'Inflation the big X-factor'

Equity investors can ill-afford to ignore the signals being sent by bond markets, strategists argue.

Two-year US government bond yields climbed on the weekend back to 2 per cent , a level last seen in 2008 at the end at the height of the global financial crisis.

The trigger for the rise came from the release of US inflation data on Friday that showed a 0.3 per cent rise in monthly core consumer prices, which exceeded economist expectations for a 0.2 per cent increase and raised the possibility that inflation could rise further.

That surge in two-year US treasury yields came hard on the heels of a jump in US 10-year Treasury yields to more than 2.5 per cent last week when signs emerged that the Bank of Japan and the European Central Bank could be preparing to reduce the liquidity that has kept global asset markets afloat since the global financial crisis.

"After barely rising in 2017, 10-year Treasury yields rose by 15 basis points in a matter of days," noted Michael Pearce at Capital Economics.

The rise in US Treasury yields - which move inversely to prices - shows that markets haven't been listening to the Federal Reserve's interest rate guidance and are now playing catch-up, said Matt Sherwood, head of investment at Perpetual.

As the US economy strengthens, a US rate rise in March is now firmly on the cards and there is a small risk that the Federal Reserve could raise interest rates four times this year instead of three, Mr Sherwood said.

"Inflation remains the big X-factor," he said, with the pace, not the size, of any increase the key.

For equity markets, while a little bit of inflation can be good for earnings, inflation can become a problem if price rises infiltrate the labour markets and costs start to rise for companies, Mr Sherwood said.

"I'm not worried in the short term. The first six months of 2018 is probably going to be good for risk markets with inflation subdued but growth strengthening," he said.

The second half of the year could be a different story, however, where the economic backdrop could move to a more reflationary environment, where both growth and inflation were strengthening, he said.

Investors needed to have realistic expectations about growth and interest rates, he said, as "not only are rates rising but valuations are looking toppy."

Another factor that could come into play for equity markets is that higher interest rates can act as a brake on economic growth as monetary conditions tighten, particularly in the US.

Mr Pearce said he was expecting this scenario to play out in 2019 and potentially as soon as the second half of 2018.

"The cumulative tightening in monetary policy will feed through to the economy, mainly through higher borrowing costs," he said. "A more marked rise in borrowing costs could lead to a sharper slowdown in consumer spending, perhaps as soon as the second half of this year."

ANZ strategists said they believed 2018 was likely to be a tipping point for markets, where optimism has been underpinned by a combination of strong global growth and abundant global liquidity.

"We think that this picture is probably as good as it gets," they said. "The foundation of a higher volatility regime continues to be laid, while risk appetite continues to stretch to ever less sustainable levels."

This story 'Inflation the big X-factor' first appeared on The Sydney Morning Herald.