Boston - The recent volatility has been at least partly driven by markets reacting to higher interest rates and a Federal Reserve that appears committed to further tightening. We expect more turbulence as investors realize the Fed and even other central banks are determined to pull back accommodative monetary policies that have supported markets since the financial crisis.
"If there is a surprise from the Fed, it will likely be more aggressive tightening to counter late-cycle inflationary pressures or the effects of fiscal stimulus."
Corporate tax reform is boosting the U.S. economy, which is in its second-longest expansion since the Civil War. Tax reform has delivered both short- and long-term impacts. The most meaningful impacts over the shorter term should continue to drive above-trend growth for the next few quarters. This should contribute to continued outperformance of the U.S. versus other major global economies. At the same time, we expect inflation to continue trending higher but to remain under control.
We don't see any reason for the Fed to veer off of its current course of gradual interest-rate hikes. If there is a surprise from the Fed, it will likely be more aggressive tightening to counter late-cycle inflationary pressures or the effects of fiscal stimulus. ECB policy could also take a more hawkish turn. In late September, President Draghi said that the ECB expects "a relatively vigorous pickup in underlying inflation," a statement that sent global bond yields higher.
The U.S. has implemented various tariffs, and there are signs that these tariffs are raising costs in certain sectors of the economy, a situation we are closely watching. That said, we remain optimistic that the U.S.'s tough stance on trade is part of a strategy to negotiate more favorable trade terms for the U.S. and not the start of a global trade war. The White House recently announced a trade deal with Mexico and Canada and is in negotiations with the EU and Japan — developments that suggest China is the focus of U.S. trade policy. With respect to China, it remains to be seen whether the administration will be able to reach an agreement. This poses downside risk to financial markets.
In addition to global trade, we are also monitoring the U.S. midterm elections, as well as the looming Brexit deadline, the fiscal policy of Italy's new populist government and the imbalances facing several emerging economies. Domestic risk markets largely ignored these and other geopolitical hot spots during the third quarter. Going forward, we believe one or more of these issues will eventually have an impact. Meanwhile, U.S. interest rates continue to rise and will likely come under additional pressure given the government's need to finance significantly higher budget deficits in the near term.
