With her speech entitled “From Adding Accommodation to Scaling It Back” on 3 March 2017, U.S. Federal Reserve Chair Janet Yellen not only cemented market expectations for the Fed’s third rate hike in this cycle, subsequently implemented in the Ides of March. She also unintentionally provided what turned out to be the leitmotif of PIMCO’s March 2017 Cyclical Forum – scaling it back. We found ourselves applying the concept to not just the monetary policy outlook but to a range of developments across the global economy.
Aided by the participation of our Global Advisory Board consisting of itschairman Ben Bernanke, Gordon Brown, Ng Kok Song, Anne-Marie Slaughter andJean-Claude Trichet, and informed by our macro team’s scenario analysis andour regional portfolio committees’ presentations, PIMCO’s investmentprofessionals debated whether our 2017 cyclical (six- to 12-month)narrative of radical uncertainty and fatter tails from last December (see “Into the Unknown”) was still intact. Our conclusion: Yes, but.
Given the continuing lack of detail on the Trump administration’s fiscaland trade policies, the lingering uncertainty about the upcoming electionsin France, Germany and potentially Italy, and the risks associated withChina’s debt bubble and capital outflow pressures, we reconfirmed our “Stable But Not Secure” secular (three- to five-year) framework and generally also our “fattertails” cyclical outlook. (“Fatter tails” refers to the distribution curveof potential outcomes in which we see a generally lower-than-usualprobability of the central or baseline scenario coming to pass andcorrespondingly higher probabilities of the tail-risk scenarios, both tothe downside, or left tail, and to the upside, or right tail.) However,given what we learned in the three months since our December forum,our cyclical story has become slightly more nuanced in several ways. Here’s how and why:
First,we scaled back the expected size of fiscal stimulus in the U.S.and now anticipate a fiscal package to be finalized in Congress only inearly 2018 – thus its impact would occur beyond our cyclical horizon.Repealing and replacing Obamacare will keep Congress busy for a while, andcomprehensive tax reform will take time and is hard to do given the risingopposition to the border adjustment tax from the adversely affectedimporting industries and in the Senate. Thus, any fiscal boost is likely tobe smaller and come later. Viewed in isolation, this somewhat reduces theprobability of a right-tail (positive) outcome for economic growth, atleast over our cyclical horizon, even though expectations of an eventualfiscal package should continue to support consumer and business sentiment.
Second, it also seems appropriate to scale back the left-tail risk of a full-blown trade warsparked by aggressive U.S. trade policy changes. To be sure, the rhetoriccoming out of the administration on trade continues to be antagonistic.However, the reported debate within the White House between moderate“globalists” and more aggressive “nationalists” suggests that the rhetoricshouldn’t be taken at face value. It would have been easy for the Trumpadministration to impose trade sanctions early on via executive orders. Thefact that this hasn’t happened even though the trade hawks were alreadyoperating in the White House early on in this administration while the moremoderate voices were still awaiting congressional confirmation suggeststhat President Trump’s statements on tariffs may be more symbolic thanreal. To be sure, this was our base case all along, but the left tail of aferocious trade war looks less likely now.
Third, and partly related to the previous item,we are scaling down the risk of a major China “accident” this year. Both our internal and external experts at the forum emphasized the willand the wherewithal of the Chinese leadership and central bank to maintainfinancial and (relative) exchange rate stability ahead of the 19th NationalParty Congress in the fourth quarter of this year. While capital outflowpressure and rising debt pose serious risks over the secular horizon, thecyclical outlook for China appears to be for relative stability. Note,however, that the lowered official growth target of around 6.5% for 2017and the heightened focus of the authorities on financial stability imply awaning of the Chinese credit impulse for the global economy in the courseof this year.
Fourth, recent polls as well as the outcome of the Dutch election last weeksuggestsomewhat lower odds of success for nationalist, anti-Europeancandidates and parties in the upcoming elections in France and Germany. In fact, as we discussed at the Forum, the momentum for Emmanuel Macronin France and Martin Schulz in Germany increases the probability of a “morerather than less Europe” outcome, which could benefit assets in theperipheral countries. Overall, however, we remain cautious on Europe giventhe near-term political event risk and also our secular concerns about theviability of the euro in its present form, asredenomination risk – albeit very remote – has resurfacedin the eurozone.
Fifth,we are scaling back our assessment of near-term inflationary pressuresin the U.S.following the recent run-up in headline inflation (which we hadanticipated). One reason is that labor force participation has increased in recent months, which is likely to damp wage inflation for now. Another reason is thatoil prices have recently declined in response to fears of an expiration oflast year’s OPEC deal on supply constraint just at a time when more U.S.shale supply is coming to the market. To be sure, we think longer-termrisks to inflation are skewed to the upside, but at the same time themomentum behind the recent reflation trade is likely to ebb temporarily inthe near term.
