FIXED INCOME MARKET OUTLOOK

Market Myths and Realities

Apr 2, 2018

In our monthly fixed income market outlook, Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income, discusses the prospects for risk assets under evolving policy liquidity.

Highlights

  • Overall, we anticipate that 2018 will be an interesting year that is difficult to find a perfect historical analogy for, particularly since some notable secular trends (such as diminished fixed income supply) begin to reverse themselves this year.
  • Many market myths have taken hold in recent months, particularly surrounding the influence Fed balance sheet reduction will have on systemic liquidity, so we seek to dispel some of those myths here, with our take on reality.
  • The economic regime we find ourselves in today should be characterized by a firm level of growth, increased inflation on the back of wage gains, and modestly higher rates, but the budget deficit-funded character of fiscal stimulus impacts rates in a manner that places this regime at longer term risk.

In our monthly fixed income market outlook, Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income, and Russ Brownback, an Absolute Return Strategies Portfolio Manager focusing on Macro Themes, discuss how they anticipate that 2018 will continue to be an interesting year that is difficult to find a perfect analogy for, particularly since some notable secular trends (such as diminished fixed income supply) begin to reverse themselves. Further many market myths have taken hold in recent months, particularly surrounding the influence Fed balance sheet reduction will have on systemic liquidity, so they seek to dispel some of those myths here with their take on reality. Finally, Rieder and Brownback argue that the economic/market regime we find ourselves in today should deliver solid growth, increased inflation on the back of wage gains, and modestly higher rates from here, but the budget deficit-funded character of fiscal stimulus impacts rates in a manner that places this regime at longer-term risk.

Where We’re Heading in 2018; Can Historical Analogies Be Helpful?

Back in October of last year, we wondered whether market returns in 2018 might look like those seen in 2013, since in some respects the return pattern witnessed in 2017 appeared close to that of 2012. In January, this analogy appeared to be playing out, but of course this simple comparison ignores the immense fundamental differences in the economic and investment regimes between these two periods. As a case in point, in 2013 the output gap as a percentage of GDP still resided in deep negative territory, whereas today it has turned positive, according to Bloomberg data as of January 2018. Further, both monetary policy and fiscal dynamics are effectively inverted today, relative to what held in 2013. Indeed, at the start of 2013 the Federal Reserve continued to pursue its near-zero interest rate policy, while today we are well into a policy rate hiking cycle, which should continue throughout this year. Also, in 2013 the budget deficit as a percentage of GDP was declining rapidly, but today is appears set to increase, as much of the fiscal stimulus set forth in recent tax cuts and the budget deal are effectively deficit financed. Finally, global growth is strengthening today in the most robust and synchronized manner that has been seen since the global financial crisis, whereas in 2013 growth remained disappointing, even if risk rallied.

Overall, monetary policy, fiscal policy, the output gap, capital investment, corporate profits and household wealth are all in a vastly different place today than they were in 2013 (primarily, much better), but are there other periods that might serve as more analogous? The 1986 to 1987 period might be one: then, like now, an ongoing secular bull market was in place, the economy was experiencing a deregulatory tailwind, a weak U.S. dollar, a relatively stable interest rate environment, and solid organic real growth that led to a collapsing output gap. In the midst of this demonstrable momentum, the 1986 Tax Reform Act catalyzed a powerful incremental risk rally during the first half of 1987, which eventually gave way to an interval of notably higher rates and historic market volatility. Still, we’re confident that today’s deeper and more mature financial markets may exhibit less volatility than witnessed in 1987.

As we look ahead in 2018, some of the long-term structural trends in the economy and markets that we have discussed in recent years appear to be poised for meaningful cyclical counter-trend movement. That does not negate the validity of the secular trend itself, but it does suggest that investors need to understand that long-term influences will, from timeto- time, reverse and retrench, before becoming firmly reestablished. To be concrete, we have long discussed the demographic trend of secular aging that is in place in the United States and most other developed market economies. That trend involves broadly lower levels of household formation as the working-age population declines, reduced consumption, and in the long run, modestly slower economic growth. Still, we think 2018 may see improvement in U.S. household formations, as Millennials who have long delayed the process finally appear to be embracing it. Indeed, according to fourth quarter 2017 Census Bureau data, the final quarter of last year saw a notably higher level of household formations, at 1.44 million, than the two prior quarters and we believe this improved momentum should continue this year.

Another longstanding trend that we have discussed for years is the lower level of fixed income supply relative to demand, particularly after central bank quantitative easing programs are accounted for (see Figure 1). As displayed in the graph, across major developed markets, this trend is set to begin to reverse in 2018, as greater levels of issuance are on the way and central bank purchasing is beginning to wane. That dynamic, alongside rising expectations of inflation, has been partly responsible for recent rate increases and may continue to press rates somewhat higher yet. Still, there are a great many misconceptions regarding how economies and markets are likely to behave under evolving monetary policy, so the next section seeks to clear up confusion.

Figure 1: Demand For Yield Will Likely Outstrip Supply, But Greater Supply is On the Way

Chart: Demand For Yield Will Likely Outstrip Supply, But Greater Supply is On the Way

Source: Morgan Stanley, data as of December 11, 2017
This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results.

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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 ...