Investor attention remains focused on trade issues. Tensions eased somewhat last week, as Chinese officials indicated they may be open to negotiating resolutions. It is possible that the Chinese government may make some concessions that would allow President Trump to claim a political win that wouldn’t disrupt global trade. Should tensions ease further, we think investors will resume focusing on economic developments, which would likely mean that they will start paying more attention to inflation.
The Federal Reserve noted last week that it expects inflation to hit its 2% target in 2019. We think there is a good chance inflation will reach that level this year. The latest reading of the core Consumer Price Index showed inflation has accelerated to 2.1% year over year and we expect it may reach 2.5% by the end of 2018.
Such a backdrop suggests that interest rates and bond yields will continue to move higher in both the United States and around the world. In our view, investors in general remain overly complacent about inflation risks, especially when it comes to the bond market. Bond yields remain quite low and are pricing in an environment of slow growth and near-zero inflation. We believe government bond yields remain lower than they should be given the economic backdrop, and we expect yields to rise in the years ahead.
Higher levels of inflation also represent a possible risk for equities, but one we expect stock markets will be able to overcome. Decent economic growth and strong corporate earnings levels bode well for equity markets, especially if and when trade worries begin to fade. A modest and slow increase in inflation and interest rates shouldn’t be enough to derail the long-running equity bull market.
Over the near-term, markets may remain in a consolidation phase, given all of the economic and political crosscurrents. A combination of reasonable valuations, fading trade fears, still-negative sentiment, good earnings results and successful tests of recent lows means we believe markets may make a run toward the higher end of the current trading range (around 2,750 to 2,800 for the S&P 500). However, downside risks also exist, and it may take some time before equity markets are ready to post new highs.