In case you missed it – which was easy given the recent gyrations in Italy and financial markets – we published our Secular Outlook this past week. Argentina, Italy and most recently President Trump’s imposition of tariffs on steel and aluminum imports from the EU, Canada and Mexico, among others, are some recent examples of rude awakenings for complacent financial markets. However, as we lay out in more detail in the outlook, these events may only be a small taste of things to come over the secular horizon. Here are the key takeaways.
Following the three-day forum with distinguished external speakers and our Global Advisory Board as well as our subsequent internal discussions, we concluded that we may be witnessing an important turning point: Ten years after the financial crisis, the global economy and financial markets look set to enter a new era of potentially radical change that will make the future look very different from the past.
The post-crisis environment has been characterized by financial repression through regulation and dominant central banks, mostly passive or restrictive fiscal policies, largely uninhibited trade and capital flows, subdued growth and inflation, and low volatility in the macro economy and markets. To be fair, the past decade had its fair share of rude awakenings, but whenever they came along, central banks were quick to step in and prop up markets and economies.
A more difficult environment ahead
We expect a very different macro landscape to emerge over the next five years, for better or worse. Already there are important shifts underway: The monetary-fiscal policy mix has been changing with central banks retreating and fiscal policy becoming more expansionary; the regulatory discussion is moving from the financial to the tech sector, and economic nationalism and protectionism are on the rise. However, bigger disruptions may lie ahead; here is a list of five potential sources of major rude awakenings for investors over the secular horizon:
- Recession returns. Our baseline continues to include a recession in the U.S. over our secular horizon, which is likely to affect large parts of the world. Such a downturn would most likely result in a wok- or saucer-shaped recession/recovery – one that is shallower but longer – rather than the traditional V-shape, but also riskier.
- Shallower, because so far we haven’t seen the spending excesses in the private sector or the leverage excesses in the financial sector that preceded past recessions.
- Longer, because there is less monetary and fiscal policy space than in the past.
- And riskier, because inflation expectations are already very low, the structural weaknesses in the eurozone will be exposed, and a recession may give rise to much more radical variants of economic nationalism and populism.
- Productivity pop-up. While not our base case, there is a reasonable chance of a significant acceleration in productivity growth due to a broader diffusion of new technologies through new business investment. While higher productivity is good news from a long-term, economic perspective, investors should be careful what they wish for: Technological unemployment could increase, many companies could be disrupted and real interest rates could rise, which would likely hurt many investors.
- Fiscal follies. A global fiscal expansion that is large enough to offset some or all of the global excess of desired saving over desired investment in the private sector would challenge the status quo of low inflation and low interest rates. Piling on more public debt at a time when central banks phase out net asset purchases or are already running down their balance sheets could increase term premia and steepen yield curves. Higher interest rates and/or the next recession will likely expose the weak links among profligate borrowers.
- Thucydides trap. Geopolitics could be another source of rude awakenings. At the forum, we discussed the Thucydides trap, which results in (sometimes armed) conflict when a rising power like China challenges the established superpower, like the U.S., on multiple fronts – economically, technologically and geo-strategically. To be sure, the trap is not inevitable. However, the likely tensions caused by China becoming a global economic and military superpower while the U.S. tries to more assertively defend its status in the areas of trade, intellectual property and defense create uncertainty and could be a source of accidents over the secular horizon.
- Radical populism. Fifth but not least, there is a significant risk of a more extreme populist backlash than the one we have seen so far, especially if and when we hit another recession. This could come in different flavors: large-scale income and wealth redistribution through taxes and universal basic income, more aggressive protectionism, nationalization of key industries and/or the breakup of tech monopolies, attacks on central bank independence and more sizeable debt monetization, etc.
Secular investment conclusions
Rather than suffering in the event of rude awakenings, investors should be prepared for a more difficult environment and be in a position to play offense when these rude awakenings arise. This may mean giving up some yield potential in exchange for this flexibility, for example by holding more highly liquid short-term investments.
We continue to expect The New Neutral framework of low equilibrium policy rates anchoring global fixed income markets to be a useful guide. Thus, we expect to maintain durations that are close to benchmark, given our expectation of fairly range-bound global fixed income markets and that we see fairly balanced upside and downside risks to the forward curves.
- We anticipate a rise in volatility and, as a result, we expect to place less emphasis on volatility sales, which in a more normal volatility environment would be a key part of our portfolio construction, and we may find targeted opportunities where buying volatility will present attractive risk/reward.
- We expect the re-establishment of higher term premia and risk spreads, leading to steeper curves. The shorter end of the curve tends to offer better yield or income per unit of duration. Higher inflation risks, perceived or realized, could also contribute to curve steepening.
- We view U.S. Treasury Inflation-Protected Securities (TIPS) as offering reasonably priced hedging against the possibility of upside U.S. inflation risks. As well as TIPS, commodities and other hard assets also offer reasonable mitigation of inflation risk.
- We believe it will pay to be much more selective on credit and to reduce corporate credit risk overall as we approach the end of the post-crisis secular recovery. We are emphasizing short-dated exposures and “bend but don’t break” positions in corporate debt and structured products with a low likelihood of default.
- With central banks more uncertain actors, we will seek to focus on investments that offer robust risk/return profiles and that do not rely excessively on central bank support. In that context we expect to be careful in particular on eurozone peripheral risk.
- We have a broadly balanced view on the U.S. dollar versus other G-10 currencies, reflecting limited valuation anomalies across markets and, in the case of the U.S., the balance between upward pressure on the U.S. dollar from rates and growth differentials and the downside pressure exerted by the twin current account and fiscal deficits.
- We expect to find good opportunities in emerging markets, across countries and sectors, guided by our EM specialist team. Idiosyncratic risk as well as the path for U.S. policy rates and the U.S. dollar and the related cyclical uncertainly will – as always – be important in navigating emerging market investments. But we also expect that over time the continuation of The New Neutral environment and overall low policy rates and developed market yields will be supportive for EM assets.
For detailed insights into the longer-term trends shaping the global economy and market environment, please read PIMCO’s latest Secular Outlook, “Rude Awakenings.”
Joachim Fels is PIMCO’s Global Economic Advisor, Andrew Balls is CIO Global Fixed Income and Dan Ivascyn is Group CIO.