The inflation cycle continues to strengthen across the board, with the US and the Eurozone leading the way. In the US, a rise in wages is supporting the inflationary rebound (as the latest core CPI numbers are stronger). In the Eurozone, inflation dynamics appear to be increasingly widespread among sub-indicators (though headline inflation remains below-target). While, in the UK, the inflation cycle appears to have reached a peak, in Japan, it has rebounded, though not in a homogenous manner. All in all, the inflation picture is exhibiting an upward trend across developed markets, with nearly all countries in the inflation or reflation phase of the cycle.
Activity-cycle momentum continues to build, led once again by the Eurozone and the US, with the expansion stage remaining well-anchored in both regions. In the US, the picture has improved substantially, as economic indicators appear to be quite positive (thanks to continued strength in ISM prints both on the manufacturing and on the services segments) and unemployment figures remain low. The much-awaited tax cuts and job reforms are likely to support short-term GDP growth in 2018 by an additional 0.7-0.9%. In the Eurozone, momentum continues to build, with confidence indicators at their highest levels in 20 years. Growth is pointing upwards in most of the G10 countries, as activity cycles are in expansionary territory in all states except New Zealand.
On the debt-cycle front, the slowdown in US credit creation – weakened by lower M&A activity, weaker loan demand due to US policy uncertainties and higher leverage – continues. Furthermore, Japan (and, to a much lesser extent, the Eurozone) has joined in the decline, though their credit growth appears to be continuing but at a slower pace. This is an important factor to take into account, as the debt cycle is a leading indicator of the activity cycle. Hence while we do not foresee any immediate declines or necessary cause for alarm at this juncture, this indicator does call for a cautious stance.
Elsewhere, the monetary cycle appears to be facing hawkish winds on the back of improving activity and inflation cycles. Following better macroeconomic and inflation prints, the Federal Reserve appears to have enough room to hike rates in the US and the Fed dot plots indicate three hikes in 2018. Janet Yellen held her last FOMC in January, when she expressed increased confidence in the economic and inflation improvements and indicated that further gradual increases in the Fed Funds rate were to be expected. We continue to monitor developments related to the potential changes on the board of the US central bank (three members stepping down in 2018) and the tone of the new chairman of the Federal Reserve. In Europe, the ECB is expected to remain accommodative, as its balance sheet will remain large over 2018, and key interest rates will be hiked only next year.
In light of the improving macroeconomic outlook and better inflation numbers in the US, we continue to hold a short position on the long end of the US curve. The implementation of the recently agreed-upon fiscal reforms is also likely to temporarily support US growth levels. As a consequence of the hefty fiscal package (including tax reforms) that was passed, the US will incur a fiscal deficit (to the tune of 5% of GDP) during an activity cycle that is already in the later stages of expansion. This would justify a more restrictive monetary policy and higher interest rates, which the latest FOMC has confirmed. We have maintained our cautious view on the short end of the US curve as markets continue to underestimate the pace of Fed tightening in 2018. NB., we remain flexible and moderate on this position as market positioning appears to be quite high on the short US rates trade. In Europe, the continuous rise in the activity cycle and the ECB’s QE tapering has incited us to continue to hold a short position on the EUR curve. Valuations continue to be at extreme levels, especially on German rates, which appear to be expensive, thereby bolstering our confidence in our strategy. Furthermore, as the ECB faces increasing calls to adopt a more hawkish stance, core rates will continue to face upward pressure.
The non-core European bond markets continue to be supported by the ECB, and flow dynamics are also positive. Despite the reduction in purchases by half from January 2018, purchases and reinvestments remain sizeable in an open-ended programme. While the overall growth and macroeconomic outlook remains strong, positioning has started to look less attractive, as investors have substantially increased their bias to peripheral sovereign bonds. Furthermore, the spectre of elections in Italy (on 4 March) is raising some concerns, as the latest polls indicate that no party has a clear majority and there is significant uncertainty over who the main protagonists of a probable coalition will be. In any case, the formation of a government is likely to be a protracted and tedious process. We believe that very little of this political risk has been priced in. In this context, we have a slightly more favourable view on Portugal and Ireland, both countries having been upgraded in the Fitch ratings on improved financial conditions and reduced debt costs. On the other hand, we are cautious on Spain and Italy, and our overall outlook on peripheral sovereign bonds is neutral.
The overall framework for inflation-linked bonds continues to point upwards, asthe favourable inflation cycle and model balance out a tepid carry (negative in the US). US break-evens appear to be particularly attractive. The dollar is likely to remain weak, recent ISM numbers have been strong and earnings rising. In this context, we have increased our exposure to US break-evens. Furthermore, valuations also continue to be attractive on Canadian and Japanese linkers. In the UK, on the other hand, valuations remain expensive. In this context, and in spite of some caution on the carry, we hold a favourable view on break-evens in the US, Canada and Japan.