A strengthening and broadening global expansion
Putting it all together, we are now more confident in our baseline viewthatthe nearly eight-year-old global economic expansion will bestrengthening and broadeningover our cyclical horizon. In fact, both world GDP growth and consumerprice inflation for 2017 are now likely to come in a quarter percentagepoint higher than previously expected, reflecting: 1) generally supportivefiscal policies (or expectations thereof) in most developed marketeconomies, 2) easier financial conditions since the start of the year, 3)more positive animal spirits as evidenced by consumer and businessconfidence data and 4) a rebound in global trade in recent months. Whileback in December we forecast 2017 world GDP growth averaging 2.5%–3.0%, we now expect growth to be in a 2.75%– 3.25% range this year, up from 2.6% in 2016. Morespecifically (and also see the forecast table), here are our baseline scenario estimates for growth and inflationin major economies around the world in 2017:
- We expect U.S. GDP to grow in an above-trend 2%–2.5% channel through2017 as business investment recovers, particularly in the energy sector,and consumer spending is supported by a further decline in unemployment,higher consumer confidence and expectations of personal income tax cuts in2018. Meanwhile, we forecast core inflation to hover sideways this year,but that the Fed will feel encouraged by above-trend growth to raiseinterest rates two more times during 2017 on top of the March rate hike.Also, we expect the Federal Open Market Committee to discuss and eventuallyagree on a plan to taper reinvestment of maturing bonds starting in 2018and thus organically shrink the Fed’s balance sheet.
- We now expect the eurozone economy to grow in a 1.5%–2% range in 2017, revised higher from our December forecast to reflect the strongermomentum into the year. While political uncertainty remains elevated aheadof crucial elections in France, Germany and potentially Italy, both fiscalpolicy and monetary policy are expansionary and the recovery in globaltrade growth supports exports and investment. We anticipate core inflationat just below 1%, making little headway toward the European Central Bank’s(ECB) “below but close to 2%” objective and that the ECB will keep buyingbonds at the recently announced reduced pace of €60 billion per monththrough December 2017,before tapering and eventually ending its purchasesfrom early next year.
- In the UK, we forecast growth to stay in a 1.75%–2.25% rangein 2017 (above market consensus) despite Brexit, reflecting robust momentumso far and supported by higher government spending and a positivecontribution of net trade on the back of the 15% fall in the pound in 2016.We forecast CPI inflation to exceed the Bank of England’s 2% target, butthat the Bank will keep policy rates unchanged throughout 2017.
- Japan’s fiscal stimulus and a weaker yen will likely propel 2017 GDPgrowth into a 0.75%–1.25% zonewhile inflation remains subdued significantly below the 2% target. Weexpect the Bank of Japan to keep targeting the overnight rate at −0.1% andthe 10-year bond yield at 0% and thus continue its standing invitation tothe government to engage in additional fiscal expansion, which we expect tohappen later this year.
- China’s public sector credit bubble and its private sector capitaloutflows will likely remain under control this year,and we anticipate growth will slow into a 6%–6.5% band in 2017 aspolicymakers prioritize financial stability over economic stimulus ahead ofthe 19th National Party Congress in the fourth quarter of 2017. Any tradewar with the U.S. will likely be engaged via words (and tweets) rather thanaction, and we expect the yuan to depreciate gradually by some 4%–5%against the U.S. dollar.
- In emerging markets, we expectBrazil and Russia will see moderate growth returning as their deeprecessions end. With inflation dropping from elevated levels, both countries’ centralbanks can cut rates multiple times. Meanwhile, Mexico’s Banxico will likelytighten policy further (following the Fed’s lead) to support the peso andquell inflation. As a consequence, growth in Mexico will likely slow into a1.25%–1.75% band in 2017.
Scaling back accommodation
But here is the catch, and it’s a big one: With improvedgrowth and inflation prospects, exhausted central banks are likely to move closer to the exit fromultra-accommodative monetary policies.And it’s not certain whether highly leveraged private and public borrowersaround the world will be able to keep dancing when the music stops.
As we learned in recent weeks, Janet Yellen and her colleagues at the Fedare now more confident that the time for “scaling it back” has come. TheFed will likely hike its policy rate twice more in the remainder of thisyear and looks set to allow assets to roll off its balance sheet graduallyin 2018 by tapering reinvestment. Moreover, the likely replacement ofalmost the entire Board of Governors (including the chair and vice chair)over the next year and the potential for fiscal expansion at a time of fullemployment raises the uncertainty about the Fed’s future monetary policyreaction function (i.e., its targeted “if-this-then-that” response to neweconomic data and conditions – a function that itself can change over timealong with the Fed’s policy approach).
In Europe, we expect the ECB to change its forward guidance on policy ratesaround midyear and to scale back its asset purchases further starting inearly 2018, which raises the specter of sharp adjustments in euro areasovereign yield levels and peripheral sovereign spreads over Bunds.
One final note, and as mentioned earlier, with the Chinese authorities’focus shifting from growth to stability, the strong Chinese credit impulsethat supported global reflation in 2016 and into 2017 is likely to wane inthe course of this year.
Needless to say, we will revisit and thoroughly discuss the longer-termrisks associated with many of these issues in our annual Secular Forum inMay.
