Resilience in the face of worry
On the eve of World War II, the British government propagandized the iconic slogan keep calm and carry on, described by Wikipedia as “evocative of the Victorian belief in British stoicism–the “stiff upper lip,” self-discipline, fortitude, and remaining calm in adversity.” We’ve adopted a similar mantra in 2019 as we endeavor to keep calm in the face of stubborn Brexit drama, and more importantly in the face of a persistent hyperbolic financial market narrative that unnecessarily emphasizes global economic left-tail risks.
Financial markets have endured significant turbulence in recent months as the market-implied forward monetary policy path pivoted from overtly hawkish late last year to ambitiously dovish more recently. The irony is that despite some modest ebb and flow in aggregate global economic indicators during this period, the global economy is enjoying some of the greatest stability in history, notwithstanding specific pockets of weakness, like European manufacturing and emerging markets. Thus, there is enough core economic stability overall to warrant holding higher-quality risky assets, in our view, so we are positioned to “keep quality and carry on.”
Policy prescriptions support the weakest link
We think the dramatically dovish U-turn in the market-implied monetary policy path is rooted in the growing realization that policy makers are increasingly faced with the dilemma that their tools are remarkably blunt, at least relative to the incredible dispersion of real economy performance within their jurisdictions. Specifically, given global secular dynamics that dictate an asymmetric distribution of risk to the deflationary tail, central banks are forced to calibrate jurisdiction-wide policy postures in order to accommodate the weakest economic link, not the broad economy overall, as is commonly believed.
So while the Federal Reserve looks at solid nationwide growth driven primarily by a handful of states, it must consider the inherent weakness in states with poor demographics, or onerous tax policies. Similarly, the European Central Bank (ECB) must consider double-digit unemployment rates in the periphery of the region, even though Germany is flirting with full employment. These dynamics are at play globally too as the marginal layer of policy posture has enormous influence on both the domestic policies of countries with managed currency regimes as well as the ebb and flow of global liquidity. To wit, two-pronged Fed tightening last year dictated liquidity-sapping U.S. dollar strength and pro-cyclical tightening in emerging markets (EM), which fed directly into severely tightened financial conditions. We are heartened that global policy has evolved toward a more pragmatic embrace of a marginally easier policy stance in deference to these economic realities.
Policy and secular economic transformations
As for the remarkable global economic stability we’re witnessing, relative to history, we’ve been very vocal about the powerful secular evolution away from a dependence on the production and consumption of goods, to a far more services-dominated global economy. The inelasticity of supply at the right side of the goods cost curve is what has historically exaggerated the amplitude of the business cycle. In contrast, a services-led economy enjoys ample elasticity on the expansionary side of its supply curve because the marginal cost of production is limited to the marginal price that the marginal worker is willing to pay. Ultimately, this is represented by their marginal disposable income. Thus, a services-dominated economy is structurally less volatile than one that is goods-dominated (see graph).
At the same time, in an environment of cyclical global growth deceleration, our enthusiasm in underwriting a diverse portfolio of quality yielding assets is enhanced by the knowledge that global policy makers have the requisite ammunition to fend off any unexpected increase in the probability of the deflationary left tail becoming a reality. Indeed, China, the U.S., and the emerging markets, which combine to generate roughly 86% of global growth, all have convincing prospective policy tools to ward off an existential growth scare.
Concurrently, while conventional wisdom views the ECB as increasingly ill-equipped to fend off structural economic weakness, due to a lack of effective new policy tools, we see room for policy innovation. Indeed, we think the ECB can aspire to reduce the European corporate sector’s uncompetitive ratio of systemic cost-of-capital to GDP growth. Specifically, while Euro-area weighted average cost-of-capital (WACC) is about 100 basis points below that seen in the U.S., its growth rate is almost 180 basis points lower. Since it would be nearly impossible to reduce Euro-area cost of debt from the currently extraordinary low levels, the ECB could choose to restore a competitive equilibrium through attempting to lower the cost of equity capital instead, by adding equities to its balance sheet via a new round of quantitative easing. Thus, the ECB too has incremental policy levers to pull if conditions warranted.
The greatest constraint to populating a diverse, high-quality yielding portfolio is that there is a severe dearth in the availability of such assets. The quantity of negative yielding assets globally has surged to nearly $10 trillion on the heels of the powerful 2019 rate rally. Corporate debt issuance is being constrained by a variety of factors, including U.S. tax law changes that have facilitated repatriation of overseas corporate cash hoards, and a lack of large-scale mergers and acquisitions deals, among other factors. Moreover, with the looming renewal of reinvestment of Fed balance sheet proceeds, quality yielding assets are going to be in even shorter supply.
Putting it all together, we like constructing a portfolio with a healthy dose of diversified and high-quality carrying assets, with U.S. investment-grade credit and securitized assets being a sweet spot for these expressions. We like owning EM assets tactically, while being highly selective with regard to specific idiosyncratic stories. Equities could benefit markedly from today’s lower risk-free and corporate discount rates, versus late last year, and could very well enjoy multiple expansion as a result. Finally, as we’ve been vocal about all year, we like employing duration as an overall portfolio hedge given the Fed’s new pragmatic posture.
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.