Our cyclical baseline forecast through 2017 is for a continuous global economic expansion, mostly supportive monetary and fiscal policies and broadly range-bound markets. However, we are concerned about risks lurking beneath the surface, especially in the context of asset prices that in many cases appear stretched. The recent bout of market volatility that followed sedated summer trading may be a guide to what lies ahead: occasional regime switches between periods of relative calm (supported by benign macroeconomic data and sedative monetary policy) and periods of rising volatility and uncertainty caused by … “whatever.” This is why we favor a more cautious portfolio positioning despite our relatively benign baseline macro outlook, in line with our “Stable But Not Secure” secular theme.
Calmer C’s have arrived, but what’s next?
When PIMCO’s investment professionals gathered earlier this month for our September Cyclical Forum, the macro and market backdrop was very different from the one before our previous Cyclical Forum in March. Back then, recession fears were still lingering after the sell-off in risk assets earlier in the year, a sharp slowing of the U.S. economy, and concerns about China and the emerging market commodity complex. Yet, we decided to dismiss the recession fears and coalesced around a cautiously optimistic cyclical outlook for 2016 (see “Calmer C’s Ahead? China, Commodities and Central Banks Dominate the Global Outlook ”).
Since then, the global economy and markets have broadly followed our script despite a pothole in U.S. growth in the first half of the year and the Brexit shock. More dovish central banks, an orderly rather than disruptive depreciation of the Chinese currency and a stabilization of the dollar on the back of the late February G-20 “Shanghai co-op” have helped maintain the status quo. In short, over the past six months, the global economy and markets arrived in the calmer seas that we anticipated back in March. And looking ahead, the resulting easing in broad financial conditions in the course of this year provides a helpful tailwind for near-term cyclical developments in the remainder of 2016.
Our baseline forecast: Lackluster but longer
Expansions don’t die of old age; they die because something kills them. History suggests that the assassin has usually been the central bank (reacting to an overheating economy), or a major oil price shock, or the bursting of a credit-fueled housing bubble. Our forecast for 2017 is for ongoing growth because we don’t expect “something” will show up – central banks are still fighting the opposite of overheating, oil prices seem capped by more elastic supply and credit and housing are not exactly booming. Hence, global recession risks appear to be contained over our cyclical horizon despite more lackluster trend growth than in previous cycles.
In numbers, we expect world GDP growth to pick up slightly from around 2.5% this year to 2.5%–3.0% in 2017 (see table). With core inflation expected to remain below target in most major developed market (DM) economies, monetary policy will likely remain accommodative overall, and fiscal policy is more likely to ease than tighten over the next year in most countries.
DM: More of the same overall, but mind diverging dynamics
Meanwhile, growth in DM as a whole in 2017 is likely to hover sideways in a range around this year’s 1.5% pace. Yet, growth and policy dynamics within DM should diverge substantially:
- We see U.S. growth returning to a 2%–2.5% channel in 2017, following the 1% soft patch during the past three quarters, helped by an expected end of the inventory correction and a revival of business investment amid ongoing robust consumer spending. With potential GDP growing at only 1%–1.5%, the remaining output gap is likely to disappear in the course of next year and slack in the labor market should erode further. This, together with a rise in headline CPI inflation from 1.1% year-over-year as of August to 2%–2.5% during 2017, will likely allow a data-dependent Federal Reserve to raise rates two or three times between now and the end of 2017, while markets price in only one hike.
- In Japan, we also expect somewhat higher growth of 0.5%–1.0% in 2017, helped by significant fiscal stimulus. With fiscal policy turning expansionary, the chances for monetary policy to find more traction have improved as well, particularly as the Bank of Japan just recalibrated its easing program with a view to minimizing the negative side effects on the financial sector. Still, we expect the quest for 2% inflation to remain elusive also in 2017, not to speak of the Bank of Japan’s newly adopted objective to overshoot the 2% target.
- Eurozone growth momentum should remain broadly unchanged in a 1%–1.5% range in 2017 and thus above potential output growth of at most 1%. Yet, with inflation unlikely to make much progress toward the European Central Bank’s (ECB) “below but close to 2%” objective, we expect a further round of monetary easing in December of this year. It will likely include an extension of quantitative easing (QE) beyond March 2017, some changes in the technical parameters of the program to address the “bund scarcity” problem and potentially a further cut in the deposit rate. Additional easing next year cannot be excluded, and if the ECB were to consider venturing into buying an additional asset class, equities would be the most obvious next choice.
- Our baseline sees UK growth slowing temporarily into a broad 0%–1% range in 2017 as Brexit-related uncertainties damp investment spending and make consumers more cautious. However, easier monetary and fiscal policies as well as the lagged effects of a weaker currency should help to contain the damage. Inflation should pick up toward and above the 2% target in the course of 2017 as the pound’s weakness is likely to feed through into import prices and inflation expectations.
