Politics not quite as usual - BlackRock · Isabelle Mateos y Lago — Chief Multi-Asset ... to a...
Transcript of Politics not quite as usual - BlackRock · Isabelle Mateos y Lago — Chief Multi-Asset ... to a...
Politics not quite as usualViews on the intersection of politics and markets
GLOBAL INSIGHTS • JUNE 2017
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Contents
3–5The big picture
6–7Geopolitics
8–11U.S.
12-15Europe
LEFT TO RIGHT
Joanna Cound — Head of BlackRock Global
Public Policy Group, Europe
Kate Fulton — BlackRock Global Public Policy
Group, U.S.
Rupert Harrison — Portfolio Manager,
BlackRock Multi-Asset Strategies
Isabelle Mateos y Lago — Chief Multi-Asset
Strategist, BlackRock Investment Institute
Jonathan Pingle — Head of Economics,
BlackRock Fixed Income Americas
SummaryWe see diminished political risks in the short run in Europe, and potential for some growth-enhancing
reforms in major economies around the world. Some of this good news is already priced in, but we
expect a steady and synchronized global economic expansion to underpin risk assets for now.
Longer term, we see significant risk of populist policies that would hurt business, such as restrictions on
trade and immigration. A starkly more transactional U.S. approach to foreign affairs challenges long-
standing security and trade pacts, and we see North Korea’s nuclear ambitions as the top security threat.
We see fading prospects for comprehensive U.S. tax reform amid legislative gridlock and distracting
probes into ties between White House officials and Russia. Yet depressed expectations lower the bar for
positive surprises, and we see regulatory easing as an underappreciated force in business and markets.
Europe may have its best opportunity in decades to push through reforms that make the EU more
sustainable and effective. These are much needed to deal with rising populism and any economic
deterioration. Potential flare-ups are Italy’s fractious politics and a possible “no deal” on UK Brexit talks.
Investors have mostly shrugged off a series of political upsets — from Brexit to U.S.
President Donald Trump’s surprise election win. Yet these developments have
long-term consequences. There are fundamental questions about the future of the
European Union (EU) and how to address the complex root causes of populism and
nationalism. An increasingly transactional U.S. approach to foreign affairs, waning
support for free trade and uncertain prospects for U.S. tax reform also have big and
differentiated implications for economies, sectors and companies.
These topics are the subject of vigorous debate among BlackRock portfolio
managers and strategists. We do not have all the answers, but here we present some
of our thinking, including Q&As with our experts.
PhilippHildebrand
BlackRock Vice
Chairman
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The big pictureWe see political risk receding for now, returning attention to a steady global expansion. Yet
ongoing discontent could lead to policy responses that pose longer-term threats to markets.
The Republican policy agenda could be derailed if the
party loses control of either chamber of Congress in
the 2018 mid-term elections. A challenge is fulfilling
the promises Trump made during his campaign, which
attracted disproportionate support from older white
males, many in the so-called rust belt states. Stagnant
wage growth for the middle class, sharply rising health
insurance premiums and an epidemic of opioid addiction
are among the issues requiring policy responses.
Our bottom line: If current governments fail to implement
policies that improve the plight of disenfranchised and
disgruntled voters, we could see more populist election
victories in the years ahead. We believe this could lead
to a further backlash against the free flow of people and
goods across borders, threatening global supply chains
and economic growth. The longer governments wait to
address voter concerns, the greater the chance of eventual
policy overreach that could hurt markets.
A series of populist surprises has riveted investors. The
political shocks of 2016 — the UK’s Brexit vote and the
election of U.S. President Donald Trump — signaled a
dissatisfaction with the status quo, particularly among
baby boomers who make up an increasing share of
electorates. Rising inequality in some countries and a
perceived loss of sovereignty in others also play a part.
Economic issues such as the state of the economy,
unemployment and public finances dominated in the
years following the global financial crisis and European
sovereign debt woes. Terrorism and immigration have
leapt to the top of voter concerns since 2014. See the
Shifting worries chart. Similar trends are driving populist
politics in many countries.
Markets have proved resilient to political shocks to date,
recovering swiftly after initial selloffs. Investor caution
leading up to these events may be part of the story. A
benign reflationary backdrop and improving corporate
earnings around the world also help.
A political cloud seems to be lifting in Europe after the
French election delivered its most pro-European president
in decades. And German chancellor Angela Merkel looks
set to win a fourth term in September. This could open a
window of opportunity for Europe’s two largest economies
to cooperate in promoting reforms vital to the eurozone’s
sustainability. See pages 12-15 for details. There are risks.
Italian elections could result in fragile coalitions, and raise
questions about Italy’s commitment to the euro. And there
is a risk that the UK cannot reach a deal with the EU before
exiting in 2019.
In the U.S., the legislative agenda has slowed amid
investigations of potential Russian election interference
and other distractions. A fractious Republican caucus with
only a slim Senate majority leaves the party leadership with
little margin of error in approving legislation. And relations
between the two major parties are as fraught as ever.
Shifting worriesPublic’s view of key issues facing the EU, 2011-2016
2016
0
20
40
60%
20142013 201520122011
Unemployment
Economic situation
Terrorism
Public finances
Immigration
Sources: BlackRock Investment Institute and the European Commission, November 2016. Note: The lines show percentage support for the top-five responses to the question “What do you think are the two most important issues facing the European Union at the moment?” in the Eurobarometer public opinion survey.
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Room to runPolitical events have the potential to sway markets, but
we believe investors also need to look through short-term
noise and focus on the big picture: underlying economic
and market trends. The outlook is pretty bright in this
regard, in our view. The U.S. economic recovery from the
financial crisis has been slow and grinding, and some
worry that it may be on its last legs. We believe it has
room to run. The slower the pace of a recovery, the longer
it takes to absorb the economic slack created in the last
recession — and the longer it takes to reach full capacity
and ultimately the peak that signals the cycle’s end. See
our Global macro outlook of May 2017 for details.
