U.S. Investors have enjoyed the return of Goldilocks in 2014. The economy has warmed up nicely, with increased employment and steady rises in corporate earnings helping to drive stock prices to record levels, but it shows no signs of overheating. Long-term Treasury yields have drifted lower over the past year, and inflation expectations, measured by the five-year/five-year forward swap rate, have broken out to the downside thanks in part to a strong dollar.
Like all things that are too good to last, this trend seems unlikely to persist, particularly in the face of two looming risks. The Federal Reserve is itching to start normalizing interest rates, and most analysts expect the first hike to occur at about midyear. Although the economy seems strong enough to take the medicine, no one will know for sure until the Fed moves. The second risk is weakness in the global economy. U.S. stocks have outperformed those of Europe and Japan since the crisis, and the gap has grown wider as those economies have struggled. Is the U.S. strong enough to lift all global boats, or will weakness in Europe and Japan drag the U.S. down?
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