The pessimistic view of this transition is that a brewing trade war will cause a spike in inflation at the same time that deficits become a problem. Such an environment could result in central banks tightening more than anticipated while growth momentum slows. This would be a negative environment for equities.
The more optimistic view is that while inflation risks are rising, the macro backdrop is essentially unchanged: Real economic growth remains supportive of corporate earnings while inflation firms but remains at or slightly below central bank targets. Such an environment would allow central banks to keep policy accommodative while slowly normalizing rates. And while rising trade protectionism would represent a risk, it would be tempered by the fact that fiscal and debt ceiling battles appear to be over.
We acknowledge the downside risks, but lean slightly more toward the optimistic camp, especially over a longer time horizon. We think volatility is likely to continue, but see little that would suggest a major decline in equity markets. Until bond yield volatility calms down and the inflation picture becomes clearer, we think stock markets are likely to remain uneven and trade sideways. As such, it is possible that we have already seen the low (around 2,225 for the S&P 500 Index)1 and the high (around 2,875)1 for all of 2018, or at least for the next several months.
On balance, we think it is important to acknowledge that a combination of rising rates, higher inflation and growing trade protectionism makes for a tough environment for stocks. But we also think a decent economic backdrop combined with strong corporate earnings and reasonable valuations suggests that the long-term path of equity prices is to the upside.
Robert C. Doll, CFA, is senior portfolio manager and chief equity strategist at Nuveen Asset Management.
1 Source: Morningstar Direct, Bloomberg and FactSet.
2 Source: Labor Department
3 Source: ISI Evercore