The much-hyped synchronized global expansion of 2017 has long receded in the rearview mirror as global growth reached its zenith around the turn of the year. But growth has not only plateaued, it has also become more uneven across regions this year. Accordingly, the current market narrative emphasizes increasing economic divergence and differentiation between and within asset classes, both of which are typical of an aging expansion. We agree, as our regular readers will know.
So much for the nowcast, but what lies ahead for macro and markets over our six- to 12-month cyclical horizon? Are we still at the “beginning of the end” of the economic expansion, as we concluded at our March Cyclical Forum, or is the end near? Conversely, are there reasons to be more optimistic on the growth outlook in the face of tax reform and strong profit and GDP growth in the U.S.? And have the sell-off in emerging markets and the widening in credit and European peripheral spreads created buying opportunities?
To discuss these and other questions, PIMCO’s investment professionals and several of our trusted senior advisors recently gathered in Newport Beach for the September Cyclical Forum. As some participants noted at the outset, a few of the “rude awakenings” that were incorporated in the longer-term theme coming out of our annual Secular Forum in May have already manifested in the last several months, including the intensification of the China-U.S. trade dispute, the brewing conflict between the EU and the populist Italian government, and of course the recent turmoil in emerging markets – all of which underscore our secular emphasis on caution and liquidity.
We agreed that these recent political and market developments are relevant for the cyclical outlook because they have tightened global financial conditions and increased political and economic uncertainties, which are all likely to damp corporate and consumer “animal spirits” around the world.
"Our cyclical baseline sees this year’s economic divergence giving way to a more synchronized deceleration of growth in 2019."
Against this backdrop and with the fiscal stimulus in the U.S. starting to fade next year, our cyclical baseline sees this year’s economic divergence – with U.S. growth accelerating but the rest of the world slowing – giving way to a more synchronized deceleration of growth in 2019. In our forecasts, the big three – the U.S., the eurozone and China – should all see lower GDP growth in 2019 than this year: Growing, but slowing.
However, economic activity in the major economies, while slowing, is still likely to keep expanding at an above-trend pace and thus absorb more of any remaining slack in labor markets over our cyclical horizon. In response, we expect the major central banks to continue to remove accommodation gradually:
- Following the expected September increase in the fed funds target range to 2.0% to 2.25%, we expect the Federal Open Market Committee (FOMC) to hike rates three more times by the end of 2019, thus aligning rates with FOMC members’ median estimate of the longer-run neutral rate.
- In the meantime, while the Federal Reserve will likely continue to run down its balance sheet over our cyclical horizon, it is possible that it ends the process by the end of 2019.
- We expect the European Central Bank (ECB) to end its net asset purchases by the end of this year but to keep reinvesting maturing bonds for the foreseeable future. A first hike in the deposit rate, which currently stands at minus 40 basis points, looks unlikely before the second half of 2019 and may be delayed even further if core inflation fails to pick up by as much as the ECB staff currently forecasts.
- The Bank of Japan (BOJ) is likely to stick to its recently introduced soft forward guidance of unchanged official rates – an overnight rate of minus 10 basis points and a 10-year JGB yield of 0% – over our cyclical horizon, but a further tweak in the operational yield curve control policy sometime next year seems likely in order to facilitate a further steepening of the curve that would support Japanese financial institutions.
In our discussions, we viewed the risks around our “growing but slowing” baseline as broadly symmetric, with trade policy being the main near-term swing factor for better or worse outcomes.
- Our macro team’s baseline forecasts incorporate the recently announced next round of tariff increases between the U.S. and China – with the U.S. imposing tariffs on an additional $200 billon of imports from China and China retaliating with tariffs on an additional $60 billion of U.S. goods.
- In a more adverse trade-war scenario, where the U.S. imposes tariffs on all imports from China and introduces tariffs on imported autos and parts from various countries, and the trading partners retaliate with tariffs and, in the case of China, a large currency depreciation, we would expect a sharp slowdown in U.S. and global growth, though an outright recession would still likely be avoided.
