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, ourfocus was to identify the key secular forces that will drive the global economy, monetary and fiscal policy, and financial markets over the next three tofive 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, andengaged with members of our Global Advisory Board, who actively participated in the forum discussions. The goal of the Secular Forum is to provide theconcept, 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 belowthose that prevailed before the crisis, a continuation of our New Neutral thesis from 2014. For the eurozone and Japan, we expected equilibrium real policyrates would remain negative over most, if not all, of our secular horizon. For the U.S., we foresaw a gradual liftoff trajectory for the federalfunds 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 ofsupporting growth and pushing up inflation toward its 2% target, and observed that the Fed balance sheet was not on autopilot. Our baseline secularscenario 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 differenttrajectory 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. andChina would have ample room to maneuver to deploy aggressive countercyclical policy. We also specifically cautioned that there “remains a tail risk ofpolitical polarization in the eurozone and/or a British exit from the European Union. In China, the planned reforms are ambitious, but success is notassured, 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 theeconomy 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
This year’s questions
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. Infact, Fed officials themselves have discussed U.S. monetary policy in terms of a time varying “neutral” policy rate, which is currently and is expected forseveral years to remain (well) below its pre-crisis old neutral level. So an important goal of this forum was to develop a new secular frameworkappropriate 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 ofthe same questions that we did the year before: How robust is the global expansion in developed and emerging economies? What are the limits ofunconventional monetary policy, and do the costs of such policies exceed the benefits? Are China’s prospects for growth, exchange rate policy and capitalaccount liberalization on track? We confronted new questions as well, about the prospects and risks for political polarization and fragmentation in Europeand 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 decidebased 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 neededto reassess our baseline scenario as well as recalibrate the likelihood and rethink the particular consequences of different tail scenarios. We organizedour agenda into four broad topics, also the four essential questions to frame our discussion:
- The global economic outlook: Is last year’s left tail this year’s baseline? (See Figure 2 for IMF’s view on this.)
- China: Is the journey as important as the destination?
- Monetary policy: Diminishing returns or dead end?
- Political populism and polarization: Flash in the pan or secular reality?
Our secular outlook
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 globaleconomy, 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 economyproves to be unsustainable. In these discussions, many of us found a useful framework in one of our guest speakers’ notions that we face “radicaluncertainty” 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 orprospective source of productivity or organic demand that would support a baseline for more robust expansion. Deflation has been avoided and output gaps inmany major economies are closing, but few if any major central banks today are even hitting their 2% inflation targets, let alone overshooting them. And sowhile the global economy has plodded along since 2009 and has thus far avoided tipping into another recession, the system has only averted collapse becauseof zero or even negative policy rates in many countries, the gusher of liquidity administered by major central banks via quantitative easing (QE), and thedebt-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 forthe 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 fiscalpolicy 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%. Onpolicy, we see the European Central Bank continuing to do the heavy lifting and eventually even pursuing an extension of the QE program that will approachde facto if not de jure monetization of fiscal deficits. Our baseline sees modest positive support for European growth from fiscal policy over the nextthree 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, leveragestabilizes 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. Withthe global recovery about to enter its eighth year, with central banks pushing even further into the realm of diminishing if not negative returns tounconventional policy, and with our secular window now open to the year 2020 and beyond, we considered another, more complex diagnosis: There is thedistinct possibility that the left tail has gotten fatter, and that monetary policy exhaustion and an overhang of debt in some major economies posematerial threats to the sustainability of the global recovery and financial stability. This is a left tail scenario and not our baseline view, butin contrast with our previous New Neutral thesis, we now believe that there is a material risk globally – if not necessarily for the U.S. – thatthe 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” availableglobally if and when monetary policy exhaustion threatens global stability. In other words, the global economy finds itself today in a state ofdisequilibrium that has remained stable thus far only via three policy props: zero or near-zero interest rate policy, QE, and levering up inChina, some other EM economies and the European periphery. We concluded there are diminishing returns to all three of these policy props, while at the sametime 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 – whichwould support higher investment, consumption and “animal spirits” – and possibilities for a shift in the global policy mix toward fiscal policy or evencoordinated monetary-fiscal “helicopter money” programs. As for productivity, our guest speakers reminded us that inflection points in productivity growthare hard to predict, so while a rebound in productivity might happen in the next three to five years, and we could cite anecdotal evidence tosupport 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 bea rather high degree of coordination between monetary and fiscal policy, and there are real prospects for even closer ties between the Ministry of Financeand the Bank of Japan in which the existing quantitative and qualitative monetary easing (QQE) program evolves into a Japanese government bondprice-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 moreexpansionary 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 tailwindto 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 andpotential consequences of monetary policy exhaustion they face. Under a left tail scenario in which this stable disequilibrium unravels sometime and insome 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 eventualendgame following such a scenario are uncertain, the plausible paths are many and complex, path dependence would be the rule and not the exception, andmuch would depend on the timeliness and boldness of the policy – including fiscal policy – response. But while there are myriad uncertainties, there is nodoubt that a global disruption of our baseline scenario would have serious repercussions for growth, inflation and financial markets. The risks areuncertain, 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 hadcharacterized 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 stabledisequilibrium – supported by a surge of financial globalization and petrodollar recycling that fueled an unprecedented explosion in private sectorborrowing, an era that today is referred to as “the great leveraging” that provided the financing for “the great moderation.” Asset prices were distortedand traditional metrics for valuation were cast aside. Momentum made money, and contrarian investors, for a time, lagged behind. Nonetheless, as early as2004 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 stabledisequilibrium, 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 – viagovernment budget deficits in the rich countries and private sector borrowing binges in some major EM countries (see Figure 3). Asset prices in somemarkets are distorted and traditional metrics of valuation are cast aside in a world of QE infinity, negative interest rate policies and subzero seven-yearsovereign yields. Although global imbalances have declined and are shrinking, they have been more than replaced by ballooning central bank balance sheetsas a source of liquidity and cheap finance for the chronically debt-addicted. This policy mix and the middling global growth and modest inflation itsupports may remain our baseline scenario. But because we see the left tail risks as elevated, just as we did during the stable disequilibrium years beforethe 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 guidehow we manage our clients’ assets over the next three to five years.
