Positioning for a Transatlantic Divide

Quick read:

The post-pandemic expansions of the US and Europe have been a study in contrasts. We believe that labor market, industrial policy, and fiscal divergences can continue in upcoming quarters.
Macro divergences have implications for interest rates, and we are positioned long European government bonds and short North American government bonds in portfolios to potentially capitalize on growth, inflation, and policy divergences.

The current global expansion has been characterized as one of US exceptionalism. Despite many developed market economies outperforming low expectations, the robustness of the US expansion has stood out. We believe this can continue based on differences between the US and European economies related to:

Labor productivity,
Industrial policy, and
Fiscal deficits.

We position for Transatlantic growth and deficit divergences to further widen the interest rate differential between the US and Europe. In portfolios like the BlackRock Tactical Opportunities Fund, we express this with long-short government bond positions. We hold long duration exposure across European government bond markets against short duration positions in US Treasuries. The upward trajectory of the US deficit also keeps us positioned for a relative steepening of the US yield curve against those of more austere European economies.

Fortune favors a dynamic labor market

Government and business responses to the pandemic in the US and Europe were a study in contrasts.¹ Policy choices in the US facilitated a historic labor market churn, with over 25% of the labor force changing employment status in 2020.² In contrast, European policies encouraged workers to remain underemployed in idled industries and resulted in labor market stasis. As a result, US workers reshuffled and rematched to new firms and industries whereas the European workforce largely remained attached to their pre-pandemic employers.

The plot below illustrates how US labor market churn reallocated workers in a way that is boosting labor productivity. American workers moved out of low productivity industries and into higher productivity sectors of the economy. There was also the greatest amount of employee churn within high productivity sectors, better matching skills within those industries. The overall effect is that Americans improved their employment matches, particularly within innovative sectors, which should deliver more productive growth going forward.

Reshuffling of the American labor force during the pandemic favored higher productivity jobs

The contrast in worker mobility has been accompanied by a divergence in business formation rates across regions. New business applications in the US jumped in 2020 and have since remained ~30% higher than their pre-pandemic average.³ In contrast, new business registrations across the European Union remain roughly at the same level today as they were in 2019.⁴ By this measure, the difference in business dynamism across the two regions has never been larger.

While productivity is notoriously difficult to measure and subject to revisions, the latest data indicate that US economic efficiency is already benefiting from the labor market reshuffle and new business formation. The chart below indexes labor productivity across the two economic blocs back to 2012. A 10% difference in economy-wide productivity has opened since the pandemic and that wedge appears to be widening further in recent quarters.⁵

Labor productivity has diverged by 2 percentage points per annum since 2019

Made in America

Numerous factors contribute to Europe’s anaemic new business formation, but the erosion of the European industrial base relative to the US has been ongoing for over a decade. Since 2009, European electricity and gas production has declined by 15% while American energy production has grown by 6%.⁶ The European combination of expensive energy paired with onerous regulation contrasts with the US shale innovation that has made America a leading exporter of fossil fuels. This wedge in energy availability was exacerbated by the Russian invasion of Ukraine and all of it raises the relative cost of doing business in Europe.

The relative attractiveness of locating manufacturing in America has been intensified by the industrial policies of the Biden Administration. The CHIPS & IRA legislation have created a set of subsidies, tax incentives, and domestic content protections that have “crowded in” private sector investments. The plot below shows the differences in manufacturing investment that has been associated with the headlines “Intel’s $20B Arizona chip plant project poised to make national impact” and “Germany’s chip ambitions hit after US tech group shelves plant plans.” In our view, this divergence in capital investment in key growth industries is likely to keep American growth outpacing Europe for years to come.