- Conversely, in the event that peace breaks out on trade, deals are done, and all the recently imposed and some of the already existing tariffs are reduced, global growth could be maintained at the current rate over our cyclical horizon.
"Trade policy is the main near-term swing factor."
Other risks we highlighted and discussed at the forum include the brewing conflict in Europe over the Italian budget and potential upside risks to business investment in the U.S. in response to strong earnings growth, deregulation and rising capacity utilization.
Fifth set, no tie break
While we reconfirmed our late-cycle thesis at the forum, one senior participant reminded us that a late-cycle environment can last a long time – in his words: “Think a fifth set at Wimbledon without a tie break.” It can last if excesses and major policy mistakes are avoided. So while being mindful of the risks of an early end, we think it is too early to run for the hills.
Indeed, a recession next year is not our base case, and so we expect to remain in the late-cycle stage for some time. So far, none of the domestic imbalances that typically precede recessions have developed: over-consumption, over-investment, a housing bubble or excessive wage growth. However, much will depend on whether or not the Fed will push rates significantly above neutral. As explained above, our base case is that it won’t, at least not next year, and that it will rather pause after raising rates to a roughly neutral 2.75% to 3.0% and end the balance sheet run-off in late 2019. Thus, while we continue to believe that a recession over our secular three- to five-year horizon is quite likely, it is not visible on our cyclical horizon yet.
By now it should be clear that our baseline for the cyclical outlook is fairly benign. Yet in terms of macro and markets, we want to pay very close attention to the broad set of risks around that baseline.
In the coming months we will get confirmation of whether the Fed is likely to end its rate-hike cycle at close to neutral or whether we see a shift to outright tight monetary policy in the U.S. The ECB will join the tightening with the expected end of quantitative easing and – likely in the second half of 2019 – the start of policy rate hikes. The BOJ has already reduced significantly the quantity of its JGB purchases, and we expect further adjustments in its yield curve targeting regime aimed at higher yields and a steeper curve.
"A late-cycle environment can last a long time if excesses and major policy mistakes are avoided."
While our baseline is for a global economy that is “growing but slowing,” there is the potential for higher macro uncertainty and volatility. Core inflation in the U.S. is set to rise above the Fed’s target at a time when the labor market is tight. Populism is a risk in the outlook from the U.S. to Italy to a number of systemically important emerging markets.
This macro and market volatility comes at a time when, in many markets, volatility is low and valuations are fair to stretched. While the growth cycle may continue, we see risks of more difficult market environments ahead and the testing of market liquidity and structure, notably in credit markets.
In our portfolio construction we think it makes sense to emphasize caution and the range of risks outside the baseline. We want to maintain flexibility to respond to both positive and negative shocks. As we said in our May Secular Outlook, if we need to give up some portfolio yield in exchange for this flexibility – for example, by holding more highly liquid short-term instruments – then that looks like a reasonable trade-off in the current environment. We will look to generate income across a broad range of sources, without relying on corporate credit overweights. We cannot precisely predict the timing of the turn in the credit cycle, but we can try to ensure that we are well-prepared for the event.
Duration: Modest underweight
We continue to believe that the New Neutral framework of low equilibrium policy rates anchoring global fixed income markets remains appropriate. While our baseline is for range-bound global markets, we see a higher probability of a significant rise in yields versus a significant decline, and so expect to maintain modest underweights in our duration positioning.
The level of yields in the U.K. is very low relative to history and relative to the U.S., in particular. Given our expectation for an orderly Brexit process – in spite of both headline and real tail risk – we think it makes sense to be underweight U.K. duration. And while maintaining global durations at fairly close to benchmark weights, we see a special case for underweighting Japanese duration, given the likelihood of ongoing shifts in the BOJ’s yield-curve-control approach and as a hedge against an unexpected significant rise in global yields that would, with a lag, be reflected in Japan.
