Rick Rieder

Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income, regarding FOMC Chair Powell’s testimony before the U.S. Congress.

Since the late-1970s, when Congress mandated that the Federal Reserve provide it with semiannual updates on the state of the economy and monetary policy, market observers have scrutinized those remarks to try to discern the future direction of policy.

Not surprisingly, this exercise has often provided little new insight, as the Chair’s prepared remarks and answers to questions typically have hewn closely to previous statements.

As a case in point, Powell delivered a fairly upbeat message on the progress of labor market gains and on economic growth, which reflected the upgraded optimism portrayed in the recent FOMC Minutes language.

Further, his remarks suggested that he remained unperturbed about the below-target inflation levels of recent times, saying that it likely reflects “transitory influences,” which are not likely to be repeated.

As a result, Powell argued that certain economic developments that have taken hold since the Committee’s December meeting (such as passage of the tax cuts and the recent budget plan), as well as continued solid organic economic growth (both in the U.S. and around the world), make a strong case for a gradual continuation of policy normalization.

When asked explicitly whether this more stimulative fiscal policy might cause the Fed to move rates more quickly than previously anticipated, Powell responded by saying that: “My personal outlook for the economy has strengthened since December.

Each member of the FOMC is going to be writing down a new set of projections as we go into the March meeting, which begins in less than three weeks.

I would not want to prejudge that new set but we will be taking into account everything that has happened.”

Clearly, in our view, the Fed in the process of incorporating stronger growth and fiscal stimulus into the policy view, which makes the Summary of Economic Projections due at the March meeting particularly important to keep an eye on.

In the end, we think the FOMC has been doing a respectable job of threading-the-needle between attaining its policy goals (including slowly getting closer to its inflation target) and attempting to avoid potential economic overheating.

This process has been very deliberate and well communicated, and contrary to what some market commentators have suggested, it is not “behind the curve” and doesn’t appear to be in a rush.

The implications for risk-assets (better), front-end yield opportunities (better), and inflation increasing further only moderately (and not in a disruptive manner) are significant. It also suggests to us that the long-end of the curve could well have further downside from here.

That’s particularly the case because duration risk in markets largely extended during the QE-era, so this segment of the market is particularly price-sensitive today, and thus particularly perilous.

Highlights

• FOMC Chair Powell’s Humphrey-Hawkins testimony took centre stage and in his prepared remarks he painted an optimistic picture of labor markets, and growth more broadly, and suggested that he remained unperturbed about below-target inflation, saying it likely reflects “transitory influences
• On monetary policy, Powell made a convincing case that “fiscal policy has become more stimulative and foreign demand for U.S. exports is on a firmer trajectory,” allowing the FOMC to thread-the-needle between returning inflation to target and potential economic overheating
• In our view, the FOMC’s policy rate normalization has been deliberate, and contrary to what some commentators allege, it is not “behind the curve” and doesn’t appear to be in a rush. The implications for risk-assets, front-end yield opportunities, and inflation increasing further (yet not in a disruptive manner) are significant, and it also suggests to us that the long-end of the curve could well have further downside from here

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Rick Rieder

The surprise election result in the United States last week saw both Donald Trump’s ticket elected to the Presidency and both houses of Congress remain in Republican hands, a result that defied all the polls and called into question a great deal of expert opinion.

The event introduces many uncertainties to the path of economic and monetary policy, the legislative agenda and regulatory framework, and international relations and trade policy, but there are some tentative points we can make about its likely influence on bond markets:

• We think a few key trends that were already in place are likely to accelerate, namely: we are probably going to see a significant shift from monetary policy stimulus to fiscal policy initiatives, particularly in the area of infrastructure investment at the federal level. This may well aid in accelerating the pick-up in inflation levels that already appeared underway, and it likely also results in a steepening in the yield curve over time. Of course, there are several ways in which this infrastructure could be financed and if done properly it could benefit from the extraordinary financing conditions we have today. Thus, we’ll be watching closely for signals of how added spending will be financed.
• While overnight Asia markets witnessed a great deal of volatility, equities were fairly subdued at the U.S. open and this underscores how difficult it is to predict the reaction of markets to uncertain political events. That said, we think there are some common misconceptions that investors should guard against. Specifically, with bonds and equities more correlated today than in the past, investors must not assume that rates will always rally when risk assets are hurt. Moreover, while some believed that the USD would ultimately decline on a Trump victory, we think this view is mistaken and the dollar is more likely to range-trade for a time, or even strengthen, depending on the direction legislation and policy take in 2017.
• We are cautious about how the election result will impact the emerging markets debt space, as trade policy uncertainty and a potentially higher USD would potentially weigh on the asset class. Still, as we’ve argued in recent months, the need for income isn’t going away, and the carry potential, particularly in the front to middle segments of select EM country rates curves should still be attractive. The thing to watch will be capital flows, as a good amount of money has shifted in EMD, but it will be important to see if investors have the patience and wherewithal to stick out any near-term headline risks.
• We think the election result should be, broadly speaking, positive for U.S. corporate credit sectors, which may now operate in a more business-friendly environment. That could potentially include relaxed regulatory burdens, lowered tax rates (and/or one time overseas capital repatriation), and several industry-specific tailwinds that aid credit markets. Interestingly, if personal income tax rates were to decline, however, and additional infrastructure spend were partly financed in municipal markets, then that could be marginally negative for muni performance.
• As a result, we continue to like rates markets ranging from the front end of the yield curve to its belly, we are still positive on long-end investment-grade corporates, we are cautiously optimistic on the carry prospects for shorter to intermediate EMD (as long as the dollar remains contained and we do not descend into a trade war), and we think TIPS have an important place in portfolios today. Further, some high-cash-flow securitized asset markets continue to appear attractive, and given that the U.S. is likely to continue to progress down a path of interest rate normalization, diversifying rates exposures globally also makes a great deal of sense.
• Finally, there’s a great deal of uncertainty about how the election changes the Fed reaction function at its December meeting, since of course a lot can happen between now and then, but if markets remain stable, and labor markets don’t dramatically falter, we would think the central bank does go ahead with a quarter-point hike.

