If January 2018 felt much like a continuation of 2017, only more so, then the tone in markets since February could not have been more different. 
In short order it was a reminder that stocks can go down, as well as up; that volatility can rise, as well as fall; and that inflation can surprise positively, as well as negatively.
Recent market jitters probably aren’t anything more sinister than a calibration of the tail risks around an otherwise positive economic base case.
Nevertheless, the re-emergence of two-sided inflation risk in some regions, and the moderation in certain higher frequency growth indicators, suggest we need to subtly shift how we express our constructive view as the economy moves through late cycle.
The pattern of coordinated, above-trend global growth enjoyed for the past few quarters is likely to extend throughout 2018. Yet the initial acceleration in growth is fading and the second derivative – how quickly the rate of growth is rising – is slowing. This may seem contradictory, but a prolonged period of stable, above-trend growth is far from unprecedented; the subtlety is that the scope for further upside surprise is diminishing.
Stocks should perform well in this environment, but the surge in global earnings expectations may be moderating, ushering in a phase where consistent delivery rather than the promise of earnings is most rewarded.
The re-emergence of two-sided inflation risks in regions like the US, Canada and the UK reinforces this outlook. Over the last year, the economic environment was characterised by a broad-based pickup in growth with benign inflation; we may be transitioning to a broad-based pickup in inflation with a benign growth backdrop.
In nominal terms, the quantum of overall growth is similar. But while an increase in real growth gives a shot in the arm to earnings generally, normalisation of inflation hands an earnings advantage to regions and firms with pricing power and superior cost controls. There is limited risk of runaway inflation – particularly with eurozone and Japanese core inflation still subdued – but global inflation is gradually rising.
There’s an irony that a central aim of quantitative easing (QE) was to normalise inflation, and now that it’s finally happening investors are concerned that central banks are behind the curve.
A case of being careful what you wish for, perhaps, but the reality is rather more mundane – simply, investors are having to dust off the playbook on trading a sustained rate hiking cycle for the first time in a decade. Investors are also calibrating how far and how fast rates can rise, as well as adjusting for the uncertainty of both a new Federal Reserve (Fed) chairman and the divergence of policy around the globe. We expect 25 basis point (bps) hikes to US rates roughly quarterly through to the end of 2019 – a pace that markets should take in their stride.
In late-cycle environments, stocks tend to perform well until monetary policy becomes genuinely restrictive – which is some way off. Nevertheless, two-sided inflation risk plus policy uncertainty will likely translate to a modestly higher level of market volatility. In this environment, earnings growth rather than multiple expansion is set to be the key driver of equity returns.
Bond yields on the other hand are expected to increase in 2018 as US policy rates are tightened. But ongoing central bank bond buying in Europe and Japan will put a cap on how far bond yields can rise, resulting in flatter US yield curves.
The Fed has certainly not yet “taken away the punch bowl,” nor do we expect it to this year; and with global monetary policy still generally loose, markets can take the ebb and flow of higher frequency economic trends in their stride. Eventually though, when policy is genuinely tight, there will be less capacity to absorb any temporary dip in activity. The good news for investors is that this is unlikely to be an issue this year as economic momentum remains strong yet inflation seems contained.
However, the subtle shifts in the balance of risk around our benign base case for global growth and inflation, reminds us that while markets can withstand a higher level of rates, investors need to be alert to the risks posed by any shift in data which might accelerate the pace of rate hikes.
John Bilton is global head of multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.