While the expansion has beenageing
gracefully, we believe the global economy is past peak growth in the cycle.
Yet it may be the derating of financial assets – rather than traditional macroeconomic overheating or overborrowing – that leads to the next recession.
In this environment, we see substantial option value in leaving room in our risk budget to respond either to specific opportunities or to a broad spread widening and rise in volatility.
Our long-standing views on risks to the status quo are being priced into financial markets, with heightened volatility one indicator. As we argued in our Secular Outlook, “Rude Awakenings,” and Cyclical Outlook, “Growing, But Slowing,” we believe the global economy is past peak growth in the cycle, central bank support continues to be reduced and political risk looms large across countries. These trends support our relatively cautious positioning and intense focus on liquid assets, which will allow us to respond either to specific opportunities or generic spread widening and higher volatility.
We expect to continue to have positive carry positions – even with an underweight in corporate cash bonds – based on specific credit opportunities, non-agency and agency mortgage-backed securities (MBS), a small amount of emerging market (EM) foreign exchange (FX) and curve steepeners. This is consistent with our still fairly constructive cyclical baseline as well as our desire to hedge against downside risks and focus on credit market structure and liquidity in the event of a rotation out of crowded positions.
This, in a nutshell, is what PIMCO’s Investment Committee distilled from the discussions at our December Cyclical Forum, which brought together the firm’s investment professionals from around the globe and several of our trusted senior advisors including Ben Bernanke, the chair of PIMCO’s Global Advisory Board, Michael Spence, the 2001 Nobel laureate in Economics, and Gene Sperling, the former Director of the National Economic Council and Assistant to the President for Economic Policy under Bill Clinton and Barack Obama.
"We also benefitted from contributions by Richard Thaler, the 2017 Nobel laureate in Economics, on how to avoid the pitfalls of groupthink and behavioral investor biases.”
We also benefitted from contributions by Alan M. Taylor, professor of economics at the University of California, Davis, on the lessons from credit booms and busts across many countries over the past 150 years, and Richard Thaler, the 2017 Nobel laureate in Economics, on how to avoid the pitfalls of groupthink and behavioral investor biases.
Thaler is a governing board member of the University of Chicago Booth School of Business Center for Decision Research – PIMCO is partnering with CDR in support of the center’s behavioral science research.
Our forum discussions centered on five key macro debates that will likely shape the cyclical and market outlook for 2019.
DEBATE #1: HOW LATE IS IT IN THE CYCLE?
We have been arguing for some time that the economy has entered the later stage of the economic expansion, a view that has become the consensus. But late-cycle phases can last quite some time, so how late is it, really?
For starters, our updated quantitative models indicate that the probability of a U.S. recession over the next 12 months has risen to about 30% recently and is thus higher than at any point in this nine-year-old expansion. Even so, the models are flashing orange rather than red.
A similar message comes from a new cycle-classification model presented at the forum. It scans and combines a large number of economic and financial market data to determine which phase of the expansion or recession we are in. The model suggests that we may still be roughly in the middle of the economic expansion. However, one year ahead, the model predicts a late expansion or even recessionary environment.
A more qualitative analysis corroborates the quant models: We currently do not see signs of overheating in labor or goods markets that have heralded some recessions in the past, nor the overspending or credit excesses that have preceded others. Thus, there is no incontrovertible evidence to suggest a recession is around the corner – yes, the expansion is old but it has been ageing gracefully so far.
Importantly, however, the current market environment makes amply clear that it doesn’t take a recession for turmoil to roil financial markets. Moreover, some participants argued at the forum that rather than traditional macroeconomic overheating or overborrowing, it may be the derating of financial assets that leads to the next recession.
DEBATE #2: THE END OF U.S. ECONOMIC EXCEPTIONALISM?
While the expansion may have room to run beyond its 10th anniversary next year, we expect the growth gap between the U.S. and the rest of the developed world to narrow.
Over the past year, the U.S. was exceptional in many ways. It had a large fiscal boost that accelerated growth while the world was slowing, a central bank that confidently raised rates every quarter, a stock market that outperformed most others, and a dollar that appreciated despite the president’s protestations.
Looking ahead, we see U.S. growth “synching lower” as tighter financial conditions start to bite, fiscal stimulus fades and the recent plunge in oil prices benefits Europe, Japan and China more than the U.S., which has become a net energy exporter. Our 2019 GDP growth forecast for the U.S. of 2.0% to 2.5% remains below consensus, and we see growth slowing to a quarterly run rate of less than 2% in the second half of the year. Thus, the U.S. and other major advanced economies are converging to trend growth.
