The 2017 environment was underpinned by growing consensus that the global economy was in a ‘Goldilocks’ phase of strong growth and low inflation. 
However, this outlook was challenged in January 2018 by unexpectedly high US inflation data. A sharp government bond sell-off ensued as investors revised upwards their expectations for interest rates, helping trigger an overdue correction in equity markets.
We expect that US economic data will continue to show evidence of higher inflation over the first half of 2018. This is likely due to supportive base effects and the lagged impacts of the weaker US dollar and Chinese reflation. We believe that investors will perceive this as a sustainable upturn in inflation, pushing government bond yields higher.
Against this backdrop, low-duration and floating-rate fixed income strategies should reward.
Performance of fund vs sector YTD
Source: FE Analytics
We hold a position in Angel Oak Multi Strategy Income, which invests primarily in US mortgage-backed securities. It performed very well in the first two months of 2018 and should remain resilient in an environment of moderately higher interest rate expectations.
In equities, we believe that the February sell-off marked the start of a new, higher-volatility regime, due to greater policy uncertainty and the implosion of short-volatility ETFs that exacerbated the market correction.
Stock markets can still make progress as long as economic growth remains strong but higher inflation should prompt a substantial market rotation. We expect the post-crisis winners with sustainable growth prospects will give way to value sectors such as financials and energy, which are more sensitive to rising inflation. We highlight Schroder European Alpha Income and Guinness Global Energy as funds that may prosper over the coming months.
The main risk for equities is that economic growth has peaked – i.e. late 2017 was ‘as good as it gets’ and markets have priced an overly optimistic future outlook for earnings. Softer Q1 economic data has reinforced these concerns and we are very alert to any evidence that growth is fading.
At this stage, we are reassured by record-high CEO confidence and capex plans in the US, which suggest that corporate spending can take over from central bank liquidity as the main economic driver and allow the US to finally transition to a higher quality of economic growth.
We believe that the defining moment of 2018 will be around the sustainability of the current upturn in inflation. We expect this debate to intensify as we reach mid-year.
Our base case is that markets will over-extrapolate the short-term pick-up in inflation and overlook the ongoing structural hurdles to sustained higher price levels.
Despite extraordinary levels of monetary accommodation, G7 central banks have consistently undershot their inflation targets over the 10 years since the financial crisis and there are compelling reasons why this may continue given trends in demographics and technology. Indeed, Japan has shown extremely limited evidence of inflationary pressures despite substantial policy stimulus and an extremely tight labour market.
The rest of the developed world may well follow Japan’s experience and it is quite possible that bond markets will offer a substantial opportunity in the second half of the year. If so, we would look to re-introduce more duration to our portfolios.
Anthony McDonald is a senior investment analyst at City Financial Investment Company Limited. The views expressed above are his own and should not be taken as investment advice.