Turning to our investment conclusions, financial markets have priced in thestronger baseline growth outlook, somewhat reduced left-tail (downside)risks and the faster path for Fed rate hikes, which we had anticipated. Atcurrent valuations we see it as appropriate to moderately scale back ourcredit exposures in our fixed income portfolios, while we expect to bebroadly neutral on equities in our asset allocation portfolios. (Fordetails on our asset allocation views and strategy, please visit ourAsset Allocation Outlookpage.)
The U.S. economy may indeed be graduating from multiple years of recoveryfollowing the global financial crisis, and there is some potential for theFed to proceed on a more traditional tightening path (though that is notour baseline outlook). However, this is set against the combination ofstill muted growth in the rest of the developed world and the prospect ofcentral banks moving closer toward the exit in Europe, the UK and Japan.One significant source of uncertainty is the prospect for U.S. dollarstrengthening and the Trump administration’s words and actions in responseto further dollar appreciation.
While there is the potential for a rise in the level of global interestrates, it remains the case that higher yields will be limited by still highlevels of public sector debt and in some cases private sector debt, as wellas demographic influences and slow growth in both productivity and creditavailability. The greater normalization we have seen in U.S. rates comparedwith Europe, the UK and Japan and historically wide spreads mean that thereis the potential for global yields to reprice closer to the U.S., and thisalso leaves the U.S. as the most attractive source of hard duration in theevent of a shock.
Given valuations and the ongoing uncertainties in the global outlook, wecontinue to see the current environment as one in which we should avoid bigcalls on macro trades and instead look to grind out alpha, take advantageof mispricings and relative value opportunities, and respond to newinformation. Maintaining a sufficient level of liquidity (or “dry powder”)should allow us to respond as active investors to market volatility andhigh conviction opportunities when they present themselves.
We expect to keep portfolios fairly neutral on overall duration, with apreference for the U.S. over European, UK and Japanese duration and tomaintain a bias toward curve steepening, based on the opportunity togenerate income, expectations of a still measured pace for the Fed andother central bank tightening and the prospect that markets will price ingreater risk premium at the longer end of global curves.
In our view, U.S. Treasury Inflation-Protected Securities (TIPS) continueto offerreasonable valuations and an attractively priced hedgeagainst higher-than-expected inflation outcomes – particularly given theuncertainty over the extent of U.S. fiscal expansion at a time when theeconomy is at full employment.
We have moderately scaled back corporate credit exposures but generallyexpect to remain overweight in credit. We expect to continue to reducegeneric investment grade and high yield positions in our portfolios, andfocus instead on “bend but don’t break” credits: defensive, high quality,short-dated and default remote credit exposures. Financials continue toprovide some good opportunities, but we will be careful on scaling of thesepositions. As always,rigorous credit researchis paramount.
We expect to be overweight non-agency mortgage-backed securities (MBS),which again offer defensive qualities in the event of weaker-than-expectedgrowth outcomes in addition to attractively priced risk premia forliquidity, complexity and uncertainty over the timing of cash flows. U.S.agency MBS also offer reasonable valuations and a source of income,although we will carefully monitor the prospects for the Fed reducing thereinvestment of coupons and the market impact.
We remain cautious on eurozone peripheral risk, based upon the challengingsecular outlook for the eurozone, political risks and the ECB’s decision toscale back its quantitative easing (QE) program and the prospect forfurther tapering later in the year. The ECB’s tapering at a time when coreinflation is a long way from target in the eurozone has called intoquestion the extent to which the ECB will support both reflation in theeurozone and peripheral sovereigns in the event of political or economicshocks. We also expect to be underweight European corporate credit atcurrent valuations.
While we see some potential for modest U.S. dollar strengthening versusother major currencies, this is subject to significant uncertainty over theTrump administration’s response to a stronger dollar. Higher-yieldingemerging market currencies offer attractive income-generating potential,but we will be careful in terms of the scaling of these positions.
More generally on emerging markets, while we do not anticipate runninglarge risk positions at current valuations, we will continue to look forgood opportunities to add diversified positions to our portfolios.
We expect to be neutral on overall equity risk in our asset allocationportfolios. Equity markets have continued to rally, driven by the earningsrecovery and the stronger global growth outlook. But we do not seesignificant upside potential for U.S. equities at current valuations in theabsence of a breakthrough on corporate tax reform in the U.S. The strongerglobal expansion has the potential to boost cheaper cyclical markets,notably Europe, but this remains subject to eurozone political risk.
Returns in and prospects for the commodity markets have improved materiallysince last year due to a combination of improved macroeconomic activity aswell as material advances in the supply-side adjustment. We believecommodity allocations should be broadly at benchmark weight, as an expectedincrease in global GDP supports commodity demand. The correlation ofcommodities to other asset classes, as well as correlation within thecommodity space, has returned to historical norms, pointing to the likelyreturn of commodities as a portfolio diversifier. The positive correlationto inflation and inflation surprises also points to the benefitscommodities may offer a portfolio, especially as infrastructure spendingincreases globally and austerity declines, as we anticipate.