BLACKROCK INVESTMENT INSTITUTE

Geopolitics’ clout on markets persists

A détente in geopolitical frictions on two key fronts – US-China tensions and Brexit – has boosted risk assets. Yet we are mindful that geopolitical risks are likely to remain elevated over the longer term, and advocate for raising portfolio resilience. Read more in our weekly commentary.

Key points

De-escalated tensions
A perceived de-escalation in US-China tensions and Brexit has driven up risk assets, yet we see geopolitical risks staying at elevated levels.
Protectionist push
Signs that weakness caused by the protectionist push is spreading beyond manufacturing have cast a shadow on the growth backdrop.
Data watch
The US and euro area purchasing managers’ indexes (PMIs) due this week could offer a glimpse at the health of the global economy.
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The impact of the protectionist push on the global economy and markets is playing out: Global growth is slowing, and geopolitical volatility has increasingly swung markets. A perceived easing of US-China trade tensions and the risk of a “hard Brexit” has supported risk assets since early October. Yet we expect more twists and turns in coming months, and see geopolitical risks staying elevated in the longer term. We advocate for raising portfolio resilience.

Chart of the week
World trade growth and Global trade BGRI, 2014-2019

Equity sources of total return in 2019

 

Sources: BlackRock Investment Institute, with data from US Customs and Border Protection, Statistics Netherlands and Refinitiv Datastream, October 2019. Notes: BGRI stands for the BlackRock geopolitical risk indicator. We identify specific words related to geopolitical risk in general and to the top-10 risks including global trade. We then use text analysis to calculate the frequency of their appearance in the Refinitiv Broker Report and Dow Jones Global Newswire databases as well as on Twitter. We adjust for whether the language reflects positive or negative sentiment. A zero score represents the average BGRI level over its history from 2003 up to that point in time. A score of one means the BGRI level is one standard deviation above the average. We weigh recent readings more heavily in calculating the average.

Our BlackRock geopolitical risk dashboard helps track geopolitical risks and their potential market impact. It features both data-driven market attention trackers (BlackRock geopolitical risk indicators, or BGRIs) and judgment-based assessments of our top 10 risks. The Global trade BGRI has historically showed a negative relationship with the world’s trade growth. A sharp rise in the BGRI in 2018 preceded a steep decline in the growth of global trade. The BGRI has since stayed at elevated levels and trade growth has languished. See the chart above. This underpins our view that trade tensions and other geopolitical risks have become key drivers of the global economy. Relatively high market attention to these risks suggests they are likely priced in to some extent.

Geopolitical risks have come to the fore in 2019 as a key market and economic driver, as detailed in our recently updated Global investment outlook. The marked escalation in the US-China conflict in particular has injected additional uncertainty into business planning, threatening to further weaken economic activity. Markets breathed a collective sigh of relief after the US and China ended the latest round of trade talk with more conciliatory gestures. Yet no agreed text was produced. The US is maintaining all existing tariffs on Chinese goods and is set to launch a new round of tariff increases on Dec. 15. A key signpost: The US and China are aiming to agree on the text of a limited trade deal for the two countries’ leaders to sign at the Asia-Pacific Economic Cooperation (APEC)’s summit on Nov. 16-17. More senior-level meetings are required to achieve the goal, likely bringing more twists and turns. We may see a temporary truce heading into 2020, but view the US-China competition as structural and long-lasting. Tensions between the two countries are broadening out to include technological and financial dimensions.

Elsewhere, Brexit negotiations appear to be turning a corner. The UK and European Union (EU) reached a deal that faces hurdles in UK Parliament. Uncertainty remains high, given tectonic shifts in British politics. Yet our base case is that we expect the UK to ask for – and the EU to grant – a short extension to the Oct. 31 deadline for the UK to exit the union. A general election will likely be called, with Prime Minister Boris Johnson’s Conservative Party potentially winning back a parliamentary majority. This would pave the way for approval of the proposed deal. Markets have become more optimistic as the odds of the UK crashing out of EU have fallen. The British pound has rebounded sharply from early October lows.

Bottom line: Geopolitical frictions will remain a powerful driver of the global economy and markets despite the apparent easing in some risks recently. We expect a pickup in global growth in the next six to 12 months as policy stimulus gradually makes its way to the real economy. Yet we could see bumps on the read in the near term, as economic data remains weak and geopolitics uncertain. This suggests we should be thinking about ways to protect portfolios against potential risks. We favour the more defensive parts of the US equity market, such as the min vol and quality style factors. We also see government bonds continuing to play an important role in building portfolio resilience – even at low yield levels.

