If we were to summarize PIMCO’s global economic outlook for 2016 in one line, it would be this: Central banks to diverge as global economies continue to converge.
We developed our outlook at our latest Cyclical Forum, held in December coincidentally the week before the year’s most pivotal Federal Reserve meeting. We concluded that, barring a “zombie apocalypse” (as one of our participants colorfully phrased it), the Fed this month would commence its first rate hike cycle since the one that began in June 2004 under Alan Greenspan and concluded in June 2006 under then Fed Chairman – and now PIMCO Senior Advisor – Ben Bernanke.
A lot has happened in those 11 years, and indeed a lot has happened since we last met in September 2015. At the September Cyclical Forum, we were focused on assessing the hard landing risk for China as well as the possibility that the Fed under Chair Janet Yellen might choose not to hike at all in 2015, or perhaps ever. Since then, concerns over China have receded somewhat – although by no means have they disappeared – and robust U.S. payrolls data and some evidence that wage inflation is increasing gave the Fed the hard data it needed to commence a rate hike cycle. And we do believe it will be a rate hike cycle – the chances of a “one and done” single-hike scenario are about equal to those of a zombie apocalypse. That said, we take Chair Yellen at her word that in this New Neutral world – and yes, even the Fed has embraced the new “neutral” real interest rate and now uses that term – the Fed’s liftoff trajectory is likely to be the most gradual on record.
The Fed will not be the only central bank hiking in 2016, with rate hikes also expected for Mexico, Brazil and South Africa. The Bank of England is also likely to follow the Fed and start tightening monetary policy in 2016. But that is a short list. Most other central banks in the world, and all the other major ones – European Central Bank, Bank of Japan, People’s Bank of China – will likely ease policy in 2016, either through rate cuts or ongoing or expanded quantitative easing (QE) programs, or at the very least keep rates on hold and close to the effective lower bound.
Yet while central bank policies are likely to diverge in 2016, we expect the world’s major global economies to continue to converge in 2016, as shown in Figure 1. A striking and little appreciated fact about the U.S. recovery from the great recession is how stable it has been, with annual GDP growth rates of 2.5% in 2010, 1.6% in 2011, 2.2% in 2012, 1.5% in 2013, 2.4% in 2014, an expected 2.5% in 2015 and a PIMCO baseline forecast of 2.25% in 2016. It has been said that “you can’t trade GDP,” but if you could, its price would not have moved very much over the past five years. Contrast the muddle-through moderation in U.S. GDP with growth in other major economies. Since the great recession of 2008–2009, Europe, Japan, Brazil and Russia have all had another recession – with Brazil and Russia still mired in one – and China’s growth, and growth prospects, have slowed sharply. But growth in Europe and Japan picked up in 2015 and are projected to increase modestly in 2016, and growth in the emerging market “BRIM” countries – which include India and Mexico in addition to Brazil and Russia – is also projected to rise. So along with the ongoing slowdown in Chinese growth, PIMCO’s projections for 2016 are for global economies’ growth rates to continue to converge as monetary policies diverge, while inflation rises closer to target in the advanced economies.
The net result is an expected sideways trajectory for the global economy, with implications for investors that we will discuss after we take a deeper dive into the individual country outlooks.
For the U.S., our baseline view is above-trend economic growth in the range of 2.0%–2.5% over the next four quarters – in line with the average growth rate of the U.S. economy during the current expansion – and headline CPI (Consumer Price Index) inflation in a range of 1.5%–2%. The odds are probably increasing that job growth exhaustion begins to set in during 2016. By way of explanation, labor income growth is the sum of job growth, hours per job and wages per hour. With job growth expected to slow as the economy reaches full employment (monthly payroll gains may fall below 100,000 at some point next year unless labor force participation rebounds), income gains will be tied more closely to real wage gains. Under our baseline, the handoff from payroll growth to wage growth results in a slowing of consumption growth. Given the middling pace of the global recovery and the strong U.S. dollar, we anticipate little if any boost to aggregate demand from international trade. On the positive side of the ledger, the recent budget agreement between the Congress and President Obama will provide the U.S. economy a modest and unexpected fiscal boost from the increase in federal spending. With respect to the Fed, after December’s initial quarter-point hike, the market is pricing in only two further quarter-point increases in 2016. We see the risks biased toward the Fed delivering more rate hikes than the market is pricing in.
Eurozone and UK outlook
For the eurozone, our baseline is for a continuation of above-trend GDP growth of about 1.5%. The European Central Bank’s (ECB) push into QE is continuing to have a positive impact on loan growth and is supporting spread compression in bank lending rates across the peripheral countries. That said, while net exports should benefit from the cumulative weakening of the euro to date, a growth slowdown in the eurozone’s major trading partners may limit the contribution to growth from net exports in 2016. We think that headline inflation will increase from roughly zero in 2015 to about 1% in 2016 on a weaker euro and oil prices, but believe that with current monetary policy settings, core inflation is unlikely to recover to the level consistent with the ECB’s definition of price stability. If so, there will be pressure on the ECB to recalibrate the size and pace of QE, opening the door to a possible expansion of the existing program (the ECB generally under-delivered on QE expansion at its December meeting versus both market expectations and its own messaging).
