After this year’s Secular Forum, PIMCO adopted its New Neutral view: We expect global economies to converge to modest trend growth rates over the next few years. What does The New Neutral mean for inflation risk around the world? Deputy Chief Investment Officer Mihir Worah, head of PIMCO’s real return and multi-asset portfolio management teams, discusses PIMCO’s expectation of low but rising inflation over the next three to five years, and what it means for investors.
Q: What is PIMCO’s secular outlook for global inflation? In a world approaching The New Neutral, is there less inflation risk?
Worah: Over the secular horizon – the next three to five years – we expect global inflation to remain muted overall, as we think there is still a degree of slack in the global economy. Moreover, supply has increased in certain commodities like crude oil and natural gas, and there have been improvements in production of base metals like nickel. While investors should stay vigilant to the possibility of commodity price spikes or other inflation surprises, our secular base case is for inflation to be modestly higher than current levels.
In the developed markets, the U.S. and Europe in particular, inflation is bottoming and poised to move up modestly. We expect inflation in the U.S. to move close to the Federal Reserve’s 2% target, though it is still likely to be relatively low over the secular timeframe. However, we have a slight bias to higher inflation since that is what the Federal Reserve wants – stronger economic growth in the U.S. cannot be achieved without higher inflation.
In Europe as well, we should see aggregate inflation move up from the currently very low 0.7% year-over-year rate to a rate north of 1%. This is still well below the European Central Bank’s (ECB) target, and we expect continued stimulative policy from them.
In emerging markets (EM), inflation is strongly tied to commodity price movements. Therefore, we expect inflation to remain more volatile in EM than in developed markets over the secular horizon. The New Neutral, and its characteristic lower developed market rates, could see portfolio flows into EM contributing to inflation surprises, if central banks waver in their discipline. In China, however, slowing growth and a need to rebalance and even weaken the currency mean that its economy is unlikely to export inflation to other markets such as the U.S.
Q: How will commodities behave in The New Neutral?
Worah: Just like most other assets, individual commodities will react to different fundamental factors. This fact alone means commodities will be important diversifiers in portfolios that consist mostly of stocks and bonds.
The lower New Neutral real policy rates – for example, we expect a 2% neutral nominal policy rate for the Fed versus the 4% others seem to expect – should be supportive of commodities, and we expect low but positive real returns over the secular horizon. While the “commodity supercycle” may be over, roll yields (returns from rolling from one futures contract to the next) have been positive, so investors are being paid to own commodities.
We have already mentioned the supply response in oil and natural gas. This means that we are unlikely to have sharp spikes in these commodities based on demand growth. That said, we believe that these are the two commodities most likely to deliver slow but steady positive returns. Crude oil, while fairly priced today, offers a roll yield of almost 10% per year. Surprisingly, natural gas, which usually has a negative roll yield, also offers a positive roll yield for futures contracts covering the next couple of years. This feature, along with increasing political will to grow exports, makes us bullish on long-term natural gas prices.
The commodity most affected by the New Neutral expectation of lower real interest rates is gold. Gold prices are well correlated with the levels of real interest rates, as they reflect the opportunity cost of holding an asset without any cash flow that nevertheless has some tail-risk-hedging properties. The lower the real interest rate, the more attractive this commodity. We find gold attractive at current valuations.
Another important thing to remember is the inflation-hedging characteristics of commodities – they are one of the best ways to hedge against inflation spikes or tail risks. Given geopolitical tensions in certain areas around the world, there is always a chance that commodity prices could spike.
Overall, just like with stocks and bonds, investors should not expect strong returns from commodities in The New Neutral. But we believe commodities play an important role as a diversifier and potential source of returns in a well-diversified, well-constructed investment portfolio.
Q: What are the implications of PIMCO’s secular outlook for investors in real assets?
Worah: Real assets, as their name implies, are typically very highly geared to the real interest rate. This is obvious in the case of Treasury Inflation-Protected Securities (TIPS) and other inflation-linked bonds, but it also applies to real estate and other longer duration assets. Since the New Neutral policy rate is lower in our opinion than previously expected, this should increase the attractiveness of real assets. Real assets also typically have a low representation in investment portfolios, and we expect to see a sustained trend of increasing real asset allocations among investors.
We have held positions in shorter maturity TIPS since late last year because the market’s inflation expectations have been lower than both our expectations and actual inflation. Currently, we also find valuations on short-term German inflation-linked bonds attractive for many of the same reasons.
Q: Do you see any implications for investors in multi-asset portfolios?
Worah: The New Neutral hypothesis has a number of very important implications for multi-asset portfolios. We have already covered the implications of lower real rates for commodities and bonds. The implications are equally important for equities since valuations are tied to the discounting of cash flows, which in turn depends on market and policy rates. For any given level of growth, lower real rates imply higher equity prices. While much of this is already reflected in various asset prices, it also probably means that current valuations are sustainable. In addition, lower rates and the lower volatility we expect in The New Neutral increase the attractiveness of EM equities and currencies. These are all themes we consider in our positioning.