The Are we there yet? chart shows U.S. economic cycles
since 1953, with each dot on a line depicting a calendar
quarter. What stands out when time is replaced by
economic progress? The current cycle (the orange line)
looks normal — and is closely tracking the previous two
cycles of 1990-2001 and 2001-2007 (blue and green).
Estimates of economic slack are imprecise. Yet even if there
is no slack left, as some labor market indicators suggest, the
economy’s anemic pace of growth implies there are years
— not quarters — to go in the current cycle, in our view.
European signs of lifeEurozone big-four GPS and market-implied GDP, 2010-2017
Ann
ual G
DP
gro
wth
2010
0
0.5
1
1.5
2%
2012 2014 2017
Market-implied GDP
Eurozone big-four GPS
Sources: BlackRock Investment Institute and Eurostat, May 2017.Notes: The BlackRock GPS shows where the 12-month consensus GDP forecast may stand in three months’ time for the top four eurozone economies: Germany, France, Italy and Spain. The market-implied eurozone GDP is based on a statistical model that analyzes co-movements in eurozone equity prices and real bond yields: Any simultaneous rise in real yields and equities is interpreted as the market pricing in a positive growth expectation. Using the GPS methodology, that is converted into a 12-month forward GDP reading.
Are we there yet?Comparison of U.S. economic cycles, 1953-2016
Prior peak
90
110
130
150
2007-present
1990-2001
2001-2007
GD
P in
dex
Trough Potential Peak
Sources: BlackRock Investment Institute, US BEA, Congressional Budget Office, National Bureau of Economic Research (NBER), May 2017. Notes: The chart shows the level of real US GDP compared against other cycles. Each line begins with the peak of the previous business cycle, as determined by the NBER. We align different economic cycles based on their peaks, troughs and the point when potential output is reached. This allows us to compare cycles of varying lengths. 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.
European optimismInvestors have long been downbeat on the eurozone’s
growth prospects. The market is pricing in GDP growth
of just 1.2% in its big-four economies in the year ahead,
based on our analysis of bond and equity valuations.
See the European signs of life chart. The market-implied
growth rate has rebounded sharply in recent months, but
still lags the forward view of the BlackRock GPS, which
combines traditional economic indicators with big data
signals such as Internet searches. The unusual divergence
between our GPS and marked-implied growth rates since
2015 can be explained by political risks: most recently,
jitters ahead of the French presidential election.
We see further room for market-implied GDP rates to play
catch-up with our GPS in the coming quarters as political
uncertainty lifts. We see this pushing European equities
and bond yields higher, reflected in our overweight view on
European equities and an underweight view on European
sovereign debt and credit. What are the risks? Nominal
income growth is still sluggish and needs to pick up as tail
winds from lower oil prices and a weaker currency fade.
Also, Europe has greater exposure to China and emerging
markets than the U.S., and could be disproportionately
impacted by any stall in economic momentum there.
Click to view interactive GPS
Click to view interactive data
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All regions of the world economy are experiencing a
synchronized upturn in 2017 for the first time in several
years. The global reflationary dynamic is reflected in a
pickup in global trade volumes. Growth in the dollar value
of trade has rebounded sharply after contracting for much
of the past two years. This is a sign of health in the global
economy. See the Budding trade recovery chart.
The volume of world merchandise trade has tended to grow
about 1.5 times faster than world output since 1981, but the
ratio has slowed to 1:1 since the financial crisis, according
to a World Trade Organization (WTO) April 2017 report.
This partly reflects weak investment in much of the world.
Structural changes such as China’s rebalancing away from
investment and toward consumption are another potential
dampener in coming years.
Any rise in protectionism could pose a threat to the
nascent global trade recovery. We do not see risks of a
significant increase in actual protectionist measures this
year. Increased U.S. pressure on China and other countries
to open up their markets may actually yield benefits. Yet
escalating protectionist rhetoric and a more transactional
U.S. approach to trade that favors bilateral over multilateral
deals is a longer-term concern. See page 7 for details.
What, me worry?Fund manager top ‘tail risks’ and global equities, 2015-2017
Tota
l ret
urn
(Oct
. 201
5 =
10
0)
Oct. 2015
Economic worry Political worry
90
110
130
World equities
May 2017
May 2016
Jan. 2016
Oct. 2016
Jan. 2017
EU disintegrationChina recessionU.S. recession
Brexit
Trump winChina credit
Trade war
Sources: BlackRock Investment Institute, MSCI and Bank of America Merrill Lynch, May 2017. Notes: The vertical lines show the top ‘tail risk,’ or the top outside risk, from the Bank of America Merrill Lynch Fund Manager Survey. Only months where the top risk accounted for more than 25% of responses are shown. World equities are based on the MSCI All-Country World Index total return, rebased to 100 at the start of October 2015.
Budding trade recoveryGlobal export volume and value, 2003-2017
Ann
ual c
hang
e
2003
Value
Volume
U.S. recession
2005 2007 2009 2011 2013 2015 2017
-30
-15
0
15
30%
Sources: BlackRock Investment Institute, IMF and CPB - Netherlands Bureau for Economic Policy Analysis, May 2017. Notes: The lines show the annual percentage change in total global export volumes and export value in U.S. dollars.
Markets have climbed a wall of worry in the past few
years. What are investors most worried about in the world
today? The top tail risk cited by investors was dominated
by economic concerns from late 2015 through early
2016, mostly around fears of China dragging the world
into recession, the Bank of America Merrill Lynch Fund
Manager Survey shows. See the What, me worry? chart.
Political concerns and uncertainty then jumped into the
spotlight, with investors’ minds dominated by Brexit,
Trump’s surprise election victory and sporadic worries
about EU disintegration. We see concerns about EU
cohesion receding until the run-up to Italian elections,
which could occur as early as September. See page 12.
