A More Cautious Optimism Will Be Required From Investors In 2018 Due To Inflation Risks
The State Street Global Markets’ Macro Strategy team says earnings growth will continue to support markets in 2018, but central banks’ policies will be less accommodative.
“Many hope that the Goldilocks economics of robust global growth and modest inflation will produce another bumper year for financial markets. However, the outlook for financial markets in 2018 is expected to be more challenging,” said Michael Metcalfe, head of Global Macro Strategy at State Street Global Markets. “Investors have been accumulating risky assets for more than a year now, expectations are higher and in some areas risk premia and volatility are alarmingly low. Economic recoveries are a year older, output gaps are closing and central bank support will begin to wane. These factors mean that doses of caution will be required in 2018, alongside the optimism that characterized much of 2017.”
Inflation expectations are playing their part.
“After almost a year of disappointing data, market-based US inflation expectations have returned to two percent,” continued Metcalfe. “While base effects will be a challenge in the coming months, State Street’s PriceStats1 online prices suggest that retailers still have a good level of pricing power. With strong inflation support, we believe the Fed will be able to deliver its promised three hikes this year, and quantitative tightening will gradually ramp up to $30 billion a month.”
“Although the risks for global markets are rising, there are opportunities for continued gains in emerging market (EM) equities,” said Dwyfor Evans, head of Asia Pacific Macro Strategy at State Street Global Markets. “The Fed’s planned hikes are not yet deemed threating to EM investors, possibly because they have been so well flagged. The early 2018 Purchasing Managers Index (PMI) readings indicate strong aggregate demand conditions, the recent confirmation of Chinese strength and EM equities valuation and earnings profiles all suggest a favourable outlook. The usual caveats apply to geo-politics, but real sector trends and investor behaviour both indicate that the strong performance of 2017 has further to run early in 2018.”
“This could though eventually prove problematic for EM bonds, which have performed strongly given absolute and relative yield differentials within developed markets,” concluded Evans. “Yield differentials remain attractive, but as monetary settings further adjust, expect some concerns on capital flight to re-emerge, while the strengthening of EM currencies could re-ignite ‘currency wars’ rhetoric. EM central banks and governments look to have a slightly more challenging environment to navigate this coming year.”