The global economy, with the exception of the UK, is going through a period of rare synchronised expansion. Corporate profits are rising, trade is expanding, and growth is robust in the US, Europe and beyond. Asia is benefiting from this global phenomenon and a continued uplift in China. Japanese equities, in particular, are finding a 'sweet spot' due to increased strength in corporate earnings and evidence of ongoing corporate reform driving better returns for shareholders. On a monetary policy level, despite the US Federal Reserve modestly tightening in the US, and the Bank of England raising rates for the first time in a decade, global monetary policy remains very accommodating.

Against this backdrop, it is not surprising that equities are trading at current levels. All things being equal, equities should continue to perform well in 2018. However, as investors we must ask ourselves what could upset this positive outlook. In addition to historically-low credit yields and the notable absence of inflation worldwide, there are geopolitical risks on the horizon, including Brexit, potential instability in Europe and US relations with North Korea, China and Mexico.

UK and Brexit risk

UK corporate earnings have disappointed and the domestic economy is slowing as a result of Brexit uncertainty, which is a concern not only for local companies but also those that invest in the UK. Should trade talks yield constructive progress, we may yet see a more certain framework within which companies and investors can make forward-looking decisions. For the time being, activity in the UK is slowing and a hard Brexit could send a geo-political shockwave through global economies and markets.

As a driving force for the UK economy, the consumer's reaction to Brexit will have an important role to play. Coupled with a more hawkish tone from the Bank of England, consumers' enthusiasm to spend may be tempered in 2018. While on a valuation basis UK equities look cheap, the earnings momentum makes them less attractive than other markets; and a serious Brexit shock could make them unpalatable.

Political instability in Europe

The upward trend of support for European populist parties was not as widespread in 2017 as the market expected, yet the potential for political instability in the region remains. Spain's situation with Catalonia could still undermine European co-ordination going forward. In Germany, we are yet to see a cohesive government emerge, and the forthcoming general election in Italy could potentially result in a lurch to the populist right. So, while markets are currently sanguine about these events, they could impact the cohesiveness seen in Europe over the last year.

US fiscal reform and foreign relations

Clearly, the actions of President Trump will be of great importance to markets. Trump thus far has been unable to implement any of his proposed policies, and some - such as trade restrictions and building a wall between the US and Mexico - have fallen away completely. Tax reforms remain in play but US earnings and growth will be impacted should they not materialise. That said, we believe the success of a tax package would likely come with some modest price upside in the short term - roughly the same as the headwind that a failed legislation would create.

From a geo-political standpoint, the US relationship with North Korea, China and Mexico could yet affect markets. Thus far, relations between the US and North Korea have not moved beyond escalating rhetoric, while trade restrictions and any resulting supply chain disruption between the US and Mexico have similarly failed to evolve into serious policy proposals. Diplomatic ties between the US and China appear to be stronger than they were a year ago, but any souring of relations could yet lead to market dislocation. So as with any 'wildcard geo-political event, while these are all risk factors that are difficult for investors to price into markets, they are worth paying close attention to.

Potential inflationary shock

Inflationary pressure has been absent in almost all the major developed economies for some time, despite levels of almost-full employment. In the US, this is in part due to dollar appreciation following President Trump's election and the disappointment of his policies not coming through as promised. More broadly, inflation expectations remain subdued across developed markets as a result of shortand longer-term factors such as commodity prices, exchange rates, new and evolving technology, and globalisation itself, which has had the effect of dampening wage growth in an increasingly competitive global labour market.

This has meant that policy settings have remained accommodative and provided support for risk assets. With global rates already near the zero lower bound, an inflationary shock would leave central banks with little room for further stimulus, leading to a destabilisation in markets.

Valuation risk in credit

We are closer to the end of the credit cycle than the beginning, and in this phase there is a rising risk of defaults as companies increase leverage and engage in late-cycle activities such as M&A and share buybacks. While this behaviour could be positive for equities, it could undermine credit valuations and unsettle markets. Credit valuations feel much richer than their equity counterparts and this is the case for high yield credit in particular. Indeed, it is becoming increasingly difficult to think of it in these terms given how far yields have fallen.

