Let’s be candid, 2017 surprised all of us.  2017 gave us a BREXIT hangover and a colorful US President.  Yet, the year ended with portfolio gains none of us expected.

What does this say for 2018 and how we should invest?

At a minimum, relative to early 2017, we can be less concerned about the stability of the US genius, and focus instead on the true risks facing the market today.

2018 will present us with unique systemic risks in Asia, the Middle East, and Europe.

At the top of all investors’ worry list is the US-North Korean conflict.  While this has presented us with some surreal Twitter banter, the reality is that both parties are now actually closer now to negotiating 1x1 than they ever have been. 

In the Middle East we have a new Saudi prince seizing power at a pace never seen before.  But for Saudi Arabia’s survival, the change is imperative.  The ARAMCO IPO will be a bell weather for the markets and for the region.  In the interim, I would expect much more instability as the Prince continues to challenge the clerics, his extended family, and his regional neighbors.  Israel’s role and reaction will be crucial.

Europe will continue to be dominated by BREXIT.  Investors and corporations continue to look for clarity and finality with regards to how the entire process will unfold.  Yet, the market has almost fully priced in the effects of BREXIT, so much of 2018 will be more information regarding the details of the negotiations.  Of note, like you, I was surprised by the ingenuity of Britain’s suggestion to participate in the TPP.

These systemic risks aside, that leaves us with market risks.  What should be top of mind for all of us as we enter 2018?

Very simple: The fixed income markets.

The US yield curve is stubbornly indicating that the USA is near a recession.  This doesn’t bode well for the rest of the global economy as the US has been leading the world out of the Great Financial Crisis, and by default the trend of quantitative easing.

Ironically, despite almost full employment, the USA is perilously close to running out of gas.  Why?  Low wage growth.

The US Federal Reserve bet the recovery on job growth, and by default, wage growth (hence all of the discussion around the Phillips Curve).  Yet there has been no appreciable wage growth.  Year over year wage numbers continue at an anemic pace (last at 2.5% YoY).  Conversely, the non-farm payroll numbers look good, and the unemployment rate remains at historic lows.

This is all concerning because while the monetary policy of QE worked in allowing the global economy to survive, it inadvertently seemed to have stalled wage growth.  Fed Chairman Janet Yellen, on multiple occasions, has reflected on the inability for the Fed to see higher wages; and by default any inflation.

One academic observation: inflation is a component of stock returns. Remember, implied within any equity valuation forecast is the rate of inflation.  Today inflation is at historic lows…so where is the market receiving the benefit of higher prices?  P/E Expansion.

In layman terms, PE Expansion is simply the ability for a new investor to pay more for an underlying asset than you paid for it without any substantial change to the underlying fundamentals (sound familiar Bitcoin fans?)

This PE Expansion is what has market experts concerned, hence all of the TV pundit banter regarding “momentum” and “growth” stocks.  This is code for an expensive market and rich valuations.

While I can be cynical of valuations, I have learned in the past that standing in front of “slowing” freight trains doesn’t accomplish much other than a painful outcome.

So regardless of my thoughts about the market, I think it is important to highlight where valuations are on a relative basis.

Geographically, the US market is quite rich in comparison to the European and Asian equity markets.  Of those two, Asia still remains the cheaper of the two.  Hence at year end, we saw a lot of fund flows from the US stock market to Europe and Asian equities.

For investors who have a higher risk tolerance, the emerging markets stand out.  Here however I would caution you to be ready for headline risk especially in regards to some of the systemic risks I described earlier.

Sectors that look “cheap” are energy, consumer staples, and financial services.  Of note, if the US finally does implement its long promised infrastructure package we should see financial service firms benefit.

There is one other key substantive point for you to consider: Volatility.

As you, and other investors are aware, market volatility has remained exceptionally low.  Why?  The central banks.

When one looks at the level of market activity (i.e. purchases of all securities), there have been several key and core investors these past several years: the Federal Reserve, the ECB, the BOJ, and the PBOC.  All four are slowing down their policies of QE.

Who has replaced them?  Retail investors.

Retail investors finally saw that despite their personal misgivings of the political landscape, that the market continued to have a bid.  Therefore, in spite of low fixed income yields investors were left with no choice but to purchase stocks.

As QE purchases slow down, we will need to carefully watch volatility.  It is my expectation that we will see a significant pickup in volatility in 2018.

Therefore, from an equity perspective, geographically we would expect investors to focus on Asia, Europe, and the US equity markets (in that order) and have a sector focus on consumer staples, financial services and energy (also, in that order).

For those of you with a more speculative appetite, look at a) the emerging markets and b) purchasing volatility.

This leaves us back where we started and with the same initial concern: the fixed income market.

My concerns regarding the fixed income market are focused on the US Federal Reserve.  Over the next few weeks, I do not think we will see a quick systemic shock to the fixed income market ahead of my next letter to you; therefore I will end this letter here and allow you the time to reconfigure your equity portfolios.

However, next we speak, we will focus on both the fixed income and the currency markets.

In the interim, avoid slowing freight trains, enjoy the Twitter wars, and I look forward to speaking next!