A Growth Recovery In Waiting

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Major central banks have eased monetary policy in recent months, delivering on the anticipated policy pivot that informs one of our key investment themes. We expect policy easing to help sustain the economic expansion, and already see easier financial conditions. Yet, the road to recovery could be bumpy due to the persistent uncertainty from protectionist policies. We see growth troughing over 6-12 months, supporting our moderately pro-risk stance over this period.

Chart of the week

The BlackRock G3 Financial Conditions Indicator and Growth GPS, 2015-2020

Source: BlackRock Investment Institute with data from Bloomberg and Consensus Economics, September 2019. Notes: The BlackRock Growth GPS shows where the 12-month forward consensus GDP forecast may stand in three months’ time. The orange line shows the rate of GDP growth implied by our financial conditions indicator (FCI), based on its historical relationship with our Growth GPS, shifted forward 180 days. The FCI inputs include policy rates, bond yields, corporate bond spreads, equity market valuations and exchange rates. Forward-looking estimates may not come to pass.

Growth expectations for key developed economies have faltered since 2018, as indicated by our BlackRock Growth GPS for G3 economies (the U.S., Japan and euro area). Financial conditions have eased in recent months in these economies thanks to policy easing, according to our Financial Conditions Indicator (FCI). The historical relationship between our FCI and GPS points to potential for a growth pickup in the coming six months. Some pockets of the economy that are more sensitive to interest rates appear to be slowly responding to easier financial conditions: In the U.S., the housing market appears to have turned a corner and auto sales have held up. In the euro area, machinery investment rebounded. But easier financial conditions have yet to support a broader economic recovery.

Central banks’ policy stimulus is here, as illustrated in our updated 2019 Investment Outlook. The Federal Reserve has delivered its second rate cut since the financial crisis – and looks set to ease policy further. The European Central Bank (ECB) materially exceeded market expectations in early September, launching a broad package with combined impact that should potentially be greater than the sum of its parts. These actions have provided support to risk assets. Yet, we do not expect a repeat, and believe markets are likely pricing in too much additional Fed easing in the year ahead. We see little near-term risk of recession, thanks to easier financial conditions and still-robust U.S. consumer spending. And it’s far from certain the Fed will try to respond to the trade war fallout with meaningfully looser monetary policy. Supply chain disruptions could hit productive capacity, fostering mildly higher inflation even as growth slows. This complicates the case for further policy easing.

What does this mean for markets? We see the monetary stimulus delivered to date operating with a lag. We are likely to see the German economy – Europe’s largest – contracting for another quarter. We still view the protectionist push as a key driver of global markets and economy. The U.S. and China appear likely to engage in trade talks again. We see some possibility of a truce, but a comprehensive trade deal as unlikely. Persistent uncertainty from protectionist policies is likely to remain a drag on corporate confidence and business spending. Robust consumer spending in the U.S. is key to our view that this long economic expansion is likely to remain intact.

Bottom line: We see moderate risk-taking likely rewarded, even as recent events reinforce our call for a greater focus on portfolio resilience. We prefer U.S. equities for their reasonable valuations and relatively high quality, and the min vol and quality factors for their defensive properties. We like emerging market debt for its coupon income. We are overweight euro area sovereigns: a relatively steeper yield curve brightens their appeal even at low yields. And we see government bonds as important portfolio stabilizers.

Assets in review

Selected asset performance, 2019 year-to-date and range

Selected asset performance, 2019 year-to-date and range

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, September 2019. Notes: The dots show total returns of asset classes in local currencies. Exceptions are emerging market (EM), high yield and global corporate investment grade (IG), which are denominated in U.S. dollars. Indexes or prices used: spot Brent crude, MSCI USA Index, DXY, MSCI Europe Index, Bank of America Merrill Lynch Global Broad Corporate Index, Bank of America Merrill Lynch Global High Yield Index, Datastream 10-year benchmark government bond (U.S. and Italy), MSCI Emerging Markets Index, spot gold and J.P. Morgan EMBI index.

A perceived easing of U.S-China tensions and an attack on Saudi Arabia’s oil infrastructure show how geopolitical frictions are key market drivers. Major central banks have taken a dovish stance – the Fed has cut rates in line with market expectations, following the ECB’s broad stimulus package. Yet, the Fed’s noncommittal stance on its future policy path reinforces our view that there are limits to how much monetary easing can be delivered in the near term. Monetary policy is no cure for the weaker growth and firmer inflation pressures associated with sustained trade tensions.

Week ahead

Sept. 30 – China PMI data offers an opportunity to assess the health of the country’s vast manufacturing sector. Factory activities have contracted since May, pressured by U.S.-China trade tensions and sluggish domestic demand.

