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Politics not quite as usualViews on the intersection of politics and markets
GLOBAL INSIGHTS • JUNE 2017
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2 POLITICS NOT QUITE AS USUAL
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Contents
3–5The big picture
6–7Geopolitics
8–11US
12-15Europe
LEFT TO RIGHT
Joanna Cound – Head of BlackRock Global
Public Policy Group, Europe
Kate Fulton – BlackRock Global Public Policy
Group, US
Rupert Harrison – Portfolio Manager,
BlackRock Multi-Asset Strategies
Isabelle Mateos y Lago – Chief Multi-Asset
Strategist, BlackRock Investment Institute
Jonathan Pingle – Head of Economics,
BlackRock Fixed Income Americas
SummaryWe see diminished political risks in the short run in Europe, and potential for some growth-enhancing
reforms in major economies around the world. Some of this good news is already priced in, but we
expect a steady and synchronised global economic expansion to underpin risk assets for now.
Longer term, we see significant risk of populist policies that would hurt business, such as restrictions on
trade and immigration. A starkly more transactional US approach to foreign affairs challenges long-time
security and trade arrangements, and we see North Korea’s nuclear ambitions as the top security threat.
We see fading prospects for comprehensive US tax reform amid legislative gridlock and distracting
probes into ties between White House officials and Russia. Yet depressed expectations lower the bar for
positive surprises, and we see regulatory easing as an under-appreciated force in business and markets.
Europe may have its best opportunity in decades to push through reforms that make the EU more
sustainable and effective. These are much needed to deal with rising populism and any economic
deterioration. Potential flare-ups are Italy’s fractious politics and a possible ‘no deal’ on UK Brexit talks.
Investors have mostly shrugged off a series of political upsets – from Brexit to US
President Donald Trump’s surprise election win. Yet these developments have
long-term consequences. There are fundamental questions about the future of
the European Union (EU) and how to address the complex root causes of populism
and nationalism. An increasingly transactional US approach to foreign affairs, waning
support for free trade and uncertain prospects for US tax reform also have big and
differentiated implications for economies, sectors and companies.
These topics are the subject of vigorous debate among BlackRock portfolio
managers and strategists. We do not have all the answers, but here we present
some of our thinking, including Q&As with our experts.
PhilippHildebrand
BlackRock Vice
Chairman
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BLACKROCK INVESTMENT INSTITUTE 3
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The big pictureWe see political risk receding for now, returning attention to a steady global
expansion. Yet ongoing discontent could lead to policy responses that pose longer-
term threats to markets.
The Republican policy agenda could be derailed if
the party loses control of either chamber of Congress
in the 2018 mid-term elections. A challenge is fulfilling
the promises Trump made during his campaign, which
attracted disproportionate support from older white
males, many in the so-called rust belt states. Stagnant
wage growth for the middle class, sharply rising health
insurance premiums and an epidemic of opioid addiction
are among the issues requiring policy responses.
Our bottom line: if current governments fail to
implement policies that improve the plight of
disenfranchised and disgruntled voters, we could see
more populist election victories in the years ahead.
We believe this could lead to a further backlash against
the free flow of people and goods across borders,
threatening global supply chains and economic growth.
The longer governments wait to address voter concerns,
the greater the chance of eventual policy overreach that
could hurt markets.
A series of populist surprises has riveted investors.
The political shocks of 2016 – the UK’s Brexit vote and
the election of US President Donald Trump – signalled
a dissatisfaction with the status quo, particularly among
baby boomers who make up an increasing share of
electorates. Rising inequality in some countries and
a perceived loss of sovereignty in others also play a part.
Economic issues such as the state of the economy,
unemployment and public finances dominated in
the years following the global financial crisis and
European sovereign debt woes. Terrorism and
immigration have leapt to the top of voter concerns since
2014. See the Shifting worries chart. Similar trends are
driving populist politics in many countries.
Markets have proved resilient to political shocks to date,
recovering swiftly after initial sell-offs. Investor caution
leading up to these events may be part of the story. A
benign reflationary backdrop and improving corporate
earnings around the world also help.
A political cloud seems to be lifting in Europe after
the French election delivered its most pro-European
president in decades. And German chancellor Angela
Merkel looks set to win a fourth term in September.
This could open a window of opportunity for Europe’s
two largest economies to cooperate in promoting
reforms vital to the eurozone’s sustainability. See
pages 12-15 for details. There are risks. Italian elections
could result in fragile coalitions, and raise questions
about Italy’s commitment to the euro. And there is
a risk that the UK cannot reach a deal with the EU
before exiting in 2019.
In the US, the legislative agenda has slowed amid
investigations of potential Russian election interference
and other distractions. A fractious Republican caucus
with only a slim Senate majority leaves the party
leadership with little margin of error in approving
legislation. And relations between the two major parties
are as fraught as ever.
Shifting worriesPublic’s view of key issues facing the EU, 2011-2016
2016
0
20
40
60%
20142013 201520122011
Unemployment
Economic situation
Terrorism
Public finances
Immigration
Sources: BlackRock Investment Institute and the European Commission, November 2016. Note: the lines show percentage support for the top-five responses to the question “What do you think are the two most important issues facing the European Union at the moment?” in the Eurobarometer public opinion survey.
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Room to runPolitical events have the potential to sway markets, but
we believe investors also need to look through short-
term noise and focus on the big picture: underlying
economic and market trends. The outlook is pretty
bright in this regard, in our view. The US economic
recovery from the financial crisis has been slow and
grinding, and some worry that it may be on its last legs.
We believe it has room to run. The slower the pace of
a recovery, the longer it takes to absorb the economic
slack created in the last recession – and the longer it
takes to reach full capacity and ultimately the peak that
signals the cycle’s end. See our Global macro outlook
of May 2017 for details.
