Fixed Income Outlook  |  Q1 2018

Solid growth makes central bank policy the key question

Fixed Income Team

Solid growth makes central bank policy the key question

The acceleration in global growth witnessed in 2017 should continue well into 2018, we believe, but likely with significant changes in its components. The U.S. economy has been on a solid pace and appears poised to do even better. The economies of Europe and Japan may improve relative to that of the United States as 2018 unfolds. Meanwhile, the United Kingdom may be headed toward a softer version of Brexit as a consequence of recent developments in the country's efforts to separate from the European Union. Overall, we expect reasonably solid global growth, continued policy tightening by the Fed, relatively benign inflation, and a generally supportive environment for risk-driven assets. We also think bond yields may continue to drift higher over the course of 2018 as rate normalization continues.

The Fed will be a key focus of investor attention as a new chair takes office and new governors join the Federal Open Market Committee. While we don't anticipate significant policy changes, we see the potential for misunderstandings in communication as the market adjusts to the tone and language of a new leader.

U.S. growth may accelerate with help from tax cuts

GDP expanded at a 3.3% annualized rate in the third quarter, the fastest pace in three years. The combination of personal consumption spending and corporate fixed investment spending has grown by approximately 2.5%. We see more of the same ahead in 2018 with no obvious downside risks to this pattern.

The Tax Cuts and Jobs Act of 2017 that became law in December is also likely to create some upward momentum. At the margin, corporate tax reforms could buoy the equity markets by raising after-tax earnings, and investment projects that are currently not viable could become worthwhile with a lower tax rate. Of course, the effect may be small because the cost of capital is already low, but it should have a measurable positive impact on growth.

The household tax cuts in the tax package will likely have little impact on consumption because they are, in net terms, very small and geared toward high-income households. But the rally in equity markets creates a wealth effect, and this will boost consumption growth in 2018. The labor market is key to household income and spending, and it continues to improve, albeit at a slower pace.

Europe may improve modestly

The eurozone's strong performance was among the biggest surprises of 2017. The region's growth is also well-balanced. Germany's export powerhouse is benefiting from the global recovery, and France is enjoying a cyclical recovery boosted by rising business confidence in the light of the Macron reform agenda. There are also signs of a rise in corporate investment.

We're paying particularly close attention to European sovereign bonds. In our view, a key policy issue for the ECB early in 2018 will be that the eurozone economy may continue to grow at a faster-than-forecast rate. If this occurs, inflation could begin to rise in the eurozone well before that happens in the United States or the United Kingdom. Increasing inflation could, in turn, lead to upward pressure on interest rates, which could affect not only European bonds, but other asset markets as well.

China turns to restructuring

China avoided a sharp downturn in 2017, but in 2018 the pace of domestic reform may accelerate, with greater emphasis placed on forcing the restructuring of state-owned enterprises (SOEs). The outcome of this restructuring effort depends on whether President Xi Jinping, who has consolidated political power, can overcome the strong links between SOEs, the ruling party, the People's Liberation Army, and a handful of leading Chinese families. Restructuring could slow the economy, and anything that destabilizes internal debt markets creates the risk of a bigger downturn. China also faces the problem of capital outflows. Although outflows stabilized in 2017, the possible appreciation of the dollar in 2018 under tighter Fed policy could cause new pressure.

Inflation remains below expectations

The trajectory of inflation provided many surprises in 2017. Core inflation was weaker than expected by many central banks, especially the Fed and the ECB. In 2017, the Fed's preferred core personal consumption expenditures (PCE) inflation measure dropped sharply, reaching 1.4% in the past few months. Among eurozone countries, core inflation fell to 0.9% over the past two months, defying ECB and market expectations that a new range of 1.1% to 1.2% would hold.

Our internal views show actual inflation rising in 2018, but only minimally, with no risk of deflation. We do not think that higher inflation is a major risk for central banks to address. Still, it's important to remember that central banks target forecasts of inflation rather than actual inflation, and so long as the forecasts show inflation increasing, policy is oriented in that direction.

The biggest risk is the Fed moving too aggressively

Monetary policy clearly is in transition, which is difficult to manage. With the real economy likely to do a bit better in 2018, the Fed has legitimate concerns about the possibility that inflation will tick higher. But the longer-term trends in the economy suggest that higher rates are risky. The impact of demographics, the persistent effects on consumer behavior resulting from the financial crisis, the global disinflationary impulse from the pattern of global competition and technological innovation, as well as high levels of corporate debt — for all these reasons, we think the capacity of the economy to deal with much higher interest rates is limited. So, we think the Fed is going to be playing a risky game in 2018.

Next: Fundamental conditions are supportive for risky assets

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The acceleration in global growth witnessed in 2017 should continue well into 2018, we believe, but likely with significant changes in its components.