Still, while it is an area we continue to watch, we do not expect to see a bond market upset next year. In part, this is because of the subdued inflation expectations and because aggressive, co-ordinated global monetary tightening in 2018 seems unlikely. More broadly, demand for high-quality sources of income remains strong.

China slowdown

Given the size of the economy, China is arguably the biggest risk to global markets and it has been a key driver of volatility in recent years. Yet economic growth in the region remains steady (at a slower and more sustainable pace), disposable income is growing at a two-year high (driving consumption as the dominant component of GDP growth), Chinese industrial profits are growing firmly, and investment outflows have fallen as domestic investors take up the baton.

China and its investors appear to have accepted the country's need to rebalance its economy. However, this journey will not be without its bumps in the road. We note, for example, that while both headline exports and imports are rising firmly, the current account surplus is being eroded. Also, China has for some time been juggling with the paradox of pursuing a controlled exchange rate, free capital movement, and an independent monetary policy simultaneously - its 'trilemma'. There are clear flashpoints for this to come to the fore over the next five years, but we do not believe this is a near-term risk.

Summary

The macro-economic backdrop is still supportive for equities and in 2018 we envisage prices rising moderately driven by continued strong fundamentals and earnings growth. But there is unlikely to be much upside in credit markets because valuations are too rich, although that's not to say investors should avoid the asset class entirely. With an absence of monetary tightening or large-scale fiscal changes on the horizon, Asia, Japan and Europe currently appear to be the best areas to take cyclical exposure to global growth. However, with geo-political and economic risks on the horizon, 2018 will require the skill of active managers to manage portfolios prudently and find investment opportunities that deliver consistent investment returns.

Asset classes in 2018

In terms of the major asset classes, we are most constructive on equities versus credit and core government bonds.

Equities

We expect corporate earnings growth of 10-15% in 2018 supported by 'Goldilocks' conditions of moderate economic growth, low inflation and asset-friendly monetary policy. Areas where we are most bullish are Japan, Europe ex-UK and Asian emerging markets.

We forecast corporate earnings growth of 8% for Japan next year, supported by higher than expected economic growth, corporate reform, receding political risk, and easy monetary policy. The commitment from a rising number of Japanese corporates to improve return on equity is an important factor.

Continued robust performance across the Euro Area is aided by strong manufacturing data and demand, while domestic consumption - a key factor for ongoing growth - has been boosted by rising employment numbers and improving household balance sheets. Confidence is high, business is buoyant and jobs are being created at an impressive pace, and so against this backdrop we believe European corporate earnings can grow by 10% next year.

But all eyes will be on the pace of the ECB's taper, the end of QE, and interest rate rises. The ECB is still buying bonds worth sixty billion euros a month and, even after it reduces these flows in 2018, it is likely to be 'in the market' for most of the year. But as the European recovery gathers steam, the ECB may well begin to question whether its easy policy stance remains appropriate.

Fixed income

The demand for high-quality income will remain a theme - this is unlikely to change given aging demographics around the world. However, given where starting yields are today, investors are unlikely to see strong excess returns from credit markets.

We have had a long-standing negative stance on core government bonds and this has not changed - we still believe them to be vulnerable, with negative term premia and depressed short-end rates, and they are far too richly valued for our liking.

We are neutral on credit, where spreads have come in a long way but still compensate for underlying corporate default risk and liquidity risk. Within this, European high yield corporate bonds offer marginally more upside than corporate investment grade bonds.

However, with yields at such low levels by historical standards, and with the global term premium so compressed, there are clearly risks that bond markets are due a correction. For now, structural supports remain in place but if yields are to reprice higher, they are most likely to do so in Europe.

Commodities

The stronger macro environment has been supportive for commodity markets, and ongoing favourable supply and demand dynamics support price rises, but we are keeping an eye on a number of factors. With energy being part of every supply chain, destabilisation in the Middle East will be a key element to watch, as will politics in China, where the government has turned its focus to environmental policies (which has been used as a way to tackle overcapacity in some heavy industries, such as steel and aluminium).

Rather than raise production in response to increased demand, companies are instead embracing supply discipline and returning funds to shareholders via buybacks and dividends. A sharp rise in oil could derail the current trajectory, but the macro environment - with strong US growth and supportive Chinese and EM markets, should support commodity prices into 2018.

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