Investors and policymakers will likely face a radically different macro environment over the next five years as the New Normal decade of subpar-but-stable growth, below-target inflation, subdued volatility, and juicy asset returns fades into the rearview mirror. What lies ahead is a more uncertain and uneven growth and inflation environment in which overall capital market returns are likely to be lower and more volatile.
In our latest Secular Outlook, “Age of Transformation,” we discuss ongoing disruptors as well as three trends that we believe will drive a major transformation of the global economy and markets. This transformation should yield good alpha opportunities for active investors capable of navigating the difficult terrain. As always, our outlook derives from our annual Secular Forum, which included PIMCO’s global investment professionals and Global Advisory Board as well as distinguished guest speakers. (This behind-the-scenes video offers a look at our forum process.) This blog post is a distillation of our outlook and investment views.
Drivers of transformation
In our 2020 Secular Outlook, “Escalating Disruption,” we argued that the COVID-19 pandemic would serve as a catalyst for accelerating and amplifying four important secular disruptors: the China–U.S. rivalry, populism, technology, and climate change. Developments over the past year have reinforced those expectations.
These four disruptors, along with the three secular trends below (which we discussed in depth at the 2021 Secular Forum), will have important implications for economic and investment outcomes in the Age of Transformation.
The transition from brown to green. Efforts to achieve net zero carbon emissions by 2050 mean that both private and public investment in renewable energy will be boosted for years to come. Of course, higher spending on clean energy is likely to be partly, but not fully, offset by lower investment and capital destruction in brown energy sectors such as coal and oil. During the transition there is a potential for supply disruptions and sharp rises in energy prices that sap growth and boost inflation. Moreover, as the process creates winners and losers, there is a potential for political backlash in response to job losses in brown industries, higher carbon taxes and prices, or carbon border adjustment mechanisms that make imports more expensive.
Faster adoption of new technologies. Data so far show a significant rise in corporate spending on technology. Similar increases in investment in the past, e.g., during the 1990s in the U.S., have been accompanied by an acceleration in productivity growth. Yet it remains to be seen whether the recent surge in tech investment and productivity growth is a one-off or the beginning of a stronger trend. Digitalization and automation will create new jobs and make existing jobs more productive. But it will also be disruptive for those whose jobs will disappear and who may lack the right skills to find employment elsewhere. As with globalization, the dark side of digitalization and automation will likely be rising inequality and more support for populist policies.
Sharing the gains from growth more widely. The third potentially transformative trend underway is the heightened focus by policymakers and society at large on addressing widening income and wealth inequality and making growth more inclusive. For example, anecdotal evidence suggests that in many companies, the balance of power in the employer-employee relationship has started to shift from the former to the latter, thus improving workers’ bargaining power. It remains to be seen whether this trend continues or whether work from home with the help of technology eventually allows companies to outsource more jobs to cheaper domestic and global locations, thus preserving or even increasing employers’ bargaining power.
We believe that the Age of Transformation will present more difficult terrain for investors than the experience of the New Normal over the past decade. But we also believe it will provide good alpha opportunities for active investors who are equipped to take advantage of what we expect to be a period of higher volatility and “fatter tails” than the common bell curve distribution.
Higher macroeconomic and market volatility is very likely to mean lower returns across fixed income and equity markets. Starting valuations – low real and nominal yields in fixed income markets and historically high equity multiples – reinforce the expectation.
In our baseline we expect low central bank rates to prevail and anchor global fixed income markets. Although we see upside risks to interest rates over the short term as economies continue to recover, over the secular horizon we expect rates to remain relatively range-bound. We expect lower but positive returns for core bond allocations.
While a sustained period of high inflation is not our baseline outlook, we continue to think that U.S. Treasury Inflation-Protected Securities (TIPS), as well as commodities and other real assets, make sense as hedges against inflation risks.
Meanwhile, macro trends, disruptors, and drivers, along with elevated debt levels, will likely lead to substantial differentiation in outcomes across regions, countries, and sectors. In Asia, the prospect of stronger growth and developing capital markets will likely provide good investment opportunities, despite the risks associated with slower growth in China and ongoing geopolitical tensions. While a number of emerging market (EM) countries face difficult secular circumstances, as always it is important to approach emerging markets as a broad opportunity set, not as a passive beta investment, and we expect to find very good opportunities across EM.
The transition from brown to green, the faster adoption of new technologies, and post-pandemic changes in supply chains and preferences will create a range of winners and losers and reinforce the importance of active management in corporate debt markets. Shifts in environmental regulation will mean uncertainty and complexity as well as opportunity. High debt levels are a particular concern in the case of countries or companies that stand to lose out in the brown-to-green transition.
Finally, we expect to remain constructive on equities in our asset allocation portfolios. We believe the post-COVID-19 recovery has underscored the need for physical infrastructure investment – after years of under-investment – owing to the trends of digitalization and automation and the push toward green adoption. Where the past decade was software-led, the coming one will be defined more by hardware investments related to these trends. The theme of differentiation and winners and losers in the recovery will be crucial across countries and sectors and at the stock selection level. In particular, we believe that semiconductor manufacturers, factory automation equipment providers, and green energy and mobility suppliers all stand to benefit, and we expect these sectors to be an important part of our portfolio construction.
In an Age of Transformation where real and nominal interest rates are likely to remain anchored at low levels, we think it makes sense to seek to maximize the opportunity in traditional fixed income strategies with flexible mandates aimed at taking advantage of the full global opportunity set. It also makes sense, in our view, to look for alternatives beyond traditional fixed income, including making use of real estate, private credit, and developing global capital markets where this is consistent with client needs and expectations.
For more details on our outlook for the global economy and investment implications over the next five years, read the full Secular Outlook, “Age of Transformation.”
Joachim Fels is PIMCO’s Global Economic Advisor, Andrew Balls is CIO Global Fixed Income, and Dan Ivascyn is Group CIO.