Executive summary

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Fundamentals strong, but market risks rise

  • Global growth expectations revised up
  • Federal Reserve expected to deliver more rate hikes
  • We expect a sustained pickup in inflation will solidify expectations of tighter monetary policy
  • Market risks have risen with increased concerns about a global trade war
  • Global risk assets expected to benefit from strong fundamentals, but duration to be more challenged

In our 2018 Outlook we described our growth expectations for this year as being robust. Three months on, the fundamentals continue to point to a year of strong global growth, with fiscal stimulus in the United States adding to the growth dynamic. Indeed, the main change in our growth outlook for this year comes from an upward revision to the US, with more modest changes elsewhere (Figure 1). As such global growth is expected to be a little stronger than previously thought, at close to 4 per cent this year. Looking ahead to 2019, we expect a moderation in global growth to 3.7 per cent as the major economies slow modestly towards their long-run sustainable rates. However, with growth expected to remain well above trend in all major economies in 2018, labour markets should continue to tighten as spare capacity is eroded (Figure 2). That is expected to put upward pressure on wage growth and inflation. We have revised up our expectation for inflation in advanced economies to 2 per cent in 2018. 

Given the growth and inflation outlook, we expect most central banks around the world to be biased towards tightening monetary policy. The Federal Reserve are furthest along that path, having raised rates to 1.5-1.75 per cent in March. We now expect a total of four rate hikes from them in 2018 and another four in 2019, taking the policy rate to over 3 per cent (Figure 3). That is a more rapid pace of rate increases than we had expected at the end of last year and reflects the combination of stronger-than-expected underlying growth momentum, the material boost from tax cuts and increased fiscal spending and the increased likelihood that inflation will overshoot the 2 per cent target in 2019. In the Eurozone we expect asset purchases to end in late 2018 (with a first rate hike in 2019), while in Japan we see the potential for the Bank of Japan reviewing its policy of yield curve control (YCC) if core inflation continues its recent steady rise to above 1 per cent. The outlook for the Bank of England remains highly dependent on developments in the Brexit negotiations, but the current balance of risks suggests at least one rate hike this year.

Era of cheap money draws to a close

We expect that the shift to tighter monetary policy – both in terms of policy rates and central bank balance sheets – will be a key market theme in 2018, resulting in more volatility across asset classes, particularly as risk premia are re-priced to better reflect fundamentals. The expected tightening in monetary policy reflects our positive global growth outlook and our expectation that the rise in inflation to central bank targets will be sustained. As always, China will continue to play a pivotal role in global markets, particularly commodities. and therefore those countries that are heavily dependent on them. We expect that China will continue to pursue systematic reforms (such as deleveraging the corporate sector, reducing excess capacity in certain industries, improving environmental outcomes and tackling corruption), but will not let growth slip too far from their target of 6.5 per cent. 

Of course there are always risks to the outlook. We have seen in the first few months of this year fears of rising protectionism and a global trade war stoked by the US seeking to impose tariffs on steel and aluminium and against a broad range of Chinese goods. While the scale of the tariffs will probably not be enough to have a material economic impact at the national, let alone global level, the sell-off in risk assets has demonstrated that the market is concerned about where any trade war may end. Outside of trade tensions, we think that the market continues to under-price the risk of central banks moving away from the post-crisis language of slow and gradual normalisation to something more active. Those risks are clearly greatest in the US. Alongside the prospect of rising rates globally, there are a range of countries and sectors that are highly leveraged and could become more challenged in that environment. 

The start of 2018 has seen increased volatility in global markets. Strong returns in risk assets, such as equities, in January were rapidly reversed in February, with further declines seen in March (Figure 4). As a result, global equities were down around 5-10 per cent year-to-date, the worst quarterly performance since 2015. Despite these declines, we remain constructive on global risk assets due to strong economic fundamentals and the associated positive earning outlook. However we recognise the increased market risk – particularly given the magnitude of either explicit or implicit volatility selling products that have built up recent years. 

As such, we have modestly downgraded our expectations for equity markets this year. We favour European and emerging market equities where strong global growth, a benign outlook for the US dollar and relatively more attractive valuations should deliver outperformance. 

On the other hand we continue to expect risk-free assets to under-perform. It has been notable how weak performance has been in duration during the equity market sell-off this year. Over the past decade almost all periods of risk aversion have been met with a sharp rally in government bond markets. But with strong global growth, tightening labour markets, steadily rising inflation and the removal of monetary policy accommodation, yields have continued to move higher. We think that duration will remain challenged through 2018, with potential for policy changes later in the year from the European Central Bank and the Bank of Japan adding to rising global term premia. 

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