The Are we there yet? chart shows US economic cycles
since 1953, with each dot on a line depicting a calendar
quarter. What stands out when time is replaced by
economic progress? The current cycle (the orange line)
looks normal – and is closely tracking the previous two
cycles of 1990-2001 and 2001-2007 (blue and green).
Estimates of economic slack are imprecise. Yet even if
there is no slack left, as some labour market indicators
suggest, the economy’s anaemic pace of growth implies
there are years – not quarters – to go in the current cycle,
in our view.
European signs of lifeEurozone GPS and market-implied GDP, 2010-2017
Ann
ual G
DP
gro
wth
2010
0
0.5
1
1.5
2%
2012 2014 2017
Market-implied GDP
Eurozone big-four GPS
Sources: BlackRock Investment Institute and Eurostat, May 2017.Notes: the BlackRock GPS shows where the 12-month consensus GDP forecast may stand in three months’ time for the top four eurozone economies: Germany, France, Italy and Spain. The market-implied eurozone GDP is based on a statistical model that analyses co-movements in eurozone equity prices and real bond yields: any simultaneous rise in real yields and equities is interpreted as the market pricing in a positive growth expectation. Using the GPS methodology, that is converted into a 12-month forward GDP reading.
Are we there yet?Comparison of US economic cycles, 1953-2016
Prior peak
90
110
130
150
2007-present
1990-2001
2001-2007
GD
P in
dex
Trough Potential Peak
Sources: BlackRock Investment Institute, US BEA, Congressional Budget Office, National Bureau of Economic Research (NBER), May 2017. Notes: the chart shows the level of real US GDP compared against other cycles. Each line begins with the peak of the previous business cycle, as determined by the NBER. We align different economic cycles based on their peaks, troughs and the point when potential output is reached. This allows us to compare cycles of varying lengths. 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.
European optimismInvestors have long been downbeat on the eurozone’s
growth prospects. The market is pricing in GDP growth
of just 1.2% in its big-four economies in the year ahead,
based on our analysis of bond and equity valuations.
See the European signs of life chart. The market-implied
growth rate has rebounded sharply in recent months,
but still lags the forward view of the BlackRock GPS,
which combines traditional economic indicators with
big data signals such as Internet searches. The unusual
divergence between our GPS and marked-implied
growth rates since 2015 can be explained by political
risks: most recently, jitters ahead of the French
presidential election.
We see further room for market-implied GDP rates to play
catch-up with our GPS in the coming quarters as political
uncertainty lifts. We see this pushing European equities
and bond yields higher, reflected in our overweight
view on European equities and an underweight view on
European sovereign debt and credit. What are the risks?
Nominal income growth is still sluggish and needs to
pick up as tail winds from lower oil prices and a weaker
currency fade. Also, Europe has greater exposure to
China and emerging markets than the US, and could be
disproportionately impacted by any stall in economic
momentum there.
Click to view interactive GPS
Click to view interactive data
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BLACKROCK INVESTMENT INSTITUTE 5
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All regions of the world economy are experiencing
a synchronised upturn in 2017 for the first time
in several years. The global reflationary dynamic
is reflected in a pickup in global trade volumes.
Growth in the dollar value of trade has rebounded
sharply after contracting for much of the past two
years. This is a sign of health in the global economy.
See the Budding trade recovery chart.
The volume of world merchandise trade has tended
to grow about 1.5 times faster than world output since
1981, but the ratio has slowed to 1:1 since the financial
crisis, according to a World Trade Organization (WTO)
April 2017 report. This partly reflects weak investment
in much of the world. Structural changes such as
China’s rebalancing away from investment and towards
consumption are another potential dampener in
coming years.
Any rise in protectionism could pose a threat to
the nascent global trade recovery. We do not see risks
of a significant increase in actual protectionist measures
this year. Increased US pressure on China and other
countries to open up their markets may actually yield
benefits. Yet escalating protectionist rhetoric and a more
transactional US approach to trade that favours bilateral
over multilateral deals is a longer-term concern. See
page 7 for details.
What, me worry?Top perceived ‘tail risks’ and world equities, 2015-2017
Tota
l ret
urn
(Oct
. 201
5 =
10
0)
Oct. 2015
Economic worry Political worry
90
110
130
World equities
May 2017
May 2016
Jan. 2016
Oct. 2016
Jan. 2017
EU disintegrationChina recessionUS recession
Brexit
Trump winChina credit
Trade war
Sources: BlackRock Investment Institute, MSCI and Bank of America Merrill Lynch, May 2017. Notes: the vertical lines show the top ‘tail risk,’ or the top outside risk, from the Bank of America Merrill Lynch Fund Manager Survey. Only months where the top risk accounted for more than 25% of responses are shown. World equities are based on the MSCI All-Country World Index total return, re-based to 100 at the start of October 2015.
Budding trade recoveryGlobal export volume and value, 2003-2017
Ann
ual c
hang
e
2003
Value
Volume
US recession
2005 2007 2009 2011 2013 2015 2017
-30
-15
0
15
30%
Sources: BlackRock Investment Institute, IMF and CPB - Netherlands Bureau for Economic Policy Analysis, May 2017. Notes: the lines show the annual percentage change in total global export volumes and export value in US dollars.
Markets have climbed a wall of worry in the past
few years. What are investors most worried about in
the world today? The top tail risk cited by investors
was dominated by economic concerns from late 2015
through early 2016, mostly around fears of China
dragging the world into recession, the Bank of America
Merrill Lynch Fund Manager Survey shows. See
the What, me worry? chart.
Political concerns and uncertainty then jumped into
the spotlight, with investors’ minds dominated by Brexit,
Trump’s surprise election victory and sporadic worries
about EU disintegration. We see concerns about EU
cohesion receding until the run-up to Italian elections,
which could occur as early as September. See page 12.
