We have been expecting a pick-up in market volatility as part of our global outlook for 2018. The current volatility episode should, however, be temporary as market participants take note of the gradual normalisation of inflation and monetary policy. All the ingredients are in place for higher inflation this year: tightening labour markets, the traditional lag between growth and inflation, as well as the late-cycle fiscal boost in the US. Signs of a change in price pressures are finally becoming visible in US wage data, strengthening commodity prices, and market-based metrics (breakeven). As highlighted in our 2018 outlook, traditional measures of core inflation should start normalising, although we are still far from overheating territory. Inflation is definitely on the comeback and starting to converge towards central banks’ targets.
Volatility usually resurfaces with increasing inflation and tightening financial conditions. Nevertheless, the context is crucial and volatility must be analysed in the light of macro fundamentals.
Severe and particularly worrisome market corrections typically go hand in hand with an economic recession and a significant decline in corporate profits.
The present economic environment, however, is quite different. Both developed and emerging economies are experiencing economic expansion and fundamentals remain strong across the board. As long as the global growth trajectory is solid, financial conditions remain favourable and companies continue to generate profits, financial markets can resynchronise with underlying fundamentals. Therefore, the current episode should be short-lived, even though market jitters of such a magnitude are painful for investors.
At Lombard Odier, we are keeping our asset allocation unchanged for now and continue to closely monitor the bond market.