China credit risks became the top investor worry in
early 2017 as the country tapped its foot on the brakes
of credit creation. The lesson from recent history is that
fundamentals have mattered much more than politics.
Markets have shrugged off most of the top political risks,
with bouts of volatility treated as buying opportunities.
The question is when and where politics may start to
impact the favorable fundamentals. For example, we could
see a failure of the UK to reach an exit deal with the EU
hurting its economy and markets. See page 15.
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The coming year brings a mosaic of elections, monetary
policy decisions and geopolitical hot spots. See the map
below. Washington lawmakers face a shrinking window
of opportunity to implement tax reform (pages 8-10).
Populists have been beaten back in Europe for now, and
our attention has turned to trouble brewing in Italy (page
12), improving the workings of the EU (page 13-14) and
the shape and outcome of Brexit negotiations (page 15).
The backdrop of synchronized global growth puts central
banks at a crossroads. We see the European Central
Bank (ECB) debating how much longer its extraordinary
amount of monetary support is needed — and how to
communicate any changes. The Fed is contemplating how
to trim its balance sheet. We see the risks as contained, as
we expect central banks to move cautiously and gradually.
GeopoliticsWe highlight key events, trends and risks to watch in 2017 and beyond.
Mark your calendarEvents and geopolitical risks to watch in 2017 and beyond
Italy General elections before May 20, 2018
U.K.Parliamentary electionsJune 8
Brexit negotiations
China19th Party CongressFall 2017Attempts to rein in credit South China Sea disputes
European UnionKey ECB meetingsJune 8, July 20, Sept. 7,Oct. 26, Dec. 14
European Council meetingsJune 22-23, Oct. 19-20, Dec. 14-15
Mexico Start of NAFTA renegotiationSummer 2017
General electionsJuly 2018
Brazil General electionsOct. 2018 or earlier
Middle EastSyria and Yemen proxy warsSaudi economic transformationFuture of Iran nuclear deal
North KoreaMissile and nuclear tests
U.S. Key Fed meetingsJune 13-14, Sept. 19-20, Dec. 12-13
Debt ceiling and 2018 budget Summer/fall 2017
Potential tax reform2017-2018
Midterm electionsNov. 6, 2018
GermanyFederal elections Sept. 24
South AfricaANC leadership electionDec. 16-20
SpainPossible Catalan independence referendumSept. 17
Russia Presidential electionsMarch 2018
FranceLegislative electionsJune 11 and 18
Source: BlackRock Investment Institute, May 2017.
China’s growth momentum has slowed as authorities are
cracking down on credit excesses. These measures and
other structural reforms are crucial to put the economy
on a sustainable long-term path, but bring short-term
risks. Accidents can happen when liquidity is tightened in
economies addicted to credit. We see the upcoming 19th
National Congress of the Communist Party as a harbinger
for both reform momentum and China’s ambitions on the
world stage. See China’s tricky transition of February 2017.
Mexican elections loom large on the EM political calendar.
We see rising risks of a populist outcome, partly reflecting
the U.S. administration’s anti-Mexican rhetoric. Brazil’s
government is in crisis, and early elections are a possibility.
Geopolitical hot spots abound, with North Korea
representing the most immediate threat (page 7).
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Former U.S. National Security Advisor Tom Donilon gives investors a geopolitical tour.
What’s the current state of geopolitics?
First, there is significant uncertainty
about the direction and tone of U.S.
national security policy. Second, the
great power relationships are evolving
and becoming more competitive.
Third, there is an unusual number of
volatile and unstable situations. These
include North Korea’s nuclear and missile drive, failed
states and the resulting effects on migration and terrorism,
Russia’s confrontation with the West, populist pressures in
Europe and increasing cyber threats.
These are grim prospects …
There are near-term positives for investors. The French
election took an existential threat to the European project
off the table for now — and I don’t see a rejection of Europe
in the upcoming German elections. U.S.-China relations
have been constructive; a trade war is unlikely this year.
Let’s return to your first point: Washington’s agenda.
The Trump campaign challenged the pillars of the U.S.-
led post-WWII order, including the value of international
alliances, trade and institutions. An experienced national
security team has since had some moderating effect,
and some campaign slogans have run into the realities of
governing. Several characteristics of a new U.S. approach
to foreign affairs have emerged: First, policy is highly
transactional and focused on immediate results. Second,
the president embraces unpredictability as an operating
style. Both have the benefits of flexibility but can call
into question the U.S.’s reliability as a long-term partner
— and unnerve allies and investors alike. Third, there is a
persistent focus on bilateral economic relations, especially
trade deficits, which are seen as a zero-sum game.
How does this play into the great power relationships?
The principal development is that Russia has turned away
from integration with the West to challenging it, from
Ukraine and probing NATO’s borders to Syria and alleged
interference in Western elections. I don’t see U.S.-Russia
relations improving any time soon. Many administration
policymakers see Russia as a significant security threat,
and there are multiple inquiries into election meddling.
How about the upstart superpower, China?
China’s leaders appear confident and eager to fill any
leadership vacuum after the U.S. announced its withdrawal
from the Paris climate accord and pulled out of the Trans-
Pacific Partnership trade agreement. President Xi Jinping
is set to put in place his team and policy agenda for the
next five years at the 19th National Party Congress this
fall. Until then, I see Xi seeking to maintain economic
growth while trying to rein in financial excesses, avoid a
direct confrontation with the U.S. and assert international
leadership in trade and climate. Next year presents
challenges for U.S.-China relations, especially on North
Korea and bilateral trade.
Which area of instability worries you most?
