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Questioning Goldilocks

In his latest Quarterly Economic Outlook, Neil Williams, Senior Economic Adviser to Hermes Investment Management, argues that the recent market moves are a useful reality check, but believes that markets may be fearing the wrong 'bear'.

The recent weakness of equity markets looks driven more by the drift-up in bond yields, US tightening expectations, and what they may mean for future growth, rather than any downturn in the economic data. A testament to recovering, rather than relapsing, economies.

The challenge now for markets questioning the ‘Goldilocks’ scenario of ever faster growth and ultra-low rates is to identify which of the ‘bear’ risks to fear.

Declines from peaks to troughs in equity markets are traditionally associated with macro shocks, and/or a toxic policy-mix. However, with policy rates still close to the floor, QE close at hand, and little effort on fiscal-deficit cuts, policy can hardly be accused of being toxic.

Two feasible triggers could be an extension of the bond-yield rise since the US Fed started its ‘belt and braces’ tightening, and a slower China, but, these should be contained. Furthermore, central banks’ skin in the game suggests they cannot afford to take us off guard. This, more than in other growth recoveries, should limit the rise in bond yields.

The far bigger risk would be a policy face-off between the US and China. The US Congress may not be able to preclude President Trump’s widespread use of ‘Super 301’ on countries he deems to engage in “unfair” trade practices. China et al could retaliate.

In which case, 2018 could be a year of two halves. The initial stimulus from President Trump’s proposed fiscal expansion could gradually become muted by threats of protectionism, driven by US disaffection with the WTO and Mid-Term elections.

Should protectionist forces build, inflation will reappear, but it will be the ‘wrong sort’. Central banks will turn a blind eye as economies stagflate, so the inflationary flame may snuff itself out. The disinflationary return to the US could be larger than anticipated.

Therefore, despite a useful reality-check for those expecting ‘Goldilocks’ to last forever, markets may be fearing the wrong ‘bear’. With, in our view, central-bank tightening and bond yields likely to be far less disruptive than the potential new risk emerging, protectionism.

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