Global reflation has more room to play out. Recent market moves stirred doubts
about the reflation dynamic’s durability. We view the market response over the
past year – higher bond yields, stronger equities with a rotation towards cyclical
plays – as a quick repricing after a bout of deflation anxiety. We see reflation
beneficiaries gaining further but at a slower speed. Our BlackRock GPS, which
gives a steer on the near-term economic outlook, signals that G7 growth is
settling into a sustained, slightly above-trend pace. Highlights in our expanded
Global macro outlook include:
• This US-led economic cycle has been unusually long and slow but has plenty
of runway. We base this on an analysis of when previous US expansions
eliminated the economic slack created by each recession. This cycle's
remaining lifespan can likely be measured in years, not quarters.
• US wage growth has room to pick up based on where we are in the cycle.
Households have room to sustain spending after an unprecedented
deleveraging. Stronger corporate investment would reinforce growth rates,
though we see a risk of the ongoing US political drama keeping businesses
cautious. This is in the context of modest potential US growth near 2%.
• Our view hinges on structural forces keeping long-term interest rates low
relative to the past. If we’re wrong, some of the current risks, such as high US
corporate leverage, could be magnified if US yields surged.
GPS: Stabilising at higher levelsThe BlackRock GPS has stabilised at higher levels, giving us confidence that
global growth is both resilient and synchronised. We expect improvement in
survey-based data to cool given the sharp run-up over the past eight months,
which we see as catch-up to steadier activity figures. The G7 GPS below still sits
at an elevated implied growth rate near 2%, well above consensus expectations.
G L O B A L M A C R O O U T L O O K • M A Y 2 0 1 7
Benchmarking reflation
Authors
Jean Boivin
Head of Economic and Markets
Research, BlackRock Investment
Institute
Rick Rieder
Global Chief Investment Officer
and Co-head of BlackRock Global
Fixed Income platform
Contributors
Joshua McCallum
Simon Wan
Economic and Markets Research
BlackRock Investment Institute
Sources: BlackRock Investment Institute and Consensus Economics, May 2017.
Notes: The GPS shows where the 12-month consensus GDP forecast may stand in three months’ time for G7
economies. The blue line shows the current 12-month economic consensus forecast as measured by Consensus
Economics.
Economic snapshotBlackRock GPS vs. G7 consensus, 2015-2017
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View GPS website
20170522-163833-452218
Getting a grip on reflationThe phrase “reflation trade” gets bandied about even
though it is poorly defined, meaning different things to
different people. Right now, “reflation” is being used to
refer to everything from inflation to economic expansion to
US President Donald Trump’s tax and deregulation plans.
The rapid market repricing on the brighter growth and
inflation outlook unfolded over just a few months in late
2016, largely because investors were quickly reassessing
their views after having been overly downbeat about
growth prospects due to the energy and commodity price
shock. China’s pick-up, thanks to heavy stimulus, also
played a role in helping emerging markets (EM) bounce
back. We believe that reassessment is largely over. We
see US growth holding at a slightly above-trend pace that
should keep intact reflation as we define it: rising wages
feeding stronger nominal growth, allowing lingering slack
from the last recession to be gradually eliminated in a way
that stirs broader inflation pressures. This economic story
needs to be separated from the many “trades” tied to it.
Context is key. The chart below shows the unprecedented
fall in inflation expectations in 2014-16. Plunging oil and
commodity prices dealt a blow to key economic sectors,
especially energy, at a time markets feared central banks
were out of ammunition. The broad economic impact was
mild, yet the fear factor was pronounced. The “secular
stagnation” theory – growth stuck at below-trend rates that
would leave inflation permanently depressed – gained
traction. That further stoked the pessimism and deflation
anxiety. In the end, those fears proved exaggerated.
Inflation expectations recovered, and the US-led reflation
trend plodded on and became more global. Our work
shows that sentiment-based data have played catch-up to
activity data that had never deteriorated as much. As
conditions have normalised, markets have settled down –
if a little too calmly for the comfort of some.
Collateral damageUS and eurozone inflation expectations, 2010-2017
Sources: BlackRock Investment Institute, Thomson Reuters, May 2017. Notes:
The eurozone line shows swap market pricing of average inflation over a five-
year period starting in five-years. The US line shows similar pricing based on
Treasury inflation-indexed bonds.
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That Trump tradeTrump’s election win unleashed a big bout of optimism on
tax cuts, deregulation and infrastructure spending – largely
based on his campaign promises and the Republican
control of Congress. The market response was immediate.
