Over the past year, much of the global economy transitioned quickly from an early cycle recovery to a mid-cycle expansion, and uncertainty has become an ongoing theme in markets, economies, and communities.
In our January 2022 Cyclical Outlook, “Investing in a Fast-Moving Cycle,” we discuss key trends across global economies, policies, and investment sectors that inform our outlook for the coming year along with high-level portfolio strategy. This blog post summarizes our views.
Economic outlook: More volatility, more uncertainty
The robust global recovery continued in 2021, although unevenly across regions and sectors. Overall, government policies to support demand amid one of the largest economic contractions in modern history produced one of the fastest recoveries. This trend aligns with our long-term outlook for a more uncertain and volatile macro environment with economic cycles becoming shorter in duration, larger in amplitude, and more divergent across countries.
With the largest economic effects of the pandemic likely in the rearview mirror, peak policy support, and therefore peak real GDP growth, was also likely realized in 2021. We expect developed market (DM) GDP growth to decelerate from a 5.0% annual average pace in 2021 to 4.0% in 2022.
The speed of the economic recovery coupled with the volatile path of the virus have contributed to more significant frictions in both goods and labor markets that have elevated inflation. We expect DM inflation to eventually moderate back toward the respective central bank targets by the end of 2022, but only after peaking at 5.1% in 4Q 2021.
As a result of the magnitude and the persistence of the recent inflation overshoot, we also now expect an earlier start of DM central bank rate hiking cycles and raised our expectations for the likely level of terminal rates in many emerging market (EM) economies.
In summary, the broad contours of our 2022 outlook include above-trend (albeit slowing) growth and moderating inflation prompting a still gradual tightening in DM monetary conditions. Nevertheless, we see three important risks to our base case, which create a generally more uncertain environment for investors. These include the possibility of persistently elevated inflation, virus variants that drive surges in COVID-19, and the potential for financial conditions to tighten more abruptly than expected.
Despite those risks, markets appear priced for a blue sky scenario where central banks achieve the elusive soft landing without any meaningful amount of rate hikes. Yet, history reminds us that sometimes “stuff happens” when monetary policy pivots.
Risk premiums and yields don’t reflect potential downside scenarios, in our view, which warrants caution and a rigorous approach to portfolio construction.
Duration and yield curve positioning
We generally intend to be underweight duration, largely on the basis of the dearth of risk premium that is embedded across the term structure. Given the likelihood for higher volatility, we anticipate active duration management to potentially be a more significant source of alpha than in the past. We continue to believe that duration can act as a diversifier to balance the more risky components of an investment portfolio, yet we monitor potential shifts in correlations.
We lean toward positioning for a steeper yield curve, though slightly less than usual, given some evidence of weakening in the structural influences that have underpinned the steepener for decades. We see opportunities to diversify our curve positioning, including by taking exposures along yield curves in Canada, the U.K., New Zealand, and Australia.
We seek an overweight to credit, but with significant caveats. For one, we seek to gain our credit exposure from diversified sources, with cash corporates making up a smaller portion of that exposure given the narrow scope for further contraction in credit spreads.
We expect that single-name selection will likely remain a driver of returns in credit markets. We are investing in select COVID recovery themes (hotels, aerospace, and tourism), though modestly, as well as financial companies, and in sectors that we believe stand to benefit from the major transformations we have identified in our recent Secular Outlook, “Age of Transformation.” We also see opportunities in a number of structured products and asset-backed securities, including U.S. non-agency mortgage-backed securities (MBS).
PIMCO has a constructive view on global equities given the slowing yet positive earnings backdrop. (For details, please see our recent Asset Allocation Outlook.) That said, we are preparing for late-cycle dynamics, placing greater attention on security selection. We expect that large cap and high quality companies stand to outperform late in the business cycle, consistent with historical patterns. Companies with pricing power also stand to gain, in our view. The semiconductor sector has potential to outperform over the long term, benefiting from strong demand related to transformational themes discussed in our Secular Outlook, including digitalization as well as many parts of the net zero carbon effort.
On emerging market (EM) local and external debt, we are mindful of a number of risks of investing in the volatile asset class, especially amid tighter monetary policy in the U.S. We are nonetheless intrigued by a number of factors that give EM appeal in the context of a diversified portfolio and our preference for a reduced footprint in cash corporate credit instruments.
We are relatively constructive on energy prices, yet expect the price of crude oil to be constrained by increased energy output in the U.S. Natural gas prices are supported by strong exports, though increased U.S. output has us more cautious on the outlook for 2022. We are attracted to the cap-and-trade emissions market, which we expect to be strongly supported by the transformation from brown to green.
For more details on our outlook for the global economy in the year ahead and the investment implications, please read the full Cyclical Outlook, “Investing in a Fast-Moving Cycle”.
Tiffany Wilding is an economist focused on North America, Tony Crescenzi is a market strategist and generalist portfolio manager, and Andrew Balls is CIO Global Fixed Income.