In the UK, we expect above-trend growth in the range of 2%–2.5% over 2016. Our view is that private domestic demand will continue to drive growth. This is predicated on a further tightening of the labor market and robust real household income growth. Our inflation expectations are in line with the consensus for a modest rise in core inflation, due to a fading effect from the rise in the sterling and modest gains in service sector inflation via higher wage costs. We expect headline CPI inflation to converge to core by the end of 2016. The key domestic risk to this outlook surrounds the potential “Brexit” referendum in Q3 2016. Whilst not our central expectation, a vote to leave would likely reduce GDP by 1%–1.5% in the 12 months thereafter, thereby skewing the risks to the downside over our cyclical horizon.
We see prospects of a modest pickup in Japanese GDP growth to about 1% in 2016, up from an estimated 0.6% in 2015. The weak yen has been very good for corporate profits and the Nikkei stock market, but in the face of the slowdown in China and other major trading partners, net exports are not expected to provide much of a boost to aggregate demand in 2016. Headline inflation is expected to remain positive in 2016, but at around 1% is well below the Bank of Japan’s (BOJ) target of 2%. We see a material probability that this inflation outcome could prompt further BOJ easing, but this is not assured as there are rising concerns among market participants as well as BOJ leadership that the BOJ’s Quantitative and Qualitative Easing (QQE) program could run up against technical limits. Large-scale monetary easing has had a major positive impact on financial markets and positive impact on inflation expectations – but not the impact on wage growth that the Japanese authorities had hoped for. An important new development in Japan is the shift in fiscal policy goals evident in Abenomics II with its three new arrows: cash transfers to the elderly and poor, an increase in the minimum wage and an expanded program of child care and elder care to increase labor force participation.
Our economic outlook for China is little changed since the September forum. We see growth of about 6% and headline inflation of about 2%. We still believe that China possesses the “will and the wallet” necessary to deal with the challenges of slower growth and the pivot toward a services economy driven by domestic demand, but we recognize that the task is difficult and that policy mistakes may occur along the way. On the monetary policy front, we anticipate additional easing – and more than is priced in – via cuts to the deposit rate and required reserve ratio. Now that the Chinese yuan has been admitted to the International Monetary Fund’s basket of reserve currencies, we foresee less need for intervention in the currency markets. We expect the yuan to depreciate by more than the 4% or so that markets are pricing in over the next year. Indeed, we see China moving toward a “dirty float” regime that would allow greater exchange rate fluctuations inside the +/− 2% band around central parity. On the fiscal side, we see a modest rise in the budget deficit due to quasi-fiscal financing of local public works by the policy banks in an effort to stimulate demand.
Outlook for Brazil, Russia, India and Mexico
We forecast BRIM growth in 2016 to increase only modestly from 2015, but remain below consensus forecasts. An important driver of our lower-than-consensus forecast is the economic contraction in Brazil following the sharp drop in confidence amidst elevated political gridlock and uncertainty. Russia is also forecast to contract in 2016, albeit at a slower pace than previously as the economy gradually recovers. Meanwhile, both India and Mexico are expected to grow in line with consensus, although in the latter we still see a modest negative output gap. On the inflation front we forecast 2016 headline CPI inflation in BRIM at 6% versus consensus at 5.9%. Brazil remains the main outlier where we expect higher-than-consensus inflation in 2016 given lower disinflation than forecasted and structural rigidities that limited the downward drift in headline CPI (e.g., indexation in wages and pensions). Price pressures in the other economies are likely to be largely contained, with Mexico’s headline CPI forecast at 3%.
Risks to our baseline view
At the Forum and subsequent portfolio management strategy meetings, we focused on a set of risks relevant to the macro outlook and in particular to investment positioning. While as our baseline view we see ongoing above-trend growth and a path of gradual reflation in the developed countries, it remains a difficult environment for investors. Here are five key macro and market risks:
First, there is a bimodal nature to the U.S. outlook. Either inflation is going to return to close to the Fed’s targeted levels over the next four quarters, or there could be further downside disappointment. We expect the Fed to successfully navigate away from the zero bound, but there is a risk that the economic or market reaction could frustrate this effort – as has been the case in other countries that have attempted to tighten monetary policy since the 2008 financial crisis.
Second, and related, commodity markets have been a major source of volatility in 2015 and this could continue in 2016. This is important for credit markets but also for the baseline of reflation. Regarding the Fed, we expect Janet Yellen and her colleagues to be very focused on actual inflation outcomes and more cautious about relying on their inflation forecasts.
Third, emerging markets remain a potential source of volatility. Regarding China, for example, our baseline view is there will be less macro spillover from China to the rest of the world, via commodity and trade channels, in the next 12 months compared with the past 12 months. The nation’s slower trajectory is now priced into macro forecasts and markets. However, Chinese policy, especially foreign exchange policy, is a key source of risk.