China credit risks became the top investor worry in
early 2017 as the country tapped its foot on the brakes
of credit creation. The lesson from recent history is that
fundamentals have mattered much more than politics.
Markets have shrugged off most of the top political risks,
with bouts of volatility treated as buying opportunities.
The question is when and where politics may start to
impact the favourable fundamentals. For example, we
could see a failure of the UK to reach an exit deal with
the EU hurting its economy and markets. See page 15.
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The coming year brings a mosaic of elections, monetary
policy decisions and geopolitical hot spots. See the map
below. Washington lawmakers face a shrinking window
of opportunity to implement tax reform (pages 8-10).
Populists have been beaten back in Europe for now,
and our attention has turned to trouble brewing in
Italy (page 12), improving the workings of the EU
(page 13-14) and the shape and outcome of Brexit
negotiations (page 15).
The backdrop of synchronised global growth puts
central banks at a crossroads. We see the European
Central Bank (ECB) debating how much longer its
extraordinary amount of monetary support is needed
– and how to communicate any changes. The Fed is
contemplating how to trim its balance sheet. We see
the risks as contained, as we expect central banks to
move cautiously and gradually.
GeopoliticsWe highlight key events, trends and risks to watch in 2017 and beyond.
Mark your calendarEvents and geopolitical risks to watch in 2017 and beyond
Italy General elections before 20 May 2018
UKParliamentary elections8 June
Brexit negotiations
China19th Party CongressAutumn 2017Attempts to rein in credit South China Sea disputes
European UnionKey ECB meetings8 June, 20 July, 7 Sept.,26 Oct., 14 Dec.
European Council meetings22-23 June, 19-20 Oct., 14-15 Dec.
Mexico Start of NAFTA renegotiationSummer 2017
General electionsJuly 2018
Brazil General electionsOct. 2018 or earlier
Middle EastSyria and Yemen proxy warsSaudi economic transformationFuture of Iran nuclear deal
North KoreaMissile and nuclear tests
US Key Fed meetings13-14 June, 19-20 Sept., 12-13 Dec.
Debt ceiling and 2018 budget Summer/autumn 2017
Potential tax reform2017-2018
Midterm elections6 Nov., 2018
GermanyFederal elections 24 Sept.
South AfricaANC leadership election16-20 Dec.
SpainPossible Catalan independence referendum17 Sept.
Russia Presidential electionsMarch 2018
FranceLegislative elections11 and 18 June
Source: BlackRock Investment Institute, May 2017.
China’s growth momentum has slowed as authorities
are cracking down on credit excesses. These measures
and other structural reforms are crucial to put
the economy on a sustainable long-term path, but
bring short-term risks. Accidents can happen when
liquidity is tightened in economies addicted to credit.
We see the upcoming 19th National Congress of
the Communist Party as a harbinger for both reform
momentum and China’s ambitions on the world stage.
See China’s tricky transition of February 2017.
Mexican elections loom large on the EM political
calendar. We see rising risks of a populist outcome,
partly reflecting the US administration’s anti-Mexican
rhetoric. Brazil’s government is in crisis, and early
elections are a possibility. Geopolitical hot spots
abound, with North Korea representing the most
immediate threat (page 7).
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Former US National Security Advisor Tom Donilon gives investors a geopolitical tour.
What’s the current state of
geopolitics?
First, there is significant uncertainty
about the direction and tone of US
national security policy. Second, the
great power relationships are evolving
and becoming more competitive.
Third, there is an unusual number
of volatile and unstable situations. These include
North Korea’s nuclear and missile drive, failed states
and the resulting effects on migration and terrorism,
Russia’s confrontation with the West, populist pressures
in Europe and increasing cyber threats.
These are grim prospects …
There are near-term positives for investors. The French
election took an existential threat to the European project
off the table for now – and I don’t see a rejection of Europe
in the upcoming German elections. US-China relations
have been constructive; a trade war is unlikely this year.
Let’s return to your first point: Washington’s agenda.
The Trump campaign challenged the pillars of the US-led
post-WWII order, including the value of international
alliances, trade and institutions. An experienced
national security team has since had some moderating
effect, and some campaign slogans have run into
the realities of governing. Several characteristics of
a new US approach to foreign affairs have emerged:
First, policy is highly transactional and focused on
immediate results. Second, the president embraces
unpredictability as an operating style. Both have the
benefits of flexibility but can call into question the US’s
reliability as a long-term partner – and unnerve allies
and investors alike. Third, there is a persistent focus on
bilateral economic relations, especially trade deficits,
which are seen as a zero-sum game.
How does this play into the great power relationships?
The principal development is that Russia has turned away
from integration with the West to challenging it, from
Ukraine and probing NATO’s borders to Syria and alleged
interference in Western elections. I don’t see US-Russia
relations improving any time soon. Many administration
policymakers see Russia as a significant security threat,
and there are multiple inquiries into election meddling.
How about the upstart superpower, China?
China’s leaders appear confident and eager to fill
any leadership vacuum after the US announced its
withdrawal from the Paris climate accord and pulled
out of the Trans-Pacific Partnership trade agreement.
President Xi Jinping is set to put in place his team
and policy agenda for the next five years at the 19th
National Party Congress this autumn. Until then, I see
Xi seeking to maintain economic growth while trying to
rein in financial excesses, avoid a direct confrontation
with the US and assert international leadership in
trade and climate. Next year presents challenges for
US-China relations, especially on North Korea and
bilateral trade.
Which area of instability worries you most?
North Korea represents the most significant security
challenge. Attempts to put it on a non-nuclear path have
failed, and all indicators are negative: nuclear tests and
increasingly capable missile technology. It represents
both a direct nuclear and proliferation threat. The
approach so far has been to push China to pressure
North Korea to denuclearise. It is unclear whether China
is able or willing to do so, making this issue a key source
of tension in US-China relations. I expect more North
Korean provocations and continuing risk of escalation
— but see military options as very difficult given South
Korea’s vulnerability.
