Highlights
• 2018 has started off strong for equities and other risk assets.
• Volatility has approached record lows. We don’t expect this trend will continue, and investors should prepare for short-term disruptions.
• The biggest risks for stocks are probably rising bond yields and higher inflation. They are not hurting markets yet, but bear watching.
Investors faced a number of negative headlines last week, including doubts over the future of NAFTA, prospects of the Bank of Japan tapering asset purchases, hawkish comments from the European Central Bank, higher inflation data and saber rattling between the United States and North Korea. But investors focused on the positives, and the risk-on trade continued with global stock prices rising, Treasury prices falling, oil advancing and credit spreads narrowing. For the week, the S&P 500 Index rose 1.6 percent, and is up 4.3 percent for the year, with only one down day (according to Morningstar Direct, Bloomberg and FactSet). We expect gains to continue, but also grow more cautious about potential risks.
Weekly Top Themes
1. 2018 has started off strong for risk assets. Equities and fixed income credit sectors have gained ground thanks to continued solid economic growth. At the same time, several high-profile companies have announced share buybacks and wage increases. We have also seen several hints of further fiscal stimulus as lawmakers have discussed relaxing sequester rules that limit federal spending.
2. Inflation appears to be moving slowly higher. The core Consumer Price Index rose 0.3 percent in December, its strongest reading in 11 months (according to the Labor Department). This helps confirm our view that inflation is firming.
3. Monetary and fiscal policy shifts are driving economic growth and pushing yields higher. After nearly a decade of easing, the Federal Reserve is reducing the size of its balance sheet while slowly increasing rates. At the same time, tax cuts, regulatory rollbacks and government spending are all helping to drive growth. These factors should put more upward pressure on both bond yields and inflation.
4. A comprehensive long-term budget deal is looking less likely. Widespread disagreements exist throughout Congress on defense spending and on immigration, which means a budget deal including those issues is highly unlikely before the January 19 deadline. The threat of a government shutdown has also risen. And President Trump’s reported remarks on Thursday certainly don’t help matters.