Legg Mason 2018 Investment Outlook

Emerging market debt and equity, equities in China, infrastructure in India and stocks in the U.S. could all be areas for investors to focus on in 2018, according to Legg Mason Global Asset Management and its affiliates.
While many of the above assets – in particular, US equities – have achieved significant gains in 2017, and many other markets are at record highs, Legg Mason’s affiliates believe there remain opportunities in such sectors, as they expect a backdrop of low interest rates and paltry returns on cash to continue into the New Year.
Fixed income markets have had a more challenging 2017. Safe-haven bonds such as treasuries and gilts have seen yields climb – incurring losses for investors – as the very prolonged process of normalisation continues in the US, and begins in the UK.
However, even here there are opportunities, particularly among the higher-yielding spread sectors.
So, what are the most attractive assets to own heading into 2018? Below, Legg Mason’s affiliates pick their top investment ideas for the coming year.
 “Abundance” of yield makes EM debt the standout choice
Kenneth Leech, Chief Investment Officer, Western Asset
“Our big theme heading into 2018 continues to be a slow bottoming process in inflation as global growth has steadied this year, and continues to improve from low levels.
“Global central banks are signalling a slow, steady process toward interest rate normalization.  Government bonds should remain underpinned by these low policy rates and spread sectors should really outperform US treasury and global sovereign bonds.”
“In particular, we think the biggest opportunity for fixed income is in emerging markets. Investors looking for yield can find an abundance of it in emerging markets, and compared to developed markets, growth is much better, while the debt load is now much lower. The demographics, by and large, are also much more positive, meaning the sector presents the best risk/reward opportunity.”
 Emerging markets – and China – best placed to shine
Francis Scotland, Global Head of Macroeconomics, Brandywine Global:
“The dominant trend shaping the investment landscape leading into 2018 is the breadth, depth, and strength of the current economic expansion, which we believe will fully supplant lingering views of financial repression and secular stagnation. While there have been other reflationary bursts since the global financial crisis, we believe this one has staying power.”
“Stimulus measures have given way to broad, synchronized global growth, benign inflationary pressures, and the expectation that developed market central banks will “go slow” in removing monetary policy stimulus—a powerful combination of necessary ingredients for helping to sustain global growth while providing a recipe for continued outperformance of emerging markets.
Many emerging markets have made incredible strides in curbing inflation, enacting much-needed economic and political reforms, boosting their current accounts, and improving levels of foreign reserves. Meanwhile, unlike developed countries, central banks in these emerging economies still have some monetary firepower left, with room to lower rates should the need arise. However, our constructive view on emerging markets would be immaterial without a corresponding favourable outlook on China. China remains a key driver of sustainable global growth, and we expect continued, steady expansion into 2018.“
 US equities to keep climbing – but time to switch from the FAANGs
Peter Bourbeau, Portfolio Manager at ClearBridge Investments:
“We believe in a continuation of the bull market across US and international markets. US equity markets are at levels where market tops have occurred, but we believe there is still room to the top as we haven’t reached the phase of euphoria.
What could change is the leadership of those markets, and the key for investors in 2018 is diversification into a variety of sectors.
Recently we saw FAANG stocks greatly outperforming the broader market, yet we are seeing opportunities elsewhere.
Next year there are opportunities for investors who move away from these big, visible technology leadership companies. For example, we are attracted to those companies which show more controversy and believe that in 2018 we should find opportunities in US energy, healthcare and financial services companies (excluding banks), as well as select consumer staples.”
 ‘Megatrend’ fintech stocks the best option in emerging markets
Kim Catechis, Head of Emerging Markets at Martin Currie:
 “Even after a strong 2017, we believe much of the positive market sentiment we are now seeing in EM is the result of clearly improved profitability, underpinned by strong fundamentals. Improvements in economic growth are feeding through to earnings expectations as an increasing number of companies issue positive outlook statements for the year ahead. Best of all, the improvement is broad-based: initially concentrated in the energy and materials sectors, it has extended into industrials, consumer discretionary and financials.
Companies like Naspers, Alibaba and Tencent are building robust digital ecosystems – competitive ‘moats’ that ensure that they can continue to tap into expanding demand domestically, and increasingly abroad. As megatrends go, this is an exciting one. Furthermore, EM companies are ahead of their developed market peers in understanding the growth potential of FinTech. A potent combination of favourable demographics, governments keen to accelerate inclusion, and tech-savvy populations leap-frogging traditional banking methods, foster EM FinTech adoption rates that outstrip developed markets in nearly every category.”
Stay flexible – and global – in fixed income
Gary Herbert, Head of Global Credit at Brandywine Global:
“Given the changing macroeconomic environment, an active and global approach to fixed income may help avoid excessive risk, address concerns over valuations, and navigate changing market conditions. Furthermore, the opportunity to exploit differences in exchange rates through active currency management provides investors with another source of potential returns.”
“A flexible and truly global approach means investors can find the most compelling, undervalued bond markets and currencies, as well as regions, countries, or sectors that offer a better yield or where duration risk should be rewarded—while avoiding or even shorting areas of concern.”