The delta is in EM
A key feature of our 2017 baseline forecast is better prospects in emerging markets (EM), where we see aggregate GDP growth accelerating from some 4.5% this year to between 4.75%–5.25% next year.
External conditions for many EM economies have improved due to the stabilization of commodity prices and the U.S. dollar. Internal conditions are more conducive to growth, too: Inflation has likely peaked, giving central banks room to ease, and several countries are making progress on structural reforms. Also, with the deep recessions in Brazil and Russia now likely to end and give way to a moderate recovery, a major drag on EM aggregate growth should disappear.
Regarding China, our base case is that the ongoing rebalancing from investment to consumption leads to a further gradual slowdown in growth, which continues to be overstated by the official statistics. However, the hard landing in the industrial complex, which is what matters most for global trade and commodities, has already happened in recent years – evidenced by the past decline in commodity prices and dismal growth rates of industrial output, exports and imports. This, together with our expectation that further currency depreciation will be gradual and orderly, suggests that China won’t throw major spanners in the wheels of the global economy and its EM peers over our cyclical horizon.
Benign baseline, but zero room for complacency
While our baseline scenario of ongoing global growth helped by better EM fundamentals and supportive policy is relatively innocuous, there is no room for complacency, for three reasons:
- First, asset markets seem fully priced for a very benign outcome and thus vulnerable to even small negative surprises.
- Second, as we explained in our Secular Outlook in May, we are concerned about longer-term risks that are lurking beneath the surface, such as high debt levels, diminishing returns to monetary easing and the longer-term consequences of rising populism.
- Third, even if these bigger secular risks remain contained, a lot can derail our and the (similar) consensus baseline forecasts even over the cyclical horizon. Therefore, we actually spent more time at the forum discussing the swing factors that could drive left tail or right tail outcomes, rather than the baseline itself.
Enter the three P’s: Productivity, policy and politics
In our view, the most relevant swing factors for the cyclical outlook are productivity, (monetary and fiscal) policy and politics. The simple framework is as follows:
- Productivity drives the supply side of the economy and thus potential output growth;
- Policy is the main determinant of aggregate demand and thus of the fluctuations of actual GDP relative to potential (the “output gap”); while
- Politics enters the forecast equation as the main non-economic source of uncertainty and volatility.
Stronger productivity: Blessing or curse?
Declining productivity growth in recent years has been the main culprit in the slowdown of potential output growth and for declining estimates of the neutral rate of interest (r*), which figures prominently in central banks’ thinking about the appropriate current and future policy stance (e.g., see this piece by the chair of PIMCO’s Global Advisory Board, Ben Bernanke).
The consensus now seems to take a continuation of weak productivity growth for granted. Yet, as guest speaker Olivier Blanchard reminded us at our annual Secular Forum in May, productivity growth is inherently difficult to forecast. Therefore, it would be foolish to dismiss the possibility that productivity growth rebounds from its recent dismal pace (−0.4% year-over-year in Q2 2016 and +0.5% annualized over the past five years) over our cyclical horizon.
In fact, a significant rebound in productivity would likely raise the Fed’s estimate of r*, would induce markets to price in a steeper path for rate hikes and could lead to an adjustment of extremely low bond yields. Whether risk assets would fare well in such a scenario is uncertain: While stronger productivity should help corporate profit margins, it cannot be taken for granted that equity markets, which have long become addicted to monetary accommodation and low real interest rates, wouldn’t suffer from withdrawal symptoms.
Policy: Fiscal could make a big difference
We’ve spent much time in previous forums debating the diminishing effectiveness of monetary policy, and the debate continued at this forum. Yet, while we continue to worry about monetary policy exhaustion on our secular horizon, it still appears that the net effects of easing are mostly positive, albeit shrinking, and central banks are now focused on mitigating the negative side effects of low or negative interest rates and flat yield curves on the financial sector with compensating measures. A major U-turn (as opposed to tinkering at the edges) by central banks on negative interest rate policy or QE thus seems very unlikely over our cyclical horizon.
Meanwhile, fiscal policy could become a bigger source of surprises next year, mostly in the form of more stimulus, particularly in DM. Japan has already announced a fiscal stimulus package amounting to around 1.5% of GDP spread out over the current and the next fiscal year. In the UK, following Brexit, the government has also indicated that policy will be eased, but details remain to be seen. In the euro area, our base case includes a moderate fiscal stimulus for next year, but given that several large countries (Germany, France, Netherlands) will hold general elections next year, policy may well turn more expansionary than currently announced. In the U.S., any expansionary fiscal measures announced and agreed with Congress by the next president would probably only be implemented in the 2018 fiscal year that starts on 1 October 2017. However, expectations for more stimulus after the election, irrespective of who wins it, could already lift confidence and thus encourage corporate and consumer spending well before implementation.
