Global reflation has more room to play out. Recent market moves stirred doubts

about the reflation dynamic’s durability. We view the market response over the

past year – higher bond yields, stronger equities with a rotation towards cyclical

plays – as a quick repricing after a bout of deflation anxiety. We see reflation

beneficiaries gaining further but at a slower speed. Our BlackRock GPS, which

gives a steer on the near-term economic outlook, signals that G7 growth is

settling into a sustained, slightly above-trend pace. Highlights in our expanded

Global macro outlook include:

• This US-led economic cycle has been unusually long and slow but has plenty

of runway. We base this on an analysis of when previous US expansions

eliminated the economic slack created by each recession. This cycle's

remaining lifespan can likely be measured in years, not quarters.

• US wage growth has room to pick up based on where we are in the cycle.

Households have room to sustain spending after an unprecedented

deleveraging. Stronger corporate investment would reinforce growth rates,

though we see a risk of the ongoing US political drama keeping businesses

cautious. This is in the context of modest potential US growth near 2%.

• Our view hinges on structural forces keeping long-term interest rates low

relative to the past. If we’re wrong, some of the current risks, such as high US

corporate leverage, could be magnified if US yields surged.

GPS: Stabilising at higher levelsThe BlackRock GPS has stabilised at higher levels, giving us confidence that

global growth is both resilient and synchronised. We expect improvement in

survey-based data to cool given the sharp run-up over the past eight months,

which we see as catch-up to steadier activity figures. The G7 GPS below still sits

at an elevated implied growth rate near 2%, well above consensus expectations.

G L O B A L M A C R O O U T L O O K • M A Y 2 0 1 7

Benchmarking reflation

Authors

Jean Boivin

Head of Economic and Markets

Research, BlackRock Investment

Institute

Rick Rieder

Global Chief Investment Officer

and Co-head of BlackRock Global

Fixed Income platform

Contributors

Joshua McCallum

Simon Wan

Economic and Markets Research

BlackRock Investment Institute

Sources: BlackRock Investment Institute and Consensus Economics, May 2017.

Notes: The GPS shows where the 12-month consensus GDP forecast may stand in three months’ time for G7

economies. The blue line shows the current 12-month economic consensus forecast as measured by Consensus

Economics.

Economic snapshotBlackRock GPS vs. G7 consensus, 2015-2017

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View GPS website

20170522-163833-452218

Getting a grip on reflationThe phrase “reflation trade” gets bandied about even

though it is poorly defined, meaning different things to

different people. Right now, “reflation” is being used to

refer to everything from inflation to economic expansion to

US President Donald Trump’s tax and deregulation plans.

The rapid market repricing on the brighter growth and

inflation outlook unfolded over just a few months in late

2016, largely because investors were quickly reassessing

their views after having been overly downbeat about

growth prospects due to the energy and commodity price

shock. China’s pick-up, thanks to heavy stimulus, also

played a role in helping emerging markets (EM) bounce

back. We believe that reassessment is largely over. We

see US growth holding at a slightly above-trend pace that

should keep intact reflation as we define it: rising wages

feeding stronger nominal growth, allowing lingering slack

from the last recession to be gradually eliminated in a way

that stirs broader inflation pressures. This economic story

needs to be separated from the many “trades” tied to it.

Context is key. The chart below shows the unprecedented

fall in inflation expectations in 2014-16. Plunging oil and

commodity prices dealt a blow to key economic sectors,

especially energy, at a time markets feared central banks

were out of ammunition. The broad economic impact was

mild, yet the fear factor was pronounced. The “secular

stagnation” theory – growth stuck at below-trend rates that

would leave inflation permanently depressed – gained

traction. That further stoked the pessimism and deflation

anxiety. In the end, those fears proved exaggerated.

Inflation expectations recovered, and the US-led reflation

trend plodded on and became more global. Our work

shows that sentiment-based data have played catch-up to

activity data that had never deteriorated as much. As

conditions have normalised, markets have settled down –

if a little too calmly for the comfort of some.

Collateral damageUS and eurozone inflation expectations, 2010-2017

Sources: BlackRock Investment Institute, Thomson Reuters, May 2017. Notes:

The eurozone line shows swap market pricing of average inflation over a five-

year period starting in five-years. The US line shows similar pricing based on

Treasury inflation-indexed bonds.

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That Trump tradeTrump’s election win unleashed a big bout of optimism on

tax cuts, deregulation and infrastructure spending – largely

based on his campaign promises and the Republican

control of Congress. The market response was immediate.

