Recessions are rare when financial conditions are favourable and private sector domestic imbalances are hard to find. The synchronised global expansion, which shifted into higher gear last year, will therefore almost certainly enter its 10th year this June and is unlikely to derail over the next six-to-12 months.
However, the causes of the stronger expansion are more uncertain. Is this just a cyclical sugar-rush fuelled by easy financial conditions, fiscal expansion in the US and a recovery in many emerging markets? Or are we witnessing the early stages of a supply-side productivity renaissance that will lead to higher trend growth?
In other words, is this the beginning of the end of global expansion, or of The New Neutral of low equilibrium interest rates?
Each of these scenarios has very different implications for the durability of the global expansion beyond 2018, as well as for inflation and monetary policy, and, in turn, for financial markets.
Is economic expansion ending?
The answer to this question is, probably yes. The global growth momentum has started to ebb as evidenced by the recent rollover of business surveys in China, Europe and Japan.
These also confirm the “Peak Growth” thesis in our 2018 outlook. In a nutshell, we concluded that 2017/2018 could well mark the peak for economic growth in this cycle. As a result, investors should start preparing for several key risks that lie ahead in 2018 and beyond.
The cyclical “oomph” added by fiscal expansion this year and next will likely sow the seeds for a downturn soon after, potentially leading to a recession in 2020. By then, the fiscal stimulus will have faded and the US Federal Reserve (Fed) will, on its current plans, have raised rates above its estimate of the long-run neutral rate.
Of course, Jerome Powell and colleagues hope to engineer a soft landing. However, in the past 30 years, a Fed funds rate above neutral has always resulted in a recession. Will this time be different? Don’t bank on it. Therefore, we believe it is prudent to gradually position more cautiously and defensively in portfolios.
We prefer to grind-out alpha with bottom-up positions rather than big top-down macro risk positions. We will also look to maintain flexibility to deploy the risk budget when opportunities present themselves. For example, we continue to think that central bank tightening will lead to higher levels of volatility, which will also be more sustained and widely felt than the February 2018 spike in volatility in equities.
Is The New Neutral over?
In our view, this probably isn’t the case. The expectation of a real neutral policy rate in the US in the range of 0-1% was a major debate at our latest forum. The question was whether we are witnessing the early stages of a supply-side productivity renaissance leading to higher trend growth, helped by lower marginal tax rates, deregulation and animal spirits? And if so, could this spell the end of The New Neutral?
After an in-depth discussion, we concluded that we continue to see The New Neutral as an appropriate framework and an anchor for fixed income valuations.
In this context, we think the recent rise in yields has largely priced in the late-stage fiscal expansion and the associated US Treasury supply shock. We expect the 10-year US Treasury yield to remain in a broad range of 2.5–3.5% this year, consistent with The New Neutral framework.
While there remains some upside risk to global yields, and we expect to maintain duration underweight positions, we do not think that we are at the start of a secular bear market for bonds.
However, we remain open to the possibility of a paradigm shift and will certainly be debating the issue again at our next Pimco forum.
DISCLOSURES
Past performance is not a guarantee or a reliable indicator of future results.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Collateralized Loan Obligations (CLOs) may involve a high degree of risk and are intended for sale to qualified investors only. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received. CLOs are exposed to risks such as credit, default, liquidity, management, volatility, interest rate and credit risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.
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This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes. Forecasts, estimates and certain information contained herein are based upon proprietary research only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pimco is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2018, Pimco.
