Posted inAsset Class in Focus

Is the decade-long global expansion nearing its end?

The global expansion is either nearing its demand-driven peak or in the early stages of a supply-driven renaissance, according to Joachim Fels, Pimco’s global economic adviser.
Is the decade-long global expansion nearing its end?

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.




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