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Good investment opportunities remain, but investors must be compensated for growing and heightened uncertainty and risks of policy exhaustion.
How stable is the global economy, and what are the risks to that stability?
Critical questions like these drove vigorous debate when PIMCO’s investment professionals gathered in May for our 35th annual Secular Forum. As always, our focus was to identify the key secular forces that will drive the global economy, monetary and fiscal policy, and financial markets over the next three to five years. To help us develop and refine our views, we heard from a stellar lineup of invited speakers, were briefed by our newest class of MBAs, and engaged with members of our Global Advisory Board, who actively participated in the forum discussions. The goal of the Secular Forum is to provide the concept, the construct and the compass to help us navigate global markets over the next three to five years. Crucial to this objective are the baseline, left tail and right tail scenarios we consider for the global economy and economic policy over that timeframe.
To set the stage for this year’s forum discussion, we briefly reviewed the baseline scenario that emerged from last year’s forum.
In May 2015, our baseline secular outlook saw central banks constrained by lofty leverage and sluggish growth to set policy rates at levels well below those that prevailed before the crisis, a continuation of our New Neutral thesis from 2014. For the eurozone and Japan, we expected equilibrium real policy rates would remain negative over most, if not all, of our secular horizon. For the U.S., we foresaw a gradual liftoff trajectory for the federal funds rate also fully consistent with The New Neutral, a liftoff trajectory that a year ago – and today – is (more than) priced in to financial markets (see Figure 1). We also saw a potential conflict between the Fed’s desire to allow its balance sheet to shrink over time and its dual mandate objectives of supporting growth and pushing up inflation toward its 2% target, and observed that the Fed balance sheet was not on autopilot. Our baseline secular scenario last year saw a world of economies converging to modest trend growth trajectories, with output gaps narrowing – in some cases only very gradually – and with inflation rising toward target. We also identified key tail risks to the baseline scenario that, if realized, would produce a far different trajectory for the global economy. For example, we noted that, were the world economy to tip into a global recession, few countries outside the U.S. and China would have ample room to maneuver to deploy aggressive countercyclical policy. We also specifically cautioned that there “remains a tail risk of political polarization in the eurozone and/or a British exit from the European Union. In China, the planned reforms are ambitious, but success is not assured, and capital account liberalization in particular will be challenging to accomplish in the timeframe announced.”
“The neutral nominal federal funds rate – defined as the value of the federal funds rate that would be neither expansionary nor contractionary if the economy were operating near potential – is currently low by historical standards and is likely to rise only gradually over time.”
– Federal Reserve Chair Janet Yellen, 16 December 2015
As we gathered in Newport Beach for the 2016 Secular Forum, we knew that our New Neutral thesis was now more than fully priced in to financial markets. In fact, Fed officials themselves have discussed U.S. monetary policy in terms of a time varying “neutral” policy rate, which is currently and is expected for several years to remain (well) below its pre-crisis old neutral level. So an important goal of this forum was to develop a new secular framework appropriate for a world in which The New Neutral is expected to prevail and is fully reflected in asset prices. We also realized that we confronted many of the same questions that we did the year before: How robust is the global expansion in developed and emerging economies? What are the limits of unconventional monetary policy, and do the costs of such policies exceed the benefits? Are China’s prospects for growth, exchange rate policy and capital account liberalization on track? We confronted new questions as well, about the prospects and risks for political polarization and fragmentation in Europe and the U.S., and the downside to negative interest rate policy in Japan and elsewhere.
But while many of the questions might remain the same, a lot – to say the least – has happened since our last forum in May 2015, and we needed to decide based on what we learned from our invited speakers, our Global Advisory Board members and our first-year class of MBAs whether and to what extent we needed to reassess our baseline scenario as well as recalibrate the likelihood and rethink the particular consequences of different tail scenarios. We organized our agenda into four broad topics, also the four essential questions to frame our discussion:
The focus of our internal discussion was on how to balance and reconcile the set of powerful forces that have been at work in the post-crisis global economy, to stress test and re-examine how likely they are to continue, and to assess what might happen if the baseline scenario for the global economy proves to be unsustainable. In these discussions, many of us found a useful framework in one of our guest speakers’ notions that we face “radical uncertainty” about the future course of the economy, policy and markets, and the idea that “stability is not sustainability.”
