ur long-standing views on risks to the
status quo are being priced into financial markets, with heightened volatility
one indicator. As we argued in our Secular Outlook, “Rude Awakenings,” and Cyclical Outlook, “Growing, But Slowing,” we believe the global economy is past peak growth in the cycle,
central bank support continues to be reduced and political risk looms large
across countries. These trends support our relatively cautious positioning and
intense focus on liquid assets, which will allow us to respond either to
specific opportunities or generic spread widening and higher volatility.
We expect to continue to have positive carry positions – even with an
underweight in corporate cash bonds – based on specific credit
opportunities, non-agency and agency mortgage-backed securities (MBS), a small
amount of emerging market (EM) foreign exchange (FX) and curve steepeners.
This is consistent with our still fairly constructive cyclical baseline as
well as our desire to hedge against downside risks and focus on credit market
structure and liquidity in the event of a rotation out of crowded positions.
This, in a nutshell, is what PIMCO’s Investment Committee distilled from
the discussions at our December Cyclical Forum, which brought together the
firm’s investment professionals from around the globe and several of our
trusted senior advisors including Ben Bernanke, the chair of PIMCO’s
Global Advisory Board, Michael Spence, the 2001 Nobel laureate in Economics,
and Gene Sperling, the former Director of the National Economic Council and
Assistant to the President for Economic Policy under Bill Clinton and Barack
"We also benefitted from contributions by Richard Thaler, the 2017 Nobel laureate in Economics, on how to avoid the pitfalls of groupthink and behavioral investor biases.”
We also benefitted from contributions by Alan M. Taylor, professor of
economics at the University of California, Davis, on the lessons from credit
booms and busts across many countries over the past 150 years, and Richard
Thaler, the 2017 Nobel laureate in Economics, on how to avoid the pitfalls of
groupthink and behavioral investor biases.
Thaler is a governing board member
of the University of Chicago Booth School of Business Center for Decision
PIMCO is partnering with CDR in support of the center’s behavioral science research.
Our forum discussions centered on five key macro debates that will likely
shape the cyclical and market outlook for 2019.
Debate #1: How late is it in the cycle?
We have been arguing for some time that the economy has entered the later
stage of the economic expansion, a view that has become the consensus. But
late-cycle phases can last quite some time, so how late is it, really?
For starters, our updated quantitative models indicate that the probability of
a U.S. recession over the next 12 months has risen to about 30% recently and
is thus higher than at any point in this nine-year-old expansion. Even so, the
models are flashing orange rather than red.
A similar message comes from a new cycle-classification model presented at the
forum. It scans and combines a large number of economic and financial market
data to determine which phase of the expansion or recession we are in. The
model suggests that we may still be roughly in the middle of the economic
expansion. However, one year ahead, the model predicts a late expansion or
even recessionary environment.
A more qualitative analysis corroborates the quant models: We currently do not
see signs of overheating in labor or goods markets that have heralded some
recessions in the past, nor the overspending or credit excesses that have
preceded others. Thus, there is no incontrovertible evidence to suggest a
recession is around the corner – yes, the expansion is old but it has
been ageing gracefully so far.
Importantly, however, the current market environment makes amply clear that it
doesn’t take a recession for turmoil to roil financial markets.
Moreover, some participants argued at the forum that rather than traditional
macroeconomic overheating or overborrowing, it may be the derating of
financial assets that leads to the next recession.
Debate #2: The end of U.S. economic exceptionalism?
While the expansion may have room to run beyond its 10th anniversary next
year, we expect the growth gap between the U.S. and the rest of the developed
world to narrow.
Over the past year, the U.S. was exceptional in many ways. It had a large
fiscal boost that accelerated growth while the world was slowing, a central
bank that confidently raised rates every quarter, a stock market that
outperformed most others, and a dollar that appreciated despite the
Looking ahead, we see U.S. growth “synching lower” as tighter
financial conditions start to bite, fiscal stimulus fades and the recent
plunge in oil prices benefits Europe, Japan and China more than the U.S.,
which has become a net energy exporter. Our 2019 GDP growth forecast for the
U.S. of 2.0% to 2.5% remains below consensus, and we see growth slowing to a
quarterly run rate of less than 2% in the second half of the year. Thus, the
U.S. and other major advanced economies are converging to trend growth.
Despite the narrowing of the growth differential with the rest of the world,
we still expect U.S. equities to outperform as companies are more profitable
and cyclical sectors have a smaller weight in the U.S. stock market. Regarding
the U.S. dollar, views expressed at the forum were more mixed. The optimism on
the greenback that characterized forums earlier this year has clearly waned,
but the favorable rate differential argues against a major weakening of the
dollar at this stage.
