takeover Tip of the Year, Entertainment One (ETO), attempts to exploit the value major media players are now putting on original content. Meanwhile our Old Reliable Tip of the Year, Relx (REL), embraces the market’s love of tech.
Our Value Tip of the Year, Phoenix Spree Deutschland (PSDL), offers exposure to structural change in the Berlin residential property market that is unlocking significant hidden value. What’s more, the European Central Bank is a monetary-tightening laggard, which means European real estate may face less risks from policy changes.
We hope readers enjoy our tips and find them an interesting source of ideas for the year ahead.