How explosive is the Middle East?
The administration has made a top priority of forging
an alliance with the Gulf states against ISIS and Iran, an
initiative well-received in the Gulf. I see the US adopting
a more confrontational stance toward Iran, but expect
the nuclear deal to hold. Saudi Arabia’s ambitious
economic and cultural transformation is pressured by
low oil prices, but we don’t expect political instability.
ISIS is being pushed out of its territory in Iraq and Syria,
increasing the risk of more terror attacks in Europe.
What risk is below investors’ radar screens?
The volume, sophistication and sources of cyberattacks
are increasing significantly — and the world has very
uneven defences. More interconnectivity thanks to
an explosion in internet-of-things devices — with little
regard to security — will make us even more vulnerable.
Tom DonilonChairman, BlackRock Investment Institute
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US The prospects for US tax reform and infrastructure spending are fading, but we see an
under-appreciated shift towards more flexible regulation that could help business.
Trump trade fizzlesUS equity performance around US election, 2016-2017
90
100
110
120Winners
Losers
Neutral
TrendInd
ex
May 2016 Nov. 2016 May 2017
Sources: BlackRock Investment Institute and Thomson Reuters, May 2017.Notes: the chart shows the price performance of individual shares in the S&P 1500 index around the 2016 US election, re-based to 100 on 8 Nov. The breakdown reflects how different shares performed in the three trading days after the election (9-11 Nov.). 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.
Growing the wrong wayUS long-term budget projections, March 2017
Shar
e o
f GD
P
Public debt share of GDP
2017 2027 2037
0
5
10
15
20
25%
Net interest
Other spending
Health
Social Security
Income tax
Payroll tax
Corporate taxOther revenue
77% 89% 113%
Deficit
RevenueSpending
Sources: BlackRock Investment Institute and Congressional Budget Office, March 2017. Notes: the data show the Congressional Budget Office extended baseline budget projections. Health programs consist of spending for net Medicare spending, Medicaid and the Children’s Health Insurance Program, as well as outlays to subsidise health insurance under the Affordable Care Act and related spending. Other revenue consists of excise taxes, customs duties, estate and gift taxes and miscellaneous fees and fines.
Media headlines paint a picture of political disarray
in Washington. Yet a closer look tells a more nuanced
story, we believe. First, a system of checks and balances
and strong institutions blunt the sharper edges of any
new president’s agenda. Second, the administration has
appointed steady and experienced hands in key posts
such as national security and defence. Lastly, the private
sector is humming along regardless of dramatic
political headlines, with a corporate earnings recovery
in full swing.
Some of the froth has come off of the so-called
Trump trade. Shares of companies that performed
best after the election such as banks have given up
some of those gains, while initial losers such as tech
have recouped relative losses. See the Trump trade
fizzles chart. Other legs of the Trump trade have
fully reversed, with the Mexican peso – a barometer
of anxiety about a tougher US stance on trade –
recovering from its post-election losses.
The US faces long-term fiscal challenges. Health care and
Social Security make up roughly half of federal spending
today, and this share is set to grow over the coming
decades as the population ages. Absent any changes,
this will lead to a steady rise in the deficit and debt levels
over time. See the Budget breakdown chart. These
dynamics leave the US with little fiscal wiggle room.
This is why most plans to reform the tax system typically
aim for budget neutrality over the long term, after
accounting for any growth-boosting effects. Unfunded
tax cuts could worsen an already poor fiscal trajectory.
Congress also has yet to draft a budget for fiscal 2018,
which starts 1 October. Controversial aspects of Trump’s
agenda, such as funding a border wall and cutting social
programs, are sticking points. Another short-term deal
to fund the government may be needed if Congress
cannot agree on a budget. A battle also looms over
raising the US debt ceiling. The second half of 2017
could be bumpy.
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A taxing challengeBlackRock Market-Driven Scenarios on potential impact of US tax reform, May 2017
Comprehensive reform Modest tax cuts Derailment
Description
Comprehensive reform, including a large cut in the corporate rate, and the closing of many personal and corporate deductions to make the plan roughly revenue-neutral.
Moderate tax cuts are only partially offset with caps on deductions, leading to larger budget deficits and rising inflation.
Congressional gridlock derails tax reform and even modest attempts at tax cuts.
Key ingredients
• Tax cuts are permanent. Deep corporate tax cut, with lower income tax rates, offset with removal of most deductions.
• One-off deemed repatriation tax on overseas corporate cash.
• End of corporate interest deductibility; immediate capex expensing.
• Tax cuts mostly expire after a decade; watered-down elements of the comprehensive scenario.
• Lower corporate and personal tax rates; caps on deductions.
• But the stimulus generates some positive investor sentiment.
• Trump administration introduces piecemeal plans to cut corporate and personal taxes.
• Proposals fail to gain traction ahead of 2018 midterm elections.
Global equities
+Highly taxed US domestic companies outperform.
+Personal income tax cuts
support consumer stocks.
—Post-election gains in value stocks are further eroded.
US credit+
Investment grade (IG) spreads tighten; highly leveraged names underperform.
+IG spreads tighten; highly leveraged
names underperform.
—Spreads widen in flight
to quality.
Government debt
—US Treasury yields rise and the
yield curve steepens.
—Treasury yields rise on the back of
rising deficits; yield curve steepens.
+Treasuries rally on lower
growth expectations.
Legislative clock is ticking Many Republicans see this as a once-in-a-generation
opportunity to rewrite an overly complex and onerous
tax code. On their menu: big cuts to the US corporate tax
rate, a one-off ‘deemed repatriation tax’ on the roughly
$2.5 trillion of corporate cash held overseas, lowered
tax rates on investment income, and a cut in the top
personal tax rate. The goal is to stimulate investment and
consumption, and thereby boost growth.