The U.S. curve looks flat, versus history or versus some other developed markets, and while there are significant risks in the outlook, we see U.S. recession risk as quite limited over the next year. The impending end of the U.S. rate-hike cycle, the prospect of higher market volatility – with less volatility suppression on the part of global central banks – and some upside inflation risk in the U.S. reinforce our structural bias toward curve-steepening positions in our portfolios, to earn income by overweighting the intermediate part of the curve. We see better risk-reward in terms of the diversification benefits of curve positioning versus large duration positions.
Cautious on corporate credit
We expect to be modestly underweight in corporate credit risk, reflecting fairly tight valuations, concerns about market liquidity and crowded positioning after multiyear flows into credit. It is quite likely that credit will continue to perform well over the cyclical horizon, but we think it is prudent to operate from an underweight position given highly uncertain liquidity in any flight to quality and steadily deteriorating underwriting standards. When the credit cycle turns, we want to be in a position of strength as liquidity providers and not forced sellers. In the meantime, we want to avoid generic investment grade and high yield cash corporate credit. We intend to emphasize instead a broad range of shorter-dated “bend-but-don’t-break” credit positions, which we would expect to perform well even in a more challenging environment, as well as the best relative value views from our global credit team.
Overweight structured credit
We continue to want to be overweight in non-agency mortgages and more broadly in structured products as our highest conviction spread position, based on valuation, the defensive nature of the credit exposures, and the limited risk of outright losses. We also see agency mortgage-backed securities as reasonably priced and a good source of income.
Currencies and emerging markets: Low scaling
We have a broadly balanced view on the U.S. dollar versus other G-10 currencies, reflecting limited valuation anomalies across markets and our expectation of more balanced growth across developed countries after 2018’s divergence. We expect to maintain small overweights in emerging market (EM) currencies, but with low scaling reflecting both attractive valuations and the significant uncertainty in the outlook across countries. Cheaper valuations and/or evidence that trade tensions will remain contained and that the Fed rate-hike cycle is ending would be key factors that could lead us to take a more positive view on EM currencies and EM markets more generally, in addition to our assessments of the path for politics and other idiosyncratic risks across countries.
Cautious on European peripherals and credit
As outlined in our Secular Outlook, with central banks more uncertain actors over the longer term, we plan to seek limited exposure to sectors that rely heavily on central bank support. The end of the ECB’s quantitative easing and the increase in supply that private sector investors will have to absorb were always going to be a challenge. The fact that Italy now has an unpredictable populist government makes the challenge harder still. Given valuations, we think it makes sense to take a cautious approach on Italy and other European peripherals and on European corporate credit risk.
Equities: Favor defensives over cyclicals
Turning more broadly to asset allocation, we expect that the late-cycle environment of Fed policy tightening, some upward pressure on inflation and increased protection will present headwinds to equity-multiple expansion. This “growing but slowing” cyclical view suggests reduced return expectations. It makes sense in this environment to shift toward greater defense by upgrading portfolio quality, with a focus on growth durability and scaling back exposure to cyclical beta. We favor less cyclical, more profitable U.S. equity markets to the rest of the world and prefer high quality large-cap equities at this stage in the cycle.
Commodities: An attractive late-cycle investment
Commodities as an asset class have historically performed best toward the end of economic expansions. Related, robust economic activity has combined with supply-side constraints, some of which are politically induced, to support the return outlook, and the income generation from a collateralized commodity investment is in meaningfully positive territory for the first time since 2014. This constructive outlook is by no means uniform across the space as the constraints on the supply side differ by commodity. We remain most constructive on petroleum as the U.S. decision to reinstitute sanctions on Iran will effectively eliminate any remaining spare capacity in global oil markets.
Regional economic forecasts
Following expansion of close to 3% this year, we expect real GDP growth to slow into a below-consensus 2% to 2.5% range in 2019, reflecting less support from fiscal stimulus, the ongoing removal of monetary accommodation, a stronger dollar and a less favorable trade and external environment.
