We think 2018 will be remembered as a rolling, cross-asset-class bear market that increased in intensity all year. There were numerous influences that drove this price action, but chief among them was a market obsession with the prospect of a pernicious inflationary paradigm, which was thought to be a near certain end-game for this economic cycle. Indeed, markets priced in Federal Reserve policy tightening as if it were on autopilot, thinking it was necessary to ensure that inflation’s “inevitable” comeuppance would be contained. We were vocal critics of this thinking last year and remain convinced that permanent secular dynamics have tamed traditional cyclical inflation on a global basis. A more nuanced analysis of increasingly tepid readings of growth and inflation reveals a larger, and underappreciated, deficit relative to policy targets than understood by conventional wisdom.
Markets price more benign policy/inflation, but details matter
Fortunately, the 2019 market narrative is unfolding in a more benign fashion as acutely tightened financial conditions in the fourth quarter of 2018 and still-slowing global growth have allowed markets to price in a forward path of policy pragmatism that acknowledges these headwinds. Specifically, the U.S. Fed has pivoted to a paradigm of patience, in deference to the lowest long-term inflation expectations in more than 50 years (see graph) and the notion that economy-wide financing costs for investment are appropriately aligned with potential growth rates today. Together, these influences construct a convincing equilibrium, upon which Fed policy patience is appropriately perched.
Moreover, a comprehensive analysis of growth and inflation must include a deeper dive into the details of data than simple observations of systemic economic averages. For example, the regional dispersion of U.S. economic data continues to challenge the value of what any “average” number would suggest. Each region (and even some states in and of themselves) has the make-up of what could be an entirely different and separate country. Specifically, five states alone (California, New York, Texas, Florida, and Illinois) together contribute 40% to U.S. GDP, an immense dichotomy to the output of just about every other state. More telling still is the most recent headline CPI inflation print of 1.6%, which would be 50 basis points lower if the Western region of the country were excluded, amounting to the greatest divergence in regional rates of inflation in years. These dispersions raise the bar for the justification of every incremental policy change, since no single policy initiative can possibly be wholly appropriate for every geographic area.
Simultaneously, much of the aforementioned inflation obsession was predicated on a tightening labor market and concomitant wage acceleration. We continue to dispute the efficacy of a link between wages and whole-basket inflation and firmly believe that accelerating wages organically slow economic growth through pressuring corporate profit margins, which paradoxically dulls future inflation. We are watching this data closely as we are worried about the wage impulse dampening forward growth prospects amid fading fiscal tailwinds.
While global growth and inflation prospects are more challenged relative to early 2018, the global policy backdrop offers a compelling positive contrast versus last year. In terms of contributions to global growth, last year the three largest influences (the emerging markets countries, China and the U.S.) were all aggressive monetary policy hawks for a variety of reasons: China as a result of pursing proactive deleveraging, the U.S. through Fed policy rate hikes and balance sheet runoff, and EM by being forced into pro-cyclical tightening in order to stave off currency crises. This year, all three of these sources of prior tightening are poised for easing if conditions warrant. Thus, the strike price of the global “central bank put” underneath risk and growth, is now substantially higher than it was last year. At the same time, true Fed “patience” likely means that the global liquidity cycle can be rebooted. All else equal, China and EM central banks now have greater scope to ease without the gravitational pull on global capital toward ever-rising U.S. risk-free rates. A clear risk to this scenario is if Fed messaging suddenly were to reverse, running counter to this thinking, but it’s increasingly likely that a new liquidity-driven cyclical bull market for risk is already underway.
Economic backdrop supports case for yielding assets, alongside rate hedges
Against an increasingly supportive policy environment, powerful ongoing technical forces buttress the case for positioning in yielding assets. The global investable asset base is roughly $150 trillion today, almost three times what it was at the turn of the century. Meanwhile, fixed income net issuance (excluding-Treasuries) has averaged just $400 billion annually post-crisis vs. $1.3 trillion in the pre-crisis period. Essentially, there are ever fewer income-generating assets for an aging population that is increasingly starved for investment income. While credit spreads and all-in yields have dropped over the past couple of months, today’s levels are still reasonably attractive relative to recent history and are key ingredients in the construction of a well-balanced portfolio, in our view. We simply don’t believe in the ominous looming credit downgrade story that many have depicted, and while we’re sympathetic to the notion of some increase in bond defaults, as the economy slows and evolves, we think the justification for collecting yield from diversified sources is a quite cogent one.
Putting it all together, the case for constructing balanced portfolios that emphasize liquid, diversified income sources, layered with developed market duration that provides portfolio ballast as a dependable hedge is compelling. We like U.S. investment-grade credit assets across the curve, as well as a variety of assets from the more liquid segments of the securitized sectors. We like EM through local rates and equities, both of which provide foreign currency exposure, as well as select hard currency credit assets that remain relatively attractive versus U.S. high yield. And while equities face the headwinds of narrowing profit margins, volatility has dampened demonstrably- which increasingly affords the opportunity to own upside potential there.
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 Head of Global Macro positioning for Fixed Income, and he contributed to this post.