North Korea represents the most significant security
challenge. Attempts to put it on a non-nuclear path have
failed, and all indicators are negative: nuclear tests and
increasingly capable missile technology. It represents both
a direct nuclear and proliferation threat. The approach
so far has been to push China to pressure North Korea to
denuclearize. It is unclear whether China is able or willing
to do so, making this issue a key source of tension in U.S.-
China relations. I expect more North Korean provocations
and continuing risk of escalation — but see military options
as very difficult given South Korea’s vulnerability.
How explosive is the Middle East?
The administration has made a top priority of forging
an alliance with the Gulf states against ISIS and Iran, an
initiative well-received in the Gulf. I see the U.S. adopting
a more confrontational stance toward Iran, but expect the
nuclear deal to hold. Saudi Arabia’s ambitious economic
and cultural transformation is pressured by low oil prices,
but we don’t expect political instability. ISIS is being
pushed out of its territory in Iraq and Syria, increasing the
risk of more terror attacks in Europe.
What risk is below investors’ radar screens?
The volume, sophistication and sources of cyberattacks
are increasing significantly — and the world has very
uneven defenses. More interconnectivity thanks to an
explosion in internet-of-things devices — with little regard
to security — will make us even more vulnerable.
Tom DonilonChairman, BlackRock Investment Institute
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U.S. The prospects for U.S. tax reform and infrastructure spending are fading, but we see an
underappreciated shift toward more flexible regulation that could help business.
Trump trade fizzlesU.S. equity performance around U.S. election, 2016-2017
90
100
110
120Winners
Losers
Neutral
TrendInd
ex
May 2016 Nov. 2016 May 2017
Sources: BlackRock Investment Institute and Thomson Reuters, May 2017.Notes: The chart shows the price performance of individual shares in the S&P 1500 index around the 2016 U.S. election, rebased to 100 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.
Growing the wrong wayU.S. long-term budget projections, March 2017
Shar
e o
f GD
P
Public debt share of GDP
2017 2027 2037
0
5
10
15
20
25%
Net interest
Other spending
Health
Social Security
Income tax
Payroll tax
Corporate taxOther revenue
77% 89% 113%
Deficit
RevenueSpending
Sources: BlackRock Investment Institute and Congressional Budget Office, March 2017.Notes: The data show the Congressional Budget Office extended baseline budget projections. Health programs consist of spending for net Medicare spending, Medicaid and the Children’s Health Insurance Program, as well as outlays to subsidize health insurance under the Affordable Care Act and related spending. Other revenue consists of excise taxes, customs duties, estate and gift taxes and miscellaneous fees and fines.
Media headlines paint a picture of political disarray in
Washington. Yet a closer look tells a more nuanced story,
we believe. First, a system of checks and balances and
strong institutions blunt the sharper edges of any new
president’s agenda. Second, the administration has
appointed steady and experienced hands in key posts
such as national security and defense. Lastly, the private
sector is humming along regardless of dramatic political
headlines, with a corporate earnings recovery in full swing.
Some of the froth has come off of the so-called Trump
trade. Shares of companies that performed best after the
election such as banks have given up some of those gains,
while initial losers such as tech have recouped relative
losses. See the Trump trade fizzles chart. Other legs of the
Trump trade have fully reversed, with the Mexican peso — a
barometer of anxiety about a tougher U.S. stance on trade
— recovering from its post-election losses.
The U.S. faces long-term fiscal challenges. Health care and
Social Security make up roughly half of federal spending
today, and this share is set to grow over the coming
decades as the population ages. Absent any changes, this
will lead to a steady rise in the deficit and debt levels over
time. See the Budget breakdown chart. These dynamics
leave the U.S. with little fiscal wiggle room. This is why
most plans to reform the tax system typically aim for
budget neutrality over the long term, after accounting
for any growth-boosting effects. Unfunded tax cuts could
worsen an already poor fiscal trajectory.
Congress also has yet to draft a budget for fiscal 2018,
which starts Oct. 1. Controversial aspects of Trump’s
agenda, such as funding a border wall and cutting social
programs, are sticking points. Another short-term deal to
fund the government may be needed if Congress cannot
agree on a budget. A battle also looms over raising the
U.S. debt ceiling. The second half of 2017 could be bumpy.
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Legislative clock is ticking Many Republicans see this as a once-in-a-generation
opportunity to rewrite an overly complex and onerous tax
code. On their menu: big cuts to the U.S. corporate tax
rate, a one-off “deemed repatriation tax” on the roughly
$2.5 trillion of corporate cash held overseas, lowered
tax rates on investment income, and a cut in the top
personal tax rate. The goal is to stimulate investment and
consumption, and thereby boost growth.
A troubled attempt to repeal and replace “Obamacare”
health legislation and controversy over Russia’s alleged
interference in the 2016 election — now being investigated
by a special counsel — add to the risk of legislative delays.
This could play out in two ways:
Positive: The investigation activates Congress to focus
more on tax reform — a key measure of legislative progress
ahead of 2018 midterm elections. The White House shows
leadership on policy priorities, and Congress passes tax
reform legislation early in the new year.
Negative: A distracted White House fails to clarify policy
priorities, and the Russia scandal deepens. Congressional
Republicans start to distance themselves from the Trump
administration. The reform agenda is derailed.
Tax: It’s all in the detailsWe see three scenarios for U.S. tax reform: major reforms
including a sharp reduction in the corporate tax rate;
a scenario whereby reforms are watered down and the
budget deficit rises; and an outcome in which tax reform is
delayed indefinitely. See the Taxing challenge table below.
Our comprehensive reform scenario would be budget-
neutral over time. It would be stimulative in the near
term, but with a payback in later years as loopholes and
deductions are limited. This would benefit global equities
and lead to rising interest rates. The modest tax cuts
scenario, which we see as the most likely outcome, would
have a similar market impact in the short run. It would
result in an economic stimulus — but with the likely cost
of higher budget deficits and inflation. Our derailment
scenario is partly priced in as expectations for tax reform
are low, we believe, but still could hurt risk assets in the
near team.
