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BlackRock 2018 Global Investment Outlook

BlackRock Investment Institute: Global Investment Outlook 2018

Setting the scene

  • We see stable global growth with room to run. Eurozone is enjoying its fastest economic expansion since 2011. EM growth looks self-sustaining and the breadth of the global recovery has expanded
    • Manufacturing figures are up in about 80% of countries and US tax cuts could provide a decent dose of fiscal stimulus
  • Consensus expectations have mostly caught up with our GPS for G7 economies over the past year. This suggests less investor drive to play catch-up and embrace the positive growth outlook
  • Expect global economic growth to chug along in 2018 but see less room for upside surprises to lift markets
  • Buoyant equity and credit markets might suggest investors are exuberant. Yet our analysis points to undertones of caution
    • “Risk ratio” gauges how much investors are bidding up the value of risk assets relative to perceived safe havens such as cash and government bonds; even with equity markets reaching new highs, US ratio is showing few signs of the type of euphoria seen just before the 2000 dot-com crash and 2008 GFC
  • We believe investors have been scarred by previous market crises which has led them to save more as a buffer against future economic shocks
    • This does not mean either risk assets or perceived safe havens are immune from potential risks such as inflation or monetary policy surprises

Theme 1: Room to run

  • Expansions come and go. We see this one hanging around for longer than many expect
  • The G7 output gap – the difference between actual output and economic potential – is shrinking as the US economy has joined Germany, the UK and Canada in running near full capacity
    • Yet, when growth is only slightly above trend, economies can run beyond potential for a long time before peaking
    • Plenty of spare capacity in parts of Europe means the developed world as a whole still has a hefty output gap
    • Suggests to us that the remaining time to this cycle’s peak is likely years, not quarters
  • Deficit-funded tax cuts could push US growth further above trend, leading to a faster buildup of imbalances that hasten the cycle’s end. The longer a cycle lasts, the more investors worry about its demise. Yet even if positive growth surprises are behind us, we believe the above-trend level of growth should be positive for risk assets
  • We believe investors are underestimating the durability of this expansion
  • Above-trend economic growth is helping companies deliver on earnings
  • Believe EM economies can withstand a moderate slowdown in China, and see growth momentum as many are in an earlier stage of expansion than DM
  • Brazil and Russia have emerged from recession while we see India bouncing back from a reform-induced slowdown
  • In EM debt, expect coupon-like market returns as 2017’s positives – low US rates and a weak dollar, accelerating Chinese growth, and EM monetary easing – reverse or fade

Theme 2: Inflation comeback

  • Our GPS has long pointed to US core inflation rising back to the 2% level. We see 2017’s surprising soft patch as fleeting and expect markets to grow more confident in the inflation outlook
  • Wages are grinding higher and one-off factors, notably an adjustment to how wireless data costs are measured, will was out of inflation readings
  • Expect modest upside in Eurozone prices but share the ECB’s outlook for inflation stuck below target at least through 2019
  • US inflation appears poised to re-awaken, whereas price pressures elsewhere are minimal
  • Fed will be under new leadership but we see it pressing ahead with shrinking its balance sheet – and delivering its projected three 0.25% rate increases in 2018 (4th move could come if Fed expects tax cuts to raise inflationary pressures)
  • Markets will be sensitive to any early signs that the ECB or BoJ may shift policy gears. We expect both will still be net buyers of assets in 2018, albeit at a slower pace

Theme 3: Reduced reward for risk

  • It was a near-perfect year for risk assets in 2017, but the road ahead looks more challenging
  • Asset valuations have risen across the board, market volatility has stayed very low and many perceived risks have not materialized
  • We believe structurally low interest rates mean equity multiples can stay higher than in the past
  • Economic expansion supports both equities and credit but we prefer to take risk in the former
  • US credit spreads against Treasuries are near their mid-2000s lows; such tight spreads mean that even a small sell-off can wipe out credit’s extra income over government bonds
  • Credit prices tend to fall hard in any equity sell-off as default worries come to the fore, albeit by less than equities

Debate 1: Volatility regime shifts

  • Outbreaks of higher equity market volatility have tended to overlap with periods of elevated volatility in economic data
  • Steady economic backdrop today suggests little risk of a shift to a high equity volatility regime
  • Move to high economic volatility typically requires excessive financial sector leverage such as that seen in the lead-up to the GFC; we are not in that place today
  • We see few warning signs of rapidly increasing leverage; financial leverage looks largely in line with history in most DMs and low in some
  • Picture is different in China. We see Beijing curbing credit growth and moving toward deleveraging, but high debt levels and fragile credit channels make the economy vulnerable to shocks
  • We see no obvious catalyst to spark a shift to a high volatility regime but hidden risks such as concentrated positioning in credit bear watching

