A year ago, PIMCO said the world was in The New Neutral, as the path to recovery dragged on years after the financial crisis. Last month, at our annual Secular Forum in which our global investment professionals gathered to discuss our long-term outlook, we affirmed that thesis, and we recently published “The New Neutral Revisited” detailing and updating our views. Scott Mather, Chief Investment Officer U.S. Core Strategies, discusses how the outlook for the U.S. differs, to a degree, from other large economies.
Q: What is PIMCO’s secular outlook for the U.S.?
Scott Mather: A key characteristic of our New Neutral thesis is that we see major economies growing at different rates, but generally modestly compared to pre-financial crisis. For the U.S., this means many of the constraints on growth and left-tail risks that were so prevalent in the aftermath of the crisis are dissipating. They are not altogether gone, but deleveraging is much less of a drag on growth.
However, while the U.S. can now grow above trend, the potential trend rate of growth has been dropping for several years due to lack of investment in both physical and human capital stock. Add in demographic trends, more regulation and tighter credit standards and the potential trend level of real growth is now below 2%. So while we expect that growth in the coming years will be better than it has been, it is unlikely to return to what was considered normal in the pre-crisis period.
Still, the headwinds that have held the U.S. back have diminished to such an extent that we believe the Federal Reserve will begin moving rates back to neutral territory, which, in our view, means a nominal policy interest rate of around 2%-2.5%.
Q: The U.S. appears to be the furthest advanced in its post-crisis normalization among developed countries. Why? And what is the chance of a surprise to the upside for growth or inflation?
Mather: There are three key reasons why the U.S. is furthest along. First, the U.S. was more aggressive in its response to the financial crisis through monetary policy, with interest rate cuts and quantitative easing. Second, private balance sheets were cleaned up more quickly, even if through defaults. Third, new regulation forced banks in the U.S. to recapitalize sooner than those in other countries. Many developed nations simply took longer to respond to the crisis for a variety of reasons, so it is not unexpected that the U.S. is further along in the normalization process.
Still, we do not believe there is a substantial probability of a growth surprise to the upside because of the long-term trend of lower potential growth. We do, however, believe the extraordinary policy response of the past few years could result in more inflation than expected.
Right now, many investors are enamored with the disinflationary forces of the last six or seven years, but we see these diminishing even as monetary policy remains very stimulative. Such policies can have long lags.
Q: How does public policy factor into the firm’s secular view? Could there be a future breakthrough on immigration, trade or energy, for example, that would affect the outlook?
Mather: Public policy initiatives throughout much of the developed world have been relatively weak and ineffective over the last decade. Inaction has developed an inertia of its own at a time when the need for and potential benefits of structural reform have rarely been greater. In the U.S., however, there is reason for hope simply because of the presidential election in 2016, which is squarely within our secular horizon.
Changes in immigration policy, trade enhancements, infrastructure investment and tax reform are all things that could add to growth in the economy relatively quickly and have an impact for many years. Meaningful action on just two or three policy issues could be powerful in putting new stimulus into the system. We are not expecting tremendous beneficial surprises on the policy front, but there’s a significant possibility that after so many years of inaction, we will begin to see the political system thaw and see some sensible policymaking that begins to address the drop in potential growth.
Q: When does PIMCO expect the Federal Reserve to begin raising its policy interest rate and how does that fit with The New Neutral thesis?
Mather: We expect the Fed to begin raising rates later this summer, most likely in September, and that will be the beginning of a multi-year normalization process. While the process will likely be slow compared to past rate hike cycles, if the Fed manages to stabilize inflation at its target of 2%, then the central bank should get to the neutral policy rate of 2%-2.5% within a couple of years. The neutral rate is the point at which the rate is neither stimulative nor contractionary; it’s equilibrium.
We should note that the Fed takes a different view of the neutral policy rate than we do. Based on its “blue dots” forecast, the Fed appears to be targeting around 3.5%, which means it has a long way to go to achieve its goal. That argues strongly for a policy rate hike soon.
With each passing day, policy is not the same – it is more stimulative to the economy. So the longer the Fed waits, the higher the chance that it will have to move rates quickly, potentially tipping the economy into recession. The goal of monetary policy should be to prolong the expansion, and the way to do that is to put rates on a glide path to the neutral rate. The sooner the Fed can do that, the greater the chance of making this the longest expansion in post-World War II history.
Q: Last year, PIMCO called for a rise in the U.S. dollar and that has come to pass. What is next for the dollar?
Mather: We think the dollar will continue to appreciate against most currencies for at least another couple of years. The annual pace may slow to perhaps 5% from 10%-15% previously, but the larger trend of a stronger dollar should continue.
Dollar trends historically have taken many years to unfold. People tend to forget that the dollar fell in value versus most other currencies for over a decade and became one of the cheapest currencies in the world before it began its latest rise. Also, with the U.S. set to gradually tighten policy while many other countries are still lowering rates, it seems reasonable to expect that the dollar will continue to appreciate.
For sure, there will be volatility, and probably more volatility than we have seen in a while, but that’s to be expected as monetary policy diverges among countries.
Q: Considering PIMCO’s views on the U.S. and global economies, what are the key investment opportunities and risks over the secular horizon?
Mather: Investors who anchor their views around The New Neutral policy rate and the normalization process should be well positioned to navigate the next few years and the risk-reward trade-offs ahead. Beyond that, there are several factors to consider.
Volatility has been a feature in the markets over the past six months and that will likely continue, especially with diverging monetary policies, so we are positioning portfolios with an eye to making volatility work for us. The period of intense financial repression – essentially taxing savers – is ending over our secular horizon. From an investor’s standpoint, that is good, but it does carry with it the likelihood of higher volatility as interest rates rise. Investors should position with higher volatility in mind; inevitably, there will be overshoots in financial assets that offer opportunities. However, risk premiums across all financial assets are relatively compressed at the moment, so it is time to think about taking less risk than over the past several years in many risk categories.
Our outlook is still positive for corporate bonds and mortgage-related investments, as well as for many credit sectors, but in our view, these markets are not quite priced for a pick-up in volatility. Many years of low interest rates and quantitative easing have been a wet blanket on volatility, and that will be taken away soon.
In terms of specific investments, we see value in U.S. inflation-linked bonds, which are mispriced given our view that inflation will be back to target levels relatively quickly and may even exceed them for a few years.
Different monetary policy cycles should also create attractive global opportunities; the impact of rising rates in the U.S., for example, can potentially be offset by investing where rates are still steady or falling. Bottom-up security selection ‒ credit selection, in particular ‒ will be important in various sectors, including energy, to find value.
Overall, we suggest investors focus on active alpha as a more important part of total return. In the past three or four years, it didn’t matter much what you bought as long as you bought more of it. Of course there were reasons to be skeptical at the time because of the big left-tail risks, but in hindsight, just buying more of most financial assets was a good strategy. This is unlikely to be a rewarding strategy over the next few years. Going forward, returns are likely to be lower, and the conventional ways of coping with rising interest rates, including buying equities and credit securities, may not serve as well in the more volatile environment. With U.S. rates rising and the normalization process underway, successful investing is going to require more discretion and skill.