A troubled attempt to repeal and replace ‘Obamacare’
health legislation and controversy over Russia’s
alleged interference in the 2016 election – now being
investigated by a special counsel – add to the risk of
legislative delays. This could play out in two ways:
Positive: the investigation activates Congress to focus
more on tax reform – a key measure of legislative
progress ahead of 2018 midterm elections. The
White House shows leadership on policy priorities,
and Congress passes tax reform legislation early in
the new year.
Negative: a distracted White House fails to clarify policy
priorities, and the Russia scandal deepens. Congressional
Republicans start to distance themselves from the Trump
administration. The reform agenda is derailed.
Tax: it’s all in the detailsWe see three scenarios for US tax reform: major reforms
including a sharp reduction in the corporate tax rate;
a scenario whereby reforms are watered down and
the budget deficit rises; and an outcome in which tax
reform is delayed indefinitely. See the Taxing challenge
table below.
Our comprehensive reform scenario would be budget-
neutral over time. It would be stimulative in the near
term, but with a payback in later years as loopholes
and deductions are limited. This would benefit global
equities and lead to rising interest rates. The modest
tax cuts scenario, which we see as the most likely
outcome, would have a similar market impact in
the short run. It would result in an economic stimulus
– but with the likely cost of higher budget deficits and
inflation. Our derailment scenario is partly priced in as
expectations for tax reform are low, we believe, but still
could hurt risk assets in the near team.
We see any market fallout as nuanced. Take the credit
markets. The removal of interest deductibility would likely
reduce new issuance, benefiting investment grade credits.
But this impact could be offset by any stimulus that leads
to rising rates. And we see more leveraged credits faring
worst from losing the ability to deduct interest expense.
Sources: BlackRock Investment Institute and BlackRock’s Risk and Quantitative Analysis group.
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Munis mull tax reformUS municipal bond implied tax benefit, 2016-2017
May 2017Jan. 2017Sept. 2016May 2016Jan. 2016
Imp
lied
tax
ben
efit
10
20
30
40
50%
US election
Sources: BlackRock Investment Institute and Bloomberg Barclays, May 2017.Notes: the market implied tax benefit is a rough measure on how munis are pricing value of their tax-exempt status. It is calculated by subtracting the ratio of the yields on the Bloomberg Barclays Municipal Bond Index and US Aggregate Corporate Index from one.
Muni murmursAsset prices have waxed and waned with expectations
of US tax reform. Municipal bonds are a case in point.
Any large cut to the top personal marginal tax rate would
diminish the value of their tax-exempt status.
Munis used to trade with a market-implied tax benefit
of just over 40%, in line with the top personal marginal
tax rate. This figure slumped to 17% when expectations
for comprehensive tax reform peaked just after the US
election, and has now recovered to almost 30%.
See the Munis mull tax reform chart. We see room
for further gains in this metric – and muni valuations.
Our ‘compromise’ scenario sees only modest personal
tax cuts being implemented, with the tax exemption
for muni income remaining intact. Any introduction of
caps on other individual deductions would only boost
demand for munis as one of the few remaining tax
shelters, we believe.
Loopholes and deductionsComprehensive tax reform has eluded both major
political parties since the mid-1980s. The ingredients
are simple: cut marginal tax rates, while reducing
loopholes and deductions to offset the budget impact.
Cutting taxes alone runs the risk of creating a big hole
in the deficit. Example: each percentage point cut in
the 35% corporate rate leads to $100 billion in lost tax
revenue over a decade, the Joint Committee on Taxation
estimates. Many potential offsets such as cutting popular
deductions are politically off limits. What’s on the table
this time?
Deemed repatriation tax: a one-off tax on corporate
profits held abroad – applied regardless of whether
companies bring the cash back. The proceeds could
be set aside to finance other policy priorities such
as infrastructure expenditure, making it potentially
appealing to both Republicans and Democrats.
Interest deduction and capex expensing: tax reformers
propose allowing companies to immediately deduct
the cost of capital expenditures from their income, rather
than depreciating it over time. This is meant to encourage
investment. It would be offset by capping the interest
deduction, which lets companies deduct net interest
payments on debt from their taxes. This would reduce
incentives to leverage up and level the tax playing field
with dividend payouts. It would make it less attractive to
issue debt and use the proceeds to buy back shares.
Border adjustment: House Republican leaders have
proposed a border adjustment tax (BAT) to pay for
deeper corporate tax cuts, increase US competitiveness
and reduce incentives to offshore production and profits.
The BAT would effectively subject imports to a 20% tax,
while exempting exports. Supporters argue the BAT’s
impact would be offset by a 25% rise in the dollar,
leaving no net impact on trade balances or consumer
prices. Opponents say the BAT risks retaliation by other
countries and is hard to apply to financial services.
We believe currency movements are driven by many
factors beyond any BAT. An imperfect dollar adjustment
would hurt importers.
We see little chance of the BAT being implemented as
proposed, given opposition in the Senate and White
House. We may see a move towards a territorial tax system.
“ Investors should move away from the notion that tax reform will have a big impact on munis – and focus on the income and value the asset class currently offers.”
Peter Hayes – Head of BlackRock’s
Municipal Bonds Group
BII0617U/E-169790-472154
BLACKROCK INVESTMENT INSTITUTE 11
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN US
BlackRock co-founder Barbara Novick highlights under-appreciated regulatory changes.
What do you see Washington getting done this year?
It is critical to look beyond the legislative efforts of
the White House and Congress. We have a lot of
independent regulators and agencies, and all have – or
will soon have – new heads who are eager to make their
mark. As they staff up, I see efforts to right-size regulation
gaining momentum.
