Each year BlackRock strategists and portfolio team members assemble to discuss the outlook for the coming 12 months. The major takeaway from our discussions this year: We believe three major themes—and a few key risks—are poised to shape markets in 2017, as we write in our new Global Investment Outlook 2017.
Theme 1: Reflation
We expect U.S.-led reflation—rising nominal growth, wages and inflation—to accelerate. Yield curves globally are liable to recalibrate to reflect this “reflationary” dynamic, and we see steeper yield curves and higher long-term yields ahead in 2017. We believe we have seen the low in bond yields—barring any big shock. Steepening yield curves suggest investors should consider pivoting toward shorter-duration bonds less sensitive to rising rates.
Expectations for global reflation are also driving a rotation within equities. See the chart below. Bond-like equities such as utilities dramatically undershot the broader market in the second half of 2016. Global banks, by contrast, have outperformed along with other value equities on expectations that steeper yield curves might boost their net interest margins—the gap between lending and deposit rates. We see this trend running further in the medium term, albeit with the potential for short-term pullbacks. We could see beneficiaries of the post-crisis low-rate environment—bond proxies and low-volatility shares—underperforming. We see dividend growers—companies with sustainable free cash flow and the ability to raise their payouts over time—as most resilient in a rising-rate environment. Our research suggests they perform well when inflation drives rates higher.
Theme 2: Low returns ahead
We see structural changes to the global economy—aging populations, weak productivity and excess savings—limiting growth and capping rate rises. Still-low rates and a relatively subdued economic growth trend are taking a toll on prospective asset returns, especially for government bonds.
This is one reason we believe investors need to have a global mindset and consider moving further out on the risk spectrum into equities, credit and alternative asset classes. U.S.-dollar-based investors should consider owning more non-U.S. equities and emerging market (EM) assets over a five-year time horizon while reducing exposure to government bonds, our work suggests.
Theme 3: Dispersion
The gap between winners and losers in the stock market is likely to widen from the depressed levels of recent years as the baton is passed from monetary to fiscal policy. Under extraordinary monetary easing during the post-crisis years, a rising tide lifted all boats. Fiscal and regulatory changes, by contrast, are likely to favor some sectors at the expense of others. The dispersion of S&P 500 weekly stock returns—the gap between the top and bottom quartile—recently hit its highest level since 2008. Other markets are likely to mirror the U.S. trend as major central banks approach the limits of monetary easing. Rising asset price dispersion creates opportunities for security selection. Yet the risk of sharp and sudden momentum reversals in sector leadership highlights the need to be nimble while staying focused on long-term goals.
At the same time, we are seeing a regime change in cross-asset correlations that challenges traditional diversification. Long-held relationships between asset classes appear to be breaking down as rising yields have led to a shakeup across asset classes. Bond prices are no longer moving as reliably in the opposite direction of equity prices. Similarly, asset pairs that have historically moved in near lockstep—U.S. equities and oil, for example—have become less correlated. This means traditional methods of portfolio diversification, which use historical correlations and returns to derive an optimum asset mix, may be less effective. Bonds are still useful portfolio buffers against “risk-off” market movements, we believe. Yet we see an increasing role for equities, style factors and alternatives such as private markets in portfolio diversification.
Key risks
2017 is dotted with political and policy risks that have the potential to shake up longstanding economic and security arrangements. There is uncertainty about U.S. President-elect Donald Trump’s agenda, its implementation and the timing. The UK has vowed to trigger its exit from the European Union (EU) by the end of March, while elections in the Netherlands, France and Germany will show to what extent populist forces hostile to the EU and euro are gaining sway. At the same time, expectations are building for the Federal Reserve to step up the pace of rate increases after a stop-and-go-slow start, and China’s Communist Party will hold its 19th National Congress, at which Xi is expected to consolidate power.
China’s capital outflows and falling yuan are also worries, as the trade-weighted U.S. dollar’s surge to near-record highs raises the risk of tighter global financial conditions. Rapid dollar gains tend to cause EM currency depreciation, apply downward pressure on commodity prices and raise the risk of capital outflows from China.
For more on these themes and risks, as well as a detailed outlook for sovereign debt, credit and equity markets, read the full Global Investment Outlook 2017.
Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.
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