Sir John Templeton famously stated that “bull markets are born in pessimism, grow in skepticism, mature in optimism, and die in euphoria.” While this thesis is often cited by investment professionals, it is also frequently used incorrectly to make a diagnosis of the contemporary investment landscape. In contrast, we apply the thesis to secular bull markets, which are multi-decade phenomena that begin with overt societal apathy and deep intrinsic value. They peak with significant societal obsession and asset overvaluation. To us, it is critically important to view every cyclical investment landscape through this secular lens. Secular investment trends are durable and tend to pull financial markets through the ups and downs of numerous smaller cycles that are embedded within them.
As we enter 2018, we are firmly entrenched in a virtuous, wealth-creating secular bull market for risk that began in earnest in late 2012. It was born of the severe pessimism surrounding the existential European debt crisis, the burdensome U.S. regulatory paradigm and the demonstrable hangover from the 2008 financial crisis. But the combination of generationally low valuations, asymmetrically easy global monetary policy and ubiquitous disruptive innovation provided the thematic underpinnings. When this secular bull ultimately peaks is anyone’s guess, but that terminal point is not close in our estimation.
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A more difficult environment in 2018
In the meantime, an ongoing cyclical ebb and flow will cause sentiment to gyrate between optimistic and pessimistic extremes. In 2015 we entered a cyclical bear phase that evolved sequentially into the current robust risk-on cycle. Ever since, accelerating economic and earnings growth alongside dormant inflation has forced valuations to chase solid fundamental realities.
However, we think 2018 is going to be a more difficult environment. Risk assets are now more fully valued, and buoyant market sentiment is more widespread. Also, the output gap has recently closed for the first time in 10 years and with no economic slack to spare, the economy is bracing for tax reform that will catalyze enhanced corporate investment. Finally, there is good evidence that wage growth is accelerating, as the economy resides near full employment.
We see respectable growth next year
This backdrop would seem primed for the onset of nefarious inflation, but there are several powerful influences that may somewhat mitigate historical drivers of price increases. First, for the more than half the world’s population that is now online, there is effectively perfect information about economic value for nearly every imaginable good and service. Thus, with little economy-wide pricing power, nascent wage increases come mostly at the expense of profit margins. And, while new fiscal incentives will drive more capital expenditure, the traditional multiplier effect will be dampened as a portion of this is diverted into research and development.
Boiling it all down, we see respectable 2018 U.S. nominal gross domestic product growth of 4.5% to 5%, with the rest of the world enjoying a synchronous growth paradigm. At the same time, visibility is murky about how a series of looming fundamental transitions may unfold. Will organic private sector growth drivers and budding fiscal policy take the baton from heretofore gushing central bank policy liquidity? Will China trade off high, but volatile, growth for slower, more stable growth while the U.S. does the opposite? In our view, simply expecting that 2017 investment themes will continue alongside of a decent growth paradigm is a precarious assumption. With the benefit of hindsight, history will judge the 2018 vintage of investment opportunities based on whether or not a new risk-off market cycle commences next year. The combination of less attractive trade entry points now, with an inherently more volatile fundamental forward environment, gives us pause.
The need for a more cautious posture
We’re opportunistically repositioning heading into 2018. For credit markets, default rates are low, but extraordinarily tight credit spreads largely already reflect that fact. Credit markets in Europe offer an especially poor risk/reward profile, as a result of omnipresent European Central Bank quantitative easing. At the same time, the recent back up at the front end of the U.S. Treasury curve has enhanced the attractiveness of shorter-dated, higher quality assets. Today, 38% of the Barclays Global Aggregate Index meets a 2% yield bogey, up from 13% last year, with most of it in the three- to seven-year bucket. Accordingly, we are migrating some of our duration exposures to the shorter part of the curve and layering in partially (or fully) rate-hedged investment-grade and municipal bonds out the curve to capture higher-quality spread.
Simultaneously, with inflation likely to accelerate modestly in the first quarter of 2018, short- to medium-term inflation breakevens offer compelling upside. With leveraged credit looking especially full, we favor emerging markets (EM) debt and certain parts of the securitized markets instead. EM fundamentals remain in a disinflationary growth sweet spot, which is likely to facilitate further EM-developed market rate compression. Finally, we still see a place for equity in portfolios today, albeit in smaller allocations and mostly in expressions that take advantage of inexpensive right-tail convexity.
As 2017 comes to a close a long secular bull cycle for risk is firmly entrenched, but it may be interrupted in 2018 by a healthy cyclical correction. The combination of full valuations, rising fundamental uncertainty and central banks that are proactively removing accommodation dictates the need for a more cautious posture next year.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog. Russell Brownback, Managing Director, is a member of the Corporate Credit Group within BlackRock Fundamental Fixed Income and contributed to this post.
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