Some people talk about this as if the sky is falling: repeal
of all rules resulting in polluted waters and banks running
amok. That narrative simply does not reflect reality. You
have to put it into context: we’ve seen an unprecedented
amount of rule-making during the previous
administration. And now policymakers are reviewing and
potentially reversing some of it. This is about lightening
the regulatory burden by making rules more efficient
and tailored. That’s why I call it right-sizing regulation.
It’s important this happens in a thoughtful way. Some
regulations had adverse unintended consequences.
An easing of regulations needs to be well thought-out to
avoid similar problems.
Why should investors care?
A lighter regulatory burden benefits business. This
tends to get lost in the noise coming out of Washington
– and is an under-appreciated market force. Even just
a business-friendly or softer interpretation of current
regulations can reduce costs substantially.
Source: BlackRock Investment Institute, June 2017.
For example, most people would agree
the US needs to replace and upgrade its
aging infrastructure. But many projects
get stuck in a quagmire of federal,
state and local permits, environmental
reviews and legal challenges. If you
want to attract private capital, you need
clear and enforceable rules, streamlined procedures,
and a consistent and predictable policy framework.
This applies to much more than infrastructure. Knowing
the rules creates a positive climate for companies to
invest in their business.
Tax reform could help in that respect. Will it happen?
We have an incredibly complicated tax code. It’s
a bipartisan goal to have a tax system that is simple,
fair and globally competitive. Of course the problem
is how you define ‘fair,’ both on the individual and
corporate level. Actual tax reform cannot be a complete
budget buster, so you’ll need some revenue raisers.
This leads you into the winners-and-losers problem
that has vexed policymakers on both sides of the aisle.
Every exemption or deduction affects a constituency
that wants to keep it. Try to take it away, and somebody
is going to complain about it – loudly. The bottom line is
that tax reform is just really hard and takes a long time to
get over the finish line.
Barbara Novick BlackRock Vice Chairman
Regulatory reviewSelected examples of regulation-related US actions and reviews, 2017
Industry Action Date
Financial
A new fiduciary rule for financial professionals is partially implemented but subject to ongoing review. 22 May
Presidential memorandums instruct the US Treasury to review the process for designating financial institutions as ‘systematically important’ and the federal government’s orderly liquidation authority.
21 April
An executive order directs Treasury secretary and regulators to revise and review Dodd-Frank rules. 3 Feb.
HealthAn executive order authorises the heads of federal agencies to waive Affordable Care Act rules that impose any fiscal or regulatory burden.
20 Jan.
InfrastructureAn executive order allows governors and agency heads to request expedited environmental reviews and approvals for infrastructure works.
24 Jan.
Resources
US announces intent to withdraw from the Paris Agreement on climate change. 1 June
The Congressional Review Act is used to revoke the Stream Protection Rule. 16 Feb.
An executive order advances the construction of the Keystone XL and Dakota Access oil pipelines. 24 Jan.
TelecomsThe Federal Communications Commission (FCC) proposes to roll back 2015 Internet neutrality rules. 18 May
The FCC loosens a 39% national cap on audience share for TV station owners. 20 April
Transport The Environmental Protection Agency announces it will re-examine fuel efficiency standards 15 March
BII0617U/E-169790-472154
12 POLITICS NOT QUITE AS USUAL
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN US
Worrying about ItalyOur bigger concern: Italy. Anti-establishment parties
hostile to the euro have total support of about 45%,
polls show. The largest is the Five Star Movement, which
has promised a referendum on eurozone membership.
Polls show Five Star running neck and neck with
former Prime Minister Matteo Renzi’s Democratic Party
heading into a national election due to be held by May
2018. We believe the election may be held as early as
September after major parties agreed on electoral
reform in late May.
We see Renzi’s party stitching together another unhappy
coalition with a coterie of other parties on the centre
and left. Forming a stable coalition will be daunting.
Changes to Italy’s electoral law have taken the system
back to a proportional representation that makes
outright majorities hard to achieve. The next coalition
is likely to be weak and fragmented, making structural
reforms a challenge.
Italy has made limited strides cleaning up bad debts
at its troubled banks, including recapitalising smaller
banks and encouraging bigger banks to raise capital.
Yet the problem remains sizable and is a brake on
growth. The combination of high debt levels, sub-par
economic growth, political instability and looming ECB
policy normalisation could lead to a spike in borrowing
costs. The path to a rescue package in any crisis would
likely be a bumpy one, given that eurozone assistance
would be conditional on a stable government able and
willing to implement harsh reforms.
We believe Italy’s risks are only partly reflected in
the yield spreads of its government bonds versus
German bunds. See the Eurozone spreads in context
chart. We expect those spreads to widen as the election
approaches and could see them blowing out if Five Star
wins. The party so far has no allies in Italy’s parliament,
but we cannot rule out a coalition of convenience with
the Northern League and others. Bottom line: we see
potential for an electoral surprise that could rattle risk
assets and peripheral bonds.
EuropeNationalist, anti-immigration parties are not going away, but Europe now has a window of
opportunity to reform and consolidate the EU so that it can endure.
Emmanuel Macron went from third place in the polls to
a large victory as French president in just four months –
all while remaining outside the mainstream parties that
have ruled France for decades. He could pave the way
for business-friendly reforms, with an immediate focus
on loosening the labour market. Even if Macron’s new
party falls short of an outright majority in the June
parliamentary elections, we believe he will likely be able
to work with centrists to pass legislation.
Macron’s victory came after the populist Freedom
Party underperformed high expectations in the Dutch
elections in March. Importantly, German Chancellor
Angela Merkel’s party has built a double-digit lead in
the polls ahead of the 24 Sept. federal election. Support
for both the pro-EU Social Democrats and populist AFD
has faded, and Merkel looks set to win a fourth term in
office just as Macron begins his term. Together, Macron
and Merkel have the potential to consolidate and revive
the European project.
