The beginning of the year was characterised by a slight rise in long-term yields and outperformance of risky assets. European peripheral bond spreads have tightened. Stocks have started the year on a tear (S&P500: +4.9%, Euro Stoxx 50: +4.2%, Nikkei: +4.6%). On the credit markets side, the high yield sector has also continued its impressive rally (Euro HY: -21bp and US HY: -28bp). Financials outperformed both on the equity and credit markets.
What is the rationale behind these trends?
- The positive synchronised upswing in global growth remains associated with a moderate rise in inflation expectations. In Europe, the recovery is intensifying and extending to all the countries. All advanced indicators are well oriented. In the US, the tax measures should provide a modest boost to economic growth. At the same time, market-based measures of inflation expectations have continued their slow but steady increase. The 10-year break-even rate has risen to 2.06%, its highest level since September 2014.
- The micro picture remains also very positive. Global earnings momentum is expected to persist. For 2018, the earnings growth forecast for the S&P 500 is 13.7%.
- The market is still expected a gradual decrease in the accommodative stance of monetary policies.
- Central Banks revised their projection for growth upward but still maintaining a cautious approach on the inflation side. The ECB projected that core inflation in the Eurozone would average 1.8% by 2020, still well below the central bank's 2% inflation target rate. In the US, core inflation should return below the Fed's 2% target in 2018.
- Central banks' communication has continued to be cautious in recent days while preparing markets for a change in policy direction. In particular, the ECB said it could revisit its communication stance in early 2018 on the back of the pace of recovery observed in the Eurozone.
This positive backdrop should remain in place in the first month of 2018. Liquidity injections by central banks are approaching their turning point but will remain positive in 2018 despite the Fed's reduced balance sheet.The main risk is an abrupt end to the current environment triggered by:
- A surprise increase in inflation. This risk is more pronounced in the US as the economy is near full employment. It is unique to see a stimulus package coming out at this stage of the cycle. A rise in inflation could prompt the Fed to act more aggressively than expected. We now anticipate three rate hikes from the Fed this year.
- Slowdown in growth. The probability of this risk has significantly declined in recent quarters.
Macroeconomic and monetary policy conditions will continue to support credit markets in early 2018. More questions will come in later months, especially if we have a further tightening in valuation.