Debate #3: Will inflation ever return?
We lowered our sights on inflation in 2019 due to the recent plunge in oil
prices and continued sogginess in core inflation in the U.S., Europe and
Japan. Our baseline sees core inflation broadly flat or slightly higher in
these three regions and thus still running below target.
Despite this benign outlook, we spent quite some time kicking the inflation
tires and debating how we might be wrong. After all, wage inflation in the
U.S. has reached 3% for the first time this expansion and has also been
picking up in Europe and Japan this year.
It is certainly possible that wages start to accelerate more in response to
declining unemployment, leading to a bend in the Phillips curve that describes
the relationship between unemployment and wages. However, we concluded that
rising productivity growth would likely moderate unit labor cost pressures and
heightened competition and transparency in goods markets due to the
would likely keep consumer price inflation subdued.
We also debated a nonconventional theory of inflation that predicts that
higher nominal interest rates cause higher inflation over time. The
Fiscal Theory of the Price Level
(FTPL) argues that if people do not believe that the government will cut
spending or raise taxes in the future in response to central bank rate
increases, which would boost government borrowing costs, and thus behaves
“irresponsibly,” a slow-moving inflation spiral could start. The
reason is that the private sector will feel wealthier with rising interest
payments on government bonds that are not backed by future tax hikes and will
spend more. If the central bank raises rates further in response, government
borrowing costs would increase further and spending and inflation would spiral
However, while such scenarios have occurred in some emerging markets in the
past, most forum participants had a hard time believing that people in
advanced economies would expect their governments to behave
“irresponsibly” over long time horizons – a precondition for
the described effects to play out, and thus for consumers to start to spend
more as interest rates rise.
Debate #4: The Fed pauses, then what?
Following a likely fourth rate hike for this year on 19 December, we expect
the Federal Reserve to raise rates only one or two times more in 2019. A pause
in the first half of 2019 thus looks increasingly likely as financial
conditions and the central bank’s
balance sheet runoff
are doing some of the tightening for the Fed.
If and when the Fed pauses, however, will this be followed by a resumption of
rate hikes, or will the next move after a shorter or longer pause be down in
It is important to note that Fed participants’ rate forecasts (aka the
dot plot) already incorporate a pause sometime next year, followed by further
hikes. This is because the median forecast of participants foresees a slowdown
in the pace of hikes from four in 2018 to three in 2019, followed by another
two in 2020.
However, at the forum we reckoned it would be difficult to communicate a pause
without markets jumping to the conclusion that this is the end of the rate
cycle and the next move will be down. As Ben Bernanke reminded us, his attempt
to signal a pause in the previous rate cycle led to significant volatility.
While central banks such as the Bank of England might get away with a pause
and continued tightening, this is more difficult for the Fed given its global
Against this backdrop, most of us believed that with the probability of
recession likely to rise over time, a resumption of rate hikes after a pause
was relatively unlikely.
Debate #5: U.S. versus China: Truce or peace?
We discussed the outlook for U.S.-China relations shortly after Presidents
Donald Trump and Xi Jinping agreed to pause their escalation of tariffs to
negotiate a deal over the coming 90 days. Some participants argued that
the worst of the trade conflict was now behind us, as both sides wanted a deal
before the negative economic consequences of higher tariffs would be felt.
However, most of us believed the conflict between the U.S. and China is more
deep-rooted and about much more than trade alone, and would thus continue to
be a source of uncertainty and volatility even if there were a deal on trade.
Mike Spence’s description of the conflict as a “clash of
systems” resonated with the audience and reminded us of our discussions
at the Secular Forum in May about the “Thucydides trap,” which
describes the risks of a confrontation between an established and a rising
As outlined above, we see our near- and long-term views on risks being priced
into financial markets. In this environment, we will look for broad,
diversified sources of carry without relying on generic corporate credit risk
and maintain an overall cautious approach in our portfolio construction.
"We think it makes sense to stay fairly close to home in terms of top-down macro risk factors, to keep powder dry and to look for specific opportunities in a more difficult environment.”
We think it makes sense to stay fairly close to home in terms of top-down
macro risk factors, to keep powder dry and to look for specific opportunities
in a more difficult environment where we see overshooting versus fundamentals.
There is substantial option value in leaving room in our risk budget (e.g.,
holding more cash or accepting lower overall portfolio yield) to be able to
respond, either to specific opportunities or in the event of a broad spread
widening and rise in volatility.
While we can take some comfort from our analysis that, judging by
macroeconomic considerations, we are still some distance from the next
recession, the current market environment makes amply clear that a recession
is no prerequisite for turmoil in financial markets. Moreover, rather than
traditional macro overheating, it may be the derating of financial assets
that leads to the next recession.