We see any market fallout as nuanced. Take the credit
markets. The removal of interest deductibility would likely
reduce new issuance, benefiting investment grade credits.
But this impact could be offset by any stimulus that leads
to rising rates. And we see more leveraged credits faring
worst from losing the ability to deduct interest expense.
A taxing challengeBlackRock Market-Driven Scenarios on potential impact of U.S. tax reform, May 2017
Comprehensive reform Modest tax cuts Derailment
Description
Comprehensive reform, including a large cut in the corporate rate, and the closing of many personal and corporate deductions to make the plan roughly revenue-neutral.
Moderate tax cuts are only partially offset with caps on deductions, leading to larger budget deficits and rising inflation.
Congressional gridlock derails tax reform and even modest attempts at tax cuts.
Key ingredients
• Tax cuts are permanent. Deep corporate tax cut, with lower income tax rates, offset with removal of most deductions.
• One-off deemed repatriation tax on overseas corporate cash.
• End of corporate interest deductibility; immediate capex expensing.
• Tax cuts mostly expire after a decade; watered-down elements of the comprehensive scenario.
• Lower corporate and personal tax rates; caps on deductions.
• But the stimulus generates some positive investor sentiment.
• Trump administration introduces piecemeal plans to cut corporate and personal taxes.
• Proposals fail to gain traction ahead of 2018 midterm elections.
Global equities
+Highly taxed U.S. domestic
companies outperform.
+Personal income tax cuts support consumer stocks.
—Post-election gains in value stocks are further eroded.
U.S. credit+
Investment grade (IG) spreads tighten; highly leveraged names underperform.
+IG spreads tighten; highly leveraged
names underperform.
—Spreads widen in flight
to quality.
Government debt
—U.S. Treasury yields rise and the
yield curve steepens.
—Treasury yields rise on the back of
rising deficits; yield curve steepens.
+Treasuries rally on lower
growth expectations.
Sources: BlackRock Investment Institute and BlackRock’s Risk and Quantitative Analysis group.
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Munis mull tax reformU.S. municipal bond implied tax benefit, 2016-2017
May 2017Jan. 2017Sept. 2016May 2016Jan. 2016
Imp
lied
tax
ben
efit
10
20
30
40
50%
U.S. election
Sources: BlackRock Investment Institute and Bloomberg Barclays, May 2017.Notes: The market implied tax benefit is a rough measure on how munis are pricing value of their tax-exempt status. It is calculated by subtracting the ratio of the yields on the Bloomberg Barclays Municipal Bond Index and U.S. Aggregate Corporate Index from one.
Muni murmursAsset prices have waxed and waned with expectations
of U.S. tax reform. Municipal bonds are a case in point.
Any large cut to the top personal marginal tax rate would
diminish the value of their tax-exempt status.
Munis used to trade with a market-implied tax benefit
of just over 40%, in line with the top personal marginal
tax rate. This figure slumped to 17% when expectations
for comprehensive tax reform peaked just after the U.S.
election, and has now recovered to almost 30%. See the
Munis mull tax reform chart. We see room for further gains
in this metric — and muni valuations. Our “compromise”
scenario sees only modest personal tax cuts being
implemented, with the tax exemption for muni income
remaining intact. Any introduction of caps on other
individual deductions would only boost demand for munis
as one of the few remaining tax shelters, we believe.
Loopholes and deductionsComprehensive tax reform has eluded both major political
parties since the mid-1980s. The ingredients are simple:
Cut marginal tax rates, while reducing loopholes and
deductions to offset the budget impact. Cutting taxes
alone runs the risk of creating a big hole in the deficit.
Example: Each percentage point cut in the 35% corporate
rate leads to $100 billion in lost tax revenue over a
decade, the Joint Committee on Taxation estimates. Many
potential offsets such as cutting popular deductions are
politically off limits. What’s on the table this time?
Deemed repatriation tax: A one-off tax on corporate
profits held abroad — applied regardless of whether
companies bring the cash back. The proceeds could
be set aside to finance other policy priorities such as
infrastructure expenditure, making it potentially appealing
to both Republicans and Democrats.
Interest deduction and capex expensing: Tax reformers
propose allowing companies to immediately deduct the
cost of capital expenditures from their income, rather
than depreciating it over time. This is meant to encourage
investment. It would be offset by capping the interest
deduction, which lets companies deduct net interest
payments on debt from their taxes. This would reduce
incentives to leverage up and level the tax playing field
with dividend payouts. It would make it less attractive to
issue debt and use the proceeds to buy back shares.
Border adjustment: House Republican leaders have
proposed a border adjustment tax (BAT) to pay for deeper
corporate tax cuts, increase U.S. competitiveness and
reduce incentives to offshore production and profits. The
BAT would effectively subject imports to a 20% tax, while
exempting exports. Supporters argue the BAT’s impact
would be offset by a 25% rise in the dollar, leaving no net
impact on trade balances or consumer prices. Opponents
say the BAT risks retaliation by other countries and is
hard to apply to financial services. We believe currency
movements are driven by many factors beyond any BAT.
An imperfect dollar adjustment would hurt importers.
We see little chance of the BAT being implemented as
proposed, given opposition in the Senate and White
House. We may see a move toward a territorial tax system.
“ Investors should move away from the notion that tax reform will have a big impact on munis — and focus on the income and value the asset class offers.”
Peter Hayes — Head of BlackRock’s
Municipal Bonds Group
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BLACKROCK INVESTMENT INSTITUTE 11
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN U.S.
BlackRock co-founder Barbara Novick highlights underappreciated regulatory changes.
What do you see Washington getting done this year?
It is critical to look beyond the legislative efforts of the
White House and Congress. We have a lot of independent
regulators and agencies, and all have — or will soon have —
new heads who are eager to make their mark. As they staff
up, I see efforts to rightsize regulation gaining momentum.
