As Good As It Gets
It’s easy to get lulled into complacency by synchronized global growth, easy financial conditions and super-low economic and financial market volatility.
Yet, while the current macro environment and outlook appear better than many of the younger market participants can remember, the last time a similar combination prevailed was in 2006 – and that didn’t end well.
Eleven years on, we don’t think another major financial crisis is likely over our cyclical horizon spanning the next six to 12 months.
However, then as now, when the macroeconomic environment is as good as it gets and valuations are tight, it is time to emphasize caution, capital preservation and diversified sources of carry away from the crowded trades. Note: you just read our main high-level investment conclusion based on vigorous internal discussions at our September Cyclical Forum.
Here’s more on the debate and the analysis underpinning our forecasts and investment conclusions.
Feeding the bull?
Of course, the road to a conclusion that emphasizes caution wasn’t straightforward and was plastered with intense and controversial debates – a hallmark of a nearly four-decade-old forum process that brings together all PIMCO investment professionals every quarter.
Looking on the bright side, our baseline economic forecast is for a continuation of synchronized world real GDP growth at a decent 3% pace in 2018 (the same as this year), low near-term recession risks, a moderate pickup in underlying inflation in the advanced economies, mildly supportive fiscal policies and an only gradual removal of monetary accommodation. Also, political risks emanating from nationalist/populist movements look more contained for now, particularly in Europe, partly as a function of better economic growth. Moreover, as our Asia-Pacific Portfolio Committee colleagues argued at the forum, China may well be successful in continuing to suppress volatility well beyond the 19th National Party Congress in October.
So, if you want to stay or become a bull on risk assets, all of this seems like good macro fodder.
The ABCs of caution
However, once you start to look through the smooth macro surface at the underlying risks and uncertainties, there are a few problems that might pop up even over the short-term cyclical horizon and upset the eerie calm in financial markets.
Apart from the obvious geopolitical threat emanating from North Korea, the most important macro uncertainties – “the ABCs of caution” – are the aging U.S. economic expansion, the coming end of central bank balance sheet expansion, and China’s political and economic course following the party congress.
On aging, as the U.S. expansion matures and slack in the labor market keeps eroding, we expect GDP growth to slow to a below-consensus 2% or less and core CPI inflation to pick up to 2% in the course of 2018. Thus, the mix of nominal growth between real growth and inflation will become less favorable as disappearing slack makes it difficult to sustain the current pace of job and output growth. True, an acceleration of productivity growth would help, but does not seem to be in the offing as business investment outside energy remains moderate. A Federal Reserve that is fixated on the Phillips curve will likely raise the policy rate two or three times between now and the end of 2018 – less than the four hikes the Federal Open Market Committee (FOMC) currently foresees but more than the extremely shallow rate hike path that markets price in right now. Thus, the front end of the U.S. yield curve looks vulnerable.
Regarding central bank balance sheets, the market has so far taken in stride the Fed’s plans to begin the process of normalizing its balance sheet in October as well as the European Central Bank’s (ECB) hints at tapering its bond purchases next year. But don’t forget that there is virtually no historical precedent for major central banks actively reducing their balance sheets. Thus, the impact of the Fed’s balance sheet unwind on the term premium and other risk premiums is unknown, especially as it will coincide with a period of uncertainty about the future Fed chair and the composition of the Board of Governors. This is one reason for us to be slightly underweight duration and to expect a steeper yield curve.
As regards China, our forum debates centered on the implications of the more centralized and concentrated leadership that is likely to result from the party congress in October. One view, as stated above, is that the new/old leadership will focus on further suppressing economic and financial volatility through a combination of continued leverage expansion, financial repression including tight capital controls and imposition of supply discipline in commodities industries. If so, unlike in 2015–2016, China would not be an exporter of volatility to global financial markets. While this is a possible outcome, another distinct possibility is that the likely consolidation and concentration of power opens the door for significant and surprising policy changes, including major reforms affecting state-owned enterprises (SOE) and forced deleveraging, which would weigh heavily on growth and could lead to more tolerance for currency depreciation. This could potentially be signaled by a highly symbolic shift, such as the leadership dropping the growth target. Such changes, or the fear thereof, have potential to disrupt global markets. In addition, a more assertive China in foreign affairs under a “paramount leader” President Xi Jinping raises the risk of an escalating trade conflict in case the U.S. administration decides to get tough on trade policy.
PIMCO concludes:
“…in an environment in which the macro climate is about as good as it is going to getand where valuations are tight, we will emphasize capital preservation in our portfolios.“
