Investment Outlook: World follows US Fed’s tightening path
Inflation is expected to rise slightly in industrialized countries, but remain stable in emerging markets. Combined with the US Fed's tight monetary policy, this is having a significant effect on the financial markets, as Credit Suisse's Investment Outlook shows.
Inflation is becoming one of the most important drivers of financial markets
The evolution of inflation in the major economies, especially the US and the euro zone, will be a key driver of financial markets in 2019. Upside inflation surprises pose a greater risk to bond and equity markets than limited disappointments in economic growth. January 2018 was a case in point, as a minor upward surprise in US wage inflation triggered the year’s largest correction in equities.
Core inflation will probably rise modestly in the US, euro zone and several other developed economies in 2019 as capacity constraints tighten. By late 2019, unemployment rates in the US and Europe will likely approach 20-year lows. Labor markets are tight in Germany, the UK, Switzerland, Canada and Australia. Even Japanese wages are now rising after declining for most of the past two decades. Yet barring an unforeseen economic shock, we believe labor markets should continue to tighten, pushing wages up further.
Inflation may continue to rise
Wage inflation does not translate directly into price inflation. Other costs, including interest expenses and input costs, especially for raw materials such as oil, are key drivers of headline inflation. If global growth continues, the price of oil and other cyclical commodities could rise further in 2019. Interest costs are also likely to creep up. While labor productivity measures in the US and other developed markets are likely to move higher, this will markedly dampen inflation. In summary, a further increase in inflation seems likely.
High energy prices are driving inflation in emerging markets
In emerging markets (EM) inflation may take a different path than in advanced economies. After 2011, inflation in EMs diverged from the advanced economies as growth remained robust in the former and weakened in the latter following the euro zone crisis. Inflation in EMs then declined on the heels of lower oil prices and weakening growth in China.
Looking ahead, headline inflation in EMs may rise to some extent due to higher energy prices and the broad weakening of EM currencies in 2018. Yet we believe it is likely that monetary authorities in most EM countries will focus on steadying currencies, helping inflation stabilize in the course of 2019.
Industrialized countries and emerging markets are following the US Fed's tightening path
Continuing economic growth and moderately rising inflation suggest that monetary policy will tighten in most advanced and some emerging economies in 2019. The futures market implied that the Fed funds rate would end up below 3 percent by the end of 2019. This would imply one to two further rate hikes in 2019, taking the real Fed funds rate to about 1 percent. The "neutral" interest rate is estimated at close to 3 percent. Hence many market participants will probably consider US policy close to tight by the end of 2019. The European Central Bank (ECB), however, is unlikely to hike rates before H2 2019. Thus, its policy will remain accommodative.
In 2018, EM central banks have had to contend with tighter Fed policy and an appreciating US dollar. The risk case for them is that the US dollar experiences a further marked appreciation while global growth weakens. That would make things very difficult for policymakers. Even in the more benign case of solid global growth and no broad US dollar uptrend, EM central bank rates will tend to rise rather than fall given rising rates in advanced economies. However, most central bank rates are globally expected to end 2019 well below the peaks of the previous cycle.