To be sure, more fiscal action would be a big deal for financial markets as it could shake up the newfound consensus that we are in secular stagnation, that central banks are the only game in town, and that therefore rates will remain low forever. As with productivity growth, it is not clear whether more fiscal stimulus will turn out to be a boon or a gift of poison for risk assets, given its likely impact on central banks’ reaction function.
Will politics trump economics?
Politics is the main non-economic wild card over our cyclical horizon, and the outcome of the Brexit vote demonstrates that polls and political betting markets can get outcomes spectacularly wrong when the political landscape is shifting. True, global mayhem didn’t materialize after the Brexit vote, but arguably this was because global central banks turned even more dovish and bond yields fell significantly on the back of this, thus propping up risk assets. And just as the Brexit vote had a material impact on actual monetary policy, policy expectations, rates, currencies and risk assets, so too could surprising outcomes in the upcoming elections in the U.S. this year and in France and Germany next year. Moreover, in the run-up to the 19th National Party Congress in China in the fourth quarter of 2017, uncertainty about the country’s future political, economic and military course is also likely to be elevated. Given the series of political risk events over our cyclical horizon, there is plenty of room for temporary bouts of market volatility or even more permanent economic, policy and political regime shifts.
While our cyclical outlook is for ongoing growth, policy that remains supportive and broadly range-bound markets, we remain focused on the secular theme of insecure stability (outlined in May) at a time when market valuations, pretty much across the board, range from fair to rich.
Stretching the limits
Diminishing returns to central bank interventions, high debt levels and rising political risks could result in higher term premiums, credit risk premiums and equity risk premiums and suggest more cautious portfolio positioning. In particular we want to be careful about positions that rely to a high degree on central bank support.
Indeed, the Bank of Japan explicitly acknowledged the declining effectiveness of its “quantitative and qualitative monetary easing with a negative interest rate framework” over the summer, with a formal review of the approach and whether it was working. It was no surprise that the central bank answered the question in the affirmative at its September meeting. Yet, its tweaked framework of “quantitative and qualitative monetary easing with yield curve control” amounts to an acknowledgement that both further negative rate cuts and lower long-term rates would be likely to do more harm than good to the financial sector and hence overall financial conditions. It serves to illustrate the limits to extraordinary monetary measures in trying to achieve long-term macroeconomic outcomes.
We expect to be fairly neutral overall in terms of duration risk, balancing unattractive valuation with downside risks in the economic outlook. We will likely favor U.S. duration overall versus a number of the global alternatives given that, in a world of low global yields, higher U.S. yields also enhance the flight-to-quality nature of the U.S. markets during periods of market disruption. We continue to favor TIPS (U.S. Treasury Inflation-Protected Securities), based on valuation, the forecast of 2%–2.5% U.S. CPI inflation in 2017 and the risk that different forms of monetary easing could lead to higher-than-expected inflation outcomes over the secular horizon. We also expect to run modest positions in agency mortgage-backed securities (MBS), given reasonable valuations.
While we continue to find opportunities across global spread markets, we have generally reduced overall spread risk in our portfolios and expect to de-risk further with tightening valuations. We continue to favor non-agency MBS and some other securitized assets. We expect to be at benchmark weight or overweight in corporate credit and will favor credit exposures that, while they may weaken during periods of market volatility, tend to have low default risk – and will also demonstrate a preference for short-dated/self-liquidating positons in investment grade and high yield credit. Financials continue to offer some good opportunities as well.
We have reduced currency risk in our portfolios as we do not see any major mispricing or opportunities in G-10 currencies.
On emerging markets, we remain cautiously optimistic. While improving domestic fundamentals and “Calmer C’s” have been reflected in strong performance of emerging markets, we expect to benefit from select opportunities in local and external markets. Higher-yielding EM currencies provide one way to express a positive view on the overall EM beta.
In asset allocation portfolios, we expect to be modestly underweight equities, preferring to take equity-like risk higher up the capital structure. While understanding the volatility and need for differentiation, we expect EM equities to outperform their DM counterparts. At current valuations we think we need to see significant earnings growth in order for equities to outperform.
We will look to grind out alpha across sectors in a low return environment, accessing the global opportunity set. In addition to top-down and bottom-up opportunities, we will continue to emphasize structural alpha opportunities, aiming to benefit from market inefficiencies and diversify alpha sources in our portfolios.
In a generally low volatility environment, we will look to benefit from the periodic volatility spikes that have been characteristic of the past few years, providing liquidity when markets demand it. These spikes may be based on little change in terms of fundamental information, with greater regulation and related reduced transactional liquidity leading to greater local market volatility – all reinforced by concerns about declining policy effectiveness.