The past several months have investors and policymakers reassessing global economic prospects amid elevated concerns over emerging market growth models andpolicy effectiveness. In the midst of these global uncertainties, PIMCO investment professionals gathered recently for our September Cyclical Forum.
At our previous Cyclical Forum in March 2015, we concluded (as detailed in our post-forum essay) that the global economy was “Riding a Wave ofAccommodation – Carefully.” Since then, while the “wave” of global monetary accommodation has if anything expanded in scale and in scope – and may welldeepen further over our cyclical horizon – to date it has been insufficient to stave off a decline in commodity and equity prices or to discourage renewedfears of disinflation amid concerns that China will not be able to navigate the New Normal trajectory for growth and global financial integration they haveset for themselves.
Although the turbulence in global markets that followed the bursting of the Chinese equity bubble in June and the fallout from the devaluation of theChinese yuan in August was the major financial event that has occurred since our March forum, our goal at the September forum – as at every forum – was to look ahead from initial conditions so as to formulate a baseline view for the global economy as well as to identify and assess the balance ofrisks to that baseline view. Our forum discussions benefited enormously from the active participation of and valuable contributions from PIMCO senioradvisors Ben Bernanke, Mike Spence and Gene Sperling. Drawing on superb presentations from our Americas, European, and Asia-Pacific portfolio committees,as well as from our emerging market (EM) team, and following a very robust and wide-ranging internal discussion, we coalesced on a baseline view thatglobal economic prospects over the next 12 months remain broadly unchanged from where we saw them in March and are consistent with global GDP growth inthe range of 2.5% to 3% and global inflation of 2% to 2.5%.
While this is our baseline cyclical view, the averages it represents mask significant and in some cases widening divergences among the world’s majoreconomies. As we shall discuss further below, our baseline view for GDP growth in the U.S., eurozone, U.K. and Japan over the next year is actuallyconsistent with a modest increase in the pace of growth for this group of countries versus the past year. On the other side of the ledger, weconcluded that prospects for growth in China are clearly deteriorating, though we note the market consensus view is converging toward PIMCO’s more bearishforecast published in March, which in fact remains roughly unchanged. Finally, other major emerging economies such as Russia and Brazil find themselves atpresent in recession with at best uncertain prospects for recovery over our cyclical horizon.
In terms of policy, although more than 40 central banks have eased monetary policy thus far in 2015, the odds for additional monetary easing by theEuropean Central Bank (ECB) and the People’s Bank of China (PBOC) are material, and further easing by the Bank of Japan (BOJ) is certainly possible. As forthe Federal Reserve, while our baseline view remains that it will commence a rate hike cycle sometime over our one-year cyclical horizon, the pace ofliftoff is likely to be even more gradual than we expected in March. Moreover, as our new and already valued colleague Joachim Fels reminded us, there is achance that the Fed, like a number of central banks in recent years, may find it impossible to escape the effective lower bound to which policy rates werecut during the dark days of the crisis some seven years ago.
As for global inflation, we see prospects for a modest pickup in inflation in many countries as the pass-through of lower oil prices – and in the case ofthe U.S., the stronger dollar – on price indexes fades. By contrast, in Brazil and Russia, where inflation well exceeds target, recession and (in Brazil)tight monetary policy are expected to bring inflation lower over our cyclical horizon.
In short, we find ourselves today – and for some time are likely to remain – in a multi-speed world for growth, inflation and economic policy; amulti-speed world that is indeed one of the key elements of PIMCO’s secular New Neutral thesis. Below is our more detailed economic outlook for thismulti-speed world over the next 12 months, and then a discussion of some of the key investment implications that flow from it.
For the U.S., our baseline view sees economic growth in the range of 2.25% to 2.75% over the next four quarters and CPI inflation of 1.75% to 2.25%. Thisbaseline represents a modest pickup in growth and inflation relative to the pace recorded in the first half of 2015, and it is slightly below the pace ofGDP growth over the most recent four quarters. Projected employment and labor income gains should support consumption, while historically low mortgagerates and a pent-up demand for housing driven by household formation and demography should boost residential construction. In contrast to robustconsumption and housing, business investment confronts the headwinds from low oil prices and cutbacks in drilling and exploration, while exports will bechallenged by the delayed effects of a stronger dollar and slower growth in emerging economies. As for the Fed, one consequence of the summer sell-offtriggered by surprise devaluation of the Chinese yuan (CNY) on August 11 has been to lower the odds that we get a hawkish mistake from the Fed. While the“Yellen put” analogy is imprecise – if there is a “put,” then where is the strike, and is this Fed really prepared to deploy its balance sheet to defendit? – it is clear from their statements that this Fed is alert to the state of financial conditions and is inclined to go slow once it starts to hike so asto avoid tightening too much.
