A variety of indications point to inflation eventually getting to where the Fed would like it to be (around 2%) and the Fed consequently not needing to keep up the current degree of monetary stimulus. In the US bond market, for example, comparing the yield on the normal 30-year Treasury bond with the yield on its inflation-compensated equivalent shows that the bond markets currently expect a long-term inflation rate of 1.9%. And US forecasters (in the Wall Street Journal’s latest, July, poll) expect inflation to average a bit more than 2% in both 2018 and 2019. They correspondingly expect that the Fed will keep raising the federal-funds rate and that the 10-year US bond yield will rise to 2.65% by the end of this year and to 3.1% by the end of 2018, up 0.8% from today’s level.

The same process looks to be getting under way in the UK and the eurozone, though more slowly. In the UK, as its latest split vote showed, the Bank of England is already very close to raising rates. In the eurozone, it is a bit further away. The latest Reuters poll of economists (published on July 14) found that roughly half of the surveyed forecasters expect that at its September meeting the ECB will say it will start to progressively wind down its bond-buying programme (a "tapering" in the current jargon). Another fourth think there will be a one off reduction in the monthly volume of bonds it buys. Only a fourth think there will be no change to current policy settings. Outright interest-rate changes are, however, still a long way away: The Reuters panel does not expect an interest-rate rise until late 2018, and even then it will be a marginal increase (an increase of 0.1% in the ECB’s deposit rate, which would leave it at negative 0.3%). In the slower-growing eurozone, it will take till 2020 for inflation to get all the way back to the ECB’s 2.0% target.

The period of ultralow bond yields and ultrahigh bond prices looks to be coming to an end. It may be a slow and protracted process, but it is already under way in the US and Canada (the Bank of Canada raised rates by 0.25% on July 12), is on the near horizon in the UK, and visible, though still a way off, in the eurozone. Barring the potential insurance value should some unexpected global market calamity emerge from left field, the economic fundamentals are running against bond returns. The difficulties will be greatest for the sectors most bid up in the previous "hunt for yield" days, with high yield (low credit quality) and emerging-markets debt likely to be under particular pressure. 

International Equities — Outlook

Equity markets have been boosted by what they saw as the prospect of higher interest rates receding recently: the US Fed would, they thought, be likely to hold off on its plans to progressively tighten American monetary policy.

It is more likely, however, that the recent slightly weaker than expected inflation and retail sales data in the US is an aberration set against a generally stronger US and world economy. There is certainly little sign of the US economy faltering. The very latest reading (the IHS Markit US Business Outlook survey for June, published on July 16), shows quite the reverse: “The net balance of firms reporting confidence towards future business activity rose from +27% in February to +35% in June. This is the highest reading since June 2014, with firms citing that sentiment was influenced by opportunities for expansion. ”The global version of the survey found an equally positive outlook for the world economy: “Global business optimism is running at a three-year high with an improved outlook for corporate profits, employment, and investment intentions underscoring the increasing robustness of the economic upturn.”

The same picture emerges from the Economist’s compilation of current economic forecasts (those of a panel of international economic forecasters, and those of its own Economist Intelligence Unit). Of the 57 countries tracked, only two (Saudi Arabia and Venezuela) are expected to experience falls in GDP this year, and only one (Venezuela again) is expected to do badly in 2018. Every other country will be growing in both years, sometimes at very impressive rates, particularly in Asia. In 2018, India is expected to grow by 7.6%, China by 6.3%.

On the plus side, this is a solid prop to corporate profit performance. While it is still early days for the current US quarterly profits reporting season, the first results suggest that companies are beating their expected sales and profits targets, and expectations are high for profit growth this year (9.6% for the S&P 500 companies) and even more so next year (11.6%), according to consensus forecasts compiled by US data company FactSet. On the minus side, the strengthening global economy means the monetary policy tightening that equity investors have been concerned about is now odds on to materialise. Equity markets will be treading a fine line between growing profits in a firming global economy, which are strongly supportive, and a growing challenge from higher interest rates to the current valuation of those profits. This will be especially acute in the US, where share price valuations are well on the expensive side of historical yardsticks.

Also on the minus side, investors have become blasé about potential risks and uncertainties. The VIX, the measure of how much volatility investors expect from holding the S&P 500, has dropped to even lower levels than usual. There is some logic to it: World equity markets have been on a sustained bull run, and investors have come to expect that risks will be steamrolled by the momentum of the global cycle. But as the latest (July 11) "Weekly Letter" from Merrill Lynch said, “a fearless market is one usually feared by seasoned investors. Slower-than-expected growth in the US, an overzealous Federal Reserve, an unexpected geopolitical event—all of these factors could trigger a spike in volatility in the months ahead.”

Performance periods unless otherwise stated generally refer to periods ended Jul 17, 2017

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