Eurozone spreads in contextEurozone government bond spreads, 1992-2017
1992
0
2
4
6
8%
1997 2002 2007 2012 2017
Introduction of the euro
Lehman collapse
SpainItaly
France
Draghi “Whatever it takes” speech
Spre
ad v
s. G
erm
an b
und
s
Sources: BlackRock Investment Institute and Thomson Reuters, May 2017.Notes: the lines show the difference between the countries’ 10-year government bond yields and German 10-year bund yields in percentage points.
BII0617U/E-169790-472154
BLACKROCK INVESTMENT INSTITUTE 13
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN US
Currency confidence comebackEuro and sterling option trading trends, 2007-2017
Ris
k re
vers
al v
ola
tilit
y
2007
-5
-4
-3
-2
-1
0
1%
2009 2011 2013 2015 2017
Sterling
Euro
Speculation on currency appreciation
Greece’s first bailout request
Brexit vote
Speculation on currency depreciation
▲
▲
Sources: BlackRock Investment Institute and Thomson Reuters, May 2017.Notes: the chart shows risk reversal for sterling and euro versus the US dollar, based on trading of one-year options. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts. This implies that more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative.
Delivering reformsOptimism on Europe’s outlook is building. Investors
are seizing on the improving political outlook
and upbeat data signalling stronger growth. See
the European wakeup call chart. Net equity purchases
were a record in the week around the finale of France’s
presidential election.
Many eurozone countries are in need of structural
reform. As the region’s biggest growth and debt
laggards, France and Italy are especially important.
We see reforms in both as key to reassuring Germany
about the willingness of the EU’s other core members to
become more competitive.
Italy’s Renzi initiated some labour market and insolvency
reforms, but that drive stalled. The OECD has listed
reforms that could lift growth by 6.3% over a decade.
These include: reducing regulation and administrative
burdens, loosening up the labour market, encouraging
more female participation and cutting taxes for low-
income earners, it argued in a 2015 report.
Macron’s proposed reforms include increasing
labour market flexibility, shrinking the government’s
role in the economy, cutting business social security
contributions and corporate taxes (the highest in
the EU), and reducing regulatory burdens.
European wakeup callEuropean equity flows vs. economic activity, 2013-2017
Net
flo
w (b
illio
ns)
PMI level
2013
-6
-4
-2
0
2
4
6
$8
Flow
2014 2015 2016 2017
44
46
48
50
52
54
56
58
Eurozone PMI
Sources: BlackRock Investment Institute, EPFR and Markit, May 2017.Notes: the bars show weekly net flows into Western European mutual funds and ETFs. The line shows the eurozone composite purchasing managers’ index (PMI). A number above 50 indicates expansion.
Macron will likely face resistance, with unions fighting
attempts to increase flexibility in implementing labour
laws. Yet he is likely to succeed in pushing at least some
reforms through, we believe. Germany could do its
part to boost growth and reduce imbalances, such as
encouraging stronger wage gains to stimulate consumer
spending and launching more public investment.
Europe-wide burden sharing or pooling of risk have so
far been a much harder sell in Berlin.
Investors have become less worried about eurozone
breakup risks, as seen in currency options pricing in
the Currency confidence comeback chart. Speculative
bets on euro depreciation are the smallest since 2009.
Spreads on selected peripheral government bonds
such as Italy’s look a bit complacent to us, given the risks
reforms won’t be carried out or watered down.
“ Sovereign risk premia for political risks and reform implementation are still not sufficient, especially for Italy.”
Scott Thiel – Deputy Chief Investment Officer of
BlackRock Global Fundamental Fixed Income
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14 POLITICS NOT QUITE AS USUAL
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN US
Not created equalBlackRock Sovereign Risk Index for Europe, April 2017
BSR
I sco
re
DE
Fiscal space
NL UK IE BE FR ES IT PT GR
-1.25
-1
-.75
-.50
-.25
0
.25
.50
.75
Overall
Willingnessto payExternal financeFinancialsector
Sources: BlackRock Investment Institute, May 2017. Notes: the data are based on the BlackRock Sovereign Risk Index (BSRI). The BSRI draws on a pool of more than 30 measures spanning financial data, surveys and political insights, and provides investors with a framework for tracking sovereign credit risk in 60 countries.
Window of opportunityWe believe policymakers now have the best chance
for reform in decades. The two largest countries
and long-time drivers of integration, Germany and
France, are poised to have pro-European, newly
legitimised governments. The region’s growth outlook
is the brightest since the financial crisis. Dealing with
Brexit, migration and the new US administration is
pushing the EU towards a united front. Merkel pointedly
said Europe must take its fate in its own hands after
trans-Atlantic meetings in May.
Pursuing deeper integration could involve a defence
union, greater fiscal and tax coordination, and lifting of
services barriers. We see progress on the Capital Markets
Union and European Banking Union as indications of
policymakers’ resolve. Bottom line: we see a window of
opportunity for the EU to complete the single market.
Forged in crisesPeople only accept change when they are faced with
necessity, and only recognise necessity when a crisis is
upon them, EU architect Jean Monnet once noted. We see
the populist uprising and other strains as both a wake-up
call and opportunity for the EU to improve its governance
and responsiveness to the economic ills of citizens.
Europe’s recent history of integration is one of big
steps taken only when forced by a crisis, as epitomised
by the eurozone’s repeated summits and emergency
decisions during the debt crisis. This has fortified
the region’s ability to respond to countries running into
economic and financial troubles. The ECB can intervene
in asset markets to limit fragmentation and it now
oversees banking regulation. The European Stability
Mechanism provides a financial firewall by providing
emergency loans to countries in need. That makes
the eurozone well equipped to handle crises in all but
the largest economies.
Current account deficits have been curtailed, but
structural imbalances remain and eurozone economic
convergence has stalled or reversed in some cases.
