Even amid significant geopolitical noise surrounding North Korea, financial markets remain highly complacent. In our opinion, this can be traced back to two main factors. On the one hand, even the pessimists have come to accept that the global economy is actually in quite good shape. On the other hand, serious inflationary pressures are still missing (with core inflation edging down somewhat in the US over the last few months) and this is being used by many market participants to claim that long-term interest rates are set to remain very low for a considerable period of time (if not forever).
One could say therefore that we are in a quasi-perfect situation for almost any kind of financial asset. World economic growth is heading north and that is obviously very good news for corporate profits. Moreover, fixed income is also doing very well with markets still expecting central banks to remain extremely prudent going forward.
But the truth is that this kind of goldilocks scenario (which is creating not only valuation pressures but also extremely low levels of volatility) is almost certainly unsustainable. As spare capacity continues to be brought down all over the world, it is only a matter of time before wage and price pressures become more apparent. This, in turn, will force central banks to react by reducing their extremely big balance sheets and also by gradually increasing interest rates (both nominal and real).
The US economy managed to grow at a 3% annualized rate during Q2 and looks poised to maintain relatively solid momentum going forward: fundamentals for private consumption continue to be strong; corporate investment is clearly in recovery mood; the real estate sector has significant room for further expansion; exports should benefit from a weaker US dollar, etc.
The unemployment rate is already below its long-term equilibrium level and should edge further down in the coming months. The consequence of this will very possibly be a further acceleration of wages, with obvious positive implications for core inflation going forward (this, of course, would show that the fall in core inflation seen at the beginning of this year was mostly due to temporary factors). Moreover, the recent dollar weakness will tend to create additional inflationary pressures over the next 6-12 months.
With geopolitical risks clearly lower than they used to be, macroeconomic data in the Eurozone continue to be extremely positive: economic growth is outpacing potential by a wide margin; expansion has clearly become broader in terms of the number of countries involved; and it is also quite positive to see demand growth coming from both internal sources as well as exports.
Significant levels of spare capacity still exist in the Eurozone, but, at the same time, one should not forget that this spare capacity is rapidly reducing and is obviously not infinite. If unemployment continues to decrease at the same pace seen over the last 12 months (something that should be achievable considering that the economy has been accelerating), the unemployment rate should reach around 8% during the second half of 2018.
Why is this figure important? It is a reasonable estimate of equilibrium unemployment for our region (the unemployment rate averaged around 8.5% during the period before the Great Recession). Some are arguing that underemployment is still high and that this means that the level of spare capacity is higher than implied by the unemployment rate alone. This might well be true, but even if one considers these other measures of spare capacity it is difficult not to see the output gap in the Eurozone closing in eighteen months or so. Countries like Germany, of course, are already running positive output gaps.
As the output gap closes, the most probable scenario going forward in Europe is for both core prices and wages to progressively accelerate. In fact, core CPI has been edging higher since March, possibly anticipating increasingly encouraging progress for this variable during the rest of 2017 and into 2018.
Taking all the above into account it is difficult not to think that public debt is showing signs of bubbly behaviour: despite the world economy doing fairly well (and so much better than many had feared), this has failed to translate into any meaningful upward movement of long-term interest rates. This would not seem to be especially rational, and even more so if one considers what equity markets have done in the meantime.
What could be the trigger for a correction in government bonds? Answering this kind of question is never easy. But we do see two possibilities unfolding over the next 6 to 12 months. On the one hand, we think it is quite probable that both wages and prices edge up more clearly in the near future. This should at some point be reflected in higher long-term rates. On the other hand, it is also possible that in the coming months central banks become progressively more vocal about the need to further normalize monetary policies.
The Fed in particular seems poised to begin trimming its balance sheet in September, while the ECB will begin debating very soon about reducing its QE from January 2018 onwards.
Our central scenario is still one in which the world economy continues to do relatively well and inflation edges progressively higher but does not significantly overshoot targets, in part because central banks gradually reduce the degree of monetary stimulus. However, if markets continue to flatten yield curves and central banks remain too prudent in a context of an improving world economy, inflation rates could well end up significantly overshooting even our above-consensus projections. Should this be the case, the upward movement in long-term rates could be quite abrupt.