Some people talk about this as if the sky is falling: repeal
of all rules resulting in polluted waters and banks running
amok. That narrative simply does not reflect reality. You
have to put it into context: We’ve seen an unprecedented
amount of rulemaking during the previous administration.
And now policymakers are reviewing and potentially
reversing some of it. This is about lightening the regulatory
burden by making rules more efficient and tailored.
That’s why I call it rightsizing regulation. It’s important this
happens in a thoughtful way. Some regulations had adverse
unintended consequences. An easing of regulations needs
to be well thought-out to avoid similar problems.
Why should investors care?
A lighter regulatory burden benefits business. This tends
to get lost in the noise coming out of Washington — and is
an underappreciated market force. Even just a business-
friendly or softer interpretation of current regulations can
reduce costs substantially.
Source: BlackRock Investment Institute, June 2017.
For example, most people would agree
the U.S. needs to replace and upgrade its
aging infrastructure. But many projects
get stuck in a quagmire of federal, state
and local permits, environmental reviews
and legal challenges. If you want to
attract private capital, you need clear and
enforceable rules, streamlined procedures, and a consistent
and predictable policy framework. This applies to much
more than infrastructure. Knowing the rules creates a
positive climate for companies to invest in their business.
Tax reform could help in that respect. Will it happen?
We have an incredibly complicated tax code. It’s a
bipartisan goal to have a tax system that is simple, fair and
globally competitive. Of course the problem is how you
define “fair,” both on the individual and corporate level.
Actual tax reform cannot be a complete budget buster, so
you’ll need some revenue raisers. This leads you into the
winners-and-losers problem that has vexed policymakers
on both sides of the aisle. Every exemption or deduction
affects a constituency that wants to keep it. Try to take
it away, and somebody is going to complain about it —
loudly. The bottom line is that tax reform is just really hard
and takes a long time to get over the finish line.
Barbara Novick BlackRock Vice Chairman
Regulatory reviewSelected examples of regulation-related U.S. actions and reviews, 2017
Industry Action Date
Financial
A new fiduciary rule for financial professionals is partially implemented but subject to ongoing review. May 22
Presidential memorandums instruct the U.S. Treasury to review the process for designating financial institutions as “systematically important” and the federal government’s orderly liquidation authority.
April 21
An executive order directs Treasury secretary and regulators to revise and review Dodd-Frank rules. Feb. 3
HealthAn executive order authorizes the heads of federal agencies to waive Affordable Care Act rules that impose any fiscal or regulatory burden.
Jan. 20
InfrastructureAn executive order allows governors and agency heads to request expedited environmental reviews and approvals for infrastructure works.
Jan. 24
Resources
U.S. announces intent to withdraw from the Paris Agreement on climate change. June 1
The Congressional Review Act is used to revoke the Stream Protection Rule. Feb. 16
An executive order advances the construction of the Keystone XL and Dakota Access oil pipelines. Jan. 24
TelecomsThe Federal Communications Commission (FCC) proposes to roll back 2015 Internet neutrality rules. May 18
The FCC loosens a 39% national cap on audience share for TV station owners. April 20
Transport The Environmental Protection Agency announces it will re-examine fuel efficiency standards March 15
BII0617U/E-169622-471642
12 POLITICS NOT QUITE AS USUAL
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN U.S.
Worrying about ItalyOur bigger concern: Italy. Anti-establishment parties
hostile to the euro have total support of about 45%, polls
show. The largest is the Five Star Movement, which has
promised a referendum on eurozone membership. Polls
show Five Star running neck and neck with former Prime
Minister Matteo Renzi’s Democratic Party heading into a
national election due to be held by May 2018. We believe
the election may be held as early as September after major
parties agreed on electoral reform in late May.
We see Renzi’s party stitching together another unhappy
coalition with a coterie of other parties on the center and
left. Forming a stable coalition will be daunting. Changes
to Italy’s electoral law have taken the system back to a
proportional representation that makes outright majorities
hard to achieve. The next coalition is likely to be weak and
fragmented, making structural reforms a challenge.
Italy has made limited strides cleaning up bad debts at its
troubled banks, including recapitalizing smaller banks and
encouraging bigger banks to raise capital. Yet the problem
remains sizable and is a brake on growth. The combination
of high debt levels, subpar economic growth, political
instability and looming ECB policy normalization could
lead to a spike in borrowing costs. The path to a rescue
package in any crisis would likely be a bumpy one, given
that eurozone assistance would be conditional on a stable
government able and willing to implement harsh reforms.
We believe Italy’s risks are only partly reflected in the yield
spreads of its government bonds versus German bunds.
See the Eurozone spreads in context chart. We expect
those spreads to widen as the election approaches and
could see them blowing out if Five Star wins. The party so
far has no allies in Italy’s parliament, but we cannot rule
out a coalition of convenience with the Northern League
and others. Bottom line: We see potential for an electoral
surprise that could rattle risk assets and peripheral bonds.
EuropeNationalist, anti-immigration parties are not going away, but Europe now has a window of
opportunity to reform and consolidate the EU so that it can endure.
Emmanuel Macron went from third place in the polls to
a large victory as French president in just four months —
all while remaining outside the mainstream parties that
have ruled France for decades. He could pave the way
for business-friendly reforms, with an immediate focus on
loosening the labor market. Even if Macron’s new party
falls short of an outright majority in the June parliamentary
elections, we believe he will likely be able to work with
centrists to pass legislation.
Macron’s victory came after the populist Freedom Party
underperformed high expectations in the Dutch elections
in March. Importantly, German Chancellor Angela Merkel’s
party has built a double-digit lead in the polls ahead of
the Sept. 24 federal election. Support for both the pro-EU
Social Democrats and populist AFD has faded, and Merkel
looks set to win a fourth term in office just as Macron
begins his term. Together, Macron and Merkel have the
potential to consolidate and revive the European project.
