The Long Climb

The Long Climb

The global economy has started to recover from the sharpest but also shortest recession of modern times. With the economy transitioning from hurting to healing as envisaged in our April 2020 Cyclical Outlook, PIMCO’s investment professionals from around the globe gathered by video in early June to update our cyclical outlook and discuss the strategy implications. This post summarizes the economic and policy outlook – stay tuned for a forthcoming midyear update of our asset allocation outlook.

Down the elevator, up the stairs

Rather than looking back at the vertiginous drop in economic activity that ended the record 128-month economic expansion in February, we discussed the likely nature and shape of the nascent recovery. We concluded that our baseline continues to be a bumpy and uneven recovery with pre-crisis level of economic activity unlikely to be reached before 2022 in most Western economies. Put differently (and quoting Federal Reserve Bank of Richmond President Thomas Barkin): The economy rode the elevator down but will have to climb the stairs back up.

While a near-term mechanical bounce in economic activity in response to the lifting or easing of lockdown measures looks likely, we expect the subsequent climb up to be long and arduous for the following reasons:

  • Social distancing, be it voluntary or mandated, will be necessary and likely until an effective medical treatment for the virus is widely available. This means many sectors will not be able to ramp up to pre-crisis capacity anytime soon.
  • Global and national supply chains will remain impaired for some time because reopening will be uneven across countries, regions, and sectors.
  • The reallocation of labor and capital from losing to winning sectors and companies is a process that takes time and may even be hampered by policy that keeps “zombie” firms in business.
  • A debt overhang in the corporate and household sector as a consequence of the recession will likely weigh on consumer and investment spending for the foreseeable future.

The good, the bad, and the ugly

However, our “long climb” baseline scenario is unusually uncertain. In fact, at our virtual forum, we reminded ourselves of a concept we have found helpful before to characterize the outlook – “radical uncertainty” (see “King, Keynes and Knight: Insights into an Uncertain Economy,” PIMCO Macro Perspectives, 14 July 2016).

This time around, the main source of uncertainty and hence the key swing factor for the economic outlook lies outside economic or policy spheres: a rapidly evolving COVID-19 pandemic that could easily push the economy into better or worse trajectories than our baseline over our cyclical six- to 12-month horizon. And so we spent much time discussing two alternative scenarios to our baseline.

The good scenario of a more rapid economic recovery would come to pass if the massive worldwide scientific race to develop a vaccine or other medical treatments produces early and scalable results and reduces the need for social distancing faster than expected. We discussed the state of play on possible vaccines and drugs, aided by a thorough review by two colleagues of the latest scientific literature and PIMCO’s medical advisor on COVID-19. However, even for the experts it is virtually impossible to make confident predictions on when effective medical cures will be available.

The bad economic scenario of a much slower recovery or even a double-dip recession would most likely result from strong and widespread second waves of COVID-19 infections that lead to renewed government-mandated or voluntary interruptions of economic activity. History and common sense suggest that second pandemic waves are the norm rather than the exception. Parts of Asia and, more recently, some regions in Europe and the U.S. have already seen a re-acceleration in new infections as mobility and activity have picked up. However, how widespread and strong such second waves will be remains a guessing game – another example of “radical uncertainty” at work.

Needless to say, a double-dip in economic activity caused by significant second waves could easily turn a bad scenario into an ugly one: Cascading bankruptcies of companies, many of them small and medium sized, that have thus far bridged the time to recovery with emergency liquidity would become more likely, and many temporary layoffs would turn into permanent job losses.

While the health situation is currently the main swing factor for the economic outlook, there are of course other, more traditional, drivers that pose risks to our baseline. In particular, we worry about a re-emergence of trade tensions between the U.S. and China in the run-up to the U.S. elections in November. A flare-up of the trade war could easily sap business confidence, tighten financial conditions, and derail a fragile economic recovery.

As noted, given the many unknowns about the health situation, attaching probabilities to these scenarios is most likely a fool’s errand. That said, most of us felt that over the next six to 12 months, the risks to our baseline “up the stairs” scenario are probably skewed to the downside.

The primacy of policy

However, if full recovery is likely to take a long time, uncertainty is pervasive, and risks to the baseline are skewed to the downside – views that most economic forecasters seem to share – why have risk markets rallied so much off the March lows?

The most plausible explanation seems to be that financial markets find it notoriously difficult to price “radical uncertainty” and thus tend to ignore it and rather take their cues from more familiar and easily observable factors such as the swift and very large policy responses by central banks and governments.

With monetary and fiscal policies playing such a crucial role in cushioning the effects of the “lockdown recession” and in propping up asset prices, here is what we concluded about the policy outlook and its likely implications.

First, while the risks to the economic outlook appear to be tilted to the downside, we expect the risks to the monetary and fiscal policy outlook to be skewed toward more easing, even in better-than-expected economic scenarios, as the concerns that had started to tilt fiscal and monetary policy toward an easier stance already before the crisis – such as below-target inflation and persistent inequality – are even more pressing now, especially in light of the recent widespread protests across the U.S. and in other developed countries.

Second, this crisis served as a catalyst for ever-closer fiscal-monetary cooperation that will be difficult to reverse. Higher public sector debt levels and larger budget deficits for longer will require ongoing central bank support. Large-scale debt monetization, explicit or implicit yield curve control, and zero or negative policy rates will thus be lasting legacies of the COVID-19 crisis, implying nominal and real interest rates will be lower for longer (see “Post-Pandemic Interest Rates: Lower for Longer,” PIMCO Blog, 13 April 2020).

Third but not least, while near-term inflation pressures are likely to be on the downside, the prospect of continued fiscal activism supported by debt monetization and repressed interest rates suggests to us that longer-term inflation risks are tilted to the upside. Thus, just like economic activity, inflation and inflation expectations may be in for a long climb from depressed levels.

Please see PIMCO’s “Investing in Uncertain Markets” page for our latest insights into market volatility and the implications for the economy and investors.

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Joachim Fels is PIMCO’s global economic advisor and a regular contributor to the PIMCO Blog.

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