The chart above breaks down the performance of the S&P
1500, which includes large, mid and small cap shares,
around the election. It separates those that responded the
most positively or negatively from those that did not
respond as strongly. Initial winners were concentrated in
financials, industrials and health care. Losers were in
telecoms, energy and technology.
The chart is telling. First, the Trump trade did not change
the overall upward move in place before the election.
Those shares less impacted – the neutral ones – went
straight back to their pre-election trend. Second, the Trump
equity trade has mostly unwound. Some energy shares are
still relative winners, likely on deregulation expectations.
But the energy sector overall is now the biggest
underperformer. Financials have given up most of their
biggest relative gains. Just as importantly, the shares most
hurt immediately after Trump’s win have recovered.
Technology, for one, has built a head of steam all year.
This sends an important message: Trump’s election impact
has not changed the underlying market trends that appear
tied more to the reflation story than that of “Trumpflation”.
The post-election market moves are not solely Trump-
driven, we believe.
Bottom line: Trump trades have been dented, but we
expect reflation trades – negative for government bonds,
positive for cyclically geared assets – to resume in an
environment of US growth slightly above trend, which we
see at around 2%.
.
Trump trades trumpedUS equity performance around US election, 2016-17
Sources: BlackRock Investment Institute, Thomson Reuters, May 2017. Notes:
The chart shows the rebased price performance of individual shares in the S&P
1500 index around the 2016 US election, with 100 set on Nov. 8. The breakdown
reflects how different shares performed in the three trading days after the
election (Nov. 9-11). Those individual shares that rose by more than one
standard deviation of their historical three-day moves relative to the overall
market move were put into the “winners" bucket. Those that fell by more than
one standard deviation are grouped in “losers". The rest represent the "neutral"
bucket.
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Benchmarking cyclesAll economic cycles share a similar trajectory. From a late-
cycle inflationary peak, a recession drives activity to a
trough. Economic activity falls below potential. Slack opens
up and a recovery begins. But growth needs to be faster
than potential to reduce the slack created in the downturn.
As spare capacity is used up, we enter a reflationary
period – the sweet spot of the cycle. We then transition
into a late-cycle period leading to a new peak. These
milestones are common to all cycles, but the time between
them varies depending on the expansion’s vigour.
The longer it takes to absorb economy-wide slack, the
longer the cycle should run. This means that economic
slack is arguably a better way to benchmark where we are
in the cycle than simply looking at the time lapsed since
the last recession. The chart below shows US gross
domestic product (GDP) cycles since 1953, with each dot
on a line depicting a calendar quarter. What stands out?
This looks like a completely normal cycle and is tracking
the previous two cycles closely. Yet lower growth rates
imply that slack is being eroded much more slowly relative
to previous cycles – especially given the sheer spare
capacity created after such a shock. Economy-wide
measures suggest that slack hasn’t been eliminated by
now unless one makes big assumptions about the
recession having been less severe or potential growth
being well below 2%. Even if there is no slack left, as some
labour market indicators suggest, the economy’s snail’s
pace of growth implies that the cycle's remaining lifespan
can be measured in years, not quarters, we believe.
Long reflationary roadComparing US economic GDP cycles, 1953-2017
Sources: BlackRock Investment Institute, US BEA, Congressional Budget Office,
National Bureau of Economic Research (NBER), May 2017. Notes: This chart
shows the level of real US GDP compared against other cycles since 1953,
excluding the short 1980-81 one. Each line begins at 100 with the peak of the
previous business cycle, as determined by the NBER. We fix different economic
cycles at key points to align each based on their peaks, troughs and the point
when potential output is reached. This allows us to compare cycles of varying
lengths. The cycles above vary from 11 to 42 quarters, with the current at 39
quarters. Potential output is reached when the economy is operating at full
capacity, having used up all the slack created by the previous downturn. We use
CBO measures of the output gap, or the difference between actual and potential
output. Each dot on a line represents a calendar-year quarter. Each cycle peak is
set at 100. All cycles since 1953 are represented.
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Missing ingredientCorporate investment has been unusually weak this cycle.
Capex overshot to the downside in the wake of the 2008-
09 financial crisis, deviating from its past relationship with
GDP growth. The chart above shows the level of non-
residential investment – from computers to buildings,
government projects and intangibles such as research and
development – implied by US and eurozone GDP.
In the US case, investment eventually caught up to a level
consistent with the modest growth environment and higher
corporate uncertainty. Then the energy shock struck and
the gap reopened. This underscores how corporate
investment has been something of a missing ingredient
over the past few years, softer than it should be even when
we account for lower potential growth. In Europe, the
investment gap is very far from being closed. See the lower
chart above. Greater investment in Europe could reinforce
its sturdy recovery.
