The transition to another calendar year invites the temptation to prognosticate about the year ahead — a fascination that is particularly acute in the financial world. We at BlackRock are not immune to that impulse. We suggest adapting the exercise to analyze a set of key secular investment themes. The following ten topics will wield economic influence in 2016, but their impact will be felt well beyond this year:
1. Returns will again be hard to come by. We’re in a period of low return potential across many asset classes — and as the volatility this past August showed, there are also alarmingly few places to take refuge from losses. Thus, in our view, the traditional model asset allocations used by many institutional investors will continue to be challenged in the year ahead. These portfolios tend to rely on a degree of asset class noncorrelation that may not materialize as expected. We also see lower upside potential to equity beta, which is often underappreciated as a main source of return for institutions.
2. Return concentration, dispersion and volatility are the order of the day. Returns are likely to be concentrated, bifurcated and volatile in the year ahead. The top ten names in the market capitalization–weighted Standard & Poor’s 500 index provided an outsize contribution to the index’s total return in recent years. Return dispersion by sector has also been remarkable. We believe this trend will continue — and even accelerate.
3. Either think hard about technological disruption in the years ahead, or suffer the consequences. Return concentration and dispersion show that the market is finally beginning to recognize what my BlackRock colleague Tom Parker has called winner-takes-all economics. Cash flow dynamics are being radically reconfigured at the corporate, industry and even national level. We think that economies and markets are in the process of adjusting to what might be the most dramatic technological evolution in history. This massive secular change is neither a theoretical future event, to be worried about later, nor is it hyperbole, as the changes are in fact very real and are already influencing markets. Indeed, these disruptions are transforming the fundamentals of business and economics in ways that hold immense implications for productivity, growth, inflation and interest rates.
4. Demographic trends don’t grab the headlines, but they count for more than much else that does. The demographic trends we have often discussed are playing out right in front of us today, as seen in the sharp decline in the working-age-population growth rate in developed markets. That is likely to have a huge influence on the trajectory of economies in the years ahead. In fact, current trends are likely to ultimately narrow the corridor of potential global growth and could hamper aggregate demand in regions with less favorable demographic profiles, such as Europe and Japan.
5. Global growth dispersion may speed up. We see the dispersion of global growth rates, and the subsequent divergence of monetary policy by region, as likely to continue. In fact, it may even gain steam. Economies will likely evolve at a faster pace than in the past, driven by factors ranging from technological disruption to China’s economic transition. Here are three questions to keep in mind: First, can commodity-dependent emerging-markets economies like Brazil evolve their economic models in tandem with China’s attempt to do so, or will they stumble further and produce slower global growth and higher volatility in developing economies? Second, will China actually succeed in its attempt to transition to a more consumption-oriented economic model? And third, can many oil-exporting Middle East countries weather the stresses of reduced cash flows caused by lower oil prices and increased political risk?
6. Investing in Europe is time horizon arbitrage. ... Yes, that statement is a gross simplification. There is something to the idea, however, that investing in Europe is a short-term long but a long-term short. We believe that Europe faces some profound long-term economic headwinds such as unfavorable demographic trends, excessive leverage in certain sectors, energy dependence and a growing refugee crisis that is aggravating an already precarious political landscape. Yet the extraordinary monetary policy accommodation by the European Central Bank should support asset prices in the short term. The region also has displayed some stronger economic fundamentals of late, though this does not obviate the long-term challenges. We think the ECB will seek to ease policy further, underpinning growth, rates and asset prices there in the short term.
7. ... and so is investing in Japan. Japan faces many of the same long-term headwinds as does Europe. It lacks the refugee crisis, but may be more poorly positioned on many fronts. Japan has some of the most challenging demographic trends in the developed world, is excessively leveraged and has been unable to sustain meaningful growth or inflation. Similar to that in the euro zone, its monetary policy is easing at extraordinary levels and suggests that timing is important with investing there. Policy efforts, however, may well make Japan one of the few remaining markets with meaningful equity beta potential.
8. Investing in carry, higher in the capital stack, makes sense. We believe that investing higher in the capital stack in places such as the U.S. and U.K. makes sense, particularly with elevated market volatility, reduced liquidity and still questionable global growth. Carry trades can also be beneficial in the current environment, especially given recent yield backups in high-yield credit or securitized assets in the U.S. We recognize, however, that late-cycle dynamics and commodity price stresses will likely result in higher default rates.
9. Reduced global liquidity increases left-tail risk potential and market volatility. The state of global liquidity is crucial to understanding today’s fixed-income markets. If we define the global monetary base as the total sum of global foreign exchange reserves and the U.S. money supply, then we have witnessed a rapid deceleration in its rate of growth over the past year. Indeed, this proxy of global liquidity is now approaching contraction territory, because economic growth has slowed across much of the globe, and many countries’ foreign exchange reserves have dwindled. Quantitative easing by the ECB and the Bank of Japan has not fully offset these declines. We thus find ourselves in an unusual situation: It would be possible to imagine the Federal Reserve, in the midst of a modest rate hiking cycle, initiating another round of quantitative easing or extending U.S. dollar swap lines in case a dollar-funding crisis were to hit a major trading partner.
10. Where one takes fixed-income risk is more important than how much is taken. Cash flow potential at all levels of the economy is changing rapidly, as we have described. The cost of debt is also rising, driven largely by expected corporate/industry future cash flow potential relative to existing leverage levels. We are witnessing the market’s occasionally ruthless way of separating businesses that may no longer be able to support existing leverage levels, given new disruptive technologies and changed business conditions, from those that are expected to thrive under the new order of things. This is the process of creative destruction in action. Investors will want their capital on the right side of this divide.
Rick Rieder, managing director, is chief investment officer of global fixed income for BlackRock in New York.