We agreed that we find ourselves today in a post-crisis global economy in which growth is just fast enough to avoid stall speed, but there is no evident or prospective source of productivity or organic demand that would support a baseline for more robust expansion. Deflation has been avoided and output gaps in many major economies are closing, but few if any major central banks today are even hitting their 2% inflation targets, let alone overshooting them. And so while the global economy has plodded along since 2009 and has thus far avoided tipping into another recession, the system has only averted collapse because of zero or even negative policy rates in many countries, the gusher of liquidity administered by major central banks via quantitative easing (QE), and the debt-financed investment boom in China and some other emerging market (EM) economies.
One plausible scenario, and indeed this remains the PIMCO baseline case, is that a version of this status quo simply continues and evolves gradually for the next three to five years. More specifically, our baseline view for the U.S. foresees GDP growth at or slightly above trend of 1.5% to 2% per year, inflation fluctuating around the 2% target, the Fed gradually lifting the federal funds rate to the New Neutral range of 2% to 3% nominal, and fiscal policy providing modest positive support to aggregate demand.
For the eurozone secular baseline, we foresee lackluster, trend-like growth of between 1% and 1.5% per year with inflation remaining somewhat below 2%. On policy, we see the European Central Bank continuing to do the heavy lifting and eventually even pursuing an extension of the QE program that will approach de facto if not de jure monetization of fiscal deficits. Our baseline sees modest positive support for European growth from fiscal policy over the next three to five years.
Finally, for China, our baseline is that of a managed slowdown, with growth between 5% and 6% and inflation around 2%. Under the baseline, leverage stabilizes in part through controlled defaults and with incremental state recapitalization of state-owned enterprises.
But the consensus in the room was that we should not take excessive comfort from this familiar refrain even if it does remain our baseline scenario. With the global recovery about to enter its eighth year, with central banks pushing even further into the realm of diminishing if not negative returns to unconventional policy, and with our secular window now open to the year 2020 and beyond, we considered another, more complex diagnosis: There is the distinct possibility that the left tail has gotten fatter, and that monetary policy exhaustion and an overhang of debt in some major economies pose material threats to the sustainability of the global recovery and financial stability. This is a left tail scenario and not our baseline view, but in contrast with our previous New Neutral thesis, we now believe that there is a material risk globally – if not necessarily for the U.S. – that the unconventional monetary policies in place today will be insufficient to maintain global growth, close output gaps and bring inflation to target. Furthermore, compared with the pre-crisis experience, with trend growth slow and with debt levels high, there are no obvious “spare tires” available globally if and when monetary policy exhaustion threatens global stability. In other words, the global economy finds itself today in a state of disequilibrium that has remained stable thus far only via three policy props: zero or near-zero interest rate policy, QE, and levering up in China, some other EM economies and the European periphery. We concluded there are diminishing returns to all three of these policy props, while at the same time we believe the costs of unconventional policy are rising and the ability to maintain growth with ever-higher leverage in some countries is limited.
We also considered right tail scenarios for the global outlook, and focused our attention on possibilities for a rebound in global productivity – which would support higher investment, consumption and “animal spirits” – and possibilities for a shift in the global policy mix toward fiscal policy or even coordinated monetary-fiscal “helicopter money” programs. As for productivity, our guest speakers reminded us that inflection points in productivity growth are hard to predict, so while a rebound in productivity might happen in the next three to five years, and we could cite anecdotal evidence to support that belief, we did not see this right tail scenario as likely enough to affect the way we expect to invest.
Regarding helicopter money, we thought it very unlikely to happen in the U.S. over our secular horizon. By contrast, in Japan, there already appears to be a rather high degree of coordination between monetary and fiscal policy, and there are real prospects for even closer ties between the Ministry of Finance and the Bank of Japan in which the existing quantitative and qualitative monetary easing (QQE) program evolves into a Japanese government bond price-pegging program. The uncertainty surrounding the impact of helicopter money scenarios is especially radical.