Eurozone and U.K. Outlook
For the eurozone, our baseline sees economic growth of 1.5% to 2.0% over the next four quarters with inflation in a range of 1% to 1.5%. This baseline alsorepresents a modest pickup in growth and inflation relative to the paces recorded in recent quarters. Unlike the U.S., the eurozone has benefited from aweaker currency and from low oil prices, and the tailwinds from low oil prices and the weaker euro currency should support aggregate demand in the yearahead. And for the first time in several years, fiscal policy is no longer projected to be a drag on eurozone aggregate demand. Moreover, the ECB isgaining traction in transmitting the thrust of accommodative monetary policy to easier credit conditions. On ECB policy, we see a significant probabilitythat the current quantitative easing (QE) program gets expanded before its scheduled conclusion in September 2016. As for the U.K., we are projecting GDPgrowth of 2.25% to 2.75% with inflation running in a range of 1.25% to 1.75%. The U.K. economy is supported by a strong labor market and the wealth effectfrom robust house prices benefiting from low interest rates. With prospects for the eurozone improving, U.K. exports should also contribute to growth. AsMike Amey (sterling portfolio manager on our European portfolio committee) reminded us, this is a typical U.K. business cycle, and one that is notthreatened by above-target inflation. If the Bank of England does hike during our horizon, it will almost certainly be after the first Fed hike, and notuntil sometime in 2016.
In previous forums, we’ve concluded that China possesses the “will and the wallet” to deal with the policy challenges it faces as it transitions from adevelopment model based on running huge current account surpluses with a closed capital account to a model based more on domestic-demand-supported growthand a more internationally open capital market. While this continues to be true, recent events require us to ask if “will and wallet” continue to besufficient. This assessment is a task that will take us (and the markets) some time to complete, and at the September forum we only just began the process.Clearly, the challenges facing China today are substantial. The economy confronts a property bust, a collapse in equity prices, falling exports and anover-levered shadow banking system. “Hot money” capital is fleeing China, and the central bank (PBOC) is losing reserves in an effort to prevent a furtheruncontrolled depreciation of the CNY exchange rate. Under these circumstances, our baseline sees GDP growth in China in a range of 5.5% to 6.5% over thenext four quarters, which is little changed from our March forecast but remains well below consensus. We see inflation in the range of 1.5% to 2.5%. In theface of such challenging economic circumstances, we expect to see a significant monetary policy response from the PBOC, with 75 basis points in depositrate cuts, a 200 basis point cut in the required reserve ratio and devaluation of the CNY to a level of 6.80 to the dollar.
The Japanese economy has suffered from the slowdown in China and the continuing drag from the 2014 hike in the VAT. Corporate profits are healthy due tothe weaker yen and the labor market is robust, but Japan faces significant structural headwinds to trend growth that have not yet been offset by the “thirdarrow” of Abenomics (the first two arrows were fiscal stimulus and monetary easing; structural reform is the third). The Bank of Japan remains extremelyaccommodative with its massive Quantitative and Qualitative Monetary Easing (QQE) program in place, yet inflation is projected to rise only modestly. Ourbaseline view is that GDP growth in Japan should rise from an outright decline in the second quarter, but only up to a range of 1.25% to 1.75% over thenext four quarters. Under this scenario, we see a possibility that over our cyclical horizon the BOJ expands yet again the QQE program, as there is alimited prospect that inflation reaches the 2% target desired by BOJ Governor Haruhiko Kuroda.
Brazil and Russia Outlook
In Brazil, the macro outlook will largely be a derivative of domestic politics as the gridlock in Congress continues. We are forecasting the recession todeepen throughout this year with meaningful downside risks as business confidence and investment remain weak. At the same time, we expect inflation willremain high but start to noticeably decline in the first quarter of 2016. Potential upside risks to inflation could arise from the outcome of wagenegotiations in the fall, a weaker currency and further fiscal slippage; downside risks could arise from a deep disinflation from the recession and lowerenergy prices. Given this backdrop, we expect only a modest rate-cutting cycle in 2016 as long as the political backdrop is stable and currency pressuresare contained. In addition, we expect to see pressures on Brazil’s sovereign external ratings following S&P’s downgrade to high yield (with negativeoutlook) as the political dysfunction continues and near-term prospects of fiscal consolidation and circuit breakers remain slim. In Russia, the recessioncontinues unabated and is set to peak in the third quarter of 2015 (in year-over-year terms) on the back of a negative terms-of-trade shock and amid theweight of Western sanctions. PIMCO expects Russia’s GDP to contract between −3.5% and −4% this year, and around −0.5% in 2016. Domestic demand remains themain drag to growth, with household spending in particular being hit under a sharp contraction in real wages. Capital expenditures are set to become themain detractor to growth going forward once the pressure on real wages subsides. Meanwhile, the disinflation trend is set to continue as the impact fromthe ruble’s weakness has been relatively contained, i.e., not validated by wage growth. We expect Russia’s central bank to continue to cut interestrates but to moderate the pace of easing going forward. The mirror image (and the silver lining) of the recession in domestic demand has been theimprovement in Russia’s external balance sheet. The current account surplus has been improving, and the deleveraging by the corporate sector has beenimpressive, if only out of necessity.