US investment in manufacturing structures has outpaced European investment by a factor of 10 since 2020

US fiscal policy is increasingly unsustainable

The relative dynamism of US labor markets and business investment has been greased by government support. Government support for businesses and workers during the pandemic and incentives for recent infrastructure investments have been costly; the budget deficit in the US continues to track over 6% of GDP. In contrast, European budgetary rules that were loosened during the pandemic have been reinstituted and there has been no convincing European answer to US industrial policy. The net result has been a material divergence of budget deficits on both sides of the Atlantic.

Differing government structures make market-relevant budgetary comparisons challenging. We create a harmonized measure of deficit sizes that accounts for central bank purchases and the maturity of the new debt issuance.⁷ This measure of 10-year equivalent bond issuance relative to GDP is the duration issuance that must be absorbed by the private sector. This measure highlights the differing debt trajectories across the regions that began in 2016 but has extended since the pandemic. US duration net supply is projected to increase by a further 10% in 2025 while the European deficit trajectory is downward as the fiscal conversations have focused on scaling back government spending and raising additional revenues.⁸ This divergence of relative bond supply is historically associated with widening of government bond yields across the regions.

The Transatlantic divergence in fiscal policy is wide – and getting wider

What does it mean for portfolios?

In our tactical multi-asset portfolios like the BlackRock Tactical Opportunities Fund, we seek to deliver diversifying returns that are lowly correlated with stock and bond markets. We do so primarily by seeking out relative value opportunities across countries’ stock, bond, and currency markets.

Our insights on divergent growth and budget dynamics across the US and Europe currently inform our fixed income positioning across portfolios. Though productivity growth in the US may help to offset some inflationary pressures, more robust US nominal growth should keep long-dated bond yields elevated versus yields in the slower growing Eurozone. And while the outcome of the US election will shift spending priorities, we see no political consensus to address the expanding US deficit. We hold short US Treasuries and long German Bunds positions into year-end to capitalize on this macro divergence.

Source

¹The US offered cash assistance to displaced workers (stimulus checks) and forgivable loans to impacted businesses (Paycheck Protection Program loans) to grease a great reshuffling of workers and employers throughout the labor market. In contrast. European policy subsidized short-term workers and wages, which encouraged workers to remain with existing employers.
²Source: US Census Bureau, September 2024.
³Source: US Census Bureau, September 2024. Seasonally-adjusted annual business applications jumped from ~300,000 to >400,000 in 2020 and have remained at that higher level since.
⁴Source: Eurostat EU27: New Business Registrations, September 2024.
⁵This regional difference in labor productivity helps to explain the difference in wage inflation too. In the US, wages surged in the aftermath of the pandemic, as workers switched from low productivity jobs to higher paying roles. As this “levelling up” process has run its course, US wage inflation has cooled swiftly, even if not to a pace consistent with 2% inflation. In contrast, European wage growth only accelerated years later when surging overall inflation pushed workers to recoup purchasing power. This has implications for corporate profitability: high US wage inflation reflected a surge in underlying labor productivity and therefore did not dent profitability; high European wage inflation reflected a catch up in real wages to rising cost of living, which would have eroded any benefit European firms got from higher pricing power.
⁶Source: BlackRock with data from Bloomberg, September 2024.
⁷Note that the early pandemic-era fiscal stimulus in the US did not add to the net supply of publicly available duration because of the magnitude of the Federal Reserve’s early 2020 asset purchases.
⁸This projection is highly sensitive to an assumption of the maturity profile of issuance next year. We have assumed that the share of issuance from bills is unchanged from 2024’s figures; any downward adjustment of the bills share would lift the projection of net duration supply even further. The Draghi Report recently recommended European authorities invest an additional 5% of GDP in the areas such as energy and defense which could add 2-3% of GDP in 10yr equivalent issuance in Europe. If this were to eventuate, it would still leave a significant gap with the US.

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The opinions expressed are as of November 2024 and are subject to change without notice.

Investing involves risk, including possible loss of principal.

This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This material is strictly for illustrative, educational, or informational purposes and is subject to change.

Prepared by BlackRock Investments, LLC, member FINRA.

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