Wide North-South differences in fiscal dynamics and
economic fundamentals exist, as illustrated by our
BlackRock Sovereign Risk Index. See the Not created
equal chart.
Europe is now discussing its future shape while trying
to manage differences in policy, economic growth and
development among its members. Macron has revived
debate of a central eurozone budget and the long-taboo
subject of fiscal transfers. This would mean countries
pooling some revenue and having a eurozone finance
minister, with funds used for investments and counter-
cyclical spending such as unemployment insurance.
The ambitious proposal has its challenges, including
how the democratic oversight would be managed. It
also faces deep hostility in parts of the German political
world. Berlin has promised to keep an open mind and
is open to treaty changes, although these are tough as
every country has to ratify them. Dealing with economic
migrants and refugees is another big challenge. Recent
immigrants need to be integrated into the workforce.
For now, a deal with Turkey has helped stem the inflow
of new asylum seekers, but any collapse in this
arrangement could strain EU solidarity.
“ Don’t underestimate the potential for the Macron-Merkel relationship to be a driving force towards reforms and faster EU integration down the line. It could lead to positive surprises for equities.”
Zehrid Osmani – Co-Manager of Pan European
portfolios, BlackRock’s Fundamental Active Equity
Click to view interactive data
BII0617U/E-169790-472154
BLACKROCK INVESTMENT INSTITUTE 15
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN US
The former UK Chancellor of the Exchequer shares his thoughts on Brexit negotiations.
Bracing for BrexitThe UK faces a big test in negotiating the terms of its exit
from the EU. The key risk we see: the UK exits without
making a deal or agreeing on an implementation phase
by the deadline of 30 March 2019.
Prime Minister Theresa May called a June snap election
with the aim to enlarge her Conservative Party’s
majority. This should give her government a freer hand
to negotiate a smoother Brexit process with the EU and
steer a deal through parliament. A narrowing of the polls
just ahead of the June election – perhaps partly reflecting
the anti-establishment currents running through politics
today – threatened this plan. A small majority, one similar
to the pre-election balance, would raise the risk that
Brexit talks fall hostage to eurosceptics.
Some UK officials scoff at reported EU demands of
a €60-100 billion divorce bill, and say that no deal
is better than a bad deal. Most of us feel a ‘no deal’
appears unlikely, given the potential economic damage
it could cause on both sides. Exporters might suddenly
face tariffs and customs checks, for example. Any market
fright of a ‘no deal’ outcome would likely send sterling
even lower.
How likely is a ‘no deal’ Brexit?
There’s a material prospect of no
deal. To get a deal that will satisfy
the UK government, the House
of Commons, EU members and
their respective parliaments plus
the European Parliament – that’s
going to be a major challenge.
It’s very easy to see how it would be possible to end
up with no deal. One of the stumbling blocks will be
determining any transition agreement. Whether it’s
determining enforcement, the role of the European
Court of Justice, the applicability of free movement, it’s
going to be quite complicated.
If you listen clearly to the EU about a transition period, it
does not want a special third regime for the UK and does
not want to spend a huge amount of time on this.
Our base case: an outline agreement starting with a two-
to three-year implementation phase. We see the UK and
EU limiting customs barriers. UK exporters would keep
tariff-free access, with some non-tariff barriers in services.
The UK would likely lose its ‘passporting’ ability to sell
financial services across the EU. Financial firms are
already preparing, and are moving some activity to EU
financial centres. We do see a possibility of a negotiated
agreement involving close regulatory cooperation and
perhaps financial joint-supervision, something the UK
Treasury and Bank of England (BoE) have long resisted.
And job losses may not be as large as initially feared,
with shifts likely to take several years. The range of
outcomes is wide.
We see the BoE looking beyond any short-term Brexit
impact unless fears of a ‘no deal’ and a significantly
weaker currency drive a sustained inflation surge. The UK
jobs market remains strong, with the unemployment rate
at four-decade lows. We see the British pound struggling
to strengthen beyond $1.30. The BoE is likely to remain
accommodative, we believe, given signs of weakness in
consumer spending and the clear vulnerabilities Brexit
poses to the medium-term outlook.
What’s the middle ground and what would ‘no
deal’ mean?
The UK government is going to have to accept some EU
conditions. This is a deal that the UK needs more than
Europe does. The Europeans are playing quite hard ball
knowing the UK needs an interim agreement. It would be
pretty bad for the UK to crash out of the EU without any
follow-up agreement. The government would do things to
minimise the impact. It would still be quite a jolt to not have
any trade or security arrangements with our neighbours.
Assuming May leads the negotiations, can she strike
a working relationship with Macron and Merkel?
It’s very important. It would help to have the same cast
of characters and no major elections in France and
Germany over this critical period. These three leaders
will need to get to know each other. Some of the recent
language has been heated. There should be more
constructive dialogue to build trust and less playing to
the galleries at home.
George OsborneSenior Advisor, BlackRock Investment Institute
BII0617U/E-169790-472154
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 June 2017 and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This material may contain ‘forward-looking’ information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. This material is intended for information purposes only and does not constitute investment advice or an offer or solicitation to purchase or sell in any securities, BlackRock funds or any investment strategy nor shall any securities be offered or sold to any person in any jurisdiction in which an offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction.
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Lit. No. BII-POLITICS-0617 008947a-US1-0617
BlackRock Investment Institute
The BlackRock Investment Institute (BII) provides connectivity between BlackRock’s portfolio managers, originates
economic and markets research, develops investment views for clients, and publishes 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 VICE CHAIRMANPhilipp Hildebrand
GLOBAL CHIEF INVESTMENT STRATEGIST Richard Turnill
HEAD OF ECONOMIC AND MARKETS RESEARCHJean Boivin
EXECUTIVE EDITORJack Reerink
BII0617U/E-169790-472154