Global Investment Outlook

We update our three 2018 investment themes against a backdrop of synchronized global growth, rising inflation and interest rates, higher equity market volatility and more economic uncertainty. We detail our asset class preferences and highlight two key risks to the global expansion and risk assets: trade wars and a spike in real yields.

2018 themes: The U.S. tax overhaul and public spending plans have supercharged growth and earnings
estimates at a time when the U.S. economy is already humming. This adds uncertainty to the economic
outlook: potential for greater business spending and productivity growth, but also a risk of overheating
and rising risk premia. Inflation has picked up, keeping the Federal Reserve on track to raise rates, but is
not high or sticky enough to reverse monetary easing in the eurozone or Japan. We see the overall
environment as positive for risk assets, but expect more muted returns and higher volatility than in 2017.
Risks: Rising U.S. protectionism is the clearest menace to the near-term global outlook, in our view. We see increasing U.S. actions against China and other countries sparking bouts of volatility but not derailing the benign economic and market backdrop. Yet any escalation into a trade war could deal knock-on blows to sentiment and change our view. A renewed surge in bond yields is another risk, but we believe equities can do well as long as yield rises are steady and driven by improving growth.
Market views: We like equities. U.S. earnings revisions have rocketed higher to factor in the boon from lower corporate taxes — and earnings momentum is rising across the world. We favor U.S. and emerging market (EM) equities but we see choppier markets and less-heady returns than last year ahead. We prefer technology, financials and the momentum style factor. We are negative on government bonds overall but see short-maturity Treasuries now offering a compelling risk/reward proposition. We are neutral on credit amid tight spreads and increasing sensitivity to rate rises.

Setting the scene

The synchronized global economic expansion rolls on. Consensus G7 growth forecasts have snuck past our BlackRock Growth GPS. Fiscal stimulus tees up the U.S. economy as the top candidate for an upside growth surprise, whereas growth expectations for the eurozone look to have overshot, with room for disappointments. See the Charging up chart.

The U.S. fiscal overhaul adds a dose of economic uncertainty. It could overheat the economy, shortening the cycle. Yet we think overheating can be contained if an ongoing rebound in business investment lifts potential growth and reinforces a global trade upswing. This trade pickup and a softer U.S. dollar have supported EMs. A more protectionist U.S. trade stance could undermine this dynamic and exacerbate any cooling of China’s economy. See our March Global macro outlook for details.

The synchronized global economic expansion is rolling on, but we see a wider array of potential outcomes ahead as the cycle matures.

The economic backdrop is holding firm, yet signs of a market transition are emerging. We have seen rising yields, sharp equity pull-backs and signs that
inflation risks are becoming more two-way. Volatility (vol) is picking up across asset classes. The bouts of equity market vol in 2018 show that the eye-popping risk-adjusted returns of 2017 — robust returns flattered by abnormally low vol —are likely a thing of the past.

This year is proving more “normal” so far. Equity vol has risen to levels more consistent with previous low-vol regimes. We have seen greater return dispersion across and within asset classes. Performance has been mixed — even as last year’s winners, such as EM equities and the momentum style factor, again lead the pack so far. See the We’re not in 2017 anymore chart. Rising rates challenge both bond prices and equity margins, and valuations remain elevated across most markets. Yet earnings growth is a powerful tonic for equities, and we still see an attractive risk/reward tradeoff.

We expect mixed and bumpy asset performance after a year of unusually low equity market volatility and steady returns.

Theme 1: Room to run

The U.S. economy is getting a fiscal shot in the arm just as it reaches full capacity. This is the first time in decades that hefty U.S. stimulus is coming outside of a recession. We see tax cuts and public spending adding about one percentage point to growth this year. See the Hello, big stimulus chart.

Faster growth could hasten the expansion’s expiration date if it does not come with increased productivity. The tax overhaul gives businesses an incentive to further boost investment after years of caution. See page 9. Greater capex and pent-up productivity gains from technology investment could lift potential growth over time, helping to contain any overheating. See our February Global macro outlook for details. A capex upswing may also help drive EM export growth, reinforcing the global cycle, we find. EM growth is set to quicken in 2018, even if China modestly slows. We see still robust growth in Europe, albeit at a slower pace than consensus, with ample spare capacity left.

