There are two competing narratives in markets at the moment with very
different investment implications.
The first narrative is the story that economic growth is
strong and earnings are good, and the consensus expects this to continue as the tailwind from the
corporate tax cut continues. The investment implications of 3% GDP growth for the next four quarters is
that short rates will move higher, long rates will move higher, IG credit spreads will narrow, HY credit
spreads will narrow, leveraged loans will perform well, and equities will perform well.
second narrative in markets is the story that global QE is coming to an end and the US is issuing a lot
more Treasuries, which taken together means less demand for global fixed income and much more supply of
risk-free assets, which overall means less appetite among investors for buying risky assets. The
investment implications of this is higher short rates, higher long rates, wider IG credit spreads, wider
HY spreads, and lower equities.
So far markets have for a while traded based on the first
“strong economy” narrative, i.e. that the economy is strong so risk-free rates should move higher and
risky assets should move higher.
Looking ahead we and the Fed and consensus continue to see
robust above-trend GDP growth for the coming 4-6 quarters with the Fed hiking rates five more times
before the end of 2019. And we see long rates moving up to 3.5% by the end of 2018. As long as inflation
remains contained and growth is solid equities will do well. But IG credit is more vulnerable because it
has acted as a substitute for Treasuries for many foreigners who now are faced with significantly higher
The bottom line is that we see volatility higher, rates gradually higher,
credit spreads gradually wider, and equities higher. But with core PCE inflation already at 2.0%, these
views are becoming more sensitive to how much inflation will overshoot 2%. If inflation overshoots the 2%
target by more than the Fed expects then the Fed can no longer allow itself to be slow, gradual, and
cautious. Which would imply a more volatile period for markets, in particular for fixed income, as
investors begin to price inflation risk premia in ways we have not seen for the past decade.
In sum, the “strong economy” narrative still dominates the “liquidity withdrawal” narrative. And the
risk to the economic narrative is not a recession but instead overheating and an associated overshoot in
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