Investors take note: 2018 is shaping up as a year of significant change in the outlook for the global economy and financial markets. As our global macro cycle chart shows, we’ve been through a relatively benign period over the last couple of years, with growth improving but inflation staying low.

This has been favourable for risk assets (such as equities and corporate bonds), which benefit from economic growth. It’s also been good for duration assets (government bonds) because low inflation has meant that central banks could keep interest rates low―a positive for bond valuations. Low and stable inflation has also helped to reinforce the negative correlation between bond returns and risk assets.

So far this year, economic data has remained strong and is likely to continue to stay firm through the second half, helped by stimulatory fiscal policy and monetary policy settings which are still very accommodative. The key question is: how long can this last?

There’s a case for arguing that market optimism may have reached its limits: many economic indicators are at record highs, causing expectations to adjust higher, and these expectations have been priced into the markets. On this basis, there seems to be little scope for more upside surprises.

At the same time, inflation risks have begun to rise as capacity constraints start to bite, and many central banks have begun “normalizing” policy: gradually raising interest rates and reducing the bond-purchase programmes. Bond yields have already started to rise as a result, and this process likely has further to run.

As the chart shows, this late-cycle environment—characterised by slowing growth and rising inflation―will generate headwinds for both risk assets and duration-exposed assets, especially as we move into 2019.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams.

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