The chart above breaks down the performance of the S&P

1500, which includes large, mid and small cap shares,

around the election. It separates those that responded the

most positively or negatively from those that did not

respond as strongly. Initial winners were concentrated in

financials, industrials and health care. Losers were in

telecoms, energy and technology.

The chart is telling. First, the Trump trade did not change

the overall upward move in place before the election.

Those shares less impacted – the neutral ones – went

straight back to their pre-election trend. Second, the Trump

equity trade has mostly unwound. Some energy shares are

still relative winners, likely on deregulation expectations.

But the energy sector overall is now the biggest

underperformer. Financials have given up most of their

biggest relative gains. Just as importantly, the shares most

hurt immediately after Trump’s win have recovered.

Technology, for one, has built a head of steam all year.

This sends an important message: Trump’s election impact

has not changed the underlying market trends that appear

tied more to the reflation story than that of “Trumpflation”.

The post-election market moves are not solely Trump-

driven, we believe.

Bottom line: Trump trades have been dented, but we

expect reflation trades – negative for government bonds,

positive for cyclically geared assets – to resume in an

environment of US growth slightly above trend, which we

see at around 2%.

.

Trump trades trumpedUS equity performance around US election, 2016-17

Sources: BlackRock Investment Institute, Thomson Reuters, May 2017. Notes:

The chart shows the rebased price performance of individual shares in the S&P

1500 index around the 2016 US election, with 100 set on Nov. 8. The breakdown

reflects how different shares performed in the three trading days after the

election (Nov. 9-11). Those individual shares that rose by more than one

standard deviation of their historical three-day moves relative to the overall

market move were put into the “winners" bucket. Those that fell by more than

one standard deviation are grouped in “losers". The rest represent the "neutral"

bucket.

20170522-163833-452218

Benchmarking cyclesAll economic cycles share a similar trajectory. From a late-

cycle inflationary peak, a recession drives activity to a

trough. Economic activity falls below potential. Slack opens

up and a recovery begins. But growth needs to be faster

than potential to reduce the slack created in the downturn.

As spare capacity is used up, we enter a reflationary

period – the sweet spot of the cycle. We then transition

into a late-cycle period leading to a new peak. These

milestones are common to all cycles, but the time between

them varies depending on the expansion’s vigour.

The longer it takes to absorb economy-wide slack, the

longer the cycle should run. This means that economic

slack is arguably a better way to benchmark where we are

in the cycle than simply looking at the time lapsed since

the last recession. The chart below shows US gross

domestic product (GDP) cycles since 1953, with each dot

on a line depicting a calendar quarter. What stands out?

This looks like a completely normal cycle and is tracking

the previous two cycles closely. Yet lower growth rates

imply that slack is being eroded much more slowly relative

to previous cycles – especially given the sheer spare

capacity created after such a shock. Economy-wide

measures suggest that slack hasn’t been eliminated by

now unless one makes big assumptions about the

recession having been less severe or potential growth

being well below 2%. Even if there is no slack left, as some

labour market indicators suggest, the economy’s snail’s

pace of growth implies that the cycle's remaining lifespan

can be measured in years, not quarters, we believe.

Long reflationary roadComparing US economic GDP cycles, 1953-2017

Sources: BlackRock Investment Institute, US BEA, Congressional Budget Office,

National Bureau of Economic Research (NBER), May 2017. Notes: This chart

shows the level of real US GDP compared against other cycles since 1953,

excluding the short 1980-81 one. Each line begins at 100 with the peak of the

previous business cycle, as determined by the NBER. We fix different economic

cycles at key points to align each based on their peaks, troughs and the point

when potential output is reached. This allows us to compare cycles of varying

lengths. The cycles above vary from 11 to 42 quarters, with the current at 39

quarters. Potential output is reached when the economy is operating at full

capacity, having used up all the slack created by the previous downturn. We use

CBO measures of the output gap, or the difference between actual and potential

output. Each dot on a line represents a calendar-year quarter. Each cycle peak is

set at 100. All cycles since 1953 are represented.

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Missing ingredientCorporate investment has been unusually weak this cycle.

Capex overshot to the downside in the wake of the 2008-

09 financial crisis, deviating from its past relationship with

GDP growth. The chart above shows the level of non-

residential investment – from computers to buildings,

government projects and intangibles such as research and

development – implied by US and eurozone GDP.

In the US case, investment eventually caught up to a level

consistent with the modest growth environment and higher

corporate uncertainty. Then the energy shock struck and

the gap reopened. This underscores how corporate

investment has been something of a missing ingredient

over the past few years, softer than it should be even when

we account for lower potential growth. In Europe, the

investment gap is very far from being closed. See the lower

chart above. Greater investment in Europe could reinforce

its sturdy recovery.

