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.

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The base case is that growth is going to pick up; it’s going to edge a little bit higher, and that means that the recovery remains intact. There are number of reasons why growth is going to get better this year. One is the thawing of trade tensions between the United States and China. But also the material easing in financial conditions that we have seen last year on the back of the pivot towards easing by central banks around the world.

In terms of the macroeconomic outlook, there are two main risks to consider. One could be that we are too cautious on the recovery gaining momentum in 2020 so that growth is materially stronger than expected. Without any material pickup in inflation pressures would be a goldilocks kind of scenario. For the level of growth that you are seeing, inflation would be weaker than it would have been historically on this side. The second risk is that we’re actually too optimistic on growth, and that instead, we’re overlooking material inflation risks that could be building, especially cost pressures that are building. That could be ending up in a mild stagflationary environment. This usually happens if you have a deterioration on the supply side of the economy, which coincides with the material slowdown in productivity growth and as a result, you have much stronger cost pressures in the economy and weaker profits.

The bottom line is that growth is going to edge higher in 2020, that the recovery remains intact and that recessions risks are overblown.

Two risks to the macro outlook
We believe global growth will edge up this year – but with two risks. Elga Bartsch, Head of Macro Research of the BlackRock Investment Institute, discusses what investors should expect.

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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

G3 GPS and financial conditions

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.

Authors

Jean Boivin
Head of BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is the Head of the BlackRock Investment Institute (BII).
Philipp Hildebrand
Vice Chairman
Philipp Hildebrand, Vice Chairman of BlackRock, is a member of the firm's Global Executive Committee.