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Winter is here, but a thaw could be on its way.

Investors should prepare for a thaw

I was recently in New York. While the snow and freezing temperatures ensured there was a chill in the air, my bigger worry was the air of complacency among investors.

Like other stock markets around the world, the S&P 500 Index and Dow Jones Industrial Average were recording all-time highs. Meanwhile, the much followed CBOE Volatility Index (VIX) has been showing stock-market volatility at extremely low levels for some time.

There is certainly much to be positive about. Our economists expect global growth to come in at almost 4% this year, well above the lackluster growth rates of most of the post-financial crisis period. Despite the strength of economic activity, inflation has remained remarkably subdued, allowing the world's major central banks to keep monetary policy loose, or tighten only very gradually.

This combination - decent global growth, subdued inflation, and little in the way of monetary policy tightening - has made for a Goldilocks environment. Not too hot or too cold, but just right.

But I sense many investors are a little too certain the Goldilocks environment will continue into 2018 and beyond. Things do not always pan out as people expect.

The global economy's ability to grow at an above-trend pace, without generating inflation and without triggering tighter monetary policy, is much reduced now that economic slack - spare resources - is dwindling.

The strength of the economic recovery is rapidly eating into spare capacity.

The unemployment rate in the U.S. has fallen to 4.1%, and could fall further. Unemployment is lower still in Japan. Even in the Eurozone, the strength of the economic recovery is rapidly eating into spare capacity.

Turning off the taps

Meanwhile, the taps that have supported the indiscriminate rise in asset prices over recent years are gradually being switched off.

Quantitative easing programs are being wound down and interest rates are starting to be hiked. The U.S. Federal Reserve is now allowing maturing assets bought under successive rounds of quantitative easing to roll off its balance sheet. And the European Central Bank may halt asset purchases by the end of this year.

There are also political and geopolitical risks that could come out of left field to upset markets: events in the Middle East, on the Korean peninsula, and in Europe.

Elections in Italy later this year are likely to be a critical test of the widespread belief that the threat from European political populism has passed.

Longer term, demographic headwinds and mediocre productivity growth still represent speed limits on the pace of economic expansion around the world.

Of course, markets may well continue to climb higher despite these risks. But to my mind, with markets pricing in sunlit uplands as far as the eye can see, now is the time to be a little bit more circumspect.

I expect the soundness of company balance sheets and cash flows to become increasingly important to share price performance in the year ahead. An environment in which many investors all have the same benign, Goldilocks view of the world also speaks to the importance of diversification.

Hopefully my worst fears are not realized, and the strength of the world economy justifies the current exuberance in markets. But investors would do well to prepare themselves for a harsh thaw quickly melting away some of the gains of recent years.

Important Information

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

This article was published in Investment Week on January 11, 2018.

ID: US-180118-55793-1