By Rick Rieder, Chief Investment Officer of Global Fixed Income, BlackRock

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BlackRock specialists discuss the developments in China.

China has replaced Greece as the main worry for financial markets – and it is fundamentally a much bigger deal. A depreciation of China’s currency, a sell-off in the country’s equity markets and declining confidence in Beijing policymakers are spooking global markets.

BlackRock investment specialists recently discussed the developments in China. The call was moderated by Richard Turnill – Chief Investment Strategist, Alpha Strategies Group. Speakers were:

• Nigel Bolton – Global Co-Head of Fundamental Equity and Head of European Equity
• Rick Rieder – Chief Investment Officer of Fundamental Fixed Income
• Helen Zhu – Head of China Equities, Fundamental Equity

Behind the Yuan depreciation

The yuan depreciation is motivated by two factors:

1. Structural: China wants to move toward a freely traded currency driven by supply and demand. Stamping out one-way bets on further appreciation means allowing more volatility.
2. Cyclical: The yuan had appreciated significantly for years – until authorities started guiding the currency lower last August. Policymakers want to mitigate the headwind of a strong currency at a time when the country is struggling to hit its growth targets.

We see three options for Chinese policymakers from here:

1. Indefinitely defend the currency through FX intervention (unlikely, we think);
2. A big, one-off devaluation (an unlikely but rising risk. This would shock global markets and raise trade tensions);
3. Gradually loosen the reins on the yuan (our base case; we expect further depreciation in the high single-digits this year).

The risk is that markets get ahead of policymakers. Capital outflows could intensify pressure on the currency, making a one-off devaluation more likely. Yet this would likely be a last resort. (Soft) capital controls to put the brakes on outflows and keeping up support for the ailing onshore stock market would likely come first. A worrying trend: Chinese capital outflows have broadened from short-term speculative swings to foreign direct investment and portfolio liquidations, JPMorgan argued in a note this weekend.

China has replaced Greece as the main worry for financial markets – and it is fundamentally a much bigger deal. The problem? Investors are losing faith in the ability of Chinese policymakers to control their markets. What could break the damaging spiral? Moving quickly and decisively to shutter excess capacity in state- owned steel and coal companies would be a game changer. Imagine the effect on commodities, for one. We see 1:5 odds for such bold action in the near term but do detect a greater appetite for tackling supply-side reforms.

Global equities have sold off, but U.S. Treasury yields are roughly unchanged since last May. We see U.S. Treasuries becoming less effective as portfolio stabilizers for three reasons:

1. The Fed is in hiking mode (albeit gently);
2. The low level of rates does not leave much upside;
3. Supply-demand dynamics have changed. There is heavy bond issuance as investment-grade companies lock in cheap financing, while price-insensitive buyers such as China and petro states have turned into sellers as their currency reserves shrink.

We see two other risks to the global economy today:

1. Oil prices and knock-on effects in the Middle East (political instability and more selling of risk assets by reserve managers);
2. Cash flow is getting much harder to come by. The global liquidity tide has crested with the Fed now raising rates and emerging markets selling FX reserves to defend currencies. Debt costs are going up – while the return on capital invested is heading down. This is a bad mix.

The good news?

Some markets have priced in the risks. We see opportunities in domestically focused companies with strong cash flow in the eurozone (where an accommodative central bank is your friend). Valuations are fair, so we do not count on market (beta) returns. In fixed income, carry is the word: We see some opportunities in the battered emerging markets, and like parts of the bifurcated high yield market (avoid energy!).

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Issued in Australia by BlackRock Investment Management (Australia) Limited ABN 13 006 165 975 AFSL 230 523 (BIMAL). This article provides general information only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this document is appropriate to your objectives, financial situation and needs. This article is not a securities recommendation. This document has not been prepared specifically for Australian investors. It may contain references to dollar amounts which are not Australian dollars. It may contain financial information which is not prepared in accordance with Australian law or practices. BIMAL, its officers, employees and agents believe that the information in this document and the sources on which the information is based (which may be sourced from third parties) are correct as at the date of this document. While every care has been taken in the preparation of this document, no warranty of accuracy or reliability is given and no responsibility for this information is accepted by BIMAL, its officers, employees or agents. Except where contrary to law, BIMAL excludes all liability for this information. © 2016 BlackRock, Inc. All Rights Reserved. BlackRock® is a registered trademark of BlackRock, Inc.

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