In general, our analysis shows that these investment gaps

tend to be corrected. This would happen as companies

gain enough confidence to unleash spending once

economic conditions stabilise – and the proverbial “animal

spirits” kick in. Corporate guidance in earnings updates

suggests a reluctance to spend. Yet the Philadelphia

Federal Reserve’s survey of manufacturer investment

intentions shot up to a 17-year high in April. US first-

quarter business investment growth was its strongest since

2013, according to the US Bureau of Economic Analysis.

Investment catch-upUS and eurozone investment trends, 2007-2016

Sources: BlackRock Investment Institute, US Bureau of Economic Analysis

(BEA) and Eurostat, May 2017. Notes: These charts show the actual level of

capital expenditure (non-residential investment) in the US and eurozone and

estimates of where the level of capex should be based on its historical

relationship with GDP growth and factoring in the Economic Policy Uncertainty

Index. The accelerator models help show the level of investment consistent with

recent past GDP growth. The data are rebased to 100 in 2007.

20170522-163833-452218

Wage growth needed…Wage growth will be key for cementing the reflationary

economic dynamic, we believe. This is true not just in the

more advanced US expansion, but in the budding stages

of Europe’s recovery and even in Japan where the labour

market is tightening thanks to a shrinking working-age

population.

The popular narrative holds that US wage growth has been

disappointing this cycle. Yet our analysis suggests that

wage growth is not abnormally weak after adjusting for the

cycle’s length and the recession’s severity. See the orange

line in the chart below. Our comparison is with cycles since

the early 1980s, when lower inflation rates have been

reflected in much lower rates of nominal wage growth. For

all the anxiety, wage growth has followed a remarkably

similar pattern and suggests that slack still remains. This is

why we find these cycle comparisons so compelling.

To be sure, the current wage recovery has taken time to

kick in and is softer than in the 1990s. Yet it is happening

in fits and starts. We are seeing the US labour market

tighten in ways not seen in decades – jobless claims as a

share of the working population are at lows since the

1970s, for example. And job shortages are popping up in

many areas, as more regional Federal Reserve banks

report.

Wage growth stalling here would suggest a structural shift

making this cycle truly distinct from all the others in the

post-war period. We have a hard time seeing why this

would be the case but see two potential factors. Poor

productivity growth could offset the labour market’s

recovery, keeping wage growth tepid. Technology’s

displacement of workers may be having a broader impact.

This cycle is typical in many ways but unusual in two:

household and corporate leverage.

Weak but not unusualUS wage growth across cycles, 1981-2017

Sources: BlackRock Investment Institute and US Bureau of Labor Statistics, May

2017. Notes: This chart shows the annual pace of US wage growth (average

hourly earnings) of production and non-supervisory workers across cycles, using

the same methodology as the GDP chart on page 3. Cycles before 1981 are not

shown because high inflation in these earlier cycles lifted wage trends to much

higher nominal levels than recent cycles.

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…in a much different contextThe anxiety about wage growth comes after the biggest

effort by US households to cut debt in the post-war period.

That goes a long way towards explaining why the recovery

has been so sluggish. The Great Recession was a

household balance sheet recession, hitting the biggest

asset of all – housing – in a way that led to such a deep

economic contraction and long-lingering scars. As a result,

households slashed debt relative to income at the sharpest

rate yet across these cycles. In that light, it’s no wonder

why the recovery has been such a tepid one – on top of the

repeated internal and external shocks.

US household debt, mainly mortgage driven, sowed the

seeds of the very deep contraction. As the chart above

shows, the difference between US household behaviour in

this cycle and the last couldn’t be more stark. This US

household deleveraging – cutting debt relative to income –

is as historic as the leveraging driving the property bubble

of the mid-2000s that led to the global financial crisis and

recession. US household debt relative to disposable

income has tumbled to its lowest levels in 14 years,

according to 2016 Fed data. As the consumer of the world,

this has had global repercussions – restraining activity and

US imports, a trend that is starting to reverse with the

recent pick-up in US demand for products abroad.

This deleveraging is also driven by the post-crisis financial

system clean-up. Stricter regulations have boosted bank

capital have also led to tighter lending standards. That has

made it harder for less-creditworthy households to borrow,

unlike in the last cycle when growth was powered by an

unsustainable debt binge and lax lending standards. The

household deleveraging story is true not just in the US:

household debt-to-income is at new decade lows in Japan,

the eurozone and UK. Strengthened balance sheets in

theory mean households today have greater capacity to

sustain spending and should be less vulnerable to shocks.

