ur long-standing views on risks to thestatus quo are being priced into financial markets, with heightened volatilityone indicator. As we argued in our Secular Outlook, “Rude Awakenings,” and Cyclical Outlook, “Growing, But Slowing,” we believe the global economy is past peak growth in the cycle,central bank support continues to be reduced and political risk looms largeacross countries. These trends support our relatively cautious positioning andintense focus on liquid assets, which will allow us to respond either tospecific opportunities or generic spread widening and higher volatility.
We expect to continue to have positive carry positions – even with anunderweight in corporate cash bonds – based on specific creditopportunities, non-agency and agency mortgage-backed securities (MBS), a smallamount of emerging market (EM) foreign exchange (FX) and curve steepeners.This is consistent with our still fairly constructive cyclical baseline aswell as our desire to hedge against downside risks and focus on credit marketstructure and liquidity in the event of a rotation out of crowded positions.
This, in a nutshell, is what PIMCO’s Investment Committee distilled fromthe discussions at our December Cyclical Forum, which brought together thefirm’s investment professionals from around the globe and several of ourtrusted senior advisors including Ben Bernanke, the chair of PIMCO’sGlobal Advisory Board, Michael Spence, the 2001 Nobel laureate in Economics,and Gene Sperling, the former Director of the National Economic Council andAssistant to the President for Economic Policy under Bill Clinton and BarackObama.
"We also benefitted from contributions by Richard Thaler, the 2017 Nobel laureate in Economics, on how to avoid the pitfalls of groupthink and behavioral investor biases.”
We also benefitted from contributions by Alan M. Taylor, professor ofeconomics at the University of California, Davis, on the lessons from creditbooms and busts across many countries over the past 150 years, and RichardThaler, the 2017 Nobel laureate in Economics, on how to avoid the pitfalls ofgroupthink and behavioral investor biases.
Thaler is a governing board memberof the University of Chicago Booth School of Business Center for DecisionResearch –PIMCO is partnering with CDR in support of the center’s behavioral science research.
Our forum discussions centered on five key macro debates that will likelyshape the cyclical and market outlook for 2019.
Debate #1: How late is it in the cycle?
We have been arguing for some time that the economy has entered the laterstage of the economic expansion, a view that has become the consensus. Butlate-cycle phases can last quite some time, so how late is it, really?
For starters, our updated quantitative models indicate that the probability ofa U.S. recession over the next 12 months has risen to about 30% recently andis thus higher than at any point in this nine-year-old expansion. Even so, themodels are flashing orange rather than red.
A similar message comes from a new cycle-classification model presented at theforum. It scans and combines a large number of economic and financial marketdata to determine which phase of the expansion or recession we are in. Themodel suggests that we may still be roughly in the middle of the economicexpansion. However, one year ahead, the model predicts a late expansion oreven recessionary environment.
A more qualitative analysis corroborates the quant models: We currently do notsee signs of overheating in labor or goods markets that have heralded somerecessions in the past, nor the overspending or credit excesses that havepreceded others. Thus, there is no incontrovertible evidence to suggest arecession is around the corner – yes, the expansion is old but it hasbeen ageing gracefully so far.
Importantly, however, the current market environment makes amply clear that itdoesn’t take a recession for turmoil to roil financial markets.Moreover, some participants argued at the forum that rather than traditionalmacroeconomic overheating or overborrowing, it may be the derating offinancial assets that leads to the next recession.
Debate #2: The end of U.S. economic exceptionalism?
While the expansion may have room to run beyond its 10th anniversary nextyear, we expect the growth gap between the U.S. and the rest of the developedworld to narrow.
Over the past year, the U.S. was exceptional in many ways. It had a largefiscal boost that accelerated growth while the world was slowing, a centralbank that confidently raised rates every quarter, a stock market thatoutperformed most others, and a dollar that appreciated despite thepresident’s protestations.
Looking ahead, we see U.S. growth “synching lower” as tighterfinancial conditions start to bite, fiscal stimulus fades and the recentplunge in oil prices benefits Europe, Japan and China more than the U.S.,which has become a net energy exporter. Our 2019 GDP growth forecast for theU.S. of 2.0% to 2.5% remains below consensus, and we see growth slowing to aquarterly run rate of less than 2% in the second half of the year. Thus, theU.S. and other major advanced economies are converging to trend growth.
Despite the narrowing of the growth differential with the rest of the world,we still expect U.S. equities to outperform as companies are more profitableand cyclical sectors have a smaller weight in the U.S. stock market. Regardingthe U.S. dollar, views expressed at the forum were more mixed. The optimism onthe greenback that characterized forums earlier this year has clearly waned,but the favorable rate differential argues against a major weakening of thedollar at this stage.