Oct. 1 – The euro area’s flash inflation reading is likely to show core inflation rising from current exceptionally low levels, but still far below the ECB’s target. Our outlook on the area’s inflation has become more subdued.

icon-up Overweight icon-neutral Neutral icon-down Underweight

Asset Class View Comments
U.S. icon-up A supportive policy mix and the prospect of an extended cycle underpin our positive view. Valuations still appear reasonable against this backdrop. From a factor perspective we like min-vol, which has historically tended to perform well during economic slowdowns.
Europe icon-neutral We have upgraded European equities to neutral. We find European risk assets modestly overpriced versus the macro backdrop, yet the dovish shift by the European Central Bank (ECB) should provide an offset. Trade disputes, a slowing China and political risks are key challenges.
Japan icon-down We have downgraded Japanese equities to underweight. We believe they are particularly vulnerable to a Chinese slowdown with a Bank of Japan that is still accommodative but policy-constrained. Other challenges include slowing global growth and an upcoming consumption tax increase.
EM icon-neutral We have downgraded EM equities to neutral amid what we see as overly optimistic market expectations for Chinese stimulus. We see the greatest opportunities in Latin America, such as in Mexico and Brazil, where valuations are attractive and the macro backdrop is stable. An accommodative Fed offers support across the board, particularly for EM countries with large external debt loads.
Asia ex Japan icon-down We have downgraded Asia ex-Japan equities to underweight due to the region’s China exposure. A worse-than-expected Chinese slowdown or disruptions in global trade would pose downside risks. We prefer to take risk in the region’s debt instruments instead.
Fixed income
U.S. government bonds icon-down We remain underweight U.S. Treasuries. We do expect the Fed to cut rates by a further quarter percentage point this year. Yet, market expectations of Fed easing look excessive to us. This, coupled with the flatness of the yield curve, leaves us cautious on Treasury valuations. We still see long-term government bonds as an effective ballast against risk asset selloffs.
U.S. municipals icon-up Favorable supply-demand dynamics and improved fundamentals are supportive. The tax overhaul has made munis’ tax-exempt status more attractive. Yet, muni valuations are on the high side, and the asset class may be due for a breather after a 10-month stretch of positive performance.
U.S. credit icon-neutral We are neutral on U.S. credit after strong performance in the first half of 2019 sent yields to two-year lows. Easier monetary policy that may prolong this cycle, constrained new issuance and conservative corporate behavior support credit markets. High yield and investment grade credit remain key parts of our income thesis.
European sovereigns icon-up The resumption of asset purchases by the ECB supports our overweight, particularly in non-core markets. A relatively steep yield curve – particularly in these countries – is a plus for euro area investors. Yields look attractive for hedged U.S. dollar-based investors, thanks to the hefty U.S.-euro interest rate differential.
European credit icon-neutral Renewed ECB purchases of corporate debt and a “lower for even longer” rate shift are supportive. European banks are much better capitalized after years of balance sheet repair. Even with tighter spreads, credit should offer attractive income to both European investors and global investors on a currency-hedged basis.
EM debt icon-up We like EM bonds for their income potential. The Fed’s dovish shift has spurred local rates to rally and helped local currencies recover versus the U.S. dollar. We see local-currency markets having room to run and prefer them over hard-currency markets. We see opportunities in Latin America (with little contagion from Argentina’s woes) and in countries not directly exposed to U.S.-China tensions.
Asia fixed income icon-neutral The dovish pivot by the Fed and ECB gives Asian central banks room to ease. Currency stability is another positive. Valuations have become richer after a strong rally, however, and we see geopolitical risks increasing. We have reduced overall risk and moved up in quality across credit as a result.

Notes: Views are from a U.S. dollar perspective over a 6-12 months horizon.

Read details about our investment themes and more in our Global Investment Outlook Q4 2019 update.

Protectionist push

U.S.-China tensions ostensibly eased ahead of a new round of trade talks in October. We don’t see any short-term deal solving long-term strategic issues such as technological dominance and implications for national security.

  • Persistent uncertainty from protectionist policies is denting corporate confidence and slowing business spending, hurting the global industrial cycle – a key reason for our global growth downgrade.
  • The longer-term risk from protectionism: The unravelling of global supply chains delivers a supply shock that saps productivity growth, reinforces a slowdown in potential output and leads to higher inflation.
  • The attack on Saudi Arabia’s oil facilities shows how geopolitical risks can materialize in multiple ways. A prolonged oil price shock, along with tariffs, could deepen concerns around the risk of lower growth and firmer inflation pressures.
  • Market implication: We favor reducing risk amid rising protectionism, including raising some cash.

Stretching the cycle

The record-long U.S. economic expansion is supported by healthy household spending and looks unlikely to morph into a deeper downturn anytime soon.

  • The Fed cut rates by a quarter point for a second time since the financial crisis, yet stopped short of bolder actions. This supports our view that the market’s easing expectations are excessive. The trade war is bad for growth, but we still see potential for U.S. inflation to rise in the near term due to the direct one-off impact of tariffs. In the longer term, the resulting hit to production capacity could also be inflationary, complicating the case for policy easing.
  • We believe policymakers should lay the groundwork for a credible plan to navigate the next economic shock that includes unprecedented coordination between monetary and fiscal measures. We lay out the contours of such a framework in our latest Macro and market perspectives. The absence of a credible plan is contributing to market anxiety and adding to the rush into the perceived safety of government bonds.
  • Chinese authorities have cut bank reserve requirements, lowered private sector borrowing costs and boosted infrastructure spending. Yet, the stimulus remains limited, with a focus still on shoring up the financial system.
  • Market implication: We like U.S. equities and EM debt. We are overweight euro area government bonds: a relatively steeper yield curve brightens their appeal even at low yields. We are neutral European equities and credit.

Raising resilience

A sharp spike higher in U.S. money market rates – a cornerstone of the financial system – jolted market participants and highlighted the importance of portfolio resilience.

  • The underperformance of momentum and outperformance of value show the importance of minimizing portfolio exposure to pockets of the market where pricing appears stretched.
  • Market implication: Government bonds play an important role in building portfolio resilience – even at low yield levels – both on a tactical basis and in long-term portfolios.

This post originally appeared on the BlackRock Blog.

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