Economic and Market Commentary

A World of Synchronized Deceleration

PIMCO’s Global Economic Advisor and CIO Global Fixed Income discuss the causes of what we predict will be a “growing, but slowing” global economy over the cyclical horizon.

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Adatia: Hi. My name's Tina Adatia, and I'm a product strategist here at PIMCO, and today I'm joined by my colleagues Joachim Fels and Andrew Balls. So with that, let’s get started.

Joachim, let me start with you, can you explain why we're expecting a growing but slowing cyclical outlook, and also the implications of the reduction in central bank balance sheets as well as higher policy rates?

Fels: Yeah. Well, Tina, indeed our story is that we're moving from a world we had a synchronized acceleration of growth back in 2017.

From synchronized acceleration to synchronized deceleration to a world of a synchronized deceleration next year, in 2019, and this year we're basically in a transition period, with fairly wide divergence between the major economies.

The reason behind that is that the U.S. has the fiscal boost, which is really supporting growth this year and has led to an acceleration of growth, whereas Europe, Japan, China, are already slowing. So looking ahead we think the U.S. will converge back down towards the others. So we will see a still growing, but slowing economy.

Two reasons for that. First of all, the fiscal stimulus will start to fade in the course of next year, and the second reason is that we will see the [lagged] effects of the past rate hikes that the fed has implemented coming through, and also the effect of the slowdown or the runoff in the fed's balance sheet.

And indeed, as the right-hand chart shows, even if you look more broadly on a global basis, look at the major central banks, the time of balance sheet expansion is coming to an end.

The ECB will end its bond purchases very likely at the end of this year, and the Bank of Japan has already been reducing the size of its monthly purchases. So that's why we see the global economy still growing, but slowing as we go into next year.

Adatia: Now the next chart shows our regional forecasts where we talk about—we've already talked about an environment of growing but slowing in terms of growth. But Joachim, if I can ask you to talk a little bit about inflation, what are the risks that inflation overshoots or undershoots the central bank's targets globally?

Fels: Well, I think if we look at the major regions or major economies, I think we'll see both overshooting and undershooting.

So let's start with Europe and Japan, or the Eurozone and Japan, where we think that inflation will continue to undershoot central bank's targets over our cyclical horizon, the next year or so.

So in Europe there are some signs that inflation is picking up, core inflation is picking up, because we've seen somewhat stronger wage growth recently. But it's very, very unlikely that we get back to the ECB's target overall cyclical horizon, and the same is true for Japan.

The story is very different in the U.S. where we think that core inflation, which is now bang-on target, 2% for core PCE inflation, which is what the fed is focusing on, we think we'll see some overshooting over the next six months or so.

Only a minor overshooting, but we think that's enough to keep the fed going. So we see the fed hiking rates into this 2.75% to 3.00% range, which most FOMC participants view as the neutral range for rates.

Adatia: Now switching to geopolitical and political risk, Andrew, let's take a look at the tail risks that PIMCO has been watching. Now our view is that any shift in trade policy is going to be the largest near-term swing factor as it comes to markets for better or for worse.

But there are also, of course, other risks on the horizon. Can you run us through your views on that?

Balls: Sure. Thank you. So Joachim and the economic teams, when doing the forecasts, have assumed that the present round of U.S. tariffs are enacted with, again, a lower proportional response from China, and that's baked into the numbers. There's upside risks as there's downside risks.

In terms of downside you could have further rounds from the U.S., further responses from China. Maybe exchange rate depreciation would be something that China would respond with. That could have a pretty significant negative impact on global economic forecasts.

On the upside it could be that we see a reduction in tariffs. President Trump may declare victory and say that everything is now okay, and reverse the trade war. There's the risk of auto tariffs in a worse scenario. NAFTA in the U.S. close to agreement with Mexico, but still uncertainties with Canada. So for good or for bad, trade is going to be one of the key cyclical swing factors.

In Europe one of the secular themes we're emphasizing is populism. You have a populist government in Italy, uncertainty over many things, including the current budget rounds. You've already seen significant rise is risk spreads in Italy. It hasn't spilled over too much, but that's a very uncertain, difficult path in the short term and in the longer term.

And yes, we're here in London. We're going through the Brexit process, getting to the key part of this first two-year period, source of risk largely confined to U.K. assets, and again, illustrating the theme of politics, populism, as we navigate financial markets in this year and the next few years.


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