Why three is the magic number for this year

In the monthly round-up of our asset allocation views, Johanna Kyrklund, Global Head of Multi-Asset Investments, discusses the three factors which will determine whether the reflationary environment continues.

For 2018, “3” is the magic number for a reflationary environment to continue.

Growth: We expect global GDP growth to remain at roughly 3% over the next two years. Last quarter we highlighted the potential for the US Congress to surprise on tax reform and this has proved to be the case but we would fade any fiscally-induced excitement at this point as we don’t expect US companies to fully spend the benefits of their tax cut. US 10-year Treasury yield: Based on our models, US equity valuations are sustainable as long as the US 10-year yield does not go above 3%. This would require inflation to remain subdued.

Inflation: As we believe that technological disruption and aging demographics are suppressing inflation, we expect an upper limit of 3% to hold and for the process of monetary normalisation to be gradual. Against this backdrop, valuations become a speed limit for returns over the medium term but we think a period of lower returns is more likely than an imminent bear market.

What could upset the apple cart?

The most obvious answer is inflation. One indicator which suggests that growth (and therefore inflation) could surprise on the upside, is that global trade has been picking up.

Another risk comes from wages. Although wage growth appears to have been unresponsive to tight labour markets so far, research by the Federal Reserve suggests that the Phillips curve is non-linear and when the unemployment rate falls below a certain threshold the relationship between unemployment and inflation will re-assert itself and core inflation will begin to rise.

When we model these two scenarios (“trade boom” and “inflation accelerates”) our global inflation forecast rises from 2.3% to over 3%. From an investment perspective, given market pricing, this outcome would cause volatility in the government bond markets but would also present an opportunity for more cyclically-exposed, value–driven areas of the equity markets to outperform.

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A disappointment on the growth front would be more concerning for us. Developed economies are currently in the “expansion” phase, which is characterised by output above trend, growth accelerating and inflation rising. This phase of the cycle is typically benign for equities. The next phase of the cycle is the “slowdown” phase and this is the worst phase for returns.