U.S. fiscal stimulus could shorten the cycle, but an ongoing investment rebound may lift potential growth and help contain overheating.

We see synchronized global growth providing a solid foundation for equities. U.S. tax and spending plans have lit a fire under earnings growth, which was already gaining momentum on the back of economic strength. The Earnings power chart shows U.S. earnings upgrades relative to downgrades have shot up as analysts factor in the stimulus. The earnings revision trend goes beyond the U.S. and makes for the healthiest global earnings outlook since the post-crisis bounce. We like equities elsewhere too, with EM stocks at the top of our list.

Dividend payouts and share buybacks are another support, particularly in the U.S. as companies look to deploy their tax windfalls. Combined with earnings growth, we see these returns of capital to shareholders offsetting some valuation challenges: Investors are typically unwilling to bid up equity valuation multiples when rising interest rates and inflation threaten to erode
corporate profit margins.

Equities look appealing amid a solid economic backdrop and earnings momentum supercharged by U.S. fiscal stimulus.

Theme 2: Inflation comeback

Inflation is perking up, led by the U.S. Our Inflation GPS points to further upside around the world, a big shift from 2017. The U.S. Inflation GPS has consumer price inflation near 2.4%, enough to pull Personal Consumption Expenditures inflation, the Fed’s preferred gauge, near its 2% target. This gives us confidence the central bank will likely forge ahead with raising rates. We do not see inflation sailing far above 2%, but the risks are now two-way after years of deflation fears dominating. See the On the rise chart.

Our GPS sees some upside for eurozone inflation but expects it to remain well below the European Central Bank’s (ECB) target. As a result, we expect the ECB to stop adding to net asset purchases by the year’s end but to hold off on raising rates until mid-2019. Japanese inflation has edged up from very low levels. We believe the Bank of Japan (BoJ) wants to see a sustained rise to above 1% before adjusting its yield curve target and asset purchases.

U.S. inflation is moving back toward target. Inflation remains muted in Europe and Japan, supporting ongoing monetary accommodation there.

Markets have long doubted the Fed’s resolve to normalize monetary policy. The market-implied path of interest rates for the coming 12 months has lagged that indicated by Federal Open Market Committee (FOMC) policymakers. Markets have now caught up. Two additional rate rises are priced in for 2018, and we could see three due to robust growth and moderately rising inflation. For 2019 and 2020, however, the Fed remains ahead of the market. See the Bowing to the Fed chart.

An even faster pace of tightening appears unlikely for now. We could see temporary inflation overshoots, but it will likely take some time for any economic overheating to challenge the central bank’s gradual pace of normalization. This, twinned with ongoing monetary accommodation by the ECB and BoJ, is why we expect yields to rise only gradually from here. It is also why we like shorter-maturity U.S. debt, as detailed on page 8.

Markets have caught up with the Fed’s pace of rate increases in 2018. We believe this points to a stable backdrop for risk assets.

Theme 3: Reduced reward for risk

The low-vol environment has felt its first tremors of change. February’s spike in equity market vol served as the first warning sign. Volatility has historically moved in regimes — high or low — our research suggests. The low volatility of 2017 was abnormal, even in the context of low-vol regimes we have seen since 1980. See the When low is really low chart.

We see the low-vol regime sticking for longer, even as vol returns to more “normal” levels. Steady, above-trend global growth is supportive of low-vol regimes, which in the past have tended to play out over many quarters. Yet we do see the potential for greater macroeconomic uncertainty — and volatility. A shot of fiscal stimulus when the U.S. expansion is already at full capacity could lead to overheating. See page 4. And the risk of tit-for-tat trade spats makes for bumpier global markets. See page 7.

Volatility is back … sort of. We expect the current low-vol regime to persist, but see potential for episodic spikes amid rising risks.

