Andrew Balls
In a world of insecure stability, investors must prepare for 5 policy pivots that will test markets.
In PIMCO’s recently published Secular Outlook, Pivot Points, authors Richard Clarida, Andrew Balls and Daniel J. Ivascyn explain how over the next five years, there could be up to five significant pivots in the direction and scope of the monetary, fiscal, trade, geopolitical and exchange rate policies pursued by the world’s major countries.
But while the direction of some of these pivots may be known, the path that policies actually take, their impact on the global economy and markets, and their ultimate destination are all highly uncertain.
These policy shifts will coincide and collide with the rising risk of recession in a world of insecure stability, with any pivot to fiscal policy that materializes unlikely by itself to boost global growth prospects in a sustainable way as the Federal Reserve attempts to hike rates and shrink its balance sheet.
Expansions may not die of old age, but if history is any guide, we believe the probability of a recession sometime in the next five years is around 70%.
Over our secular horizon, we see rising downside risks to the outlook for Chinese growth and eurozone stability.
Since the last Secular Forum in May 2016, the global economy has surprised on the upside, and markets have shrugged off and indeed rallied after Brexit and the U.S. Presidential election. Risk appetite has been robust, resulting in lofty equity valuations, tight credit spreads and low realized volatility.
We believe markets now look too relaxed and medium-term risks are building. In this environment, investors should consider using cyclical rallies to build cash to deploy when markets correct and risks are re-priced.
Secular pivot points with baseline outlook
- Monetary policy: We expect Fed balance sheet normalization, but less than many think, with a New Neutral destination for the fed funds rate.
- Fiscal policy: We expect that any U.S. fiscal package that passes will be tilted to tax cuts, but light on reform; we see limited fiscal space in Europe.
- Trade policy: We expect the U.S. to focus on bilateral deals (e.g., China, NAFTA) and aggressive use of existing authority within the WTO.
- Exchange rate and geopolitical policies: Amid populist movements in Europe and beyond, we expect the euro to survive and Italy to remain in the eurozone. The Chinese yuan is likely to grind weaker.
Macroeconomic risks …
- In our view, downside and upside risks are roughly balanced for the U.S.; downside risk to growth in both Europe and China is rising over the secular horizon.
- We see a significantly lower tail risk of global deflation.
- We see a risk the fed funds rate lands to the downside of New Neutral levels.
- We are monitoring the global economy’s “driving-without-a-spare-tire” risk in the next recession, whenever it happens.
… and portfolio responses
- Focus on valuation – lots of “good news” is priced in to markets.
- Maintain focus on capital preservation.
- Seek relative value in rates and credit.
- Look to a global opportunity set, including emerging markets.