On the risk of regime shifts

The macro debate tends to center on the state of the business cycle and the risk of a recession. We think that this is too narrow a question to ask. We consider a broad range of macro regimes that drive market returns. Our expectations for the current macro regime – and the risks around a potential shift – help shape our tactical asset allocation calls for 2020.

Overview

The unprecedented central bank pivot to policy stimulus helped loosen financial conditions last year, cushioning any fallout from the manufacturing-led global slowdown. Yet a puzzling divergence between growth and financial conditions remains. We find that a sharp rise in geopolitical risk helps explain this historically unusual wedge.

An unusual gap
BlackRock G3 Growth GPS and Financial Conditions Indicator, 2010-2020

Sources: BlackRock Investment Institute, with data from Bloomberg and Refinitiv Datastream, January 2020. Notes: The BlackRock G3 Growth GPS, the yellow line, shows where the 12-month forward consensus GDP forecast for the US, eurozone and Japan may stand in three months’ time. The orange line shows the rate of G3 GDP growth implied by our financial conditions indicator (FCI), based on its historical relationship with our Growth GPS. 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.

One macro puzzle that has cropped up over the past year: why the large loosening of financial conditions has not translated into stronger GDP growth as much as it seems to have in the past. Has the transmission channel from financial conditions to growth broken down – and are market expectations for a growth recovery in 2020 misplaced? This is a troubling prospect, suggesting central banks are becoming less effective in driving growth higher. But we don’t think that’s the case. Dissecting our proprietary indicators, we find certain strong, reinforcing shocks that offset supportive financial conditions. Elevated trade policy uncertainty has become a drag on confidence and investment, while the weakness in global trade has also been surprisingly sharp. These offsetting factors are closely interrelated: the uncertainty has contributed to the trade weakness but is also tied to China’s slowdown. This goes beyond trade weakness and reflects the impact of Beijing’s attempts to deleverage and rein in shadow banking.

When looking at how our Growth GPS has historically reacted to changes in our financial conditions indicator (FCI), we find that over the past year growth has far underperformed relative to what the FCI would have implied. See the gap in our U.S. Growth GPS and FCI in the chart below. Yet if we account for our BlackRock Geopolitical Risk Indicator (BGRI) to reflect the rise in geopolitical uncertainty, we find a stronger relationship (more on the next page). So the delay of an FCI-driven growth rebound can be explained by shocks to world trade growth and elevated geopolitical uncertainty.

Recession probabilities

Our BII recession probability model shows a one-in-four probability of a U.S. recession in the next 12 months. In 2019, slowing growth prompted many forecasters to dust off recession models. When the yield curve briefly inverted in the second half of the year, a probability based on the curve and the Bloomberg consensus were both showing rising chances of a recession as shown in the chart below. We disagreed with this view.

Steady recession risks
U.S. recession probabilities, 1985-2020

Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, January 2020. Note:: The top chart shows the estimated four-quarter ahead probability of a U.S/ recession .The recession probability is estimated by gauging the probability of that future growth – projecting a four-quarter average of GDP based on recent data trends – below a certain threshold. The probability is based on an adjusted distribution of historical GDP data relative to GDP, our FCI and our FVI. The threshold is consistent with growth rates seen during U.S. recessions since 1985. The 2019 and 2020 probabilities are based on a range of likely outcomes of financial conditions, financial vulnerabilities and growth.

Yield curve-based estimates are distorted by the decline in term premium embedded in long-term interest rates. And understanding recession risks does not depend on the yield curve’s shape or the ups and downs in monthly activity data. We see financial vulnerabilities as the key trigger of a recession So it is important to gauge whether financial vulnerabilities are building underneath the surface and making the U.S. economy more susceptible to shocks. Our financial vulnerabilities index (FVI) is climbing gradually but doesn’t suggest any imminent risk to the expansion.

Our macro regime work puts the business cycle in a slowdown regime – but we could see a shift to a risk asset-friendly goldilocks regime or a market-unfriendly mild stagflation regime. The expected uptick in growth underpins our mildly positive view on risk assets in our 2020 Global Outlook. We are overweight Japanese and emerging market (EM) equities, as well as EM and high yield debt. The overlooked risk of upside inflation surprises drives our preference for inflation-linked bonds.

Macro regimes

It is important to understand what macro regime currently dominates and how it could evolve. Yet it is even more important to understand whether the regime could switch altogether and what kind of regime might come next when assessing the tactical outlook for financial market returns and asset allocation. Traditional approaches to gauging where the economy is in the business cycle often miss some key dimensions and overlook alternative regimes to the current one, according to our ongoing work on regime identification and potential changes.

Source: BlackRock Investment Institute, January 2020. Note: For illustrative purposes only. Subject to change without notice.

We have built a comprehensive set of macro regimes – based on the interaction of growth and inflation – to drive our asset return expectations, starting with the U.S. economy. We zero in on four interacting cycles with two dimensions each that jointly drive investment outcomes: a business cycle (demand vs. supply), a financial cycle (credit conditions and leverage), a policy cycle (monetary vs. fiscal) and a risk cycle (macro uncertainty and market resilience). We then analyze all possible combinations to identify persistent regime patterns and estimate regime transition probabilities – that is, we let the data do the talking rather than impose a view based on our priors. We uncover an array of potential regimes but find only six that have shown persistence since the 1960s – see the image above: goldilocks, hawkish squeeze, reflation, running hot, slowdown and stagflation. We look separately at the rare case of recessions, which can hit risk assets hard but are already well defined. Despite the uptick in growth, we will likely remain in a slowdown regime.

We then look at the risks around each regime by identifying which macro shocks are likely behind the dynamics of the respective cycle. We use, for instance, the growth-inflation mix to assess to what extent the business cycle is likely to be driven by demand or supply shocks. We find some intuitive results. Those include how supply and demand shocks overlap with the equity-bond correlation, how the interaction of monetary and fiscal policy affects bond yields or how changes to bank credit supply affect credit spreads. This framework also allows us to map out in an interactive way how different cycles and their key drivers signal which regime is dominant at any given moment – rather than looking at each in isolation. Incorporating uncertainty – macro, financial and policy – adds another layer of richness to the risk/return profile. The result? A nuanced view on what the evolving regimes mean for our tactical asset allocation framework.