At the outset we reminded ourselves of the pre-pandemic secular framework laid out in our essay “Dealing With Disruption” in May 2019. Back then, we had anticipated “a difficult investment environment, subject to radical uncertainty and a range of secular disruptors” such as China’s rise and the resulting geopolitical tensions, populism, deflationary demographic trends, financial vulnerabilities related to valuations and pockets of excess leverage, and technology and sustainability issues that create winners and losers.
Sadly, major disruptions and radical uncertainty indeed unfolded this year, albeit from an unexpected source – the COVID-19 pandemic that has already cost more than one million lives worldwide, caused the deepest economic recession since the Great Depression, and sparked staggering fiscal and monetary policy responses.
We concluded that the core of our “dealing with disruption” framework remains intact: We believe investment success over the secular horizon will continue to be defined by being prepared for disruptions from a variety of sources and by actively pursuing the opportunities that arise when volatility occurs. This is even more important now that markets will have to grapple with the longer-term consequences of the pandemic shock, its propagation, and the policy responses.
Cyclical healing but long-term scarring
The first half of our secular horizon is likely to be characterized by “The Long Climb” to recovery, with above-trend growth for a couple of years as the global economy emerges from the deep hole of the COVID recession. The two key swing factors that could produce upside or downside surprises are (1) the health situation – renewed infection waves versus effective vaccines and treatments – and (2) the degree to which fiscal policy stays active or retreats. While more stimulus is already on the horizon in Europe with the EU recovery fund starting to disburse funds during 2021, the outcome of the U.S. election in November will (hopefully) provide more clarity on the scope and nature of continued fiscal support.
While a continuation of the cyclical recovery over the next year or two is very likely, we think the concerns voiced by several speakers at our forum about “economic scarring” that will weigh on steady-state potential output growth are warranted. Longer spells of unemployment typically imply an erosion of individuals’ skills and thus labor productivity. Also, higher uncertainty will likely depress business investment for a long time to come. Together with an increasing “zombification” of the corporate sector due to massive government and central bank support, this will likely weigh on longer-term productivity growth.
However, we also discussed more positive longer-term growth scenarios that mostly centered on the possibility of much more active fiscal policies promoting private and public investment via infrastructure spending, stronger research and development spending as part of the new technology race, green deals, improving human capital formation via education, and tax reform. While such a “positively disruptive” scenario is not our baseline, it is an important upside risk to our more cautious baseline scenario.
Moreover, we were positively surprised by the European policy responses to the crisis, in particular the new EU recovery fund and the forceful and swift action by the European Central Bank (ECB) via its new pandemic emergency purchase program. These developments serve to underscore the time-tested refrain that European integration only progresses through crises. While we continue to expect occasional setbacks due to political risks in a range of countries, the chances have increased of a less crisis-prone euro area with further steps toward a more complete banking union and a larger joint fiscal capacity.
Crisis amplifies four secular disruptors
Zooming in on potential disruptions, we concluded that several of the trends that we identified as disruptive in the past are likely to become even more pronounced over the secular horizon:
China’s rise as an economic power that disrupts higher-value-added producers elsewhere in the world and challenges the established geopolitical order dominated by the U.S. is likely to be accelerated by its earlier and stronger rebound from the COVID crisis and its strengthened focus on its strategic plan, which was recently rebranded from “Made in China 2025” to a “dual circulation strategy” focused on cutting its dependence on global markets and technology, while remaining open to international markets.
Populism and its close cousins protectionism and nationalism are likely to be fortified by the pandemic recession and its impact on rising inequality along several dimensions, which was one of the focal points of our discussions. Against this background, we considered but eventually dismissed the thesis that we have already seen “peak populism” around the world.
Climate-related risks and their impact on human lives and economic activity became even more apparent and acute this year, focusing attention on “fat tail” catastrophic environmental events. Apart from these physical risks, transition risks related to the move to a greener economy are an increasing focus for policymakers, companies, and investors – as also highlighted by Mark Carney, one of our forum guest speakers and the latest addition to PIMCO’s Global Advisory Board, who referred to the risk of a climate “Minsky moment” (i.e., collapse in asset prices, building on the phrase coined by former PIMCO chief economist Paul McCulley). Moreover, as we already emphasized last year, investors will have to factor in additional government responses to climate and other environmental risks in the form of regulation, corporate reporting requirements, carbon taxes, and public investment, including the explicit green focus in the large new EU recovery fund. These are now mainstream issues and, depending on the policy choices, will likely affect fiscal policy, private sector decisions, capital flows, and asset prices over the secular horizon. With many winners and losers in the corporate sector, these trends call for active management of credit and default risks.
Technology’s role as a beneficial yet also disruptive force has been amplified by the COVID-19 crisis. While work and consumption patterns are likely to revert some way toward pre-crisis levels once the pandemic recedes, the additional economic prowess of established and new technology companies gained during the crisis will make them an even stronger disruptive force. Successfully distinguishing the winners and losers from digitalization will be an important source of alpha for active investors over the secular horizon.
Monetary policy: Trapped
Given the difficult near-term and longer-term economic backdrop, and with disruption likely to lead to repeated bouts of volatility in financial markets, we expect monetary policy rates in most advanced economies to stay low or go even lower for much or all of the next three to five years. We view negative rates as a desperate tool with adverse side effects that become larger the longer rates stay negative (see “A Negative View on Negative Rates”). However, with bond yields already low or negative and yield curves flat, more central banks are likely to venture into negative (or more deeply negative) territory in response to future adverse shocks, along with further purchases across a wide spectrum of financial assets.
The Federal Reserve’s move to flexible average inflation targeting (FAIT) was also a topic of debate. We concluded that, based on the Bank of Japan’s experience with its overshooting commitment adopted in 2016, this may well remain an aspirational goal for a long time, especially as the Fed’s commitment to actually overshoot seems rather lukewarm so far and there appears to be a lack of consensus among Fed leadership. While central banks including the Fed have the means to provide a backstop for asset markets in times of crisis, credibly achieving their inflation targets requires a tool they cannot control: fiscal policy.
Fiscal policy holds the key
The unprecedented global fiscal response to the crisis, facilitated by massively expanded central bank purchases of government bonds, has opened up a much wider range of possible secular scenarios for fiscal policies around the globe.
On one end of the spectrum of possible outcomes, fiscal stimulus during the crisis would remain a one-off followed by a return to passive or restrictive policies caused by political gridlock or a renaissance of deliberate austerity policies. Thus the current weak form of fiscal dominance, where monetization is in the interest of both the government and the central banks, remains an episode. In this scenario, inflation and inflation expectations remain low or drift even lower and central banks on their own are not able to engineer on-target or above-target inflation.
In an opposite scenario we discussed, as the economy returns to normal fiscal policy stays expansionary or becomes more active, for example by focusing on additional spending programs to address inequality, infrastructure needs, and green projects. In this scenario, weak fiscal dominance turns into a hard form of fiscal dominance as monetary policy is coerced into keeping rates low and monetizing deficits even as inflation eventually takes off.
While the likely fiscal path in most major economies probably lies somewhere in between, each of the extreme scenarios now seems somewhat more likely than before the pandemic shocked governments out of their respective fiscal comfort zones. As a consequence, we believe the inflation tail scenarios have increased – that is, both deflation and high inflation outcomes driven by different fiscal policies have become more likely.