(first published January 14)
- 2017 was a stellar year for asset markets: simply being long risk was sufficient to achieve strong returns. For 2018, market participants are optimistic on the back of expectations of above-trend global growth and broadly ac-commodative monetary conditions. Indeed, the new year started with a bang.
- Yet, challenges abound: market and liquidity risks have become elevated and medium term vulnerabilities weigh heavily. The key risks include 1) the outlook for US and DM economic policy, 2) the so-called ‘volatility paradox’ and 3) local EM election risk.
- The greatest risk to asset markets stems not from short term rates (Fed hiking) but both to and from long term rates. The risk of a significantly accelerating US economy is limited, while Fed balance sheet operations and the unfunded fiscal expansion (possibly amplified by spending increases) will pressure long term yields upwards and disrupt the rosy outlook for risk assets.
- A reversal of long-term yields will not just weigh on rates markets, but in particular on stretched equity markets whose relative attractiveness is on the wane. Given the combination of low volatility and high leverage, the adjustment to changing conditions risks being sharp.