Recent market volatility demonstrated that institutional investors are fully alert to the risks posed by higher inflation, according to the latest Guide to the Markets report from J.P. Morgan Asset Management (JPAM).
“One strong wage print in the U.S. jobs report for January sent equity and bond investors running for cover—and the sensitivity is understandable,” researchers observe. “Higher U.S. wage inflation would cause the Federal Reserve to tighten monetary policy faster than expected, having implications for the wider economy and equity markets. However, we expect wage acceleration to be moderate, leading the Fed to raise interest rates another three times this year, only once more than the market expects.”
Mike Bell, global market strategist for JPAM, hastens to add that interest rates aren’t anticipated to pose a problem for the economy or equity markets this year. “Instead, financial stocks should benefit,” Bell says.
Historically, JPAM finds, equities have not come under pressure until the U.S. two-year Treasury rate reaches above 3.5%.
“U.S. household debt-to-GDP has reduced significantly since the financial crisis. However, U.S. corporate leverage has been rising again,” the analysis suggests. “While currently manageable, we think it will be important to monitor the risk of higher interest rates feeding through into higher corporate debt service ratios.”
The research goes on to suggest the “flattening of the yield curve” is one trend to continue to watch for in 2018. Related to this, historically, the two-year Treasury yield has risen above the 10-year Treasury yield prior to recessions, JPAM researchers observe.
“While the curve has flattened in recent years, it hasn’t inverted yet,” Bell notes. “Importantly, equity markets have historically only peaked after the curve has inverted and often quite some time after.”
JPAM pins the first sell off 2018 to fears of higher inflation and interest rates, and the more recent sell off has been driven by fears of a trade war.
“Concerns around a trade war are currently overblown,” Bell suggests. “Even if tariffs do end up being imposed, it is important to put them in perspective. The U.S. economy is nearly $20 trillion, China’s is close to $13 trillion and annual global GDP is about $80 trillion. So, while a full blown global trade war would be an unfavorable scenario for the global economy, even if the measures that have currently been threatened were actually imposed, the tariffs would be equivalent to only 0.2% of U.S. GDP and 0.3% of Chinese GDP.”
Bell concludes by pointing out that, last year, the U.S. economy grew by 4.5% in nominal terms and the Chinese economy grew by 9.7%.
“That’s not to say that trade concerns aren’t worth monitoring, but it does suggest they’re not yet worth panicking about,” Bell says.