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. But, 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. Moreover, central banks’ ‘skin in the game’ suggest they cannot take us off guard, which should, more than in other growth recoveries, limit the rise in bond yields.
The far bigger risk would be a policy face-off between the US and China. 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 spark retaliation.
In which case, 2018 could be a ‘year of two halves’. The initial stimulus from Mr Trump’s proposed fiscal expansion could gradually become muted by threats of protectionism. US disaffection with the WTO and elections provide extra incentives.
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.
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...