All things equal, it bodes well for this long expansion’s

durability.

An historic deleveragingUS household debt vs. disposable income, 1953-2016

Sources: BlackRock Investment Institute and Federal Reserve, May 2017.

Notes: This chart shows the cumulative change in US household debt as a share

of disposable income over the course of different cycles since 1953. It uses the

same methodology as the GDP chart on page 3.

20170522-163833-452218

Leveraging the balance sheetOne source of concern is the build-up of debt by US

corporates in the period since the crisis – a trend that looks

like a potentially destabilising late-cycle excess. We

believe companies have had compelling reasons to pile on

low-cost debt, making this leveraging up different relative

to the past.

The chart below shows US corporate debt relative to

revenue (based on gross valued added). Debt has climbed

to unprecedented levels compared with previous cycles.

Yet companies have had reasons to act in such a manner.

The realisation that we are in an environment of

structurally lower interest rates would make debt more

attractive for financing. Companies naturally took

advantage of record low rates to conduct a balance sheet

arbitrage by issuing long-term bonds, partly with an eye to

cutting outstanding equity. A desire to boost shareholder

returns in the short term added to the incentives for

emphasising debt over equity on the balance sheet.

Share buybacks have exceeded corporate debt issuance

through most of the current cycle: In the past six years, US

companies cut $11.6 trillion of equity liabilities and raised

$9.2 trillion of loans and bonds, according to –end 2016

Fed data. In many ways, companies are responding

exactly as central banks might want to the incentives of

record low interest rates: locking in historically rock-bottom

borrowing rates – and at longer maturities. But something

more than ultra-low rates will be needed for companies to

make bigger investments.

Companies have fortified themselves securing low rates

with bonds featuring longer maturities. Bloomberg Barclays

data show the current average duration of the US

investment grade corporate index is 7.2 years as of May

2017, near record highs, versus 5.8 years in the mid-

2000s. This should help reduce future refinancing risks.

VulnerabilitiesThe International Monetary Fund highlighted US corporate

sector leverage as a potential threat in its April 2017 Global

Financial Stability Report. Net interest costs as a share of

revenues have fallen only slightly for US companies even

with the Fed having cut interest rates to nearly zero and

being slow to raise them. See the chart above. That

interest costs haven’t dropped more reflects just how much

debt companies had added during this cycle. It also stands

in contrast to the the large drop in financing costs that the

UK and eurozone have engineered.

There are risks. The IMF warned that US energy and

smaller companies are the most exposed to any surge in

financing costs given their weaker positions to cover higher

interest rate burdens. Beyond corporate debt, concerns

have been raised about US auto and student loan lending.

We see higher US corporate leverage as a potential

vulnerability if interest rates soared and drove corporate

bond yields sharply higher, causing painful debt

refinancings or even defaults. But these risks look

contained for now. A surge in interest rates would be

needed for this to prove problematic – one we view as

unlikely. Any such hiccups would also likely constrain the

Fed’s policy normalisation path. Structural forces – ageing

populations, high debt levels and weak productivity growth

– should prevent yields from going back to historical

averages on a sustained basis, as highlighted in our 2017

Global Investment Outlook. Importantly, corporate leverage

is worrying to the extent it leads to massive capital

misallocations. This may be the case in some sectors, but

the overall problem of this expansion remains one of

insufficient – rather than excessive – investment.

US tax reforms could transform how companies approach

capital and spending: Any shift to immediate expensing for

capex could bring forward spending plans, while any end to

interest expense deductibility could cut debt issuance and

share buybacks while reviving equity issuance.

US debt bingeBusiness net interest cost as share of revenue, 2000-2016

Source: BlackRock Investment Institute, BEA, UK Office for National Statistics,

Eurostat, May 2017. Notes: The chart shows net interest costs as a share of

revenue (gross value added) for the US, UK and eurozone.

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Leveraging upUS corporate debt as share of revenue, 1953-2016

Sources: BlackRock Investment Institute, BEA, May 2017. Notes: This chart

shows the cumulative change in corporate debt as a share of revenues (gross

value added in the national accounts data) over the course of different cycles

since 1953. It uses the same methodology as the GDP chart on page 3.

20170522-163833-452218

Seeking animal spiritsIt’s not just companies that have been extra cautious in the

post-crisis environment. Even as equity indices have kept

pushing to new highs and stirred worries that overvalued

markets are poised for a major reversal, our work has

found that investors also remain reluctant to embrace risk.