In general, our analysis shows that these investment gaps
tend to be corrected. This would happen as companies
gain enough confidence to unleash spending once
economic conditions stabilise – and the proverbial “animal
spirits” kick in. Corporate guidance in earnings updates
suggests a reluctance to spend. Yet the Philadelphia
Federal Reserve’s survey of manufacturer investment
intentions shot up to a 17-year high in April. US first-
quarter business investment growth was its strongest since
2013, according to the US Bureau of Economic Analysis.
Investment catch-upUS and eurozone investment trends, 2007-2016
Sources: BlackRock Investment Institute, US Bureau of Economic Analysis
(BEA) and Eurostat, May 2017. Notes: These charts show the actual level of
capital expenditure (non-residential investment) in the US and eurozone and
estimates of where the level of capex should be based on its historical
relationship with GDP growth and factoring in the Economic Policy Uncertainty
Index. The accelerator models help show the level of investment consistent with
recent past GDP growth. The data are rebased to 100 in 2007.
20170522-163833-452218
Wage growth needed…Wage growth will be key for cementing the reflationary
economic dynamic, we believe. This is true not just in the
more advanced US expansion, but in the budding stages
of Europe’s recovery and even in Japan where the labour
market is tightening thanks to a shrinking working-age
population.
The popular narrative holds that US wage growth has been
disappointing this cycle. Yet our analysis suggests that
wage growth is not abnormally weak after adjusting for the
cycle’s length and the recession’s severity. See the orange
line in the chart below. Our comparison is with cycles since
the early 1980s, when lower inflation rates have been
reflected in much lower rates of nominal wage growth. For
all the anxiety, wage growth has followed a remarkably
similar pattern and suggests that slack still remains. This is
why we find these cycle comparisons so compelling.
To be sure, the current wage recovery has taken time to
kick in and is softer than in the 1990s. Yet it is happening
in fits and starts. We are seeing the US labour market
tighten in ways not seen in decades – jobless claims as a
share of the working population are at lows since the
1970s, for example. And job shortages are popping up in
many areas, as more regional Federal Reserve banks
report.
Wage growth stalling here would suggest a structural shift
making this cycle truly distinct from all the others in the
post-war period. We have a hard time seeing why this
would be the case but see two potential factors. Poor
productivity growth could offset the labour market’s
recovery, keeping wage growth tepid. Technology’s
displacement of workers may be having a broader impact.
This cycle is typical in many ways but unusual in two:
household and corporate leverage.
Weak but not unusualUS wage growth across cycles, 1981-2017
Sources: BlackRock Investment Institute and US Bureau of Labor Statistics, May
2017. Notes: This chart shows the annual pace of US wage growth (average
hourly earnings) of production and non-supervisory workers across cycles, using
the same methodology as the GDP chart on page 3. Cycles before 1981 are not
shown because high inflation in these earlier cycles lifted wage trends to much
higher nominal levels than recent cycles.
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…in a much different contextThe anxiety about wage growth comes after the biggest
effort by US households to cut debt in the post-war period.
That goes a long way towards explaining why the recovery
has been so sluggish. The Great Recession was a
household balance sheet recession, hitting the biggest
asset of all – housing – in a way that led to such a deep
economic contraction and long-lingering scars. As a result,
households slashed debt relative to income at the sharpest
rate yet across these cycles. In that light, it’s no wonder
why the recovery has been such a tepid one – on top of the
repeated internal and external shocks.
US household debt, mainly mortgage driven, sowed the
seeds of the very deep contraction. As the chart above
shows, the difference between US household behaviour in
this cycle and the last couldn’t be more stark. This US
household deleveraging – cutting debt relative to income –
is as historic as the leveraging driving the property bubble
of the mid-2000s that led to the global financial crisis and
recession. US household debt relative to disposable
income has tumbled to its lowest levels in 14 years,
according to 2016 Fed data. As the consumer of the world,
this has had global repercussions – restraining activity and
US imports, a trend that is starting to reverse with the
recent pick-up in US demand for products abroad.
This deleveraging is also driven by the post-crisis financial
system clean-up. Stricter regulations have boosted bank
capital have also led to tighter lending standards. That has
made it harder for less-creditworthy households to borrow,
unlike in the last cycle when growth was powered by an
unsustainable debt binge and lax lending standards. The
household deleveraging story is true not just in the US:
household debt-to-income is at new decade lows in Japan,
the eurozone and UK. Strengthened balance sheets in
theory mean households today have greater capacity to
sustain spending and should be less vulnerable to shocks.
