The world’s financial markets have begun 2018 in the same bullish fashion that they ended 2017. In the United States, stock markets celebrated the new year by promptly advancing to new record highs. And this performance was echoed in Asia. In Hong Kong the benchmark Hang Seng index gained 2.7 per cent in the first three trading days of 2018, adding to the 36 per cent run-up recorded in 2017.
Investors are largely confident this upward trend will continue through the coming year. Underpinning their confidence is the first simultaneous global upswing the world has enjoyed in years, with each of the major economic regions growing solidly at once.
In the US, economic growth continues to tick over at its not-too-hot, not-too-cold pace, with the possibility of an additional boost from the tax reform bill President Donald Trump signed into law two weeks ago.
In China, the rate of growth has moderated in recent years. But Beijing has so far avoided the financial crunch many outside observers feared. And by trimming excess capacity and pushing state concerns to deleverage, policymakers have established growth on a more sustainable basis, at least for the next year or so.
Meanwhile, emerging economies in Asia have been lifted by the China-driven revival in commodity prices, coupled with last year’s weakening of the US dollar, which made servicing their foreign debts easier.
And even the world economy’s long-time laggards – the eurozone and Japan – are seeing a welcome pick-up in activity, fuelled by the massive money-printing programmes of the local central banks.
So, with global growth humming along nicely, interest rates low, easy financial conditions suppressing volatility, and earnings expectations buoyant, most investors are looking for world stock markets to extend 2017’s gains through the coming year.
With so many people so sure things are going right, the temptation to ask what could go wrong is irresistible.
Of course, there are plenty of dangers that could derail the global bull market. For example, Saudi Arabia and Iran could graduate from their current proxy war to open conflict, sending the price of oil through the roof. Or further weapons tests by North Korea could prompt a military response from Washington.
But the probability of such geopolitical disasters is essentially unknowable. Instead, the biggest identifiable risk that troubles investors is the possibility that 2018 could be the year that global inflation finally makes a comeback.
For years now, inflation has been the economic dog that didn’t bark in the night. As central banks around the world embarked on unprecedented money-printing exercises in a desperate bid to push up nominal growth rates, inflation defied conventional economic wisdom by stubbornly failing to materialise.
In the US for example, nine years after the Federal Reserve cut interest rates to zero and fired up its printing presses, core measures of consumer inflation are still far below the central bank’s modest 2 per cent target rate. In the eurozone, Japan and China, headline measures of consumer price rises remain similarly subdued.
Lately, however, some analysts and investors have begun to fret that inflationary pressures may be starting to emerge. In the US, unemployment has fallen to just 4.1 per cent, well below the 5 per cent rate at which many economists long thought that a shortage of workers would begin to push up wages and prices in a self-reinforcing inflationary spiral.
Similarly, in Germany the jobless rate has declined to a post-reunification low of 3.7 per cent, while in Japan the ratio of job vacancies to applicants has climbed to its highest since 1973.
On top of all that, China is no longer exporting deflation to the rest of the world. Indeed, Chinese policymakers have spent the past two years actively pursuing domestic reflation, with – it has to be said – considerably more success than their counterparts in the developed world.
Through a combination of forced reductions in industrial capacity together with efforts to stimulate the property and construction sector, Beijing has pumped up prices for industrial goods. These increases have been reflected in a rise in producer price inflation – in a nutshell, the prices paid by corporations rather than consumers – to 6 per cent, from an average of minus 3 per cent between 2012 and 2015. Globally, this reflation effort has helped to push key commodity prices up by 30-60 per cent over the last two years.
In short, the early signs of increased inflationary pressure are beginning to build up around the world. The question for investors is whether price rises could accelerate to such an extent over the course of 2018 that heightened inflation expectations prompt central banks to tighten monetary policy much further and faster than currently expected, causing a nasty sell-off in global markets.
Happily for investors, the chances do not look great. What typically triggers such a sustained risk-off move is an abrupt change in central bank policy direction. In the US, that looks unlikely. The Fed is already tightening, and will continue to do so in response to incoming data. In China too, the central bank has shown itself willing to tighten policy to moderate growth and contain excessive inflation pressure if necessary. Neither is likely to change its stance. Nor, by much, is the Bank of Japan, which has repeatedly said that it wants inflation to exceed its target rate.
That leaves the European Central Bank. So far the ECB has declared its intention to continue printing money until September at least, and to keep interest rates negative well beyond that. However, if wages and prices in the eurozone take off faster than projected, the ECB could find itself forced to signal a reversal in its policy earlier than investors currently expect.
The probability may be relatively small, but the consequences could be far-reaching: such a reversal could prove to be the shock that derails the global bull market. So, investors enjoying the early January run-up in world stock markets might well like to keep a close eye on European inflation data as the year progresses. ■
Tom Holland is a former SCMP staffer, who has been writing about Asian affairs for more than 20 years