Despite the narrowing of the growth differential with the rest of the world, we still expect U.S. equities to outperform as companies are more profitable and cyclical sectors have a smaller weight in the U.S. stock market. Regarding the U.S. dollar, views expressed at the forum were more mixed. The optimism on the greenback that characterized forums earlier this year has clearly waned, but the favorable rate differential argues against a major weakening of the dollar at this stage.
DEBATE #3: WILL INFLATION EVER RETURN?
We lowered our sights on inflation in 2019 due to the recent plunge in oil prices and continued sogginess in core inflation in the U.S., Europe and Japan. Our baseline sees core inflation broadly flat or slightly higher in these three regions and thus still running below target.
Despite this benign outlook, we spent quite some time kicking the inflation tires and debating how we might be wrong. After all, wage inflation in the U.S. has reached 3% for the first time this expansion and has also been picking up in Europe and Japan this year.
It is certainly possible that wages start to accelerate more in response to declining unemployment, leading to a bend in the Phillips curve that describes the relationship between unemployment and wages. However, we concluded that rising productivity growth would likely moderate unit labor cost pressures and heightened competition and transparency in goods markets due to the Amazon effect would likely keep consumer price inflation subdued.
We also debated a nonconventional theory of inflation that predicts that higher nominal interest rates cause higher inflation over time. The Fiscal Theory of the Price Level (FTPL) argues that if people do not believe that the government will cut spending or raise taxes in the future in response to central bank rate increases, which would boost government borrowing costs, and thus behaves “irresponsibly,” a slow-moving inflation spiral could start. The reason is that the private sector will feel wealthier with rising interest payments on government bonds that are not backed by future tax hikes and will spend more. If the central bank raises rates further in response, government borrowing costs would increase further and spending and inflation would spiral ever higher.
However, while such scenarios have occurred in some emerging markets in the past, most forum participants had a hard time believing that people in advanced economies would expect their governments to behave “irresponsibly” over long time horizons – a precondition for the described effects to play out, and thus for consumers to start to spend more as interest rates rise.
DEBATE #4: THE FED PAUSES, THEN WHAT?
Following a likely fourth rate hike for this year on 19 December, we expect the Federal Reserve to raise rates only one or two times more in 2019. A pause in the first half of 2019 thus looks increasingly likely as financial conditions and the central bank’s balance sheet runoff are doing some of the tightening for the Fed.
If and when the Fed pauses, however, will this be followed by a resumption of rate hikes, or will the next move after a shorter or longer pause be down in rates?
It is important to note that Fed participants’ rate forecasts (aka the dot plot) already incorporate a pause sometime next year, followed by further hikes. This is because the median forecast of participants foresees a slowdown in the pace of hikes from four in 2018 to three in 2019, followed by another two in 2020.
However, at the forum we reckoned it would be difficult to communicate a pause without markets jumping to the conclusion that this is the end of the rate cycle and the next move will be down. As Ben Bernanke reminded us, his attempt to signal a pause in the previous rate cycle led to significant volatility. While central banks such as the Bank of England might get away with a pause and continued tightening, this is more difficult for the Fed given its global importance.
Against this backdrop, most of us believed that with the probability of recession likely to rise over time, a resumption of rate hikes after a pause was relatively unlikely.
DEBATE #5: U.S. VERSUS CHINA: TRUCE OR PEACE?
We discussed the outlook for U.S.-China relations shortly after Presidents Donald Trump and Xi Jinping agreed to pause their escalation of tariffs to negotiate a deal over the coming 90 days. Some participants argued that the worst of the trade conflict was now behind us, as both sides wanted a deal before the negative economic consequences of higher tariffs would be felt.
However, most of us believed the conflict between the U.S. and China is more deep-rooted and about much more than trade alone, and would thus continue to be a source of uncertainty and volatility even if there were a deal on trade. Mike Spence’s description of the conflict as a “clash of systems” resonated with the audience and reminded us of our discussions at the Secular Forum in May about the “Thucydides trap,” which describes the risks of a confrontation between an established and a rising power.
As outlined above, we see our near- and long-term views on risks being priced into financial markets. In this environment, we will look for broad, diversified sources of carry without relying on generic corporate credit risk and maintain an overall cautious approach in our portfolio construction.
"We think it makes sense to stay fairly close to home in terms of top-down macro risk factors, to keep powder dry and to look for specific opportunities in a more difficult environment.”
We think it makes sense to stay fairly close to home in terms of top-down macro risk factors, to keep powder dry and to look for specific opportunities in a more difficult environment where we see overshooting versus fundamentals. There is substantial option value in leaving room in our risk budget (e.g., holding more cash or accepting lower overall portfolio yield) to be able to respond, either to specific opportunities or in the event of a broad spread widening and rise in volatility.
