Davos brief

BlackRock Investment Institute

The global economic expansion is stretching, but powerful structural trends are testing limits — and intersecting with the near-term outlook. The trends include rising inequality and surging social unrest; deglobalization and fragmentation into trade blocs; an intensifying focus on sustainability and the physical effects of climate change; and the limited toolkit that central banks have to fight the next downturn.

Highlights

• We see global economic growth edging up over the first half of 2020. The unusual late-cycle, dovish pivot by central banks has led to a dramatic easing in financial conditions – one that we expect to start filtering through to the economy and result in an uptick in growth.
• U.S.-China trade tensions are likely to move sideways this year. Yet we see no let-up in U.S.-China strategic competition, especially in the technology arena. Other geopolitical themes on our radar: global fragmentation and domestic polarization, social unrest, and rising risk of cyber attacks.
• We are modestly overweight risk assets due to the firming growth outlook and pause in trade tensions. Yields near lower bounds make government bonds less effective portfolio stabilizers, but we still see U.S. Treasuries providing resilience.
• The increasing focus on sustainability by a widening array of investors has set the stage for a significant reallocation of capital. We believe assets perceived as most resilient to climate and other sustainability-related risks could outperform in the long transition period to a more sustainable world.
• This calls for building sustainable portfolios, improving access to sustainable investing and intensifying engagement with companies on sustainability. Sustainability – the theme uniting leaders at the 2020 World Economic Forum in Davos, Switzerland – is the new investing standard.
• Dealing with the next downturn will require unprecedented coordination between monetary and fiscal policy. Interest rates and long-term yields are nearing lower bounds in many economies. This means fiscal policy should play a greater role, but it is unlikely to be effective on its own.

By Philipp Hildebrand and Tom Donilon

Growth edges up as uncertainty ebbs

One macro puzzle that has cropped up over the past year: Why has the loosening of financial conditions not offset more of the growth slowdown? Has the transmission channel from financial conditions to growth broken down–and could expectations for a growth recovery in 2020 be misplaced? We don’t think this is the case.

The elevated level of our BlackRock Geopolitical Risk indicator helps explain this gap, in our view, as well as why actual growth is so weak relative to what the FCI would signal. But we see this gap gradually closing this year amid a pause in trade tensions.

A puzzling gap
BlackRock U.S. Growth GPS and FCI, 2010-2020

Read our full 2020 Global Outlook for details.

A modest tilt into risk

We see less room in 2020 for dovish monetary policy surprises. The U.S. and China have strong incentives to hit pause on their trade conflict ahead of the U.S. presidential election, though there may be turbulence along the way. We see growth taking the reins as the primary driver of risk asset returns as a result. We see this backdrop and reasonable valuations paving the way for modest return potential in global equities and credit.

We have moved to a moderately more cyclical posture, from a more defensive one we took in our midyear 2019 outlook. Our estimate of the equity risk premium (ERP) — or the expected return of equities over the risk-free rate —shows that the ERP still looks relatively attractive in a long-term context, as shown in the chart below. With income crucial in a slow-growth, low-rate world, we also favor EM and high yield debt.

Reasonable valuations
Equity risk premia, 1995-2019

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Three trends on our radar

Geopolitics — especially trade tensions — were key economic and market drivers in 2019. We see trade tensions moving sideways this year, giving the global economy room for a projected uptick in growth. Recent developments underscore this view and have been positive for markets — including the signing of an initial, albeit limited, trade agreement between the U.S. and China, the likely ratification of the U.S.-Mexico-Canada Agreement on trade, and a significantly reduced risk of a no-deal Brexit in the UK. Yet other geopolitical risks — such as further escalation between the U.S. and Iran — could undermine the growth uptick we expect and the returns of risk assets. The market’s attention to geopolitical risks remains at elevated levels, as shown below.

Politics on the mind
BlackRock Geopolitical Risk Indicator (BGRI), 2010-2020

In the year ahead, we think investors should be alert to several broad dimensions of geopolitical risk: 1) geopolitical fragmentation, 2) ongoing protest movements against establishments and institutions, and 3) cybersecurity risks. 

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A tectonic shift

Growing interest in sustainability and a shift in society’s preferences are likely to spur political and regulatory changes. This could lead to a transformation in investor behavior–and a major, yet gradual, capital reallocation. Assets under management in dedicated environmental, social and governance (ESG) funds have tripled in the past decade to a little under $1 trillion, according to IMF estimates as of June 2019. Yet we see a far bigger structural shift afoot — akin to the multi-decade impact of the post-war “baby boom.” This shift is unlikely captured in today’s asset prices.

Gathering momentum
Growth in ESG funds under management, 2010-2019

Against this backdrop, BlackRock is making an increased commitment to integrate sustainability across its technology platform, risk management and investment strategies. Among the many steps underway, we are:

1. Building sustainable portfolios, including minimizing or eliminating exposure to certain sectors, for example, active portfolio exposures to that derive more than 25% of revenues from thermal coal production.
2. Improving access to sustainable investing, particularly for indexes.
3. Intensifying engagement between investors, companies, and regulators.

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Coordination needed

Monetary policy is almost exhausted in many developed economies as global interest rates sit near zero or below. A central bank’s entire tool kit is geared toward lowering short- or long-term interest rates to stimulate spending when needed. Yet this channel is almost tapped out because all rates are already low and are reaching limits. The chart below shows why, using today’s German bund yield curve (yellow line) as an example. The red line is a hypothetical yield curve based on median curve moves during past recessions. Short-term rates would have to fall deep into negative territory – beyond estimates of the lower bound at which interest rates can be feasibly set. This implies there is not enough monetary policy space to deal with the next downturn.

Running out of ammunition
Hypothetical German yield curve in recessions, 2019

Fiscal stimulus, which doesn’t rely on lowering rates, is the obvious answer if monetary policy is tapped out. There is fiscal space as debt servicing costs are near record lows. Yet, fiscal policy is typically not nimble enough as it takes time to agree politically and implement. With global debt at record levels, major fiscal stimulus could also raise interest rates or stoke expectations of future fiscal consolidation, undercutting its stimulative boost.

As a result, policymakers will inevitably find themselves blurring the boundaries between fiscal and monetary policies to fight the next downturn. This raises important governance questions – and underscores the need to put guardrails around such policy coordination. Our paper Dealing with the next downturn outlines the contours of a framework to enable an unprecedented coordination through a monetary-financed fiscal facility. This should mitigate the risk of a loss of central bank independence and uncontrolled fiscal spending in the next downturn.

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