Eurozone spreads in contextEurozone government bond spreads, 1992-2017
Spre
ad v
s. G
erm
an b
und
s
1992
0
2
4
6
8%
1997 2002 2007 2012 2017
Introduction of the euro
Lehman collapse
SpainItaly
France
Draghi “Whatever it takes” speech
Sources: BlackRock Investment Institute and Thomson Reuters, May 2017.Notes: The lines show the difference between the countries’ 10-year government bond yields and German 10-year bund yields in percentage points.
BII0617U/E-169622-471642
BLACKROCK INVESTMENT INSTITUTE 13
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN U.S.
Currency confidence comebackEuro and sterling option trading trends, 2007-2017
Ris
k re
vers
al v
ola
tilit
y
2007
-5
-4
-3
-2
-1
0
1%
2009 2011 2013 2015 2017
Sterling
Euro
Speculation on currency appreciation
Greece’s first bailout request
Brexit vote
Speculation on currency depreciation
▲
▲
Sources: BlackRock Investment Institute and Thomson Reuters, May 2017.Notes: The chart shows risk reversal for sterling and euro versus the U.S. dollar, based on trading of one-year options. A positive risk reversal means the volatility of calls is greater than the volatility of similar puts. This implies that more market participants are betting on a rise in the currency than on a drop, and vice versa if the risk reversal is negative.
Delivering reformsOptimism on Europe’s outlook is building. Investors are
seizing on the improving political outlook and upbeat
data signaling stronger growth. See the European wakeup
call chart. Net equity purchases were a record in the week
around the finale of France’s presidential election.
Many eurozone countries are in need of structural reform.
As the region’s biggest growth and debt laggards, France
and Italy are especially important. We see reforms in both
as key to reassuring Germany about the willingness of the
EU’s other core members to become more competitive.
Italy’s Renzi initiated some labor market and insolvency
reforms, but that drive stalled. The OECD has listed
reforms that could lift growth by 6.3% over a decade.
These include: reducing regulation and administrative
burdens, loosening up the labor market, encouraging
more female participation and cutting taxes for low-
income earners, it argued in a 2015 report.
Macron’s proposed reforms include increasing labor
market flexibility, shrinking the government’s role in the
economy, cutting business social security contributions
and corporate taxes (the highest in the EU), and reducing
regulatory burdens.
European wakeup callEuropean equity flows and economic activity, 2013-2017
Net
flo
w (b
illio
ns)
PMI level
2013
-6
-4
-2
0
2
4
6
$8
Flow
2014 2015 2016 2017
44
46
48
50
52
54
56
58
Eurozone PMI
Sources: BlackRock Investment Institute, EPFR and Markit, May 2017.Notes: The bars show weekly net flows into Western European mutual funds and ETFs. The line shows the eurozone composite purchasing managers’ index (PMI). A number above 50 indicates expansion.
Macron will likely face resistance, with unions fighting
attempts to increase flexibility in the implementation of
labor laws. Yet he is likely to succeed in pushing at least
some reforms through, we believe. Germany could do
its part to boost growth and reduce imbalances, such as
encouraging stronger wage gains to stimulate consumer
spending and launching more public investment. Europe-
wide burden sharing or pooling of risk have so far been a
much harder sell in Berlin.
Investors have become less worried about eurozone
breakup risks, as seen in currency options pricing in the
Currency confidence comeback chart. Speculative bets on
euro depreciation are the smallest since 2009. Spreads on
selected peripheral government bonds such as Italy’s look
a bit complacent to us, given the risks reforms won’t be
carried out or watered down.
“ Sovereign risk premiums for political risks and reform implementation are still not sufficient, especially for Italy.”
Scott Thiel — Deputy Chief Investment Officer of
BlackRock Global Fundamental Fixed Income
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14 POLITICS NOT QUITE AS USUAL
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN U.S.
Not created equalBlackRock Sovereign Risk Index for Europe, April 2017
BSR
I sco
re
DE
Fiscal space
NL UK IE BE FR ES IT PT GR
-1.25
-1
-.75
-.50
-.25
0
.25
.50
.75
Overall
Willingness to payExternal financeFinancial sector
Sources: BlackRock Investment Institute, May 2017. Notes: The data are based on the BlackRock Sovereign Risk Index (BSRI). The BSRI draws on a pool of more than 30 measures spanning financial data, surveys and political insights, and provides investors with a framework for tracking sovereign credit risk in 60 countries.
Window of opportunityWe believe policymakers now have the best chance
for reform in decades. The two largest countries and
long-time drivers of integration, Germany and France,
are poised to have pro-European, newly legitimized
governments. The region’s growth outlook is the brightest
since the financial crisis. Dealing with Brexit, migration
and the new U.S. administration is pushing the EU toward
a united front. Merkel pointedly said Europe must take its
fate in its own hands after trans-Atlantic meetings in May.
Pursuing deeper integration could involve a defense
union, greater fiscal and tax coordination, and lifting of
services barriers. We see progress on the Capital Markets
Union and European Banking Union as indications of
policymakers’ resolve. Bottom line: We see a window of
opportunity for the EU to complete the single market.
Forged in crisesPeople only accept change when they are faced with
necessity, and only recognize necessity when a crisis is
upon them, EU architect Jean Monnet once noted. We see
the populist uprising and other strains as both a wake-up
call and opportunity for the EU to improve its governance
and responsiveness to the economic ills of citizens.
Europe’s recent history of integration is one of big steps
taken only when forced by a crisis, as epitomized by the
eurozone’s repeated summits and emergency decisions
during the debt crisis. This has fortified the region’s
ability to respond to countries running into economic and
financial troubles. The ECB can intervene in asset markets
to limit fragmentation and it now oversees banking
regulation. The European Stability Mechanism provides
a financial firewall by providing emergency loans to
countries in need. That makes the eurozone well equipped
to handle crises in all but the largest economies.
