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The calendar has rolled over but global markets are still thriving on the 2017 playbook. That means, however, that big questions over why growth and inflation are so out of whack with each other remain unanswered.
The first week of 2018 delivered more of the same good times for investors: gains for risky assets, a soft U.S. dollar, low volatility and government-bond yields locked into a narrow, low range. That was matched by a continuation of the economic growth story, with strong readings globally for purchasing managers’ indexes released last week, in particular signaling continued gains in employment.
Still, the pace of the gains might raise some eyebrows. The MSCI World index of developed-market stocks rose 2.5% in the first week of 2018; its emerging-market peer climbed 3.7%. In Europe, the crisis laggards performed well, with Italian stocks up more than 4%.
In credit markets, U.S. high-yield corporate bonds gained, with the spread over Treasurys falling below 2017’s tightest point already. Bloomberg Barclays’ index of local-currency emerging-market bonds gained 1.4% last week. The dollar is back down at levels last seen in September, helping to support risk appetite.
The question that perplexed many investors in 2017 hasn’t gone away: what is going on with developed-market inflation, particularly in the U.S.? The combination of greater optimism on growth but no sign of accelerating price rises has meant supportive conditions for both bonds and stocks. For equities, stronger growth has been the dominant factor; for bonds the absence of inflation. In turn, central banks like the Federal Reserve and European Central Bank have been able to stick to clearly-communicated plans.
This happy situation will face a challenge at some point. It still seems likely that bonds may face harder times rather than equities: right now, a rise in inflation looks more likely than a slowdown in growth. The gap between yields on U.S. Treasurys and inflation-protected securities has widened in recent weeks, signalling a rise in inflation expectations.
One clear concern is that there is already plenty of inflation, all of it in asset prices. Markets are expensive. But that hasn’t stopped them from becoming more expensive; in the short term, valuations aren’t a good guide to market action. Until investors get a clearer signal on the balance between growth and inflation, the old playbook is the one to go by.
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