Fed Bigger Risk to Markets than China in 2018

The stock market rally will continue in 2018, says Vanguard - as long as the Federal Reserve doesn't wrongfoot the market

Emma Wall 11 January, 2018 | 8:36AM

China is a growth area not a risk says Vanguard

Worried about Chinese debt derailing the bull market? You shouldn’t be, according to Vanguard. Instead, the key to determining when the correction will come is the labour market. Vanguard’s chief economist for Asia-Pacific, Dr Qian Wang this week said that investors looking to time their exit from toppy stock markets should watch the unemployment figure.

“We are near or at record lows of unemployment in the US, Japan and the UK. If this falls further we will see wages rise as the jobs market reaches capacity, which in turn will mean an inflation spike and the Federal Reserve will be forced to hike interest rates,” she said.

If the Fed raises rates faster and steeper than the market expects – currently two to three rate rises in 2018 are priced in – then bond and stock markets will drop, she warns.

It is the Fed acting out of character, or making a bad policy decision, which will cause a stock market crash rather than China’s debt issues, states Wang.

Should Investors Worry About China?

Emerging markets delivered considerable returns to investors in 2017 – the average India fund gained 47%, the average China fund was up 42%, and diversified emerging markets were up 34%. But investors remain wary of emerging markets. In the UK we allocate just 14% of our portfolios towards the sector.

Part of this is a lack of knowledge about the market; what we do not understand, we fear. This is not a phenomenon unique to UK investors; as one Hong Kong based wealth manager this week told me: “For Chinese investors, the UK can be considered a risky investment, just as UK investors are sometimes wary of emerging markets.”

But it could mean investors are missing out on profits. Wang expects China to grow at a rate of 6.5% this year, only slightly down from 6.8% in 2017. The slight reduction is due to a regulatory overhaul – policymakers in China are implementing regulation around corporates’ environmental impact and encouraging banks to deleverage.

Wang addressed the concerns over the threat of a sharp economic downturn – or “hard landing” – saying: “The chances of a hard landing are low. The economic slowdown in China [from 14% in 2007 to 6.8% GDP growth last year] is policy engineered. The government has increased its tolerance to slower growth, it is just not ready to give up growth entirely yet.

“Should growth disappoint, they will simply relax the regulations which are slowing economic expansion. The chance of a hard landing is less and less likely.”

What to Expect in 2018

Vanguard expects US equities to deliver 4% a year over the next 10 years, compared to 6.5% annualised from Japan, emerging markets and Europe. Wang says that the Fed is unlikely to be wrongfooted in 2018 – instead the inflation impetus is more likely to hit in 2019.

That is not to say there is not a risk of a market correction in 2018. According to Vanguard calculations there is a 70% chance of a market correction of 10% or more this year – and the US is most at risk compared to other global markets.

 “We are expecting a good year,” she says. “The fundamentals bode well for risk assets. But we start 2018 with even higher valuations and lower volatility than 2017. The chances of a bumpy ride are much elevated.”

 

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About Author Emma Wall

Emma Wall  is Senior Editor for Morningstar.co.uk