We took another look at a gauge we introduced in the

November 2016 Global macro outlook to take a deep dive

into how money flows through the financial system and

what that reflects about investor risk appetite. We looked

at how the value of US risk assets changes relative to that

of perceived safe assets, mainly money and government

bonds while excluding bonds bought by central banks –

what we call the risk ratio. The risk ratio helps show

whether investors are venturing out the risk spectrum. The

latest data capture the risk asset run higher during the last

quarter of 2016. What did we find? Very little movement. In

fact, the risk ratio even ticked down slightly in the fourth

quarter. While the level is consistent with moderate risk

taking, we are far away from any kind of “irrational

exuberance” seen in the late-1990s or mid-2000s.

Cautiousness remains pervasive, even eight years on.

This just goes to show how long it takes for confidence to

return after such a severe crisis. The equity gains of the

past eight years have been doubted almost every step of

the way rather than being taken as a positive signal.

Climbing the wall of worry has been a constant exercise.

As with other parts of the cycle that are slowly normalising,

investors are likely to start embracing more risk. We are

seeing signs of risk appetite picking up globally. After a

long pause, flows into developed market equities have

picked up again, rising nearly $180 billion in the six months

through early May, according to EPFR Global.

Globalising reflationOnce a US-led phenomenon, reflation is now global. More

than 80% of the countries making up the Markit global

composite PMI – combining manufacturing and services –

posted stronger readings from a year earlier in April, one of

the highest shares since the immediate recovery from the

crisis. See the chart above.

Europe’s recovery has largely been overlooked, partly due

to constant worries about political risks. These risks are

now subsiding after the business-friendly Emmanuel

Macron’s clear victory in France’s presidential election.

Economic growth rates implied by eurozone equities and

bonds have been persistently low relative to actual GDP

performance, leaving plenty of scope for a rebound, as we

highlighted in the March 2017 Global macro outlook:

Europe’s stealth recovery. Political uncertainty has been a

clear factor holding back the market pricing of the

reflationary dynamic. The rebound in commodity prices and

China’s credit-driven reacceleration have given the global

economy an extra jolt over the past year. China is playing a

role in helping transmit the solid rate of global growth from

developed economies to EM. See our February 2017

Global macro outlook: China’s role in global growth. EM

economies have bounced back after a three-year slump

tied to the commodity sell-off and investors taking a

dimmer view of the excesses in some countries. Global

trade is picking up.

Bottom line: We see the market settling its focus on

sustained economic expansion after an accelerated

repricing of reflation. We believe reflation has legs given

the slow pace at which US economic slack is being

absorbed. That allows the Fed to press ahead with a

gradual policy normalisation. Our BlackRock GPS points to

reflation broadening beyond the US. We are negative on

government debt and positive on reflation beneficiaries:

European, Japanese and EM equities, as well as cyclicals

and factors such as value.

Better breadthGlobal PMI and share of rising countries, 2001-2017

Sources: BlackRock Investment Institute, Markit, May 2017. Note: This chart

shows the global composite PMI and the share of countries reporting higher

PMIs compard with 12 months ago.

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Not so euphoricUS risk ratio, 1955-2016

Sources: BlackRock Investment Institute, Federal Reserve, May 2017. This chart

shows gauges of a financial asset risk ratio based on U.S. flow of funds data.

The risk ratio is defined as the ratio between risk assets (such as equities,

mortgages and corporate bonds) and less risky assets (government and agency

bonds plus money) but excluding central bank holdings since those are

effectively removed from the market. It is based on a four-quarter average to

smooth out seasonal effects.

20170522-163833-452218

This material is prepared by BlackRock and is not intended to be relied upon as a forecast, research or investment advice, and is not a

recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of May 2017

and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and

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warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any

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risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less

government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often

heightened for investments in emerging/developing markets or smaller capital markets.

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respective owners.

The BlackRock Investment Institute (BII) provides connectivity between BlackRock’s portfolio managers, originates

economic and markets research, develops actionable views for clients, and publishes investment insights. Our goals are to

help our portfolio managers become even better investors and to produce thought-provoking investment content for clients

and policymakers.

BlackRock Investment Institute

BLACKROCK VICE CHAIRMAN

Philipp Hildebrand

GLOBAL CHIEF INVESTMENT STRATEGIST

Richard Turnill

HEAD OF ECONOMIC AND MARKETS RESEARCH

Jean Boivin

EXECUTIVE EDITOR

Jack Reerink

FOR INSTITUTIONAL, PROFESSIONAL, QUALIFIED/WHOLESALE INVESTORS ONLY. FOR PUBLIC DISTRIBUTION IN THE US ONLY.

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