Debate #3: Will inflation ever return?
We lowered our sights on inflation in 2019 due to the recent plunge in oilprices and continued sogginess in core inflation in the U.S., Europe andJapan. Our baseline sees core inflation broadly flat or slightly higher inthese three regions and thus still running below target.
Despite this benign outlook, we spent quite some time kicking the inflationtires and debating how we might be wrong. After all, wage inflation in theU.S. has reached 3% for the first time this expansion and has also beenpicking up in Europe and Japan this year.
It is certainly possible that wages start to accelerate more in response todeclining unemployment, leading to a bend in the Phillips curve that describesthe relationship between unemployment and wages. However, we concluded thatrising productivity growth would likely moderate unit labor cost pressures andheightened competition and transparency in goods markets due to theAmazon effectwould likely keep consumer price inflation subdued.
We also debated a nonconventional theory of inflation that predicts thathigher nominal interest rates cause higher inflation over time. TheFiscal Theory of the Price Level(FTPL) argues that if people do not believe that the government will cutspending or raise taxes in the future in response to central bank rateincreases, which would boost government borrowing costs, and thus behaves“irresponsibly,” a slow-moving inflation spiral could start. Thereason is that the private sector will feel wealthier with rising interestpayments on government bonds that are not backed by future tax hikes and willspend more. If the central bank raises rates further in response, governmentborrowing costs would increase further and spending and inflation would spiralever higher.
However, while such scenarios have occurred in some emerging markets in thepast, most forum participants had a hard time believing that people inadvanced economies would expect their governments to behave“irresponsibly” over long time horizons – a precondition forthe described effects to play out, and thus for consumers to start to spendmore as interest rates rise.
Debate #4: The Fed pauses, then what?
Following a likely fourth rate hike for this year on 19 December, we expectthe Federal Reserve to raise rates only one or two times more in 2019. A pausein the first half of 2019 thus looks increasingly likely as financialconditions and the central bank’sbalance sheet runoffare doing some of the tightening for the Fed.
If and when the Fed pauses, however, will this be followed by a resumption ofrate hikes, or will the next move after a shorter or longer pause be down inrates?
It is important to note that Fed participants’ rate forecasts (aka thedot plot) already incorporate a pause sometime next year, followed by furtherhikes. This is because the median forecast of participants foresees a slowdownin the pace of hikes from four in 2018 to three in 2019, followed by anothertwo in 2020.
However, at the forum we reckoned it would be difficult to communicate a pausewithout markets jumping to the conclusion that this is the end of the ratecycle and the next move will be down. As Ben Bernanke reminded us, his attemptto signal a pause in the previous rate cycle led to significant volatility.While central banks such as the Bank of England might get away with a pauseand continued tightening, this is more difficult for the Fed given its globalimportance.
Against this backdrop, most of us believed that with the probability ofrecession likely to rise over time, a resumption of rate hikes after a pausewas relatively unlikely.
Debate #5: U.S. versus China: Truce or peace?
We discussed the outlook for U.S.-China relations shortly after PresidentsDonald Trump and Xi Jinping agreed to pause their escalation of tariffs tonegotiate a deal over the coming 90 days. Some participants argued thatthe worst of the trade conflict was now behind us, as both sides wanted a dealbefore the negative economic consequences of higher tariffs would be felt.
However, most of us believed the conflict between the U.S. and China is moredeep-rooted and about much more than trade alone, and would thus continue tobe a source of uncertainty and volatility even if there were a deal on trade.Mike Spence’s description of the conflict as a “clash ofsystems” resonated with the audience and reminded us of our discussionsat the Secular Forum in May about the “Thucydides trap,” whichdescribes the risks of a confrontation between an established and a risingpower.
As outlined above, we see our near- and long-term views on risks being pricedinto financial markets. In this environment, we will look for broad,diversified sources of carry without relying on generic corporate credit riskand maintain an overall cautious approach in our portfolio construction.
"We think it makes sense to stay fairly close to home in terms of top-down macro risk factors, to keep powder dry and to look for specific opportunities in a more difficult environment.”
We think it makes sense to stay fairly close to home in terms of top-downmacro risk factors, to keep powder dry and to look for specific opportunitiesin a more difficult environment where we see overshooting versus fundamentals.There is substantial option value in leaving room in our risk budget (e.g.,holding more cash or accepting lower overall portfolio yield) to be able torespond, either to specific opportunities or in the event of a broad spreadwidening and rise in volatility.
While we can take some comfort from our analysis that, judging bymacroeconomic considerations, we are still some distance from the nextrecession, the current market environment makes amply clear that a recessionis no prerequisite for turmoil in financial markets. Moreover, rather thantraditional macro overheating, it may be the derating of financial assetsthat leads to the next recession.
