BofA Merrill Lynch Global Research has issued a bullish macro outlook for 2018, predicting robust global economic growth, steady US expansion and solid stock returns that peak in the first half of the year.
But it warns of signs that the long bull market run is nearing its end, triggering a mid-year pullback alongside potential for some of the best returns in the last gasps of the cycle.
The research team forecasts modest returns in equities and credit, negative bond returns, a stronger dollar, higher levels of volatility and tighter credit spreads in 2018. Inflation is expected to be the big story of the year, particularly in the US, where the labor market is expected to further tighten and inflation pressures are building.
Passage of US tax reform is the main upside risk to economic growth, with far-reaching effects, particularly for emerging markets, that have not been fully priced into the market.
‘Our overall outlook for the year ahead is macro bullish, so much so that we’re ultimately market bearish,’ says Michael Hartnett, head of global investment strategy at BofA Merrill Lynch Global Research, in a statement accompanying the research.
‘Investors are chasing growth and high-yielding assets in a bull market that’s been driven and enabled by central bank liquidity. We see an end to this Icarus trade and an aggressive downgrade of risk assets once profits peak, investor positioning becomes excessively enthusiastic and central banks start withdrawing liquidity as they scale back support.’
According to BofA Merrill Lynch market strategists, building investor optimism this year has been fueled by impressive stock returns and historic low volatility. Next year could be the year of euphoria: sentiment is now a more important driver of the S&P 500 than fundamentals, and sentiment suggests there is still room for stocks to move higher in the near term.
The bull market in the S&P 500 is on a path to become the longest ever on August 22, 2018 and, if equities outperform bonds for a seventh consecutive year, it would be the first time since 1928 and only the third time in the past 220 years. A top target of 2863 is forecast for the S&P 500 early in 2018, with the Nasdaq composite reaching 8000, before an anticipated 10 percent or greater correction, followed by slower growth for the remainder of the year.
‘We have entered the later stage of a long bull market, a phase of positive and improving economic growth that favors strong momentum and growth but also higher risk,’ adds Candace Browning, head of BofA Merrill Lynch Global Research, in the statement.
‘History suggests that some of the best returns can come at the end of bull markets. With valuations and sentiment as high as they are, amid relative economic calm despite political turmoil, we view a pullback in the market next year as an expected norm. And for well-positioned investors, it could very well be a buying opportunity.’
At the annual presentation of BofA Merrill Lynch’s year-ahead outlook, held in New York on Tuesday, analysts summarized their views on the market and made the following 10 macro calls for the year ahead:
1. S&P 500 Index continues to rise: The Standard and Poor’s 500 Index is expected to reach 2800 by the end of next year.
2. Solid global economic growth: Real global GDP is forecast to grow to a solid 3.8 percent, up slightly from 3.7 percent in 2017.
3. Steady US economic growth: US GDP growth of 2.4 percent is expected in 2018, up from 2.2 percent in 2017, but capped by low productivity gains and a slower pace of hiring.
4. Inflation is back on radar: Inflation is expected to rise in the US, with core inflation reaching 1.8 percent at the end of 2018 and 2 percent at the end of 2019. Both wage and price inflation should also trend higher.
5. Emerging markets move lower: Higher US rates, a higher US dollar, European Central Bank tapering and Chinese slowdown mean investors will need to be more selective in emerging market bonds and equities, which outperformed in 2017.
6. Monetary fiscal policy points to higher rates: The market may be underpricing the risk that US tax reform may be more impactful than expected. Should the market begin to appreciate the implications of tax reform, US rates could make a significant move higher in the first quarter, adding inflation pressure in emerging markets.
7. Higher foreign exchange volatility: The US dollar is expected to rally in the first quarter, supported by rising US interest rates and potential repatriation flow occurring as a result of tax reform.
8. Modestly constructive on commodities: While higher US interest rates and a strong US dollar could act as a headwind to commodities, robust global demand and tight supplies should see Brent crude oil rise to $70 per barrel by mid-year. Diesel fuel pricing could reach $90 per barrel on rising demand.
9. Credit spreads tighten; disappearing supply: Fundamental trends in the credit markets are divergent, and there continues to be no single global credit cycle.
10. Global investment strategy: Stocks are expected to outperform bonds for the seventh consecutive year in 2018, a track record not seen since 1928.
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