Presently, there are a number of risks posed to markets. First, the outcome of the Italian elections produced a populist government with anti-EU sentiment, marrying the left and the right together. Many in Italy feel they have been left behind in the decade since the global financial crisis. Hence, it is natural that there should be antagonism towards the establishment in Italy and Europe. Given Italy’s large stock of public debt, the new government’s emphasis on fiscal expansion has rattled markets.
Second, we have seen weaker than expected global (and especially European) growth in the first months of 2018. I suspect that ‘soft patch’ will pass, but if not concerns about corporate profits could weigh on markets.
Third, investors are wary that inflation may accelerate in various countries, as that outcome would prompt a more aggressive response from central banks.
Finally, we can add protectionism to the list of concerns. The US has now imposed tariffs on steel and aluminium imports against its NAFTA partners and Europe. Retaliation is likely; whether that escalates into even greater trade frictions will be decisive for equities.
The US dollar has rebounded smartly from its weakness in 2017. A key reason has been weakness in European economic activity, as well as in the emerging markets, which has not been matched in the US. That growth discrepancy has driven the dollar higher. My sense, however, is that the dollar’s rebound is unlikely to continue, in part because weakness in European growth earlier this year was probably seasonal owing to Q1 weather, flu and holiday effects rather than to anything more fundamental.
As growth in Europe re-accelerates the dollar ought to peak in currency markets. However if it does not, and other factors such as populism in Western Europe drive the dollar even stronger, the impact is likely to be profound for multi-asset portfolios. In particular, emerging debt and equity markets are most vulnerable to dollar strength.
At the upcoming Federal Reserve meeting investors widely anticipate, as do we, a further 25 bps rate hike. The market also discounts a similar hike for September and rising odds of a December move as well. We agree. US growth remains resilient, job formation is above trend, wage inflation is edging higher and core price inflation is already at the Fed’s target. Although the Fed has said it would accommodate a modest inflation overshoot it has also communicated a message that it sees the need for three further hikes this year, followed by more tightening in 2019.
Provided inflation does not move much above the 2% Fed target, rate hikes can be absorbed by the market. They are already anticipated in market pricing. The Fed remains an important factor, but more important is the course of inflation. Inflation has the ability to disrupt everything, which is why it merits particular attention.