While we can take some comfort from our analysis that, judging by macroeconomic considerations, we are still some distance from the next recession, the current market environment makes amply clear that a recession is no prerequisite for turmoil in financial markets. Moreover, rather than traditional macro overheating, it may be the derating of financial assets that leads to the next recession.
We think this is a period when we need to favor liquid instruments, except in specific cases where we are paid for illiquidity.
MODESTLY UNDERWEIGHT DURATION, OVERWEIGHT TIPS
The recent rally in global duration has put yields close to the low end of our expected ranges, but in an uncertain environment we want to be fairly close to home in terms of duration positioning, with only a modest underweight in global duration outside of Japan.
We see Japan underweights as a good hedge against an (unexpected) shift higher of the range for global duration and given our expectation that the Bank of Japan (BOJ) will continue to reduce its net asset purchases/tweak its yield curve cap frameworks toward somewhat higher yields and a steeper curve.
While our base case calls for continued modest inflation, Treasury Inflation-Protected Securities (TIPS) breakevens have repriced lower, and we see TIPS as relatively attractively priced and as offering a hedge against possible inflation upside surprises in the U.S. in this late stage of the cycle.
CURVE: LONG THE BELLY, SHORT THE LONG END
We see global curve-steepening positions as a structural source of income generation and, in the current environment, have a preference for the belly of the curve versus the long end of the curve based on valuation. The curve is already very flat given that we do not see recession risk over the next 12 months as all that high. Central bank balance sheet reduction is underway in the U.S., while the European Central Bank (ECB) is poised to end quantitative easing (QE), which we continue to think should lead to the reestablishment of a term premium over time. There is also of course some in-built protection in terms of curve steepeners in the event that we are wrong on recession risk and a significantly weaker economic environment does force the Fed to reverse rate cuts.
CAUTIOUS ON GENERIC CORPORATE CREDIT
We will target corporate credit underweights, with the focus on being underweight generic corporate credit beta, while looking for opportunistic credit trades. Credit valuations have moved closer to long-term averages, but we don’t see credit as cheap, while volatility is rising and the slowing economy could reveal underlying weaknesses in terms of leverage. We continue to be concerned about crowded credit positioning in the market and credit market structure/illiquidity, which could lead to significant overshooting in the event of a more generalized bout of credit market weakness. We want to stay up in quality and up in liquidity, sticking to credits where our global credit analyst team sees value and remote default risk. We are focused on downside risks and credit market structure/liquidity in the event of a rotation out of crowded positions.
RELATIVE VALUE IN FINANCIALS AND MBS
As discussed above, we expect to find good opportunities where we see real cheapness in a more volatile environment, and we want to keep some powder dry for these opportunities. We continue to see financials offering attractive relative value. Based on our view that a chaotic no-deal Brexit is a very low probability, we see U.K. financials as attractive at current valuations. If the tail risk case is realized, while it is clearly likely that U.K. financials’ positions would underperform in the short term, the capital positions of the U.K. banks look robust – as the Bank of England also concluded in its recent very challenging stress test.
We continue to see non-agency mortgages as offering a defensive alternative to investment grade (IG) credit, with a better downside risk profile in the event of weaker macro/credit market outcomes. We also see agency mortgage-backed securities (MBS) as an attractive and relatively stable source of income in our portfolios.
UNDERWEIGHT EUROPEAN PERIPHERAL RISK
We remain cautious on European peripheral sovereign credit risk and corporate risk given the immediate challenges in Italy and the longer-term risks to the eurozone more generally in the next recession. Yet we remain open to specific opportunities where we are amply compensated for eurozone credit exposure.
OPPORTUNITIES IN EM FX AND BONDS
In a world in which growth is synching lower across countries, we have a balanced view on the U.S. dollar versus other G-10 currencies. We will target modest EM FX overweight positions in strategies where this risk is appropriate and, more generally, we expect to find good opportunities in local/external EM bonds in a difficult market environment.
EQUITIES: FOCUS ON HIGH QUALITY DEFENSIVE GROWTH
More broadly, on asset allocation, we anticipated the late-cycle environment would put downward pressure on equity valuation multiples. Looking forward, we expect downward pressure on profit growth expectations as tailwinds fade and lagged effects of financial conditions tightening are realized. We believe equity markets will remain volatile, favoring cautious positioning overall and a focus on high quality defensive growth and minimal exposure to cyclical equity beta. We continue to favor more profitable U.S. equity markets to the rest of the world and prefer high quality large-cap equities at this stage in the cycle, while we wait for select opportunities to present themselves over the cyclical horizon.
