Global fixed income markets are flashing caution on “reflation trades” predicated on an expansionary economic environment. Positions that have recently come undone include betting on steepening yield curves and inflation expectations (inflation-linked over nominal bonds)—and in equity markets, picking value over growth shares. Yields have halted their late-2016 climb, curves have flattened, and market-based inflation expectations have waned.

Yet we believe these market moves mostly reflect a temporary flight to safety in the face of political uncertainties—rather than a breaking down of the underlying reflationary dynamic. We see this dynamic as alive and well, with the global economy moving from acceleration to a phase of sustained growth, as I write in my new Fixed Income Strategy piece Reevaluating reflation.

A recent pullback in headline consumer price inflation across developed economies has challenged the notion of steady, if unspectacular, increases in inflation from depressed levels. Yet core inflation in the U.S.—which strips out volatile food and energy prices—appears to be broadening, our analysis suggests, with an increasing share of Consumer Price Index components clocking gains. Global Purchasing Managers Indexes (“PMIs”) stand at six-year highs. And our BlackRock GPS, which combines traditional economic indicators with big data signals such as Internet searches, still points to above-trend growth as the global economy transitions from catchup to steady expansion.

We see steady economic growth and inflation extending the lifespan of the reflation theme without the need for further rises in the pace of those measures. Reflation is alive and well according to our definition: rising wages (albeit slowly this cycle) feeding stronger nominal growth, allowing lingering slack from the last recession to be gradually eliminated, stirring higher inflation over time. And to be sure, many financial asset prices still reflect a dominant reflationary view. Equity markets overall are buoyant. Global financials are holding up, despite a recent bout of underperformance, and credit markets are looking robust.

Credit spreads today look to be roughly where you would expect based on their historical relationship with global PMI levels, our analysis shows. See the chart below. Investment grade and emerging market debt spreads are right in line with the historical trend line since 2006.

High yield bond spreads are a little tighter than they should be according to the analysis. This highlights rich valuations, which contribute to our “up-in-quality” preference in credit. It implies today’s strong PMI levels are already priced in, with future returns in credit likely to be more muted than in the recent past. Returns will likely come mostly from income (or carry), not from further spread tightening, we believe.

Credit conundrum

The divergence between sovereign debt and the credit market’s pricing of reflation is on the surface a bit of a conundrum. One possible explanation is that when market uncertainty increases, investors have two choices as to how to reduce risk in their portfolios. They can sell risky assets such as credit, or buy less risky assets such as government bonds, adding a buffer to their portfolios.

Investors tend to choose the latter of these two options, since government bonds are a much more liquid asset class than credit, with lower transaction costs. U.S. Treasuries are also regarded as the ultimate hedge against geopolitical risks. Jitters around the recent French presidential election—not fears that reflation is dead—likely lie behind the recent flows into U.S. Treasuries, we believe, as risk-on and risk-off episodes are becoming increasingly global, our research suggests.

Bottom line

We see stable global growth and inflation helping the Federal Reserve make good on its promise to Normalize normalization. Global developed bond yields appear vulnerable to further increases as French political risk fades, leaving improving fundamentals as a longer run driver for eventual global policy normalization. We remain overweight U.S credit for its income potential, but prefer investment grade debt given elevated credit market valuations. We are underweight European credit and sovereign debt amid tight spreads and improving growth.

Read more market insights in my monthly commentary on fixed income markets.

Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.

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