We think this is a period when we need to favor liquid instruments, except inspecific cases where we are paid for illiquidity.
Modestly underweight duration, overweight TIPS
The recent rally in global duration has put yields close to the low end of ourexpected ranges, but in an uncertain environment we want to be fairly close tohome in terms of duration positioning, with only a modest underweight inglobal duration outside of Japan.
We see Japan underweights as a good hedge against an (unexpected) shift higherof the range for global duration and given our expectation that the Bank ofJapan (BOJ) will continue to reduce its net asset purchases/tweak its yieldcurve cap frameworks toward somewhat higher yields and a steeper curve.
While our base case calls for continued modest inflation, TreasuryInflation-Protected Securities (TIPS) breakevens have repriced lower, and wesee TIPS as relatively attractively priced and as offering a hedge againstpossible inflation upside surprises in the U.S. in this late stage of thecycle.
Curve: Long the belly, short the long end
We see global curve-steepening positions as a structural source of incomegeneration and, in the current environment, have a preference for the belly ofthe curve versus the long end of the curve based on valuation. The curve isalready very flat given that we do not see recession risk over the next 12months as all that high. Central bank balance sheet reduction is underway inthe U.S., while the European Central Bank (ECB) is poised to end quantitativeeasing (QE), which we continue to think should lead to the reestablishment ofa term premium over time. There is also of course some in-built protection interms of curve steepeners in the event that we are wrong on recession risk anda significantly weaker economic environment does force the Fed to reverse ratehikes.
Cautious on generic corporate credit
We will target corporate credit underweights, with the focus on beingunderweight generic corporate credit beta, while looking for opportunisticcredit trades. Credit valuations have moved closer to long-term averages, butwe don’t see credit as cheap, while volatility is rising and the slowingeconomy could reveal underlying weaknesses in terms of leverage. We continueto be concerned about crowded credit positioning in the market and creditmarket structure/illiquidity, which could lead to significant overshooting inthe event of a more generalized bout of credit market weakness. We want tostay up in quality and up in liquidity, sticking to credits where our globalcredit analyst team sees value and remote default risk. We are focused ondownside risks and credit market structure/liquidity in the event of arotation out of crowded positions.
Relative value in financials and MBS
As discussed above, we expect to find good opportunities where we see realcheapness in a more volatile environment, and we want to keep some powder dryfor these opportunities. We continue to see financials offering attractiverelative value. Based on our view that a chaotic no-deal Brexit is a very lowprobability, we see U.K. financials as attractive at current valuations. Ifthe tail risk case is realized, while it is clearly likely that U.K.financials’ positions would underperform in the short term, the capitalpositions of the U.K. banks look robust – as the Bank of England alsoconcluded in its recent very challenging stress test.
We continue to see non-agency mortgages as offering a defensive alternative toinvestment grade (IG) credit, with a better downside risk profile in the eventof weaker macro/credit market outcomes. We also see agency mortgage-backedsecurities (MBS) as an attractive and relatively stable source of income inour portfolios.
Underweight European peripheral risk
We remain cautious on European peripheral sovereign credit risk and corporaterisk given the immediate challenges in Italy and the longer-term risks to theeurozone more generally in the next recession. Yet we remain open to specificopportunities where we are amply compensated for eurozone credit exposure.
Opportunities in EM FX and bonds
In a world in which growth is synching lower across countries, we have abalanced view on the U.S. dollar versus other G-10 currencies. We will targetmodest EM FX overweight positions in strategies where this risk is appropriateand, more generally, we expect to find good opportunities in local/external EMbonds in a difficult market environment.
Equities: Focus on high quality defensive growth
More broadly, on asset allocation, we anticipated the late-cycle environmentwould put downward pressure on equity valuation multiples. Looking forward, weexpect downward pressure on profit growth expectations as tailwinds fade andlagged effects of financial conditions tightening are realized. Webelieve equity markets will remain volatile, favoring cautious positioningoverall and a focus on high quality defensive growth and minimal exposure tocyclical equity beta. We continue to favor more profitable U.S. equity marketsto the rest of the world and prefer high quality large-cap equities at thisstage in the cycle, while we wait for select opportunities to presentthemselves over the cyclical horizon.
Commodities: Modestly positive on oil
We are broadly neutral overall on commodity beta risk, combined with amodestly positive view on crude oil. An unexpected surge in U.S. productioncoupled with softening global demand has moved the oil market into surplus.OPEC’s recent announcement of a cut in production suggests the desire tosupport oil prices in the low $60s, avoiding the very low levels of 2014, butnot tightening markets enough that it causes more market share losses toshale. Outside of oil, natural gas prices are weather-dependent andinventories remain low, but the current level of winter prices is having aclear impact on demand and production is surging, suggesting limited furtherupside without strong weather support. We continue to see gold as along-duration asset and prefer other long-duration assets, such as U.S. TIPSat current valuations.