All things equal, it bodes well for this long expansion’s
durability.
An historic deleveragingUS household debt vs. disposable income, 1953-2016
Sources: BlackRock Investment Institute and Federal Reserve, May 2017.
Notes: This chart shows the cumulative change in US household debt as a share
of disposable income over the course of different cycles since 1953. It uses the
same methodology as the GDP chart on page 3.
20170522-163833-452218
Leveraging the balance sheetOne source of concern is the build-up of debt by US
corporates in the period since the crisis – a trend that looks
like a potentially destabilising late-cycle excess. We
believe companies have had compelling reasons to pile on
low-cost debt, making this leveraging up different relative
to the past.
The chart below shows US corporate debt relative to
revenue (based on gross valued added). Debt has climbed
to unprecedented levels compared with previous cycles.
Yet companies have had reasons to act in such a manner.
The realisation that we are in an environment of
structurally lower interest rates would make debt more
attractive for financing. Companies naturally took
advantage of record low rates to conduct a balance sheet
arbitrage by issuing long-term bonds, partly with an eye to
cutting outstanding equity. A desire to boost shareholder
returns in the short term added to the incentives for
emphasising debt over equity on the balance sheet.
Share buybacks have exceeded corporate debt issuance
through most of the current cycle: In the past six years, US
companies cut $11.6 trillion of equity liabilities and raised
$9.2 trillion of loans and bonds, according to –end 2016
Fed data. In many ways, companies are responding
exactly as central banks might want to the incentives of
record low interest rates: locking in historically rock-bottom
borrowing rates – and at longer maturities. But something
more than ultra-low rates will be needed for companies to
make bigger investments.
Companies have fortified themselves securing low rates
with bonds featuring longer maturities. Bloomberg Barclays
data show the current average duration of the US
investment grade corporate index is 7.2 years as of May
2017, near record highs, versus 5.8 years in the mid-
2000s. This should help reduce future refinancing risks.
VulnerabilitiesThe International Monetary Fund highlighted US corporate
sector leverage as a potential threat in its April 2017 Global
Financial Stability Report. Net interest costs as a share of
revenues have fallen only slightly for US companies even
with the Fed having cut interest rates to nearly zero and
being slow to raise them. See the chart above. That
interest costs haven’t dropped more reflects just how much
debt companies had added during this cycle. It also stands
in contrast to the the large drop in financing costs that the
UK and eurozone have engineered.
There are risks. The IMF warned that US energy and
smaller companies are the most exposed to any surge in
financing costs given their weaker positions to cover higher
interest rate burdens. Beyond corporate debt, concerns
have been raised about US auto and student loan lending.
We see higher US corporate leverage as a potential
vulnerability if interest rates soared and drove corporate
bond yields sharply higher, causing painful debt
refinancings or even defaults. But these risks look
contained for now. A surge in interest rates would be
needed for this to prove problematic – one we view as
unlikely. Any such hiccups would also likely constrain the
Fed’s policy normalisation path. Structural forces – ageing
populations, high debt levels and weak productivity growth
– should prevent yields from going back to historical
averages on a sustained basis, as highlighted in our 2017
Global Investment Outlook. Importantly, corporate leverage
is worrying to the extent it leads to massive capital
misallocations. This may be the case in some sectors, but
the overall problem of this expansion remains one of
insufficient – rather than excessive – investment.
US tax reforms could transform how companies approach
capital and spending: Any shift to immediate expensing for
capex could bring forward spending plans, while any end to
interest expense deductibility could cut debt issuance and
share buybacks while reviving equity issuance.
US debt bingeBusiness net interest cost as share of revenue, 2000-2016
Source: BlackRock Investment Institute, BEA, UK Office for National Statistics,
Eurostat, May 2017. Notes: The chart shows net interest costs as a share of
revenue (gross value added) for the US, UK and eurozone.
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Leveraging upUS corporate debt as share of revenue, 1953-2016
Sources: BlackRock Investment Institute, BEA, May 2017. Notes: This chart
shows the cumulative change in corporate debt as a share of revenues (gross
value added in the national accounts data) over the course of different cycles
since 1953. It uses the same methodology as the GDP chart on page 3.
20170522-163833-452218
Seeking animal spiritsIt’s not just companies that have been extra cautious in the
post-crisis environment. Even as equity indices have kept
pushing to new highs and stirred worries that overvalued
markets are poised for a major reversal, our work has
found that investors also remain reluctant to embrace risk.