Stay on dry land and preserve capital
In recent years we have described “riding a wave” of central bank interventions, as a range of unconventional policies have been rolled out acrosscountries, driving asset price returns. This wave-riding has worked well in the past. Looking out over the secular horizon, however, diminishing returns tocentral bank interventions – and the potential for policy activism to do more harm than good, notably in the case of negative policy rates – advise againstsuch 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 (discussedin detail above), including China and the eurozone, monetary policy exhaustion, political gridlock and the rise of populism. These potential shocks to theglobal economy increase the prospects for permanent debt write-downs over the secular horizon. Overall, we expect to have more cautious positioning in ourportfolios, and to make capital preservation the number-one priority. It will be critical to target high quality income-generating assets in our portfoliosbut not necessarily the highest-yielding assets – we will tend to look for structural seniority, and we want to see sufficiently strong fundamentals orhard asset coverage to help investments weather the uncertainties over the secular horizon. We cannot rely solely on central bank support. The seculartimeframe is likely to remain a very difficult environment for investing, and we will seek to avoid investments where there is a real risk of permanentcapital loss.
Guard against negative yields and guard against the asymmetric risk of rising yields
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 twoyears. 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 yieldsthan those priced into forward curves.
Grind out alpha in a low return environment
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 seethis 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 whatto own. Also, we reaffirm the importance of PIMCO’s long-term tradition of structural alpha positions, which seek to benefit from exploiting marketinefficiencies and provide a diversified source of return from other top-down and bottom-up active positions.
Seek to benefit from periods of high volatility
The outlook for growth at the global level and across globally important countries and regions we see as subject to fairly normal, bell-shapeddistributions. But this fairly normal outlook reflects a very unusual level of central bank and other policy interventions. Market valuations range fromfair to stretched and remain highly influenced by central bank interventions. As the Federal Reserve looks to unwind stimulus and other countries, notablyJapan, get further and further into extreme intervention territory, the margin for error is thin. The experience of the past years has shown that it doesnot take much in terms of policy actions and mistakes to prompt repricing in markets. While maintaining overall fairly cautious portfolio positioning, wewill 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 needcareful portfolio construction and rigorous risk management of our positions.
Very selective on the eurozone
The eurozone secular outlook in particular is subject to a series of risks – economic, political and regulatory – and significant uncertainty over thereliability of property rights and the protection of the rule of law (recent examples of the latter include Portugal and Austria). In recent years we havefavored 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 andvery selective on eurozone holdings in our portfolios.
Look for opportunities in emerging markets
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. Oursecular outlook of broad stability for the U.S. dollar, in part owing to China’s constraint on Fed policy tightening, along with commodity markets thathave 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-countryand sector-by-sector basis for good investment opportunities in emerging markets.
Bottom-up over beta
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 andcredit analysts, focusing on picking the winners and avoiding the losers in the capital structure and investing in industries and companies where weperceive pricing power and barriers to entry.
Scour the world and diversify
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 awide range of diversified positions and to identify attractive liquidity and complexity premiums – and we will strive in portfolio construction and riskmanagement to guard against excessive correlated risk in our portfolios.
Guard against the right tail
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-expectedmacro outcomes – notably inflation, which, along with default risk, constitutes in our opinion the biggest risk to fixed income portfolios, particularly atvery low levels of real and nominal yields. Given the extent of increasingly experimental monetary policies in place globally (with the potential for moreto come), all with a core objective of boosting inflation rates, we find inflation protection is attractively priced. Different countries face a range ofpotential inflation outcomes, but we see U.S. Treasury Inflation-Protected Securities (TIPS) as offering both good value and valuable protection againstthe possibility of higher inflation in the U.S. Risk management will be crucial to investment outcomes over the secular horizon.
Investment RisksLeft tail risks are building, with consequential implications for portfolios.
- In the absence of structural reforms, we are approaching the limits of central bank policy.
- Increasingly experimental policy is creating greater uncertainty and stretching valuations.
- Unsustainable debt levels mean that long-term risks of capital impairment or inflation are rising.
- Political uncertainty is increasing.
- Greater regulation and related reduced transactional liquidity are enhancing local market volatility.
… And Responses
- Be patient.
- Be tactical and flexible.
- Provide liquidity when others need it.
- Prepare for market turning points. This is one of the key advantages of active management.
- Avoid or underweight assets that solely or primarily rely on central banks to support valuations.
- Hedge against a tail scenario in which inflation overshoots central bank targets. Although this is unlikely in the near term, the risk issignificant over our secular horizon.