While investors saw unexpectedly healthy macroeconomic growth across the globe in 2017, they should watch for warning signs heading into the new year.

That was a key message by James Swanson, chief investment strategist at MFS Investment Management, during a presentation of a year-end investment outlook on Tuesday.

Read: Institutional investors expect volatility spike in 2018

When it comes to equity valuations, it’s tricky to determine whether the United States is in the middle or late in the cycle, he said, emphasizing several warning signs equity traders should keep an eye on. For one thing, over the past 22 years, market valuations have been cheaper 89 per cent of the time than they are today. “From a world point of view, do we want to commit more assets to these markets? We better be darn convinced that free cash-flow generation and profitability are on the rise,” he said.

As well, credit markets, barring U.S. high-yield corporate offerings, and sovereign emerging market debt, are very close to all-time highs, said Swanson.

“A lot of the return in the markets is being driven by outsized earnings from a handful of companies,” he said. Smaller, listed companies aren’t generating anywhere near the same levels of return, so while famous “winner-take-all type names” are doing well, the overall market isn’t following the trend, said Swanson. For growth in equities to continue, he continued, the outlook for smaller companies will need to improve.

Read: Why bond yields are likely to stay low

As well, merger and acquisition activity is worryingly high, he said, since it usually takes place later in the cycle when organic growth begins to slow down. Another late-cycle sign is that zombie companies — organizations that can’t finance their own debt service from their own cash flow — are also on the rise. “We’re seeing leveraging increase throughout the system, particularly for companies that economically, perhaps, are not viable,” he said.

When it comes to the yield curve, things are perplexingly low, said Swanson. “Everything’s telling you that interest rates should be rising and yet government bond markets seem to be sending another message.” He also noted that while the market may not be heading towards an inverted yield curve, a flattening trend is a reason for concern.

And in terms of capital preservation, investors should watch China closely, said Swanson. While he doesn’t believe the slowdown in China will be too dramatic,lower growth has the ability to affect a number of commodities that could, in turn, weaken areas such as the U.S. industrial sector.

Indeed, in 2017, China — along with Europe, Japan, the United States and emerging markets as a whole — demonstrated a “synchronized improvement in global growth conditions, especially when compared to the weakness in 2015/16,” said Erik Weisman, chief economist and fixed-income portfolio manager at MFS, during the presentation.

Read: Is China becoming more open to institutional investors?

“Core measures on inflation across the globe, despite output gaps that look like they’re closing or are closed, haven’t really gone anywhere,” he noted. While those measures are off from their 2016 lows, they remain weak considering the growth the world has seen during the past year, he added.

Globally, better volumes of output and trade were noticeable, said Weisman. “The way that we can see this is if we look at how we ship things around the world: by air, by sea, by rail, by truck. All of those measures are pretty constructive.”

By region, the United States has seen both industrial production and core capital goods orders trend higher since 2015, as well as single-family home and automobile sales. Those indicators lead Weisman to take a constructive outlook for the coming year.

Europe and Japan, meanwhile, were surprisingly robust, he said, suggesting years of monetary policy finally appear to be kicking in. In 2018, the Europe will be entering the mature portion of the business cycle and is benefiting from the structural reforms that have taken place in France, Portugal and Spain. Japan has also seen structural reforms, reduced corporate tax rates and increased participation of women in the workforce. “All of this speaks well for what we might see in 2018,” added Weisman.

In China, however, the better-than-expected growth during much of 2017 may not have as firm an underpinning, he said. Indicators such as housing starts have slowed down, which are key since they usually correlate to credit growth, the sale of big-ticket items and commodity prices. Together, they have the power to affect the global economy. “You may recall the mess of the weakness in 2015, where we thought maybe we were heading into a global recession, which seemed to be precipitated by weakness in China,” said Weisman. He noted, however, that China would have less of an impact given the improved economic health of other key emerging markets like Brazil and India.

In addition, the Chinese government is in a better position than it was a few years ago to handle slowdowns in a more nimble way, making it a more measured force in global markets, he added.

Read: 2017 Top 40 Money Managers Report: Investing in the age of Donald Trump

Copyright © 2017 Transcontinental Media G.P. Originally published on benefitscanada.com

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