Turning to more traditional fiscal policy options, the world’s three major economies – the U.S., Germany and China – all have space to run more expansionary fiscal policies, and in a right tail scenario they do so and with a focus on infrastructure and the supply side.
Finally, a potential positive for the global outlook in our baseline scenario is that the secular correction in commodity prices and the secular tailwind to the strong dollar appear to be largely complete.
In sum, our secular thesis is that with risks to global economic stability rising, investors should be compensated up front for the growing and heightened uncertainty and potential consequences of monetary policy exhaustion they face. Under a left tail scenario in which this stable disequilibrium unravels sometime and in some fashion during our secular horizon, no one has a crystal ball to determine what it would look like. The timing and precise dynamics of the eventual endgame following such a scenario are uncertain, the plausible paths are many and complex, path dependence would be the rule and not the exception, and much would depend on the timeliness and boldness of the policy – including fiscal policy – response. But while there are myriad uncertainties, there is no doubt that a global disruption of our baseline scenario would have serious repercussions for growth, inflation and financial markets. The risks are uncertain, but they are real, and active investors can aim to put a price on them.
Here we can learn another lesson from history: “A Stable Disequilibrium” was in fact the theme of our 2006 Secular Forum, and this was the way we had characterized the world in the years leading up to the global financial crisis. At that time, PIMCO was early and saw the world in a state of stable disequilibrium – supported by a surge of financial globalization and petrodollar recycling that fueled an unprecedented explosion in private sector borrowing, an era that today is referred to as “the great leveraging” that provided the financing for “the great moderation.” Asset prices were distorted and traditional metrics for valuation were cast aside. Momentum made money, and contrarian investors, for a time, lagged behind. Nonetheless, as early as 2004 we had begun to prepare and position our portfolios for the eventual unwind, knowing full well that our crystal ball was opaque and that the stable disequilibrium, although doomed to collapse eventually, could persist for some time – as of course it did.
Although the situation today differs in many respects from the pre-crisis experience, there are some parallels. Global leverage is again exploding – via government budget deficits in the rich countries and private sector borrowing binges in some major EM countries (see Figure 3). Asset prices in some markets are distorted and traditional metrics of valuation are cast aside in a world of QE infinity, negative interest rate policies and subzero seven-year sovereign yields. Although global imbalances have declined and are shrinking, they have been more than replaced by ballooning central bank balance sheets as a source of liquidity and cheap finance for the chronically debt-addicted. This policy mix and the middling global growth and modest inflation it supports may remain our baseline scenario. But because we see the left tail risks as elevated, just as we did during the stable disequilibrium years before the crisis, we believe it makes sense coming out of this forum to prepare and position ourselves with this elevated macro risk in mind.
In a world in which stability is becoming increasingly unsustainable, how do we invest? These are some of the key secular themes that we expect to guide how we manage our clients’ assets over the next three to five years.
In recent years we have described “riding a wave” of central bank interventions, as a range of unconventional policies have been rolled out across countries, driving asset price returns. This wave-riding has worked well in the past. Looking out over the secular horizon, however, diminishing returns to central bank interventions – and the potential for policy activism to do more harm than good, notably in the case of negative policy rates – advise against such an approach. Debt levels globally remain very high, and the more levered sectors are relying on (potentially less effective) central bank support. While our baseline secular outlook sees a fairly benign macroeconomic path and fairly range-bound markets, there are a range of downside risks (discussed in detail above), including China and the eurozone, monetary policy exhaustion, political gridlock and the rise of populism. These potential shocks to the global economy increase the prospects for permanent debt write-downs over the secular horizon. Overall, we expect to have more cautious positioning in our portfolios, and to make capital preservation the number-one priority. It will be critical to target high quality income-generating assets in our portfolios but not necessarily the highest-yielding assets – we will tend to look for structural seniority, and we want to see sufficiently strong fundamentals or hard asset coverage to help investments weather the uncertainties over the secular horizon. We cannot rely solely on central bank support. The secular timeframe is likely to remain a very difficult environment for investing, and we will seek to avoid investments where there is a real risk of permanent capital loss.