Risks to the Baseline View
All probability distributions have right as well as left tails. Today, the most significant left tail risk to the global economic outlook is for a hardlanding in China, which in the extreme could trigger a currency war and could increase the odds of outright global deflation. This is not our base case, inno small part because we project significant policy easing by the PBOC over the next year as they seek to clip this left tail risk.
On the optimistic side, thus far the positive stimulus to global aggregate demand from low oil prices has been less than projected by the Organisation forEconomic Co-operation and Development, the International Monetary Fund and other experts. If in fact the stimulus from low oil prices has only beendelayed, not overestimated, global growth in the year ahead could surprise on the upside.
Overall, we see the balance of risks to the global economy tilted somewhat to the downside, in part because of diminishing returns of unconventionalmonetary policy and also the market volatility stemming from developments in China.
While our baseline views on the global macro outlook have not changed significantly, we see somewhat higher macro and in particular market risk. To theextent that there is an impact on macro variables from the market volatility, we expect that central banks will respond over the cyclical path, including aslower pace of hikes by the Fed and increased QE from the BOJ and the ECB. As the Federal Reserve noted in its statement following its September meeting –just after our Cyclical Forum – while most of the FOMC members expect to raise interest rates before the end of this year, global developments have raisedthe risks to the U.S. outlook for growth and inflation in the near term.
At the same time, we see central banks migrating from being a source of endogenous stability in markets to being a source of some exogenous instability.The willingness to attempt to suppress volatility is there, but the ability to do so is diminished. Over-reliance on central banks (versusfiscal/structural policy) has led to a wedge between market valuations and fundamentals that requires a careful approach to portfolio construction andclose attention to correlated risk positions and stress tests.
In broad terms, we see global fixed income markets as anchored by our New Neutral secular framework for interest rates. Lower central bank policy ratesover the next three to five years mean that fixed income markets look fair to somewhat rich – but not grossly mispriced.
In terms of portfolio positioning, this translates into modest duration underweights for the most part. We expect markets to price more risk premiums intodeveloped country curves, starting with the U.S. and the Fed rate hike cycle.
We think that markets are probably pricing insufficient tightening by the Fed, based upon our baseline forecast of above-potential growth and inflationgetting back to the Fed’s 2% target over the next four quarters. Globally, we see the same pattern of forward rates that look fair to slightly rich innominal duration. In U.S. Treasury Inflation-Protected Securities (TIPS), we see valuation as attractive, given our expectation for gradually risinginflation.
We continue to expect to maintain broad credit spread overweights in our portfolios, with some increased uncertainty in the outlook compensated for by moreattractive valuations following recent market weakness. We continue to see investment grade and high yield credit industrials and financials as attractive.We will be vigilant on liquidity and ensure appropriate new issue premiums are on offer before adding in primary markets.
We continue to see value in non-agency mortgages given housing market strength, broadly range-bound rate markets, and the fairly defensive nature of thesecurities due to seniority in the capital structure.
On currencies, we will maintain an overweight to the U.S. dollar, reflecting macro and policy divergence at a time when the U.S. economy is outperformingand the Fed is set to tighten policy, while we expect ongoing policy loosening outside the U.S. We will favor a diversified basket of funding currencies,G-10 currencies and Asian emerging market currencies.
We will be cautious on emerging markets holdings, reflecting macro and market risks, but will continue to look for select opportunities to add risk atattractive valuations.
On global equities, we are broadly neutral overall. At a time of peaking U.S. profits and a stronger U.S. dollar, we will continue to favor European andJapanese equities based on earnings growth momentum and supportive central banks.
On commodities, we expect to see supply and demand as broadly balanced over the next 12 months and have a neutral outlook at current prices.