We think this is a period when we need to favor liquid instruments, except in
specific cases where we are paid for illiquidity.
Modestly underweight duration, overweight TIPS
The recent rally in global duration has put yields close to the low end of our
expected ranges, but in an uncertain environment we want to be fairly close to
home in terms of duration positioning, with only a modest underweight in
global duration outside of Japan.
We see Japan underweights as a good hedge against an (unexpected) shift higher
of the range for global duration and given our expectation that the Bank of
Japan (BOJ) will continue to reduce its net asset purchases/tweak its yield
curve cap frameworks toward somewhat higher yields and a steeper curve.
While our base case calls for continued modest inflation, Treasury
Inflation-Protected Securities (TIPS) breakevens have repriced lower, and we
see TIPS as relatively attractively priced and as offering a hedge against
possible inflation upside surprises in the U.S. in this late stage of the
Curve: Long the belly, short the long end
We see global curve-steepening positions as a structural source of income
generation and, in the current environment, have a preference for the belly of
the curve versus the long end of the curve based on valuation. The curve is
already very flat given that we do not see recession risk over the next 12
months as all that high. Central bank balance sheet reduction is underway in
the U.S., while the European Central Bank (ECB) is poised to end quantitative
easing (QE), which we continue to think should lead to the reestablishment of
a term premium over time. There is also of course some in-built protection in
terms of curve steepeners in the event that we are wrong on recession risk and
a significantly weaker economic environment does force the Fed to reverse rate
Cautious on generic corporate credit
We will target corporate credit underweights, with the focus on being
underweight generic corporate credit beta, while looking for opportunistic
credit trades. Credit valuations have moved closer to long-term averages, but
we don’t see credit as cheap, while volatility is rising and the slowing
economy could reveal underlying weaknesses in terms of leverage. We continue
to be concerned about crowded credit positioning in the market and credit
market structure/illiquidity, which could lead to significant overshooting in
the event of a more generalized bout of credit market weakness. We want to
stay up in quality and up in liquidity, sticking to credits where our global
credit analyst team sees value and remote default risk. We are focused on
downside risks and credit market structure/liquidity in the event of a
rotation out of crowded positions.
Relative value in financials and MBS
As discussed above, we expect to find good opportunities where we see real
cheapness in a more volatile environment, and we want to keep some powder dry
for these opportunities. We continue to see financials offering attractive
relative value. Based on our view that a chaotic no-deal Brexit is a very low
probability, we see U.K. financials as attractive at current valuations. If
the tail risk case is realized, while it is clearly likely that U.K.
financials’ positions would underperform in the short term, the capital
positions of the U.K. banks look robust – as the Bank of England also
concluded in its recent very challenging stress test.
We continue to see non-agency mortgages as offering a defensive alternative to
investment grade (IG) credit, with a better downside risk profile in the event
of weaker macro/credit market outcomes. We also see agency mortgage-backed
securities (MBS) as an attractive and relatively stable source of income in
Underweight European peripheral risk
We remain cautious on European peripheral sovereign credit risk and corporate
risk given the immediate challenges in Italy and the longer-term risks to the
eurozone more generally in the next recession. Yet we remain open to specific
opportunities where we are amply compensated for eurozone credit exposure.
Opportunities in EM FX and bonds
In a world in which growth is synching lower across countries, we have a
balanced view on the U.S. dollar versus other G-10 currencies. We will target
modest EM FX overweight positions in strategies where this risk is appropriate
and, more generally, we expect to find good opportunities in local/external EM
bonds in a difficult market environment.
Equities: Focus on high quality defensive growth
More broadly, on asset allocation, we anticipated the late-cycle environment
would put downward pressure on equity valuation multiples. Looking forward, we
expect downward pressure on profit growth expectations as tailwinds fade and
lagged effects of financial conditions tightening are realized. We
believe equity markets will remain volatile, favoring cautious positioning
overall and a focus on high quality defensive growth and minimal exposure to
cyclical equity beta. We continue to favor more profitable U.S. equity markets
to the rest of the world and prefer high quality large-cap equities at this
stage in the cycle, while we wait for select opportunities to present
themselves over the cyclical horizon.
Commodities: Modestly positive on oil
We are broadly neutral overall on commodity beta risk, combined with a
modestly positive view on crude oil. An unexpected surge in U.S. production
coupled with softening global demand has moved the oil market into surplus.
