Over the next three to five years, PIMCO expects the global economy will continue along a New Neutral path in which major economies tend to drift along atmodest growth rates. At our annual Secular Forum last month, our global investment professionals rigorously debated the longer-term, or secular, outlookfor the global economy and markets, and the broad conclusions we reached are detailed in “The New Neutral Revisited.” Mihir Worah, Chief Investment OfficerReal Return and Asset Allocation, drills down on the firm’s views on the future of inflation and the role of commodities in inflation and growth estimates.
Q: What is PIMCO’s outlook for inflation over the secular horizon, and what are the risks to that outlook?
Mihir Worah:The inflation outlook is an important component of our secular New Neutral view, which factors in major central banks conducting reflationary monetarypolicies to support economic growth. Our base case view is that global inflation will accelerate gradually from the current very low levels toward centralbank targets of around 2% over the next few years, with the U.S. economy leading the way.
While there is always two-way risk around the base case, we think inflation is more likely to surprise to the upside, overshooting central bank targets.This is a very real possibility over the secular horizon in the U.S., less so in Europe or Japan. Note that the Federal Reserve, with its massive balancesheet and its extraordinary monetary policies, still has not generated sufficient inflation. But as the economy has healed and the amount of slack hasreduced, we might see the old definition of inflation reappear: too much money chasing too few goods. Frankly, many central banks would probably welcome amodest overshoot.
We don’t think the downside risk – deflation – is likely in the next several years. Back when the economy was just coming out of the global financialcrisis, we were constantly flirting with the possibility of deflation. A combination of lack of global aggregate demand as well as the correction incommodity prices (too much supply) contributed to this. Unprecedented policy actions by major central banks, including the Fed, the European Central Bankand the Bank of Japan, have largely contributed to this diminished likelihood of deflation. While we are calling for a modest overshoot of the Fed’s 2%target, not runaway inflation, I would stress that PIMCO’s view is counter to the prevailing view of many economists and market participants who stillfactor in significant deflation risk.
Q: What will be the main drivers of global inflation?
Worah:Over the secular horizon, the drivers of inflation will be more balanced, with both services and goods contributing to higher prices. Goods inflation sawmajor swings over the past several years, dominating overall inflation during the commodity supercycle and then shifting into deflationary mode with thedrop in commodity prices. Now that we see the price correction is largely over, goods deflation should moderate, though the strength of the U.S. dollarcould still present some drag.
Services inflation has been generally steady all that time, with a one-time downward shock in medical inflation due to the Affordable Care Act. Over thesecular horizon, we should see services inflation supported by growing economies, higher wages and higher rents. The key difference over the next fiveyears compared with the past is that services and goods inflation will both be contributing to inflation, with much reduced volatility from the goods orcommodity sector.
Q: What is PIMCO’s overall secular outlook for commodities?
Worah:First, let me affirm our view that the commodity supercycle is definitively behind us. In the early 2000s, supply growth was unable to keep up with demandgrowth from a rapidly expanding global economy and the rapid infrastructure build-out in China and other emerging economies, leading to price spikes. Thesehigher prices led to a supply response, and commodity prices corrected – dramatically, in some cases. Now we believe the correction is mostly over, supplyand demand are well balanced, and commodity prices will see fewer big swings over the secular horizon.
While volatility in overall commodity prices should be muted, commodities also are not going to move as one monolithic asset class anymore, the way theyhave over the last 10 or 15 years. Prices across individual commodity sectors – oil, gold, industrial metals, grains – now are likely to respond moreindependently to idiosyncratic supply and demand factors, whether economic growth, geopolitics, weather or even shifting domestic policies and priorities(such as changing biofuel standards, easing restrictions on energy exports, etc.).
I’ll add that with commodity prices steadier, we no longer expect to see gaps of the same magnitude and frequency between headline inflation and coreinflation that characterized the past five or 10 years.
Q: Could you discuss PIMCO’s outlook for oil?
Worah:In the oil market, as with the other commodities mentioned, supply and demand are fairly well matched and are likely to rise gradually in tandem over thesecular horizon – at least provided global economic growth continues along its current trajectory. On the demand side, we think the world will continue toconsume about 1 million barrels per day more crude oil each year than it did the previous year. On the supply side, we see shale and other unconventionalsources – along with a little more cushion from OPEC as members defend market share – continuing to answer the demand. Over the next three to five years,we could see oil prices stabilizing around the low to mid $70s per barrel of Brent crude.
Geopolitical risks always play some role in the oil outlook, though at present market participants seem to be taking conflicts in stride. The Middle East,in particular, historically tends to be a source of disruption in oil supplies, usually leading to higher prices. While those risks persist today, I wouldadd that for the first time in a long time, we also see the possibility of a downside surprise in oil prices coming from the region in the form of apotential peace treaty with Iran, which could lead to increased supply if it actually comes to pass.
Q: Given PIMCO’s outlook of inflation rising modestly over the long term from very low
levels, how should investors think about allocating to inflation-hedging assets?
Worah:We believe such an allocation makes sense for two reasons. First, in general, a well-diversified portfolio should hedge against the full range of long-termrisks, including inflation risks. For example, even if the base case is not for runaway inflation, it may still be appropriate to hedge against aninflation surprise as neither stocks nor bonds would do well in this scenario. Second, while our base case secular outlook sees inflation rising towardcentral bank targets, our risk case over the next five years is tilted toward higher inflation – as opposed to the past five years, when the risk case wasfor lower inflation or even deflation.
We see many inflation hedges, such as U.S. Treasury Inflation-Protected Securities (TIPS), as attractively priced in the current environment, probablybecause many market participants are still stuck in the past when they were more justifiably worried about deflation or “lowflation.” TIPS prices, in ourview, reflect an insufficient risk premium. These U.S. government-backed bonds, and inflation-linked bonds of several other nations, can be the cornerstoneof a portfolio of inflation-hedging assets, depending on the specific objectives of each investor.
A diversified portfolio could also include commodities, which tend to help hedge short-term inflation spikes. A geopolitical conflict, a drought or a coldwinter could push up prices at the grocery or the gas pump, and commodities – though they tend to be volatile – are a generally liquid investment optionfor hedging these kinds of short-term sharp moves. Gold, however, is an exception; it has lost its shine in our opinion since its value tends to moveinversely to real interest rates and the U.S. dollar, which should both be headed up, in our view.
Of course, investors willing to give up some liquidity and take a longer-term view may consider real estate, which may offer an attractively valuedinflation hedge for the secular horizon.
In summary, given our longer-term view on inflation, we believe a diversified portfolio of inflation-linked assets may offer a valuable hedge against therisk that inflation erodes a portfolio’s purchasing power.