Demand shock or supply shock?
This is a key question in understanding how global trade tensions are affecting the economy.
Learn more Learn more

Assets in review
Selected asset performance, 2019 year-to-date and range

Selected asset performance, 2019 year-to-date and range

 

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, October 2019. Notes: The two ends of the bars show the lowest and highest returns versus the end of 2018, and the dots represent year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in US dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, MSCI USA Index, the ICE US Dollar Index (DXY), MSCI Europe Index, Bank of America Merrill Lynch Global Broad Corporate Index, Bank of America Merrill Lynch Global High Yield Index, Datastream 10-year benchmark government bond (US , German and Italy), MSCI Emerging Markets Index, spot gold and J.P. Morgan EMBI index.

A détente in geopolitical frictions on two key fronts – US-China tensions and Brexit – has boosted risk assets. Yet signs that the drag on economic activity from the global protectionist push is spreading beyond manufacturing have cast a shadow on the growth backdrop. Major central banks have taken a dovish stance — the Federal Reserve has cut rates in line with market expectations, following the European Central Bank’s broad stimulus package. We expect a pickup in global growth in the next six to 12 months, yet see limits to how much monetary easing can be delivered in the near term. Monetary policy is no cure for the weaker growth and firmer inflation pressures that may result from sustained trade tensions. 

Week ahead

Oct. 24 – The US and euro area PMIs will offer some hints on the health of the global economy. PMIs have declined in both economies, led by manufacturing in the euro area. Yet we believe easier financial conditions underpin our view that global manufacturing weakness is unlikely to lead to a broader economic downturn in the near term.

Oct. 24 – The European Central Bank’s outgoing president Mario Draghi’s last monetary policy meeting. Markets do not expect any rate cut, and will focus on the forward guidance.

icon-up Overweight     icon-neutral Neutral     icon-down Underweight

 

Equities
Asset Class View Comments
US icon-up A supportive policy mix and the prospect of an extended cycle underpin our positive view. Valuations still appear reasonable against this backdrop. From a factor perspective we like min-vol and quality, which have historically tended to perform well during economic slowdowns.
Europe icon-neutral We have upgraded European equities to neutral. We find European risk assets modestly overpriced versus the macro backdrop, yet the dovish shift by the European Central Bank (ECB) should provide an offset. Trade disputes, a slowing China and political risks are key challenges.
Japan icon-down We have downgraded Japanese equities to underweight. We believe they are particularly vulnerable to a Chinese slowdown with a Bank of Japan that is still accommodative but policy-constrained. Other challenges include slowing global growth and an upcoming consumption tax increase.
EM icon-neutral We have downgraded EM equities to neutral amid what we see as overly optimistic market expectations for Chinese stimulus. We see the greatest opportunities in Latin America, such as in Mexico and Brazil, where valuations are attractive and the macro backdrop is stable. An accommodative Fed offers support across the board, particularly for EM countries with large external debt loads.
Asia ex Japan icon-down We have downgraded Asia ex-Japan equities to underweight due to the region’s China exposure. A worse-than-expected Chinese slowdown or disruptions in global trade would pose downside risks. We prefer to take risk in the region’s debt instruments instead.
Fixed income
US government bonds icon-down We remain underweight US Treasuries. We do expect the Fed to cut rates by a further quarter percentage point this year. Yet market expectations of Fed easing look excessive to us. This, coupled with the flatness of the yield curve, leaves us cautious on Treasury valuations. We still see long-term government bonds as an effective ballast against risk asset selloffs.
US municipals icon-neutral Favourable supply-demand dynamics and improved fundamentals are supportive. The tax overhaul has made munis’ tax-exempt status more attractive. Yet muni valuations are on the high side, and the asset class may be due for a breather after a 10-month stretch of positive performance.
US credit icon-neutral We are neutral on US credit after strong performance in the first half of 2019 sent yields to two-year lows. Easier monetary policy that may prolong this cycle, constrained new issuance and conservative corporate behaviour support credit markets. High-yield and investment-grade credit remain key part of our income thesis.
European sovereigns icon-up The resumption of asset purchases by the ECB supports our overweight, particularly in non-core markets. A relatively steep yield curve – particularly in these countries – is a plus for euro area investors. Yields look attractive for hedged US dollar-based investors thanks to the hefty US-euro interest rate differential.
European credit icon-neutral Renewed ECB purchases of corporate debt and a “lower for even longer” rate shift are supportive. European banks are much better capitalised after years of balance sheet repair. Even with tighter spreads, credit should offer attractive income to both European investors and global investors on a currency-hedged basis.
EM debt icon-up We like EM bonds for their income potential. The Fed’s dovish shift has spurred local rates to rally and helped local currencies recover versus the US dollar. We see local-currency markets having room to run and prefer them over hard-currency markets. We see opportunities in Latin America (with little contagion from Argentina’s woes) and in countries not directly exposed to US-China tensions.
Asia fixed income icon-neutral The dovish pivot by the Fed and ECB gives Asian central banks room to ease. Currency stability is another positive. Valuations have become richer after a strong rally, however, and we see geopolitical risks increasing . We have reduced overall risk and moved up in quality across credit as a result.