International stocks more attractive than US equities in 2018
James Norman, President at QS Investors:
“While many investors may not have positioned their portfolio at the start of 2017 to capitalize on the benefit of global stock diversification, we believe there is still time to capture relative outperformance in 2018.”
“On a near-term basis, we find stocks attractive and our tactical asset allocation model forecasts international-developed stocks to outperform US stocks. Key drivers include a multi-year underperformance of international markets that has led to relatively more attractive valuations, strong global trade and leading economic indicators.”
“We also see steeper yield curves in international-developed countries, which investors can learn a lot from. Steeper government bond yield curves often precede strong stock market returns, as lower short-term rates can stimulate economies while larger long-term rates can be an indication of investors’ expectations of stronger economic growth and potential rising inflation.”
Potential tax cuts and overseas exposure to power US small caps
Bill Hench, Portfolio Manager at Royce Funds:
“For small cap investors, its worthwhile taking a look at industrial companies in the US. Whether that be aerospace or commercial vehicles, order books are very strong and we expect this trend to continue in 2018. In addition, inventory is really being held in check so companies are able to get very good margins without the excesses of past cycles.
“We are also finding a number of investment opportunities in the defence and construction sectors where companies have an exposure to international markets. Year-to-date in 2017, many small cap companies benefitted from stronger business outside the US, and the current environment is supportive for a pro-cyclical, deep value approach to small cap investing.
“If we see tax reform in 2018, that will be beneficial to small/micro-cap companies that pay the 30% to 35% federal rate. As those companies do not have subsidiaries in places like Ireland where they can cut their tax bill in half, they have the greatest upside from a reduction in the corporate tax rate.”
Frank Gannon, Chief Investment Officer of Royce Funds:
“In 2018, we see opportunities to own quality cyclical companies that serve global end markets in an expanding global economy, combined with a weaker U.S. dollar. It is worth remembering that more than 400 companies in the Russell 2000 currently derive a third or more of their revenue from outside the U.S.  Solid-to strong small-cap earnings, combined with relatively attractive valuations in sectors like technology, industrials and materials look poised to lead—and we are happy to be holding many.”
 European and Indian infrastructure opportunities abound in New Year
Nick Langley, Co-founder and CEO of RARE Infrastructure:
“Accommodative monetary policy in Europe should continue to support economic growth expectations and in turn the valuations of economically sensitive infrastructure securities, namely toll roads and rail stocks. There is therefore the potential for the world’s largest toll road operator to be formed if the merger between Italian group Atlantia and Spanish company Albertis goes ahead.
“While Trump Administration watchers wait for long-promised legislation, smart investors can also find attractive opportunities in select US infrastructure securities. These opportunities include mid-stream oil and gas pipelines, and higher growth utility companies (particularly those investing heavily to satisfy local, State-based, renewable energy and regulatory requirements).
“Finally, there are opportunities in Emerging Markets, particularly in the Indian gas sector which is one of the largest untapped thematics within India. India has a strong demand for natural gas but has a supply constraint and needs new infrastructure to ease those constraints.  We expect the utilisation of some pipeline volumes to double over the next five years.”
Bank loans in 2018: A wind of change
Mike Buchanan, Deputy CIO of Western Asset:
“Bank loans had a difficult 2017, but that is poised to change. Most bank loans are now above their LIBOR floor, meaning they will participate one-to-one in increases in LIBOR, and performance can begin to accelerate.
“Bank loans have also gone through an unprecedented period of repricing where, essentially, coupons were lowered by the companies. That typically happens when there is strong demand for loans, and when a significant universe of the loan market trades above par.
This wave of re-pricings is going to continue to trend lower, and although we are not worried about official interest rates moving materially higher, we think you will see some further hikes which will benefit bank loans.”
 US real estate a hedge as lower-for-longer cycle continues
Tim Wang, Head of Investment Research at Clarion Partners:
“Going into 2018, the macro economic signals suggest an extended slower-for-longer real estate cycle.   A continuing trend towards urbanization is also supportive of healthy supply/demand fundamentals in the US real estate market, which has driven solid net operating income growth in recent years.
“US demographics also remain supportive, with approximately 1% population growth and 1.2 million new household formations annually.”
“The real estate market US continues to offer interesting opportunities, particularly in core assets – well-leased, high-quality apartments, industrial, office and retail properties in established markets, as well as hotel and other niche properties.
 Can financials be income stars again as rates rise?
Mark Whitehead, Head of Income at Martin Currie:
“After a low-growth, low-inflation decade, 2018 could be a ‘Goldilocks’ year propelled by higher growth and low inflation. With global unemployment at cyclical lows, an uptick in inflationary pressures could follow, and if Central Bank actions support gradual rate rises globally, we see a revival of fortunes for areas such as financials.
“Meanwhile in the energy sector, productivity improvements at several oil companies – coupled with potential and any further rises in oil prices are likely to positively impact margins.  Elsewhere, industrial manufacturing and technology are set to be beneficiaries of the reflationary outlook.”