Debate 2: Assessing vulnerabilities

bucketing risk

Debate 3: China on the global stage

  • Reform is center stage in China after President Xi Jinping cemented his grip on power
  • Among his priorities: cutting industrial capacity, cleaning up the environment, cracking down on property speculation and curbing rapid credit growth
  • Key challenges: 1) maintaining domestic stability amid reforms; 2) reducing financial leverage without upsetting financial stability; and 3) managing conflict with the US in the quest for economic supremacy
  • China has all but stopped exporting deflation to the rest of the world. Capacity cuts have put a floor under commodities prices and boosted the value of Chinese exports
  • Prices of US imports from China are still falling, but at a slowing rate. And overall import prices in the US and Eurozone are rising on the back of higher commodities prices
  • We see an inflation bump out of China modestly helping to prop up global inflation

Debate 4: Geopolitical risk

  • Markets may be eerily calm but geopolitical risks abound. They range from North Korea’s nuclear program and missile launches to proxy wars between Saudi and Iran
  • US Treasuries and gold provide a buffer against any risk asset sell-offs
    • These perceived safe havens tend to rally ahead of “known unknowns” such as elections, then lag after the event as fading uncertainty boosts risk assets
  • Geopolitical risks have historically tended to cause only short-lived sell-offs in global risk assets, provided the economic backdrop is steady
  • A tougher US approach on trade looms as a major threat to the global free-trade regime
  • We see US tensions with China over trade and security increasing and view NAFTA negotiations as a barometer for the new “America first” stance

Government bonds and credit

  • Yield curves have been flattening, particularly in the US. This is usually a late-cycle phenomenon but these are unusual times. Low growth and inflation expectations, coupled with insatiable global demand for income, have held down long-term yields across the world
  • We expect income-starved and safety-seeking investors to keep chasing relatively scarce G3 bonds – holding rates well below historical averages
  • The global search for yield has driven many fixed income investors into unfamiliar territory
  • Many have embraced more credit risk, spurred by negative rates in many DM economies and low yields on perceived safe-haven assets. Some have ventured beyond the bond markets
  • Investing in higher-yielding but often illiquid credit and selling options can be self-reinforcing, driving volatility lower on the way down, but exacerbating any reversals on the way up
    • We prefer an up-in-quality stance in credit amid tight spreads, low absolute yields and poor liquidity

Equities

  • All major regions increased earnings at a clip faster than 10%, the strongest growth since the post-crisis bounce
  • Expect more good things in 2018 but 2017 will be a tough act to follow
  • We see the economic and earnings backdrop as positive for equities, with fuller valuations a potential drag, especially the US corporate tax cuts would boost US earnings, with different effects across sectors and companies
  • Equities in Japan, the only major region to see multiple contraction in 2017, look well positioned
  • EM equities had a tiger in their tank in 2017, ending years of underperformance versus developed peers. We believe they can run higher
  • EM companies have reduced wasteful investments and our math finds FCF yield for non-financials exceeds that of DMs for the first time since 2007. ROE is finally improving and valuations are rising
  • We see the greatest opportunities in EM Asia but note positive progress in Brazil and Argentina. We do not see moderate Fed tightening or USD gains harming the investment case

Commodities and currencies

  • Strong global growth momentum lifted industrial metals prices until recently
  • We see capex discipline and China’s supply-side reforms propping metals prices in 2018
  • The rise of EVs has brightened prospects for copper as well as for niche commodities such as lithium, cobalt and graphite
  • We see rapid EV adoption reducing oil demand in time but an easing in the supply glut and geopolitical risks put a floor under prices in the short term
  • We prefer commodities exposure via related equities and debt. Both have lagged the growth in underlying spot prices and a number of resource firms are sharpening their focus on profitability
  • We could see the USD appreciating at least in the first half. We expect any gains to be modest as the Fed stays slow and steady in normalizing rates
  • Any dollar strength may stall when markets start focusing on when other central banks might shift their policy gears
  • We expect the ECB and BoJ to be wary of any sharp currency rises as these could stymie efforts to ignite inflation
  • We see scope for a pound rebound if the UK can strike a transition deal with the EU

Factors and private markets

  • The momentum factor reigned in 2017 – led by technology companies. Its share in the MSCI ACWI Momentum Index jumped to 42% at the latest rebalancing in December from 30% in June. This is followed by financials in a distant second at 17%
  • We also like the value factor, home to the cheapest companies across sectors. The additional perk: Value would likely outperform in any momentum sell-off, if the long history of negative correlation between the two factors is any guide
  • Number of US-listed companies has dwindled from a mid-1990s peak, while private firms are rising in number
    • Reasons include robust M&A activity and a dearth of IPOs amid easier access to private capital
    • There are around 100,000 US private firms with 100 employees or more, more than 25x the number of public companies
    • Story is similar in credit: public US high yield market has shrunk for a second straight year in 2017
  • Private markets tend to be illiquid and are not suitable for all investors. Yet for those with longer horizons and a willingness to deal with complexity, they are worth a look
  • We prefer less-explored pockets such as assets levered to e-commerce in private equity; opportunistic and middle-market credit; and growth areas such as renewable power in infrastructure

Image Source: BlackRock Investment Institute

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