COMMODITIES: MODESTLY POSITIVE ON OIL
We are broadly neutral overall on commodity beta risk, combined with a modestly positive view on crude oil. An unexpected surge in U.S. production coupled with softening global demand has moved the oil market into surplus. OPEC’s recent announcement of a cut in production suggests the desire to support oil prices in the low $60s, avoiding the very low levels of 2014, but not tightening markets enough that it causes more market share losses to shale. Outside of oil, natural gas prices are weather-dependent and inventories remain low, but the current level of winter prices is having a clear impact on demand and production is surging, suggesting limited further upside without strong weather support. We continue to see gold as a long-duration asset and prefer other long-duration assets, such as U.S. TIPS at current valuations.
Regional economic forecasts
Following expansion of close to 3% during 2018, we continue to expect real GDP growth to average a below-consensus 2% to 2.5% in 2019, reflecting the recent tightening of financial conditions, fading fiscal stimulus and slower growth in China and elsewhere. Growth momentum is likely to moderate during the year, converging to trend growth of just below 2% during the second half.
We expect employment growth to moderate in 2019 and average around 150,000 nonfarm payroll gains per month, which would still exceed the level of job gains that is consistent with a stable unemployment rate over time. Headline inflation looks set to drop sharply over the next several months, reflecting base effects and the recent plunge in oil prices. Meanwhile, core CPI inflation of about 2% is expected to trend sideways as inflation expectations remain anchored and the (inflation) Phillips curve is quite flat.
Against this backdrop, following the expected December rate hike to a target range of 2.25% to 2.5%, we expect one or two more increases in the fed funds rate by the end of 2019, with a high chance of the Fed pausing or even ending the hiking cycle in the first half of the year.
We expect eurozone GDP growth to slow to a below-consensus 1.0% to 1.5% range in 2019 from close to 2% in 2018. Our downward revision from September reflects the tightening in financial conditions in Italy, which will take a toll on growth, as well as weaker global growth.
Core consumer price inflation has been stuck at around 1% for several years now, but we expect it to pick up somewhat over the next year as unemployment is likely to keep falling and wage growth has accelerated, particularly in Germany. Yet, this would still fall short of the ECB’s own forecasts and keep inflation under the “below but close to 2%” objective.
Nonetheless, we expect the ECB to end net asset purchases by the end of this month, as already signaled by the central bank, and a first rate hike being implemented during the second half of 2019. However, if a pause by the Fed occurs in the first half of 2019, which looks quite likely, and the euro appreciates significantly versus the U.S. dollar in response, the ECB may well extend its forward guidance of unchanged rates into the following year.
We see nominal GDP growth in 2019 in line with consensus but expect a more favorable split between real output growth and inflation.
Our forecast of real GDP growth in a range of 1.25% to 1.75% is based on our expectation that a chaotic no-deal Brexit will be avoided as there will either be a deal on a transition agreement that will be accepted by U.K. Parliament or an extended stop-the-clock negotiation period.
Our below-consensus inflation forecast sees inflation coming back to the 2% target over the course of next year as import price pressures fade and weak wage growth keeps service sector inflation subdued.
Against this backdrop, we see one to two additional rate hikes from the Bank of England over the next year.
We expect moderate GDP growth in Japan in 2019 in a 0.75% to 1.25% range, supported by a tight labor market and a supportive fiscal stance. The consumption tax hike currently planned for October 2019 will cause some quarterly volatility in consumption as households will aim to bring forward purchases of large-ticket items. However, we expect the government to more than compensate for the tax hike in the form of higher spending and reductions in other taxes, so that fiscal policy will be accommodative overall.
However, with inflation expectations low and sticky and improving labor productivity keeping unit wage costs in check despite rising wage growth, core inflation ex the consumption tax is likely to creep up only slightly into a 0.5% to 1% range, remaining well below the ambitious 2% target.
We expect the Bank of Japan to further tweak its Japanese government bond (JGB) buying operations and to continue to stealth taper its purchases, with lower purchases in the 10-plus year sector contributing to a further steepening of the yield curve. This is aimed at easing some of the negative side effects of the low interest rate environment on the financial sector.
Our baseline forecast is for 2019 GDP growth to slow to the middle of a 5.5% to 6.5% range, which is meant to convey the large uncertainties around the outlook caused by trade tensions with the U.S., domestic pressure to deleverage, and economic policy that tries to satisfy partially conflicting targets (e.g., growth and employment versus financial stability). Our baseline forecast foresees more constrained monetary stimulus in the form of further reductions in reserve requirements rather than rate cuts, and incorporates a fiscal expansion worth about 1.5% of GDP, focused mainly on tax cuts for corporates and households.
Any further currency depreciation against the U.S. dollar is likely to be moderate in our baseline scenario. However, if trade negotiations between the U.S. and China fail and tensions escalate, we would expect monetary easing and a sharp currency depreciation.