Current account deficits have been curtailed, but structural
imbalances remain and eurozone economic convergence
has stalled or reversed in some cases. Wide North-South
differences in fiscal dynamics and economic fundamentals
exist, as illustrated by our BlackRock Sovereign Risk Index.
See the Not created equal chart.
Europe is now discussing its future shape while trying
to manage differences in policy, economic growth and
development among its members. Macron has revived
debate of a central eurozone budget and the long-taboo
subject of fiscal transfers. This would mean countries
pooling some revenue and having a eurozone finance
minister, with funds used for investments and counter-
cyclical spending such as unemployment insurance.
The ambitious proposal has its challenges, including how
the democratic oversight would be managed. It also faces
deep hostility in parts of the German political world. Berlin
has promised to keep an open mind and is open to treaty
changes, although these are tough as every country has to
ratify them. Dealing with economic migrants and refugees
is another big challenge. Recent immigrants need to be
integrated into the workforce. For now, a deal with Turkey
has helped stem the inflow of new asylum seekers, but any
collapse in this arrangement could strain EU solidarity.
“ Don’t underestimate the potential for the Macron-Merkel relationship to be a driving force toward reforms and faster EU integration down the line. It could lead to positive surprises for equities.”
Zehrid Osmani — Co-Manager of Pan European
portfolios, BlackRock’s Fundamental Active Equity
Click to view interactive data
BII0617U/E-169622-471642
BLACKROCK INVESTMENT INSTITUTE 15
FOR INSTITUTIONAL, PROFESSIONAL, WHOLESALE AND QUALIFIED INVESTORS/CLIENTS. FOR PUBLIC DISTRIBUTION IN U.S.
The former UK Chancellor of the Exchequer shares his thoughts on Brexit negotiations.
Bracing for BrexitThe UK faces a big test in negotiating the terms of its exit
from the EU. The key risk we see: The UK exits without
making a deal or agreeing on an implementation phase by
the deadline of March 30, 2019.
Prime Minister Theresa May called a June snap election
with the aim to enlarge her Conservative Party’s majority.
This should give her government a freer hand to negotiate
a smoother Brexit process with the EU and steer a deal
through parliament. A narrowing of the polls just ahead
of the June election — perhaps partly reflecting the anti-
establishment currents running through politics today
— threatened this plan. A small majority, one similar to the
pre-election balance, would raise the risk that Brexit talks
fall hostage to euroskeptics.
Some UK officials scoff at reported EU demands of a €60-
100 billion divorce bill, and say that no deal is better than
a bad deal. Most of us feel a “no deal” appears unlikely,
given the potential economic damage it could cause on
both sides. Exporters might suddenly face tariffs and
customs checks, for example. Any market fright of a “no
deal” outcome would likely send sterling even lower.
How likely is a “no deal” Brexit?
There’s a material prospect of no deal.
To get a deal that will satisfy the UK
government, the House of Commons,
EU members and their respective
parliaments plus the European Parliament
— that’s going to be a major challenge.
It’s very easy to see how it would be possible to end
up with no deal. One of the stumbling blocks will be
determining any transition agreement. Whether it’s
determining enforcement, the role of the European Court
of Justice, the applicability of free movement, it’s going to
be quite complicated.
If you listen clearly to the EU about a transition period, it
does not want a special third regime for the UK and does
not want to spend a huge amount of time on this.
Our base case: an outline agreement starting with a two-
to three-year implementation phase. We see the UK and
EU limiting customs barriers. UK exporters would keep
tariff-free access, with some non-tariff barriers in services.
The UK would likely lose its “passporting” ability to sell
financial services across the EU. Financial firms are already
preparing, and are moving some activity to EU financial
centers. We do see a possibility of a negotiated agreement
involving close regulatory cooperation and perhaps
financial joint-supervision, something the UK Treasury and
Bank of England (BoE) have long resisted. And job losses
may not be as large as initially feared, with shifts likely to
take several years. The range of outcomes is wide.
We see the BoE looking through any short-term Brexit
impact unless fears of a “no deal” and a significantly weaker
currency drive a sustained inflation surge. The UK jobs
market remains strong, with the unemployment rate at
four-decade lows. We see the British pound struggling
to strengthen beyond $1.30. The BoE is likely to remain
accommodative, we believe, given signs of weakness in
consumer spending and the clear vulnerabilities Brexit
poses to the medium-term outlook.
What’s the middle ground and what would “no deal” mean?
The UK government is going to have to accept some EU
conditions. This is a deal that the UK needs more than
Europe does. The Europeans are playing quite hard ball
knowing the UK needs an interim agreement. It would be
pretty bad for the UK to crash out of the EU without any
follow-up agreement. The government would do things to
minimize the impact. It would still be quite a jolt to not have
any trade or security arrangements with our neighbors.
Assuming May leads the negotiations, can she strike a
working relationship with Macron and Merkel?
It’s very important. It would help to have the same cast of
characters and no major elections in France and Germany
over this critical period. These three leaders will need to
get to know each other. Some of the recent language has
been heated. There should be more constructive dialogue
to build trust and less playing to the galleries at home.
George OsborneSenior Advisor, BlackRock Investment Institute
BII0617U/E-169622-471642
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Lit. No. BII-POLITICS-0617 8663A-US1-0517
BlackRock Investment Institute
The BlackRock Investment Institute (BII) provides connectivity between BlackRock’s portfolio managers, originates
economic and markets research, develops investment views for clients, and publishes 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 VICE CHAIRMANPhilipp Hildebrand
GLOBAL CHIEF INVESTMENT STRATEGIST Richard Turnill
HEAD OF ECONOMIC AND MARKETS RESEARCHJean Boivin
EXECUTIVE EDITORJack Reerink
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