Davos Brief

Inflation jitters

We have been flagging higher inflation since the unprecedented policy response to the pandemic, and this prospect is now driving markets. Our core new nominal theme implies that rising inflation will have more benign market implications than in the past. Central banks are likely to lean against any sharp rises in nominal government bond yields. As a result, real interest rates could stay negative into the medium term. This makes for a positive backdrop for risk assets, and keeps us pro risk with tactical overweights in equities and credit. Yet markets have risen significantly, and we see potential for pullbacks driven by pandemic and vaccine rollout dynamics.

Globalization rewired

The pandemic has accelerated a rewiring of globalization – with a bipolar U.S.-China world order at its center. We see the new U.S. administration bringing greater predictability in trade policies. Climate is likely to become a central policy priority – and an area for potential U.S.-China cooperation. Yet economic, technological and strategic competition with China looks here to stay – and we believe investors need exposures to both poles of global growth.

Rising debt

A spike in government debt to record levels – a result of a policy revolution in cooperation between fiscal and monetary authorities – was a necessary response to the Covid shock. It may be politically tough for governments to unwind large-scale fiscal support, and the perceived safety premium for holding government bonds could eventually erode. But we are not concerned about these dynamics in the near term as central banks face pressures to maintain a stable, low-rate environment, keeping a lid on debt servicing costs.

Unprecedented response

The joint fiscal-monetary policy revolution has delivered historic support to help bridge economies to a post-pandemic world when vaccines become more widely available. We have seen an unprecedented rise in peacetime spending, with discretionary fiscal stimulus far exceeding what we saw after the global financial crisis (GFC). The increase in debt under the current shock also exceeds that of the GFC, even in the absence of large-scale bailouts this time. This has happened against a backdrop of much higher debt levels than a decade ago. As a result, debt-to-GDP ratios have soared to record levels globally.

Key risks ahead

Fiscal and financial dominance are key risks that could be mutually reinforcing. It could become politically difficult for governments to unwind large-scale fiscal support. And raising interest rates will become more politically fraught for central banks against a backdrop of high debt levels. Even a courageous central bank may end up having to backtrack if an attempt to normalize policy were to result in a “taper tantrum” event that significantly tightened financial conditions.

A bipolar world order

The pandemic has accelerated a rewiring of globalization – with a bipolar U.S.-China world order at its center. We see the Biden administration as bringing greater predictability and taking a different approach on trade and climate policy. Yet overall tensions with China appear set to stay elevated amid ongoing economic, technological and strategic competition – and we believe investors need exposures to both poles of global growth.

Globalization rewired, one of the three key investment themes introduced in our 2021 Global Outlook, is about an acceleration of geopolitical transformations. At its center: a bi-polar U.S.-China world order and the remapping of global supply chains. This is not the same as deglobalization.

Clear changes ahead

We expect a clear change of tenor and tone in the Biden administration’s foreign policy approach, including a shift to working with allies on key issues: China, Russia, Iran, democracy and cyber security. The Biden administration will likely use alliances with groups of countries to engage China. The nomination of veteran Asia specialist Kurt Campbell to serve the new role of Indo-Pacific Coordinator is a signal of such an approach – as well as the administration’s expectation that intense competition is likely to dominate U.S.-China relations. This is taking place as China has emerged stronger from 2020 with its successful containment of the virus and a lead in the economic restart. It has also signed important trade deals including an investment agreement with the European Union, and a regional free trade agreement with Asia-Pacific nations including Japan and South Korea.

Climate action

Climate is likely to become a central policy priority under the Biden administration – and an area for potential cooperation in U.S.-China relations amid broader tensions around trade and human rights. Frictions may extend to the financial arena, as evidenced in the forced delisting of some Chinese companies in the U.S. market. We see this as a reason for carefully implementing China exposures, perhaps including consideration of greater direct allocations to China-listed securities over time. Yet how to implement China exposures will depend on investor constraints, including political and legal ones.

Portfolio insights

Strategically, we see assets exposed to Chinese growth as core holdings that are distinct from emerging market exposures. Tactically, we are overweight Asia ex-Japan equities as many Asian countries have been more effective at containing the virus and are further ahead in the economic restart. Risks to China-exposed assets include China’s high debt levels, currency volatility and heightened U.S.-China conflicts. But we believe investors are well compensated for these.

BlackRock’s 2021 investment themes

The new nominal

We see stronger growth and lower real yields as the vaccine-led restart accelerates and central banks limit nominal yields gains even as inflation expectations climb. Inflation will likely have different implications to the past.

Strategic implication: We are underweight government bonds and see equities supported by falling real rates.

Tactical implication: Our low rate outlook keeps us pro-risk. We like U.S. equities and prefer high yield for income.

The first half of 2021 is likely to be choppy. The pandemic challenges public health and the activity restart, while we see more policy support in the U.S. on top of the recent $900 billion fiscal package. We prefer a barbell approach to risk exposures, with selected cyclicals such as U.S. small-caps and emerging market equities on one end and quality assets including U.S. and Asia ex-Japan equities on the other. We also like tech and healthcare. These sectors can benefit from structural trends turbocharged by the pandemic, in our view, and their strong balance sheets and cash flows help provide some resilience against volatility. Yet we recognize U.S. tech could face challenges from greater regulation and corporate taxes.

We remain pro-risk overall, favoring overweights in both equities and credit, but see a potentially bumpy path for asset prices broadly, especially as markets have moved a lot since we published our 2021 global outlook in early December.

Globalization rewired

Covid-19 has accelerated geopolitical transformations such as a bipolar U.S.-China world order and a remaking of global supply chains, placing greater weight on resilience – even at the expense of efficiency.

Strategic implication: We favor deliberate country diversification and above-benchmark China exposures.

Tactical implication: We like EM equities, especially Asia ex-Japan, and are underweight Europe and Japan.

Turbocharged transformations

The pandemic has added fuel to pre-existing structural trends such as an increased focus on sustainability, rising inequality within and across nations, and the dominance of e-commerce at the expense of traditional retail.

Strategic implication: We prefer sustainable assets amid a growing societal preference for sustainability.

Tactical implication: We take a barbell approach, favoring tech and healthcare as well as selected cyclical exposures.