Market optimism may be misplaced

Consumer confidence in the euro area has risen to its highest level in a year, while stock market indices are near all-time highs. The more optimistic mood pulsating through consumers and investors since the start of the year seems to be connected to a string of items from the milder winter and falling energy prices to the surprising resilience of the economy and the labour market. Contrary to forecasts just a few months ago, Europe may now avoid a recession.

There is also the fact that inflation is coming down. The rate of growth in prices in Ireland fell for the third straight month in January, mirroring the moderation in inflation seen in other countries.

Slicing through this more upbeat outlook, however, are some worrying signs. Goldman Sachs and Bank of America now say they expect the US Federal Reserve to raise interest rates three more times this year, lifting their estimates after recent data pointed to more persistent inflation and a resilient labour market. A tighter jobs market has the potential to push up wages, which fuels inflation.

Another more generalised reason why inflation might stay elevated is the reversal of globalisation. Geopolitical tensions, populism and trade barriers are going to make trade costlier, keeping prices higher. For decades the West – under the globalisation agenda – has effectively exported inflation by shifting business to low-cost destinations, which kept a lid on prices, but that process has stalled.

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The optimism on markets may also just be that: optimism. Most stock indices are driven by retail investors that have enjoyed a significantly long bull run. The wall of money that fed investment in stocks and real estate over the past decade was chasing yield in a world of zero interest rates. Investors could simply “buy the dip” as any sudden negative moves in markets prompted central banks to step in and buy assets.

That’s all changed. The credit cycle has flipped. By summer the return on US 10-year bonds could be 5.5 per cent. And the fear of financial instability has been replaced by fear of persistent inflation.