We’ve often argued that market participants appear to solely fixate on one thing at a time, and moreover their collective attention span appears to be very short, as these things, or themes, continually shift during the course of a year. To that end, we think it might be useful as the year gets going to reflect on a few critical themes that we believe will persist in their importance to markets in 2018. Hopefully, this may aid investors in tuning out the parade of market noise that ultimately won’t matter much to the year’s investment prospects.
1. G3 Monetary Policy Liquidity Slowly Waning; Organic Drivers Should Step Up
A proxy for global liquidity (defined by the year-over-year change in aggregate G3 central bank balance sheets, in U.S. dollars, plus changes in global foreign exchange reserves) grew by nearly $14 trillion from 2008 through 2017, according to Federal Reserve and Bloomberg data as of September 2017. That massive infusion of liquidity helped to restore confidence in both the financial and real economies in the wake of the global financial crisis, yet at this stage, with the global economy enjoying one of its most powerful synchronized expansions since the crisis, it only makes sense that this liquidity be reined in. In fact, we argued that the process should have started a couple years before it did, as it resulted in some significant market distortions and excessive valuations, but nevertheless 2018 will now be an important inflection point for policy.
This raises the vital question, then, of what the prospects are for risk assets under evolving policy liquidity? Overall, we think global growth, fiscal policy and organically derived forms of liquidity will likely more than offset the slow pace of central bank tightening this year. Still, it must be recognized that organically derived liquidity, by its very nature, is more volatile than the kind supplied by central banks, so we fully expect market volatility to rise alongside this transition.
2. U.S. Fiscal Policy More Supportive of Economy/Markets Than Many Acknowledge
At the end of 2017, the U.S. Congress and Administration passed the Tax Cuts and Jobs Act, which represents the most fundamental re-thinking of tax policy in the U.S. in 30 years. Among many other provisions, the Act lowered individual income tax rates, lowered the top corporate rate from 35% to 21%, allowed for the full write-off of corporate capital expenditures through 2023, included a deemed repatriation tax for corporations and shifted the country to a largely territorial tax system, bringing it closer in line with most of the rest of the world. We’re not going to suggest the legislation was perfect, but we do think it is more supportive of the economy and markets than many commentators have acknowledged.
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The U.S. budget deficit as a percentage of gross domestic product is likely to continue to grow, even as the output gap closes, whereas typically deficits would be narrowing at this point (see graph above). In many respects, with a partially deficit-financed tax cut, alongside the new capex and expensing provisions, we are likely to witness a greater drawing forward of economic activity and demand than otherwise would have been the case; essentially, we’re borrowing future growth for the present. At the same time, significant deregulation in the U.S. has been working its way through the system, interest rates, while higher, are still running at accommodative levels, and as mentioned, global liquidity is still growing at a solid pace. Investment is by far the most volatile component of economic growth, and while it is poised for a rebound (partly spurred by the tax bill), we think this will result in greater economic volatility alongside of higher velocity (with solid growth, and wages and inflation picking up), facts investors should be prepared for.
3. The Transformation of Commerce Will Continue in 2018, and More Rapidly Than People Expect
We have long argued that both unfolding demographic trends and the rapid rise of technological advancement are changing the very nature of commerce, and we continue to see this development outpacing many people’s expectations. Indeed, consumers around the world have witnessed a veritable revolution is how, where and at what price their demand for goods and services is met.
One of the most obvious signs of this change is the well-known shift to online retailing that is displacing brick-and-mortar sales (particularly at department stores), but the extent of this disruption and its impact on commercial real estate markets may still be underappreciated. Last year, thousands of retail stores closed their doors, and it is likely that hundreds of shopping malls will have to close in the years ahead (many from middle-range markets), as online retailing of myriad goods becomes ever more entrenched. Beyond the location of purchase, the price-comparison function of the web has radically diminished pricing power in some markets. On the whole, technological innovation has resulted in a broadly disinflationary influence on the economy, allowing consumers to do more with less, even as it continues to significantly reshape corporate cash flow dynamics and disrupt entire industries. Clearly, it’s vitally important for investors to understand and adapt their investment process to these dynamics.
In the end, while investors will be inundated with innumerable “news stories” in 2018 that ostensibly have “information value” for markets, most of these will be simple noise. If, instead, investors remain focused on the key themes discussed above, we think they’ll stand a much better chance of effectively allocating capital. We see respectable economic growth in 2018, but with potentially higher levels of both economic and market volatility, so investors may well face a more difficult market environment this year, as full asset valuations in many areas combine with greater gyrations.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog. Russell Brownback, Managing Director, is a member of the Corporate Credit Group within BlackRock Fundamental Fixed Income and contributed to this post.