We took another look at a gauge we introduced in the
November 2016 Global macro outlook to take a deep dive
into how money flows through the financial system and
what that reflects about investor risk appetite. We looked
at how the value of US risk assets changes relative to that
of perceived safe assets, mainly money and government
bonds while excluding bonds bought by central banks –
what we call the risk ratio. The risk ratio helps show
whether investors are venturing out the risk spectrum. The
latest data capture the risk asset run higher during the last
quarter of 2016. What did we find? Very little movement. In
fact, the risk ratio even ticked down slightly in the fourth
quarter. While the level is consistent with moderate risk
taking, we are far away from any kind of “irrational
exuberance” seen in the late-1990s or mid-2000s.
Cautiousness remains pervasive, even eight years on.
This just goes to show how long it takes for confidence to
return after such a severe crisis. The equity gains of the
past eight years have been doubted almost every step of
the way rather than being taken as a positive signal.
Climbing the wall of worry has been a constant exercise.
As with other parts of the cycle that are slowly normalising,
investors are likely to start embracing more risk. We are
seeing signs of risk appetite picking up globally. After a
long pause, flows into developed market equities have
picked up again, rising nearly $180 billion in the six months
through early May, according to EPFR Global.
Globalising reflationOnce a US-led phenomenon, reflation is now global. More
than 80% of the countries making up the Markit global
composite PMI – combining manufacturing and services –
posted stronger readings from a year earlier in April, one of
the highest shares since the immediate recovery from the
crisis. See the chart above.
Europe’s recovery has largely been overlooked, partly due
to constant worries about political risks. These risks are
now subsiding after the business-friendly Emmanuel
Macron’s clear victory in France’s presidential election.
Economic growth rates implied by eurozone equities and
bonds have been persistently low relative to actual GDP
performance, leaving plenty of scope for a rebound, as we
highlighted in the March 2017 Global macro outlook:
Europe’s stealth recovery. Political uncertainty has been a
clear factor holding back the market pricing of the
reflationary dynamic. The rebound in commodity prices and
China’s credit-driven reacceleration have given the global
economy an extra jolt over the past year. China is playing a
role in helping transmit the solid rate of global growth from
developed economies to EM. See our February 2017
Global macro outlook: China’s role in global growth. EM
economies have bounced back after a three-year slump
tied to the commodity sell-off and investors taking a
dimmer view of the excesses in some countries. Global
trade is picking up.
Bottom line: We see the market settling its focus on
sustained economic expansion after an accelerated
repricing of reflation. We believe reflation has legs given
the slow pace at which US economic slack is being
absorbed. That allows the Fed to press ahead with a
gradual policy normalisation. Our BlackRock GPS points to
reflation broadening beyond the US. We are negative on
government debt and positive on reflation beneficiaries:
European, Japanese and EM equities, as well as cyclicals
and factors such as value.
Better breadthGlobal PMI and share of rising countries, 2001-2017
Sources: BlackRock Investment Institute, Markit, May 2017. Note: This chart
shows the global composite PMI and the share of countries reporting higher
PMIs compard with 12 months ago.
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Not so euphoricUS risk ratio, 1955-2016
Sources: BlackRock Investment Institute, Federal Reserve, May 2017. This chart
shows gauges of a financial asset risk ratio based on U.S. flow of funds data.
The risk ratio is defined as the ratio between risk assets (such as equities,
mortgages and corporate bonds) and less risky assets (government and agency
bonds plus money) but excluding central bank holdings since those are
effectively removed from the market. It is based on a four-quarter average to
smooth out seasonal effects.
20170522-163833-452218
This material is prepared by BlackRock and is not intended to be relied upon as a forecast, research or investment advice, and is not a
recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2017
and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and
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risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less
government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often
heightened for investments in emerging/developing markets or smaller capital markets.
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respective owners.
The BlackRock Investment Institute (BII) provides connectivity between BlackRock’s portfolio managers, originates
economic and markets research, develops actionable views for clients, and publishes investment insights. Our goals are to
help our portfolio managers become even better investors and to produce thought-provoking investment content for clients
and policymakers.
BlackRock Investment Institute
BLACKROCK VICE CHAIRMAN
Philipp Hildebrand
GLOBAL CHIEF INVESTMENT STRATEGIST
Richard Turnill
HEAD OF ECONOMIC AND MARKETS RESEARCH
Jean Boivin
EXECUTIVE EDITOR
Jack Reerink
FOR INSTITUTIONAL, PROFESSIONAL, QUALIFIED/WHOLESALE INVESTORS ONLY. FOR PUBLIC DISTRIBUTION IN THE US ONLY.
20170522-163833-452218