Six key questions for 2018

By Adam Chester, Head of Economics at Lloyds Bank Commercial Banking

2017 was a year characterised by an elevated level of political and economic uncertainty, with Brexit, Trump, and an unexpected election impacting markets across the globe. So, as we enter the new year, many market participants will be wondering what the next 12 months have in store. Here we take a look at the year ahead, and consider the key factors that will affect financial markets during 2018.

How far will UK interest rates rise in 2018?

We believe rates won’t move much, but more, however, than the markets expect. Our central forecast is for one further quarter-point rise in the third quarter, taking the Bank rate to 0.75%. With unemployment at its lowest since 1975, inflation well above the Bank of England’s 2% target and the Brexit negotiations having made some clear progress, the risks around our forecast are, if anything, biased to the upside. By contrast, the market is not fully priced for even one more rate rise before spring 2019.

Our rate forecast is based on the UK economy seeing another year of relative resilience. We are forecasting GDP growth this year little changed at 1.5%, while the impact of the earlier fall in the pound on prices should increasingly dissipate, pulling headline inflation down over the course of 2018. But inflation is still expected to remain above 2%, with longer-term upside risks if productivity fails to improve and the tight labour market causes wages to accelerate more sharply.

What about US and euro interest rates?

Despite repeated warnings, the US central bank caught financial markets off-guard last year, raising interest rates three times to an upper bound of 1.5%. With economic growth likely to be further supported by the recently agreed package of tax reforms – including significant tax cuts – we expect the Fed to raise its key policy rate a further three times this year, to an upper bound of 2.25%. US GDP growth is forecast to remain little changed, but solid, at 2.2%.

In the euro area, the ECB has committed to keeping interest rates unchanged for “an extended period of time, and well past the horizon of our net asset purchases”. The acquisition of public and private sector securities, in a move to revive inflation, will be halved to €30bn a month from January until at least September. Thereafter, they are expected to wind down, paving the way for a modest rate rise next year.

And what about Brexit?

At home, broad-based agreement on the UK’s exit terms has raised cautious optimism that a Brexit compromise can be reached. The government is hoping that a transition lasting around two years from 29 March 2019 can be agreed over the next three months, with a deal on the nature of the UK’s longer-term relationship secured by October.

These deadlines continue to look very tight, particularly as unanimous agreement is needed among the other EU members. Still, the potential for an agreement in principle, with the finer details fleshed out during a transition period, may be possible.

Geopolitics – a big risk elsewhere?

2018 looks set to be another year of significant political risk elsewhere. The US midterm elections in November will be the first key test of the depth of Donald Trump’s support. The Democrats seem likely to regain control of the House and possibly the Senate too. If that happens, the President’s remaining two years in office are likely to be gridlocked.

Before then, Italy goes to the polls on 4 March. Support appears principally split three ways between the euro-sceptic Five Star Movement, the centre-left Democrat party and a resurgent centre right, Forza Italia, led by ex-PM Silvio Berlusconi. With the winner unlikely to get a majority, and Five Star having so far ruled out joining a coalition, forming a new and stable government is likely to prove difficult. If that is the case, yet another election could be on the cards later in the year.

There are also either general or presidential elections in Sweden, Brazil, Russia, Venezuela, Iraq and Mexico this year. Civil unrest in Iran, the independence movement in Catalonia, the conflict in Syria and the unpredictability of North Korea also have the potential to move financial markets.

Has the pound turned?

The success or otherwise of the Brexit talks looks likely to be the key driver of the pound this year. Recent signs of progress have helped propel the UK currency up to around 1.35 against the US dollar and have kept it above 1.10 against the euro. Given the extent of recent currency moves, we believe the pound is likely to remain volatile, which could worsen in the near term as negotiations continue.

Overall, we expect the pound to slip over the next six months, but recover a little over the second half to end the year at $1.33 and €1.09.

Will the bubble burst?

Global equity markets have started this year much as they did in 2017, in a euphoric mood. Market participants appear to be betting on the prospect of another ‘goldilocks’ year, characterised by decent world growth, benign price pressures and, crucially, limited rises in interest rates or government bond yields. If the latter proves wrong, equity markets are likely to face a much more challenging year, especially as earnings multiples are at cyclical highs.

We expect central banks to remain highly attuned to the risk of unsettling global financial sentiment through their actions. Although we think interest rates in the UK and US will rise by slightly more than the markets are currently expecting, the difference is limited. With central banks likely to maintain a significant degree of policy stimulus and inflation pressures expected to remain contained, we doubt there will be a major economic catalyst for a correction. As such, geopolitics could pose the bigger risk.

Looking back to our predictions for 2017, our forecasting record doesn’t look too bad. We called the relative resilience of the UK economy and the sharp rise in UK inflation. Our predictions that US interest rates would start to rise more sharply, while the European Central Bank would keep rates unchanged and continue with its monthly asset purchases, also proved correct.

As for 2018? Only time will tell.