Note: Views are from a US dollar perspective over a 6-12 month horizon

Read details about our investment themes and more in our Midyear 2019 Global Investment Outlook.

Protectionist push

 

The US and China agreed on an outline of what the first part of a limited deal on trade may look like, marking a temporary de-escalation in tensions. The lack of a written agreement points to ongoing negotiations.

  • Read more

    • No tariff was reduced, but a tariff increase set for Oct. 15 was scrapped. There was little movement on longer-term strategic issues. The US has stuck to its harder stance on technology, national security and human rights concerns.
    • The UK and the EU struck a new deal on Brexit. Uncertainty is still high, yet our base case is for a short extension to the Oct. 31 deadline, followed by a UK general election.
    • Persistent uncertainty from protectionist policies is denting corporate confidence and slowing business spending, hurting the global industrial cycle — a key reason for our global growth downgrade.
    • The longer-term risk from protectionism: The unravelling of global supply chains delivers a supply shock that saps productivity growth, reinforces a slowdown in potential output and leads to higher inflation.
    • Market implication: We favour reducing risk amid rising protectionism, including raising some cash.
Stretching the cycle

 

The record-long US economic expansion looks unlikely to morph into a deeper downturn any time soon, supported by healthy household spending.

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    • Central banks have eased policy significantly with the aim of offsetting the trade shock and to sustain the economic expansion in the face of a deepening manufacturing recession.
    • We do not see the Fed’s resumption of overnight repo operations to alleviate short-term funding pressures as a form of QE. The Fed is specifically targeting the Fed funds rate and not looking to shape long-term rate expectations.
    • The trade war is bad for growth, but we still see potential for US inflation to rise in the near term due to the direct impact of tariffs and in the long term due to the hit to production capacity, complicating the case for policy easing.
    • We believe policymakers should lay the groundwork for a credible plan to navigate the next economic shock that includes unprecedented coordination between monetary and fiscal measures. We lay out the contours of such a framework in Dealing with the next downturn. Absence of a credible plan is contributing to market anxiety, and adding to the rush into the perceived safety of government bonds.
    • Market implication: We like US equities and EM debt. We are overweight eurozone government bonds: a relatively steeper yield curve brightens the appeal even at low yields. We are neutral European equities and credit.
Raising resilience

 

Most government bonds play an important role in building portfolio resilience – even at low yield levels – both on a tactical basis and in long-term portfolios.

  • Read more

    • Most government bonds play an important role in building portfolio resilience – even at low yield levels – both on a tactical basis and in long-term portfolios.
    • Last month’s sharp reversals in the momentum and value factors show the importance of minimizing portfolio exposure to pockets of the market where pricing appears stretched.
    • Market implication: We prefer US Treasuries over German bunds for portfolio diversification on a strategic basis. The recent underperformance of bunds relative to Treasuries in recent risk-off events suggests core euro area government bond yields are approaching their perceived effective lower bound.
Thomas Donilon
Chairman — BlackRock Investment Institute
Mike Pyle
Chief Investment Strategist, BlackRock Investment Institute.
Scott Thiel
Chief Fixed Income Strategist — BlackRock Investment Institute
Elga Bartsch
Head of Macro Research — BlackRock Investment Institute

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