Yet, with economic growth remaining above potential (about 1.8%), job growth should average around 150,000 per month and the unemployment rate should decline further toward 3.6% or so. We expect core CPI inflation (2.2% on the most recent print) to peak at around 2.5% year-over-year in response to the lagged effects of tariff increases before moderating somewhat as inflation expectations should remain anchored and the (inflation) Phillips curve is quite flat.
Against this backdrop, following the expected September rate hike to 2% to 2.25%, we forecast three more increases in the fed funds rate by the end of 2019, bringing it up to FOMC participants’ median estimate of the long-run neutral interest rate of close to 3%.
We also see a distinct possibility that the Fed’s Board of Governors will decide to increase the countercyclical capital buffer later this year, which would require large banks to build an extra margin of capital over a period of up to 12 months and would be aimed at addressing financial stability concerns.
We expect eurozone GDP growth in a 1.5% to 2.0% range over the next year, down significantly from 2.5% in 2017 but still exceeding potential output growth. Recent PMIs (Purchasing Manager Indexes) point to a growing divergence within the eurozone, with Italy falling behind. This bears close watching given the anti-establishment government’s anti-euro leanings, which have been swept under the carpet for now.
Core consumer price inflation has been stuck at around 1% for several years now, but we expect it to pick up over the next year toward 1.4% as unemployment is likely to keep falling, wage growth has started to rise, particularly in Germany, and the euro has stopped appreciating. Yet, this would still fall short of the ECB’s own forecasts and keep inflation under the “below but close to 2%” objective.
Nonetheless, we expect the ECB to end net asset purchases by the end of this year, as already signaled by the central bank, and we think it is more likely than not that a first rate hike will be implemented during the second half of 2019. Viewed in conjunction with our view that the Fed will pause hiking at some stage next year and could finish running down its balance sheet by the end of 2019, this will make for an interesting divergence of monetary policy paths, with potentially significant currency implications.
We see nominal GDP growth in 2019 in line with consensus but expect a more favorable split between real output growth and inflation.
Our above-consensus forecast of real GDP growth in a range of 1.5% to 2% is based on our expectation that Brexit negotiations will make progress and a hard Brexit will be avoided. This should help domestic demand over 2019.
Our below-consensus inflation forecast sees inflation coming back below the 2% target over the course of next year as import price pressures fade and weak wage growth will keep service sector inflation subdued.
Against this backdrop, we see one to two additional rate hikes from the Bank of England over the next year.
We expect steady real GDP growth in Japan in 2019 in a 1% to 1.5% range, supported by a tight labor market and an accommodative fiscal stance.
However, with inflation expectations low and sticky and improving labor productivity keeping unit wage costs in check despite rising wage growth, core inflation is likely to creep up only slightly into a 0.5% to 1% range, remaining well below the ambitious 2% target.
While we don’t expect the Bank of Japan to raise official interest rates over our cyclical horizon, we anticipate a further stealth tapering of the JGB purchases, with lower purchases in the 10-plus-year sector contributing to a further steepening of the yield curve. This is aimed at easing some of the negative side effects of the low interest rate environment on the financial sector.
Our baseline forecast is for 2019 real GDP growth roughly in the middle of a 5.5% to 6.5% range that is meant to convey the large uncertainties around the outlook caused by the trade tensions with the U.S. and an economic policy that tries to satisfy partially conflicting targets (e.g., growth and employment versus financial stability and deleveraging). Our baseline assumes only the recently announced round of additional tariff increases between the U.S. and China and no further escalation. It also incorporates a fiscal expansion worth about 1% of GDP, focused on higher public investment and a tax cut for households.
Meanwhile, we project a moderate rebound of CPI inflation to 2.5% on rising energy and food prices and expect the People’s Bank of China (PBOC), which has reversed all of the tightening put in place in 2016, to keep interest rates and required reserve ratios unchanged over our forecast horizon. Any further currency depreciation against the U.S. dollar is likely to be moderate in our baseline scenario. However, in a full-blown trade-war scenario, we would expect monetary easing and a sharp currency depreciation of around 10%.