Last year was nearly nirvana for diversified portfolios. Returns were strong —and volatility was exceptionally low. A hypothetical global portfolio of 60% equities and 40% bonds would have seen its Sharpe ratio, a measure of returns over cash relative to realized volatility, soar in 2017. See the Back to earth chart. Yet more muted returns, rising cash rates and “normal” volatility challenge this dynamic. The 60/40 portfolio’s Sharpe ratio would have plunged this year.

Another challenge: As rates rise, bonds may be less effective portfolio shock absorbers. The rolling 90-day correlation of S&P 500 and 10-year U.S. Treasury daily returns has been negative for most of the new millennium, but periodic post-crisis “tantrums” have occasionally flipped the relationship. This means bond and stock prices can both go down at the same time. Also, the yield spread between U.S. Treasuries and corporate bonds has tightened, meaning credit offers thinner insulation against rate rises. See page 8. What to own when bonds offer less shelter? Duration will likely still work when it matters most (global risk-off events), but we prefer higher-quality and shorter-maturity bonds.

Diversification needs a rethink as bonds work less reliably as shock absorbers.

Risks

Rising U.S. protectionism is a key risk to the benign economic backdrop. Planned U.S. tariffs on a wide range of Chinese imports have already prompted threats of retaliation. The actions test the post-WWII trade architecture long championed by the world’s largest economy. Import duties have dwindled over the period. See the Shifting trade winds chart.

We view U.S. trade actions targeting China more as an opening gambit for negotiations than the start of a trade war. We expect China to try to address its trade deficit with the U.S. by opening up its markets in the medium term. We take some comfort that talks are led by seasoned trade pros on both sides. We also see a decreased chance of the U.S. withdrawing from the North American Free Trade Agreement as negotiations appear to have become more productive. What would change our mind? Escalation triggers include the U.S. announcing and implementing harder-hitting trade measures, the trade pros losing control of negotiations and China retaliating with meaningful trade actions or a sharp currency devaluation.

Rising protectionism is a big risk but we do not see trade wars for now.

The speedy rise in government bond yields this year has unnerved investors. It was driven by a mix of higher inflation expectations and rising real yields on market fears of a supply glut in the short run and a re-assessment of long-term growth. We see yields climbing further, if not at the brisk pace of recent months. And we believe risk assets can do well in this scenario: Improved growth implies stronger corporate earnings.

We would be more concerned about a surge in rates unrelated to the growth outlook, such as one driven by fears of central banks getting behind the curve on inflation. That would likely be reflected in a spike in the term premium, or the extra yield investors demand for holding long-term bonds. See the Getting real chart. Yet we see an ongoing investor thirst for income, as well as structural factors — lower potential growth, aging populations and abundant global savings — keeping rates low relative to the past.

We see risk assets doing well if yields rise on a strong growth outlook.

Government bonds and credit

Short-maturity bonds offer enough income to offset inflation for the first time in years. Why? Rising U.S. rates. To boot, short-term yields now provide a thicker cushion against further rate rises than longer maturities. See the Get shorty chart. Rates would need to jump more than one percentage point to wipe out a year of income in the two-year U.S. Treasury note, we estimate. This is nearly double the cushion on offer two years ago — and far larger than the thin insulation provided by longer-term bonds today. For details, see
A mighty (tail)wind of March 2018.

Higher U.S. rates are largely an illusion for hedged eurozone and Japanese investors. These non-U.S. dollar investors pay higher costs for hedging U.S. dollar exposure. The flipside: U.S. investors are now paid to hedge purchases of foreign debt. This makes European and Japanese bond markets more attractive to dollar-based investors, despite lower absolute yields.

Short-term U.S. debt now offers compelling income, along with a healthy buffer against the risk of further interest rate rises.

Rising interest rates dim the appeal of credit. Tight credit spreads reflect low default risks against a backdrop of solid global growth and modestly rising inflation. Credit spreads in many markets are trading at the lowest levels as a percentage of their overall yield in a decade. See the Fading attractions chart. This is leading to a rising correlation with rate swings. Spreads are tightening by less than usual as rates rise — and in some cases are widening. That makes credit less effective in cushioning against rising rates. We are neutral on U.S. credit
and prefer up-in-quality exposures.