Fourth, while Europe and Japan are set to continue with expansionary QE policies at the same time as the Fed tightens policy, there are questions about the willingness, ability and effectiveness of these interventions. This is particularly important given the wedge that central bank interventions have driven in many markets between pricing and fundamentals.
Fifth, reduced market liquidity has led to markets tending to overreact to relatively small shifts in information or in policy. The liquidity reduction is due in large part to regulatory initiatives that make it more expensive for banks to devote balance sheet capacity to trading, though a secondary contributor is crowdedness in investor positioning resulting from – and indeed in part the target of – QE-type interventions.
Taking central bank divergence, convergence across economies and the identified risks to the baseline, clearly the path for the Federal Reserve, commodity prices and emerging markets are likely to be key to investment outcomes in the coming year.
The Federal Reserve in line with our expectations delivered a “dovish hike” in December. Our baseline is for a successful escape from the zero bound, in the context of ongoing above-trend growth and inflation that moves closer to the Fed’s 2% target over the next four quarters. There is significant uncertainty around the path for policy rates. The Fed itself said in its statement that it will “carefully monitor actual and expected progress” toward its inflation target in making its monetary policy decisions, moving faster or slower as a result. If the Fed, in line with our baseline view, gets off the zero bound without an adverse market/macro feedback loop and if the inflation/reflation outcomes are in line with our forecasts, then over time the Fed should become more confident in the actual and projected inflation path, less tentative in its communications, and in turn the market may price in a higher path for short rates. The Fed in its quarterly forecasts publishes its “blue dots,” indicating members’ expectations for the policy rate. The median forecast puts the fed funds rate at 1.4% at the end of 2016 and 2.6% at the end of 2017. There is certainly the potential for markets to price a path closer to the Fed’s expected path as disinflationary fears recede.
In terms of portfolio positioning, we expect to maintain duration underweights in most portfolios, reflecting the potential for some upward pressure on U.S. and global yields as the Fed continues to tighten monetary policy and the fact that term premia across interest rate curves are generally low in the U.S. and across developed markets. We continue to favor TIPS (U.S. Treasury Inflation-Protected Securities), seeing valuation levels as attractive versus nominal bonds given our expectations of a return to inflation close to 2% over the cyclical horizon.
We are broadly neutral on agency mortgage-backed securities, while we like non-agencies, including their seniority in the capital structure at a time when we remain constructive on the outlook for the U.S. housing market.
In a world of fair to expensive valuations, the credit risk premium looks reasonable. Outside of the energy sector, credit fundamentals are solid, and we generally expect to add credit over the next year, taking advantage of periods of market weakness. We see opportunities across investment grade, high yield, U.S. bank senior debt and bank capital in Europe.
On currencies, we see the potential for the U.S. dollar to continue to appreciate, though at a slower pace than over the past 18 months. After this period where U.S. dollar long positions have contributed to many of our portfolios, we expect to reduce currency positions, notably on the euro and Japanese yen, which have moved significantly versus the dollar and where valuations are no longer as supportive. We continue to favor long dollar positions versus a basket of Asian emerging market currencies, reflecting policy divergence at a time when the Federal Reserve is tightening and the good probability that China’s currency depreciates more than forward markets have priced in.
For emerging markets, in addition to our views on Asia currencies, we expect to maintain an overall cautious stance in most portfolios outside of dedicated emerging market strategies, but we will look for select EM opportunities at a time of market dislocations.
Looking at Europe, we continue to favor strategies linked to the ECB’s efforts to reflate the eurozone economy. However, we recognize that the speed and depth of movement in these assets in the near term could well be reduced by perceptions that the ECB may be somewhat constrained by internal debate over the appropriate amount of new monetary accommodation and/or the efficacy of its policies.
We expect to be broadly neutral on commodities in our asset allocation portfolios. Our outlook for 2016 is one of guarded optimism for energy. Recent near-record warmth is contributing to a sharp sell-off into year-end, which will further speed up capital spending reductions and set the stage for higher oil prices in 2016. The outlook for other commodities is less rosy as the slowdown and rotation toward a consumer-led economy in China will likely continue to weigh on base metals. Overall, we favor commodities with quicker natural supply response and greater consumer orientation, both of which leads us to favor petroleum.
We are broadly neutral on equities. In the U.S., foreign exchange and commodity headwinds along with high margins will make it difficult to sustain capital appreciation. But ongoing growth means we also expect multiples to be maintained. We have a small underweight in U.S. equities, offset by small overweight positions in Europe and Japan, where central banks remain supportive of risk assets. We are broadly neutral on emerging market equities, reflecting the balance of cheaper valuation versus challenging fundamentals.
Over the cyclical horizon in our portfolios we will endeavor to be prepared for bouts of volatility and be prepared to benefit from them. This requires careful scaling of risk positions and a significant focus on the liquidity premium embedded into asset prices to make sure that we receive proper compensation for holding less liquid assets. By maintaining room to add to risk assets during periods of stress, we can look to provide liquidity profitably when markets demand it.