Regional economic forecasts
Following expansion of close to 3% during 2018, we continue to expect real GDPgrowth to average a below-consensus 2% to 2.5% in 2019, reflecting the recenttightening of financial conditions, fading fiscal stimulus and slower growthin China and elsewhere. Growth momentum is likely to moderate during the year,converging to trend growth of just below 2% during the second half.
We expect employment growth to moderate in 2019 and average around 150,000nonfarm payroll gains per month, which would still exceed the level of jobgains that is consistent with a stable unemployment rate over time. Headlineinflation looks set to drop sharply over the next several months, reflectingbase effects and the recent plunge in oil prices. Meanwhile, core CPIinflation of about 2% is expected to trend sideways as inflation expectationsremain anchored and the (inflation) Phillips curve is quite flat.
Against this backdrop, following the expected December rate hike to a targetrange of 2.25% to 2.5%, we expect one or two more increases in the fed fundsrate by the end of 2019, with a high chance of the Fed pausing or even endingthe hiking cycle in the first half of the year.
We expect eurozone GDP growth to slow to a below-consensus 1.0% to 1.5% rangein 2019 from close to 2% in 2018. Our downward revision from Septemberreflects the tightening in financial conditions in Italy, which will take atoll on growth, as well as weaker global growth.
Core consumer price inflation has been stuck at around 1% for several yearsnow, but we expect it to pick up somewhat over the next year as unemploymentis likely to keep falling and wage growth has accelerated, particularly inGermany. Yet, this would still fall short of the ECB’s own forecasts andkeep inflation under the “below but close to 2%” objective.
Nonetheless, we expect the ECB to end net asset purchases by the end of thismonth, as already signaled by the central bank, and a first rate hike beingimplemented during the second half of 2019. However, if a pause by the Fedoccurs in the first half of 2019, which looks quite likely, and the euroappreciates significantly versus the U.S. dollar in response, the ECB may wellextend its forward guidance of unchanged rates into the following year.
We see nominal GDP growth in 2019 in line with consensus but expect amore favorable split between real output growth and inflation.
Our forecast of real GDP growth in a range of 1.25% to 1.75% is based on ourexpectation that a chaotic no-deal Brexit will be avoided as there will eitherbe a deal on a transition agreement that will be accepted by U.K. Parliamentor an extended stop-the-clock negotiation period.
Our below-consensus inflation forecast sees inflation coming back to the 2%target over the course of next year as import price pressures fade and weakwage growth keeps service sector inflation subdued.
Against this backdrop, we see one to two additional rate hikes from the Bankof England over the next year.
We expect moderate GDP growth in Japan in 2019 in a 0.75% to 1.25% range,supported by a tight labor market and a supportive fiscal stance. Theconsumption tax hike currently planned for October 2019 will cause somequarterly volatility in consumption as households will aim to bring forwardpurchases of large-ticket items. However, we expect the government to morethan compensate for the tax hike in the form of higher spending and reductionsin other taxes, so that fiscal policy will be accommodativeoverall.
However, with inflation expectations low and sticky and improving laborproductivity keeping unit wage costs in check despite rising wage growth, coreinflation ex the consumption tax is likely to creep up only slightly into a0.5% to 1% range, remaining well below the ambitious 2% target.
We expect the Bank of Japan to further tweak its Japanese government bond(JGB) buying operations and to continue to stealth taper its purchases, withlower purchases in the 10-plus year sector contributing to a furthersteepening of the yield curve. This is aimed at easing some of the negativeside effects of the low interest rate environment on the financialsector.
Our baseline forecast is for 2019 GDP growth to slow to the middle of a 5.5%to 6.5% range, which is meant to convey the large uncertainties around theoutlook caused by trade tensions with the U.S., domestic pressure todeleverage, and economic policy that tries to satisfy partially conflictingtargets (e.g., growth and employment versus financial stability). Our baselineforecast foresees more constrained monetary stimulus in the form of furtherreductions in reserve requirements rather than rate cuts, and incorporates afiscal expansion worth about 1.5% of GDP, focused mainly on tax cuts forcorporates and households.
Any further currency depreciation against the U.S. dollar is likely to bemoderate in our baseline scenario. However, if trade negotiations between theU.S. and China fail and tensions escalate, we would expect monetary easing anda sharp currency depreciation.
Join us on 9 January 2019 for a live discussion of the key insights from our Cyclical Forum and answers to client questions.
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