FIXED INCOME MARKET OUTLOOK

Separating market news
from noise amid the
reflationary regime shift

Mar 2, 2017 / By Rick Rieder

In our monthly fixed income market outlook, Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income, discusses how investors can easily lose sight of meaningful news items amidst the market noise, so we focus on what we think are the three most significant investment themes today: the industrial sector rebound, the U.S. monetary policy transition, and that fiscal policy may pick up the reins from the Federal Reserve. Further, contrary to the popular narrative, the monetary-to-fiscal policy transition is important because more normal interest rate and yield curve dynamics are likely to promote a better functioning financial transmission mechanism. Finally, the new market regime is profoundly influenced by secular demographic trends and technological innovation, two longstanding themes of keen interest to us, so we examine precisely how.

Market Outlook Summary:

  • A few months ago we suggested that the fourth quarter of 2016 represented a critical turning point in economic, policy, and market landscapes, and that 2017 could see improved growth and inflation. We argued that this improvement would be led by greater capital spending in the United States, on the back of increased confidence, lower taxes, more fiscal spending and moderated regulation. Finally, we suggested that this growth would be facilitated by improvements to financial transmission mechanisms (the key component that drives systemic velocity and productivity, in our view), and generally speaking we think these themes are unfolding roughly as expected.
  • In our view, the three most significant news items, or investment themes that investors must understand at this stage are: 1) we are in the midst of a cyclical rebound in the industrial sectors from recessionary conditions (see Figure 1 from the market outlook), 2) developed market monetary policy has begun a meaningful transition, and 3) after years of stagnation, fiscal policy may pick up the reins from monetary authorities and help drive the economy forward. All three of these factors combine to suggest to us that we are witnessing a significant shift in investment regime, as we have outlined in recent months.

A cyclical recovery in the industrial sectors is underway

Contributions of the sub-components of the Morgan Stanley Global Trade Leading Indicator

 Figure 1: A cyclical recovery in the industrial sectors is underway 

Source: Bloomberg, data as of January 2017

  • We believe that markets are digesting this regime shift in a two-stage process: first, they are likely incorporating a reduced probability of a deflationary left-tail scenario, as global growth returns to trend (cyclical recovery); and second, they might eventually re-price a higher likelihood for an inflationary right-tail possibility, with growth accelerating to above-trend levels (monetary-to-fiscal policy shift). We would argue that only the first of these two stages is reflected in asset prices today.
  • Given this economic, market and policy backdrop, we think it’s important to also step back and focus on some of the secular trends that have long been of concern to us. More specifically, we think that both the long-term demographic trend of population aging and a remarkable technological revolution are having profound and lasting influences on our economy today and will continue to do so for decades to come.
  • In a real sense, the long-term size of the economic pie in the U.S. (and in the developed world more broadly) is no longer likely to grow as rapidly as in the past. Rapid corporate growth, therefore, must come through market disruption, or “taking a larger share of that slowly growing pie,” and for that to occur research and development budgets will be much more important to look at than mere corporate capital expenditures per se. Both the disinflationary impact of technological advances as well as the aging population trend (meager working age population growth) are likely to keep a structural lid on overall future inflation too, which to us suggests that “2% price inflation today is the new 3%.”
  • There is reason to believe that the cyclical recovery in goods-producing sectors within the U.S. is also presenting itself as strength in other regions of the world as well. Actual global merchandise trade volumes have started to recover from a protracted slump. One significant concern regarding potential fiscal policy, however, is the risk of protectionism. Disappointingly, after a long stretch of global trade openness from 1990 to 2005, we have seen an uptick in discriminatory and restrictive trade measures and a marked decline in free trade agreements.
  • Still, our view is that the U.S. economy is in the midst of a significant reflationary trend and will continue to be so for some time, which provides some confidence to our bullishness in down-the-capital-stack U.S. assets. And while by some measures these assets appear to hold high valuations, we believe that corporate revenue and earnings growth could improve alongside moderately elevated inflation expectations, particularly if the monetary-to-fiscal policy transition is effectuated within a reasonable amount of time.
Rick Rieder
Managing Director, Chief Investment Officer of Global Fixed Income
Rick is BlackRock's Chief Investment Officer of Global Fixed Income. He is a member of BlackRock's Fixed Income Executive Committee, a member of its Leadership ...