(Bloomberg View) -- What could go wrong? Apparently nothing, based on the performance of financial markets in the first week of 2018. Equities globally continued to reach new records, highlighted by the Dow Jones Industrial Average surging above 25,000 for the first time on Thursday. The MSCI All Country World Index's three-day gain of 2 percent gain is the most since April.
But the animal spirits extend beyond equities. In the bond market, the cost to protect junk-rated corporate debt from default with credit derivatives fell to the lowest since 2014. An MSCI measure of emerging-market currencies has soared to its highest level since 2013. A Bloomberg measure of risk sentiment rose to the highest since 2015. All of this would be concerning if the fundamentals weren't cooperating -- but they are, and in a big way. In the major economies, the data has been exceeding estimates at a rate not seen since 2010, according to Citigroup indexes. In a report dated Jan. 3, Wells Fargo boosted its major economy growth forecast to 2.3 percent in 2018 from its prior estimate of 2.2 percent. Real interest rates are still negative and corporate earnings are on the rise.
Even Jeremy Grantham, long known for his bearish views, says the market's next move could take stocks much higher. “As a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market,” Grantham, the chief investment strategist for GMO in Boston, wrote in a letter to investors Wednesday.
INFLATION JITTERS
Of course, that doesn't mean the risks are nonexistent. Many investors are noting that inflation is finally showing signs of stirring. And if that's the case, it could cause central banks to remove monetary policy accommodation at a pace that's faster than is currently priced in by the markets. Worldwide data have recently made clear that producer-price increases have picked up steam, according to Bloomberg News' Liz Capo McCormick and Sid Verma. They note that U.S. breakeven rates on bonds, or what traders expected the rate of inflation to be over time, are above 2 percent in many tenors for the first time since March. While few are betting on runaway increases anytime soon, even a modest uptick in prices could have an outsize impact on sentiment and change the prevailing narrative. “For the markets, inflation is an underappreciated risk in 2018,” Peter Boockvar, the chief financial officer at Fairfield, New Jersey-based Bleakley Financial Group, told Bloomberg News. The strongest manufacturing activity since the aftermath of the global financial crisis is slowly draining commodities surpluses, sending the Bloomberg Commodities Spot Index, which tracks the price of 22 raw materials, to its highest since December 2014 on Thursday. The gauge has risen for a record 14 days in a row.
GLOBAL DEBT REACHES $233 TRILLION
The Institute for International Finance came out with a report Friday that should please bond market bears and bulls alike. The bad news is, the amount of global debt outstanding rose by $16.5 trillion in the first nine months of 2017 to a record $233 trillion, adding to notions that the worldwide economy is awash in debt it can never pay back. The good news is that at around 318 percent, global debt-to-GDP is 3 percentage points lower than its all-time high of 321 percent in the third quarter of 2016. The IIF said a combination of factors including synchronized above-potential global growth, faster inflation in places such as China and Turkey, and efforts to prevent a destabilizing build-up of debt in China and Canada all contributed to the decline. Overall, 34 of the 47 countries in its sample have recorded a decline in debt-to-GDP ratios. To be sure, debt levels are still at historically high levels, and as a result the IIF expects central banks to remove accommodation very slowly so as not to inflict massive losses that could jeopardize the global economy.
JUNK BOND WARNING
While stocks may get the headlines, the tremendous rally in junk bonds can't be overlooked. The Bloomberg Barclays U.S. Corporate High Yield Bond Index also continues to reach new highs as corporate profits rise. The cots to insure the debt against default has dropped this week to 2.95 percentage points, down from more than 3.5 percentage points a year ago. But to Morgan Stanley Wealth Management, it's too late in this market cycle to bet on the bonds, according to Bloomberg News' Dani Burger, who reports that the $2 trillion money management arm is completely slashing its allocation to junk bonds. Although tax cuts are expected to inject fresh momentum into high-flying stocks, the boost may be short-lived and mask balance-sheet weaknesses, Mike Wilson, the firm's chief investment officer, wrote in a research note distributed Wednesday. “While the tax cuts just enacted in the U.S. may lead to better growth in the short term, they may also bring forth the excesses we typically see before a recession — which is something credit markets figure out before equities,” according to the note. “We recently took our remaining high yield positions to zero as we prepare for deterioration in lower-quality earnings in the U.S. led by lower operating margins.”
THE DOLLAR AS SAVIOR
And what about central banks and the notion that monetary policy is undergoing a change to a less accommodative environment, which could dent animal spirits? Well, if you are worried about that then you should be thankful that the dollar has suddenly turned weaker again in recent weeks. The Bloomberg Dollar Spot Index fell Thursday to its lowest level since September. That's significant because a weaker dollar could do the work of global central banks, according to Bloomberg News' David Goodman, Anchalee Worrachate and Enda Curran. They report that analysts at Bank of New York Mellon and Credit Agricole say further declines could mean central banks don't have to tighten monetary policy as much as they may now be planning. The argument goes that by forcing up rival exchange rates, a decline in the U.S. currency could slow economic growth and inflation elsewhere, creating room for interest rates to stay lower than they otherwise would be. With the euro already close to a three-year high against the dollar, a further slide in the U.S. currency may have implications for the European Central Bank's path away from its stimulus plan. President Mario Draghi has previously stepped in to curb the surge in the euro, warning in September that currency volatility could have a detrimental impact on price stability.
TEA LEAVES
The first week of 2018 has been marked by animal spirits in financial markets, as optimism over the global economy only gets stronger. It's unlikely the monthly U.S. jobs report Friday will do anything to limit the euphoria. Although the median estimate of economists surveyed by Bloomberg is for a dip in job creation last month to 190,000 from 228,000 in November, that's still a level that marks a robust labor market and should help put upward pressure on wages. Bloomberg Economics projects a mild acceleration in the pace of hiring in the first half of 2018, but as labor-cost pressures build with an unemployment rate dipping below 4 percent, productivity will ultimately accelerate, as well.
If you'd like to get The Daily Prophet in e-mail form, right in your inbox, please subscribe to this link. Thanks!
DON'T MISS
Commodities' Modest Growth Is Offset by Risk: Shelley Goldberg
Dovish Views on U.S. Labor Market Are Wrong: Charles Lieberman
Global Markets Are Less Stable Than They Appear: Satyajit Das
Who's Running This World? Look Beyond the Ballot: Daniel Moss
Short-Term Thinking Distorts Economic Policy: Michael R. Strain
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Robert Burgess is editor of Bloomberg Prophets.
To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.
For more columns from Bloomberg View, visit http://www.bloomberg.com/view.
©2018 Bloomberg L.P.
Essential Business Intelligence, Sharp Market Insights, Practical Personal Finance Advice, Daily Fuel, Gold and Silver Prices and Latest Stories — On NDTV Profit.
