Cyclical Outlook Key Takeaways: Inflation Inflection
PIMCO’s baseline outlook for the cyclical horizon has the global economy continuing its uneven recovery before shifting to a more moderate pace of above-trend growth in 2022. And although inflation is spiking, particularly in the U.S., we continue to view the factors driving the recent price surge as transitory. Nonetheless, heightened macro volatility can translate into heightened market volatility. And as investors, we believe it’s important to maintain portfolio liquidity and flexibility so we can respond to and take advantage of these developments.
In our June Cyclical Outlook, we discuss the outlook for global growth and inflation over the next year, as well as implications for investors. This blog post summarizes those views.
Peak pandemic, peak policy, and peak growth
With the pandemic receding across much of the world, policy support has also likely peaked and will turn into an outright drag on growth in the months ahead. Meanwhile, several developed market (DM) central banks have either begun taking steps toward policy normalization or signaled plans to do so.
These factors will tend to affect growth to varying degrees across industries and regions, and will likely result in desynchronized growth across DM regions in 2021. However, we expect the growth rebound in 2021 will give way to a synchronized moderation in 2022, albeit to a still-strong, above-trend pace. Meanwhile, slower vaccination rates in emerging market (EM) countries will likely delay a fuller recovery relative to DM.
Since inflation follows growth with a lag, we project inflation in developed markets will peak in the coming months. However, the exact timing and magnitude is more uncertain due to supply constraints, including a global shortage of semiconductors. These constraints are expected to ease in 2022, while peaking goods demand will likely moderate inflation in the second half of 2021.
Overall, we forecast DM inflation to end 2021 running at a 3% average annual pace, before moderating back to 1.5% in 2022 – below DM central bank targets. Notwithstanding the expected changes to DM central banks’ quantitative easing (QE) programs, we don’t expect DM central banks to begin hiking policy rates over our cyclical horizon.
Since we see fewer high-conviction opportunities and believe valuations are generally rich, we think it makes sense to be patient and maintain liquidity and flexibility in our portfolios to respond to opportunities.
At the moment it is very hard to read the incoming data given the unprecedented COVID-related disruption and recovery. Moreover, any Fed taper talk – however carefully communicated – could lead to market disruption, especially in spread sectors.
On duration, we expect to stay close to home while maintaining a modest underweight position versus our benchmarks. We also expect to have a curve-steepening position, in line with our long-held structural bias and also as a potential source of income.
In our view, U.S. non-agency mortgage-backed securities (MBS) offer good value versus generic cash corporates, along with favorable risk profiles. On corporate credit, we see little potential for significant spread tightening. But there is also likely to be strong ongoing demand for credit, even at compressed spreads, given low government yields. Single name selection will likely continue to be an important alpha driver in specialist credit mandates, with a likely focus on financials, cyclicals, housing-related sectors, and COVID-19 recovery trades.
Commodities have had a meaningful move higher on the back of strong global demand. Looking forward, we believe spot price gains will be lower as producer hedging increasingly caps longer-dated prices. We expect to be fairly neutral on U.S. Treasury Inflation-Protected Securities (TIPS), although in some portfolios a TIPS overweight may continue to make sense given the still reasonably priced hedge against upside inflation surprises.
We continue to favor U.S. dollar underweights – with careful scaling – versus G-10 commodity-related currencies and select EM currencies. We also expect to find good opportunities in EM local and external bonds.
In our view, equity valuations are now fair with the U.S. equity risk premium at 3.5%, in line with the mid-cycle expansion average. Given valuations, the focus is now on sector and security selection of companies likely to benefit from the further reopening of the service sector, as well as cyclicals in secularly supported sectors with pricing power and barriers to entry, like semiconductors, technological automation, and green industries.
For more details on our outlook for the global economy in the year ahead and the investment implications, please read the full Cyclical Outlook, “Inflation Inflection.”
Tiffany Wilding is an economist focused on North America and Andrew Balls is CIO Global Fixed Income.
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