Markets now price in the New Neutral outlook for central banks and for market rates, which has been a central theme of our secular outlook for the past two years. Over the coming secular horizon, we will guard against negative yields in Japan and the eurozone, looking for more attractive global alternatives. Overall in our baseline outlook we expect government bond market yields to be fairly range-bound, but there is a clear asymmetric risk toward higher yields than those priced into forward curves.
The combination of fixed income markets that price in The New Neutral and fairly full equity valuations means we are operating in a low return environment. This reinforces the importance of active management, with alpha set to be a higher proportion of total return than during the secular bull market. We see this as an environment in which active managers can improve upon low passive returns. We believe critical decisions have evolved beyond the straightforward how much of a given asset class, sector or region to own in a portfolio, and instead see a need for greater discretion in selecting what to own. Also, we reaffirm the importance of PIMCO’s long-term tradition of structural alpha positions, which seek to benefit from exploiting market inefficiencies and provide a diversified source of return from other top-down and bottom-up active positions.
The outlook for growth at the global level and across globally important countries and regions we see as subject to fairly normal, bell-shaped distributions. But this fairly normal outlook reflects a very unusual level of central bank and other policy interventions. Market valuations range from fair to stretched and remain highly influenced by central bank interventions. As the Federal Reserve looks to unwind stimulus and other countries, notably Japan, get further and further into extreme intervention territory, the margin for error is thin. The experience of the past years has shown that it does not take much in terms of policy actions and mistakes to prompt repricing in markets. While maintaining overall fairly cautious portfolio positioning, we will seek to benefit from periods of volatility in which assets have the potential to cheapen significantly. To be in a position to benefit, we will need careful portfolio construction and rigorous risk management of our positions.
The eurozone secular outlook in particular is subject to a series of risks – economic, political and regulatory – and significant uncertainty over the reliability of property rights and the protection of the rule of law (recent examples of the latter include Portugal and Austria). In recent years we have favored eurozone markets with a secular bias to be overweight but, at current valuations and given the risks to the outlook, we expect to be cautious and very selective on eurozone holdings in our portfolios.
Two of the key challenges to emerging markets in the past few years have been the strength of the U.S. dollar and the weakness of commodity prices. Our secular outlook of broad stability for the U.S. dollar, in part owing to China’s constraint on Fed policy tightening, along with commodity markets that have largely repriced to China’s reduced and less commodity-intensive growth path suggests that two key negatives for emerging markets have been removed. While there are of course country-specific challenges in emerging markets, and liquidity conditions have deteriorated, we will look on a country-by-country and sector-by-sector basis for good investment opportunities in emerging markets.
In credit markets, where market beta valuations look fair but not cheap, we will seek to add value using our global team of credit portfolio managers and credit analysts, focusing on picking the winners and avoiding the losers in the capital structure and investing in industries and companies where we perceive pricing power and barriers to entry.
We will scour the world for investment opportunities across sectors, using our global team of 295 portfolio managers and analysts. We will look to take a wide range of diversified positions and to identify attractive liquidity and complexity premiums – and we will strive in portfolio construction and risk management to guard against excessive correlated risk in our portfolios.
As well as seeking to protect against left tail risks, we need to seek to protect against right tail risks, given the possibility of better-than-expected macro outcomes – notably inflation, which, along with default risk, constitutes in our opinion the biggest risk to fixed income portfolios, particularly at very low levels of real and nominal yields. Given the extent of increasingly experimental monetary policies in place globally (with the potential for more to come), all with a core objective of boosting inflation rates, we find inflation protection is attractively priced. Different countries face a range of potential inflation outcomes, but we see U.S. Treasury Inflation-Protected Securities (TIPS) as offering both good value and valuable protection against the possibility of higher inflation in the U.S. Risk management will be crucial to investment outcomes over the secular horizon.
CIO Global Fixed Income
Former Global Strategic Advisor, 2006-2018
Group Chief Investment Officer
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