We are cautious on euro credit. Spreads are tight after ongoing ECB purchases of corporate debt, and the risk of shifting policy adds uncertainty. The hedging dynamic described above does create opportunities for U.S. dollar investors.

We like EM debt for its relatively high income, and see local-currency debt and short-duration strategies as more resilient in a more uncertain environment.

Credit is looking less attractive, with a diminishing cushion against interest rate spikes and a rising correlation with rate swings.

Equities

The global expansion and U.S. tax overhaul have laid the groundwork for an upswing in business spending. Our text mining of corporate conference calls suggests the lion’s share is going toward technology. We have favored the sector as earnings have outpaced the S&P 500’s in recent years. See the Inside the tech powerhouse chart. We now see upside to 2018 tech earnings as companies upgrade their platforms. Hardware providers may have a leg up as their products now qualify for immediate expensing.

Increased capex in developed markets also has an outsized impact on EM growth, we find, strengthening our conviction on EM equities. Tech and EM aside, we observe a reluctance among some U.S. large caps to spend big. We expect many to emphasize share buybacks. These can be turned on — and off — on a dime, unlike business investment and dividends. Yet we see earnings growth as the biggest return driver globally and, therefore, favor U.S. equities over developed market peers.

An upswing in U.S. company spending could be a boon for tech providers.

High-yielding stocks, or “bond proxies,” have tended to outperform in most economic downturns. We are not in that place today. Their recent slog illuminates two key points: 1) Bond proxies, other “stable” dividend stocks and min-vol strategies tend to play poor defense when rates are rising, and 2) higher rates mean they face competition from bonds for the first time since the financial crisis. Nominal yields have caught up with dividend yields, and real yields are closing in. See the Closing the gap chart.

We believe defense today requires stocks that can keep up with inflation — and prefer dividend growers to the highest yielders. Our picks fall outside the RUST (REITS, utilities, staples and telecoms) belt and include selected tech companies and U.S. banks. We see the latter resilient in any market selloff driven by higher rates rather than recession fears. And we like the momentum style factor. See our April Global equity outlook for more.

Bond proxies are losing their luster as defensive plays. We prefer stocks offering both income and growth potential.

Commodities and currencies

The U.S. dollar has tumbled in the past year, even as its yield advantage over other currencies marched higher. This is a puzzling disconnect: The factors driving currencies are ever-changing, but one constant is that global capital tends to seek returns in higher-yielding currencies, pushing them higher. The recent dollar decline has flipped the usual correlation between major currencies and interest rate differentials. See the Correlation collapse chart.

What explains this anomaly? One theory: The U.S. dollar’s recent performance is a mirror image of global risk appetite. Non-U.S. investors look to have embraced domestic risk assets, instead of plowing more funds into U.S. assets. This has left the greenback in the dust and boosted currencies such as the yen, weighing on Japanese stocks. We expect the U.S. dollar to gain some support as this portfolio rebalancing runs its course and economic uncertainty rises. Yet we see upside being capped as major non-U.S. central banks start to raise rates or prepare to wind back policy support. This keeps us neutral on the U.S. dollar.

We see upside potential for the U.S. dollar, but gains are likely to be capped as non-U.S. central banks move toward normalizing policy.

Commodity prices are riding the wave of global economic momentum. Healthier demand, tighter inventories and OPEC production cuts have corrected the supply glut that was depressing oil prices. See the Oil’s well chart. Prices have bounced back from 2016 lows and are now hovering near their highest level in three years. Increased U.S. shale oil production is likely to put a
lid on further appreciation, we believe.

U.S. dollar weakness has added to commodity price gains, but we see other factors driving prices from here. Commodities have historically performed better in later parts of the economic cycle as demand for resources outpaces supply. We prefer commodities exposure via related equities and debt. Both have lagged the recovery in underlying spot prices. Major producers’ capex discipline and sharper focus on profitability are encouraging.

We see commodities underpinned by the global expansion and prefer commodity-linked equities and debt over the actual commodities.