OPEC’s recent announcement of a cut in production suggests the desire to
support oil prices in the low $60s, avoiding the very low levels of 2014, but
not tightening markets enough that it causes more market share losses to
shale. Outside of oil, natural gas prices are weather-dependent and
inventories remain low, but the current level of winter prices is having a
clear impact on demand and production is surging, suggesting limited further
upside without strong weather support. We continue to see gold as a
long-duration asset and prefer other long-duration assets, such as U.S. TIPS
at current valuations.
Regional economic forecasts
Following expansion of close to 3% during 2018, we continue to expect real GDP
growth to average a below-consensus 2% to 2.5% in 2019, reflecting the recent
tightening of financial conditions, fading fiscal stimulus and slower growth
in China and elsewhere. Growth momentum is likely to moderate during the year,
converging to trend growth of just below 2% during the second half.
We expect employment growth to moderate in 2019 and average around 150,000
nonfarm payroll gains per month, which would still exceed the level of job
gains that is consistent with a stable unemployment rate over time. Headline
inflation looks set to drop sharply over the next several months, reflecting
base effects and the recent plunge in oil prices. Meanwhile, core CPI
inflation of about 2% is expected to trend sideways as inflation expectations
remain anchored and the (inflation) Phillips curve is quite flat.
Against this backdrop, following the expected December rate hike to a target
range of 2.25% to 2.5%, we expect one or two more increases in the fed funds
rate by the end of 2019, with a high chance of the Fed pausing or even ending
the hiking cycle in the first half of the year.
We expect eurozone GDP growth to slow to a below-consensus 1.0% to 1.5% range
in 2019 from close to 2% in 2018. Our downward revision from September
reflects the tightening in financial conditions in Italy, which will take a
toll on growth, as well as weaker global growth.
Core consumer price inflation has been stuck at around 1% for several years
now, but we expect it to pick up somewhat over the next year as unemployment
is likely to keep falling and wage growth has accelerated, particularly in
Germany. Yet, this would still fall short of the ECB’s own forecasts and
keep inflation under the “below but close to 2%” objective.
Nonetheless, we expect the ECB to end net asset purchases by the end of this
month, as already signaled by the central bank, and a first rate hike being
implemented during the second half of 2019. However, if a pause by the Fed
occurs in the first half of 2019, which looks quite likely, and the euro
appreciates significantly versus the U.S. dollar in response, the ECB may well
extend its forward guidance of unchanged rates into the following year.
We see nominal GDP growth in 2019 in line with consensus but expect a
more favorable split between real output growth and inflation.
Our forecast of real GDP growth in a range of 1.25% to 1.75% is based on our
expectation that a chaotic no-deal Brexit will be avoided as there will either
be a deal on a transition agreement that will be accepted by U.K. Parliament
or an extended stop-the-clock negotiation period.
Our below-consensus inflation forecast sees inflation coming back to the 2%
target over the course of next year as import price pressures fade and weak
wage growth keeps service sector inflation subdued.
Against this backdrop, we see one to two additional rate hikes from the Bank
of England over the next year.
We expect moderate GDP growth in Japan in 2019 in a 0.75% to 1.25% range,
supported by a tight labor market and a supportive fiscal stance. The
consumption tax hike currently planned for October 2019 will cause some
quarterly volatility in consumption as households will aim to bring forward
purchases of large-ticket items. However, we expect the government to more
than compensate for the tax hike in the form of higher spending and reductions
in other taxes, so that fiscal policy will be accommodative
However, with inflation expectations low and sticky and improving labor
productivity keeping unit wage costs in check despite rising wage growth, core
inflation ex the consumption tax is likely to creep up only slightly into a
0.5% to 1% range, remaining well below the ambitious 2% target.
We expect the Bank of Japan to further tweak its Japanese government bond
(JGB) buying operations and to continue to stealth taper its purchases, with
lower purchases in the 10-plus year sector contributing to a further
steepening of the yield curve. This is aimed at easing some of the negative
side effects of the low interest rate environment on the financial
Our baseline forecast is for 2019 GDP growth to slow to the middle of a 5.5%
to 6.5% range, which is meant to convey the large uncertainties around the
outlook caused by trade tensions with the U.S., domestic pressure to
deleverage, and economic policy that tries to satisfy partially conflicting
targets (e.g., growth and employment versus financial stability). Our baseline
forecast foresees more constrained monetary stimulus in the form of further
reductions in reserve requirements rather than rate cuts, and incorporates a
fiscal expansion worth about 1.5% of GDP, focused mainly on tax cuts for
corporates and households.
Any further currency depreciation against the U.S. dollar is likely to be
moderate in our baseline scenario. However, if trade negotiations between the
U.S. and China fail and tensions escalate, we would expect monetary easing and
a sharp currency depreciation.
Join us on 9 January 2019 for a live discussion of the key insights from our Cyclical Forum and answers to client questions.
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