Reflation is going global as the second quarter of 2017 begins. Global growth expectations are on the rise—and we see room for more upside surprises. Our BlackRock GPS—which combines traditional economic indicators with big data signals such as Internet searches—points to a rise in G7 growth estimates in the months ahead. Other signs of global reflation include a rebound in inflation expectations from mid-2016 lows, a bottoming out in core inflation and wages, and a synchronized pick-up in economic activity indicators and corporate earnings estimates.
What are the risks to our reflation thesis? First would be an overshoot in expectations of monetary tightening leading to a sharp rise in the U.S. dollar, tightening global financial conditions. Second, corporate investment could be slower to materialize than surveys have indicated. This could set markets up for disappointment, particularly in the U.S. Any rise in protectionism could also curb growth and lift inflation. We see upside risk in Europe, where we do not expect elections to deliver the populist outcomes that markets have been fearing.
Against this backdrop, we believe three interrelated themes are likely to shape investing this quarter, as we write in our updated Global Investment Outlook.
Theme 1: Broadening reflation
We believe the reflation trade—overweighting cyclical equities—has room to run, especially outside the U.S. We see an inflection point in growth, inflation, and monetary policy, and markets are catching up to these fast-changing dynamics. Spreading global reflation is driving a long-awaited rebound in global corporate earnings, with the sharpest recoveries seen outside the U.S. This synchronized global recovery in corporate earnings is supporting equities. Cost discipline (resources), hopes for regulatory easing (financials) and innovation (technology) are all also contributing to strong 2017 earnings expectations. Earnings momentum is particularly strong in Japan and emerging markets (EM), while solid in Europe. This supports our preference for stocks in those regions. See the Earnings upswing chart.
In the U.S., the “Trump trade” appears to be taking a breather. U.S. small caps and value stocks such as banks have been underperforming this year after a post-election run-up. Yet strong equity returns globally, including Japanese small caps, suggest our reflation theme is intact. Strengthening reflation also reinforces our view that we have seen the bottom in bond yields globally after a multi-decade slide. As a result, we see most government bond markets challenged this year. Many lack the buffers to defend against capital losses as yields rise. Yet we do see limits to how high yields can go. Central banks in Europe and Japan appear set to keep running ultra-easy policies. Many investors are ready to jump on higher yields to lock in income. Aging populations and historically weak rates of economic growth also act as brakes. Our expectation of higher yields underpins our overall preference for equities over bonds.
Theme 2: Low returns ahead
We see muted returns across asset classes in the coming five years, as structural dynamics such as aging populations help keep us in a low-return world. The search for yield is still on in this low-return environment—and income-producing assets are in short supply. Some of the largest fixed income sectors, such as government bonds, offer paltry or even negative yields. See the blue bubbles in the So little yield, so much duration chart.
Many, such as Japanese government bonds, are also relatively long duration. Ultra-low yields expose holders to significant interest rate risk. Yet the few sectors offering decent yields are relatively small and becoming pricey. Examples include U.S. high yield or EM corporate debt. This mismatch is one reason to be cautious and dynamic in fixed income and guard against the risk of sudden yield back-ups.
Theme 3: Different diversification
Equity market volatility is historically low despite persistent political uncertainty. In fact, volatility looks unusually depressed across asset classes, with the exception of foreign exchange. Global reflation and ample liquidity have consistently trumped politics in recent years. Yet a lot is now brewing under the surface. Correlations between stocks and equity sectors, for example, have declined markedly in the U.S. and Europe, our research shows.
Depressed volatility is also covering up falling correlations across asset classes. Our Multi-Asset Concentration index—a measure of correlations across 14 global asset classes—is hovering well below its post-crisis average, according to our Risk and Quantitative Analysis group. See the Go your own way chart.
This is a break from recent years, when many asset classes rode a wave of central bank liquidity and moved in near lockstep. To be sure, correlations can change quickly—especially under a scenario of a downward jolt to growth expectations. And volatility is subject to sporadic outbursts that can wrong-foot investors. We still see bonds acting as effective shock absorbers in portfolios in such times of market stress. But they offer little safety cushion at today’s still-low yields. We believe investors should consider a broader diversification approach than a traditional bond/equity mix, including adding factor exposures and asset classes such as private credit and real estate.
Low volatility, weakening correlations and still-muted risk appetite all point to an environment favoring risk taking and putting a premium on security selection, in our view. We see the investment landscape increasingly being dominated by the differentiated effects of reflation, and, in economies such as the U.S., by politics and policy. Read more in our full outlook.