20 to 26 February: Ides of March

After 3 weeks of heightened volatility, there were still signs of nervousness last week, but only small aggregate moves. We think there are a number of event risks in March, which could shape near term sentiment:

• 4^th March = A general election in Italy and the confirmation (or not) of the “grand coalition” in Germany. Failure to form a government in Italy and continuation of a minority government in Germany, would be negative for French President Macron’s vision of further European integration
• 8^th March = An ECB meeting at which we expect a change to forward guidance
• 9^th March = US employment data, which may confirm an acceleration of average hourly earnings
• 21^st March = A FED meeting at which we expect a 25bps rate hike

12 to 18 February: Getting Comfortable

Last week saw the steepest gains for equity markets in a number of years as around half the recent losses were recouped. We don’t think this means investors have forgotten about higher inflation and interest rates. Rather, we believe there has been an important shift in regime, which required an adjustment, and that consensus is now building that monetary tightening will be gradual and therefore not (near-term) enough to de-rail growth.

5 to 11 February: Growing Pains

After the volatility explosion of the past 2 weeks, which came after 2 years of market calm and serenity, it would be easy to get carried away. However, the outlook can really be distilled to a single question:

Is enough inflation building to prompt a monetary tightening that will derail the (booming) global economy?

In a word, our answer is no. As we have repeated over the past few weeks, the US (where there is the greatest potential for higher rates) is later cycle than most peers and therefore not a fair proxy for the rest of the world. Indeed, even stateside inflation expectations remain relatively subdued (the 5Y5Y forward inflation swap roughly unchanged over 12 months at 2.39%). However, we should be equally clear that the market has entered a new, more volatile, regime. Central bank liquidity will now be biased to tighten, and every strong data print will have investors considering the negative implications of overheating and inflation. Our judgement is simply that (for now) the build up of such headwinds will be modest and insufficient to stop growth in its tracks.

29 January to 4 February: A Long Time Coming

Every week this year, we have written that the nature of the equity market rally has changed – that the acceleration in global growth has started to stimulate higher bond yields and energy prices, thus sowing potential headwinds. In the short run, we saw 3 “canaries” for investors: the US 10 year bond yield, the oil price and wage growth.

Last week, as if like clockwork, equities experienced their heaviest losses in 2 years after all 3 measures broke out of their almost 4 year range. The question now is whether this represents the end of the bull market, or a release of pressure before new highs. We view the latter as more likely. Rising bond yields are rightly highlighting that global monetary policy is starting to tighten. However, aside a single US labour market data print on Friday (see below), core inflation pressures remain lacklustre. Moreover, we would suggest that the US is later cycle than its global peers and has less “slack” – i.e. whilst it is important, it is not fully representative of the global economy (see European inflation data below). Nonetheless, the market has confirmed the 2 big (and related) risk factors; higher bond yields and inflation.

22 to 28 January: Hold On If You Want to Go Faster

To repeat our message of these first few weeks of 2018: we believe the gang-busters rally we have seen so far this year in equities is of a different flavour to that which preceded it over the prior 18 months. The strength and breadth of global growth, which this week helped propel WTI oil to its highest level in 3 years (above USD 65), is starting (slowly) to catch the attention of fixed income markets (US 10-year yield at a 4-year high, US 2-year yield at a 9.5 year high). In this sense, growth is starting to sow its own headwinds, with a more widespread monetary tightening likely on the way as the year progresses. Indeed, this is exactly what a weaker dollar is telling investors; expectations are rising that it will soon not just be the FED raising rates. However, this week, central bankers did their best to maintain the status quo – both the ECB and BOJ arguing that it is too early to normalise policy for now.

15 to 21 January: Shut-down

Oil prices took a breather from their recent rally last week. Given the production caps in place for OPEC member, the IEA in Paris published an interesting report, which forecasts the US could surpass Saudi Arabia as an oil producer in 2018 as shale production comes on-line at higher prices. US production in 2017 was the highest for almost 50 years.

This week we have central bank meetings in Europe and Japan and ongoing discussions in the US to unlock the government shut down.

8 to 14 January: Sooner or Later?

To reiterate our comments from last week, conditions in 2017 were near perfect for equity markets with strong and broadening growth but no inflation and central banks therefore still in (aggregate) easing mode. The second week of 2018 started where the first left off – with a different flavour of equity market rally. Specifically, with investors increasingly attuned to the risk of interest rate tightening and inflation (oil is now up 50% since June), fixed income sold off to leave bond yields near their highest levels in recent years.

For now, yields remain at very low levels, with the magnitude of recent moves contained. They key factor, will be inflation data, which although suggesting an increased pace of price rises, is still well short of target for most major central banks. Still, the market is at least waking up to the idea that the “perfect calm” cannot last forever.

US markets are closed today for Martin Luther King Day.

1 to 7 January: Back with a Bang

Whilst 2017 was a year in which economic conditions were favourable for just about all asset classes, 2018 has kicked off in more traditional “risk-on” style. Last week equities rallied aggressively (with more cyclical and emerging markets out-performing) but government bonds were mostly lower. If this trend continues, at some point there will be a feedback loop in which higher borrowing costs prompt a re-evaluation of equity prices and economic forecasts. Given the strength of global growth, it is probably too early to worry about this. Indeed, the real “canary in the coalmine” will be higher inflation. This would force the hand of central banks and risk a proper bond market tantrum.

25 December to 1 January: Ringing in the New Year

After a perfect year for passive investors (positive returns across asset classes and low volatility), 2018 is likely to be more discriminating. Economic momentum is strong and provides a positive impetus, but will play against a tightening in monetary conditions and rich valuations across developed markets. There are also a number of dynamics that will divide opinion. These include:

• In the US, whether tax reform will provide a boost to demand or simply redistribute wealth, whether new leadership at the FED will change the course of interest rate policy and whether low unemployment will finally force wage growth.
• In commodity markets, whether oil can continue its recent resurgence (Brent and WTI up 18.8% and 16.9% respectively in Q4) after OPEC members agreed to a 9-month supply cut extension.
• In Italy, Russia, Mexico and Brazil, the outcomes of general and presidential elections.

We believe a number of emerging markets remain well positioned on a relative basis. Of particular note, the election of Cyril Ramaphosa as President of the ANC, has a chance of reversing a decade long decline in South African business confidence and unemployment.

11 to 17 December – New Year’s Resolutions

As we’ve highlighted over the past few weeks, it is a busy end to 2017, with political event risk all the way up to Christmas. Over the weekend, we had the second round of the Chilean elections, with market friendly candidate Pinera triumphant and ANC elections in South Africa, with results due this morning. There was also a victory for the Modi government in Gujarat. This week has the potential to deliver US tax reform. There is also a BOJ meeting in Japan.

Looking into 2018, it is likely that central bank liquidity will start to tighten (in aggregate) for the first time in a decade. Given also flat yield curves, tighter labour markets and expensive valuations in developed markets, there is much more potential for volatility than in 2017. We continue to view emerging markets as relatively more attractive, given cyclical positioning, structural growth and value.

The global market update now takes a break and will return on the 2^nd January 2018.