PIMCO: Financial markets poised for new era of change

Photo of Joachim Fels (pictured), Andrew Balls, Daniel Ivascyn, PIMCO By Joachim Fels (pictured), Andrew Balls, Daniel Ivascyn, PIMCO

min read

Major shifts underway and here is what’s driving them.

Ten years after the global financial crisis, the world economy and financial markets could be entering a new era of potentially radical change that will make the next decade look very different from the last.

Investors who assume the future will resemble the post-crisis past could be in for a series of rude awakenings. They need to be prepared for the challenges ahead and be able to be offensive.

The post-GFC environment has been characterised by financial repression through regulation and dominant central banks. There have been mostly passive or restrictive fiscal policies, weak growth in productivity and real wages, subdued inflation, largely uninhibited trade and capital flows, and low macro and market volatility.

Meanwhile, aggregate global debt levels have continued to rise.

Over the secular horizon of three to five years we expect a very different macro landscape to emerge, for better or worse. Important shifts are already underway: the monetary-fiscal policy mix is changing as central banks retreat and fiscal policy becomes more expansionary; the regulatory discussion is moving from the financial to the tech sector; and economic nationalism and protectionism are on the rise.

One way the real economy could break out from the post-GFC lull on a sustainable basis is through a significant pick-up in productivity growth as the diffusion of new technologies finally accelerates through stronger business investment. However, stronger potential growth would also probably produce higher real interest rates.

Another scenario that could come to pass in, or after, the next recession is a more extreme populist backlash than seen thus far.

Our secular baseline includes a recession
In our view, a recession in the US over the next three to five years is more likely than not, and large parts of the rest of the world would not be immune.

Fiscal stimulus in the US is arriving at a time when the unemployment rate is already below 4 per cent, which raises cyclical overheating risks. Assuming no additional stimulus in 2020, the fading of the US fiscal sugar-rush after 2018–2019 could lead to withdrawal symptoms that could exacerbate a cyclical slowdown.

Any overheating induced by fiscal policy might force the Federal Reserve – which seems unwilling to tolerate a prolonged overshoot of its inflation target by more than a couple of tenths of a percentage point – into pushing policy rates significantly above neutral. This has usually not ended well in past cycles.

A more difficult environment
Among the many potential drivers of significant change over our secular horizon, we are focused on productivity, fiscal policy and more extreme incarnations of economic nationalism and populism than we are currently seeing.

First, regarding productivity, some at PIMCO argue for a mean reversion (ie higher productivity growth) after a disappointing stretch of several years, partly helped by cyclical factors such as on-the-job learning in an almost fully employed US economy. Others expect technology-driven efficiency advances to lift productivity and potential output growth on a more sustained basis, thus lifting natural real interest rates over time.

However, such productivity gains may be slow in coming and more likely to become meaningful on the super-secular horizon rather than in the next three to five years. To become more optimistic on productivity over the long term, we would need to see a significant pick-up in investment spending in the coming years.

Second, a global fiscal expansion/public dis-saving that is large enough to offset some or all the global excess of desired saving over desired investment in the private sector would challenge the status quo of low inflation and low interest rates.

So far, the US is the only major economy that has embarked on meaningful fiscal stimulus, which will take effect over the next few years. While this is unlikely to be enough to absorb the global savings glut, it is possible that even more expansionary policies could be adopted ahead of the 2020 US presidential elections, and other countries might join in.

Third, there is a significant risk of a populist backlash, especially if we hit another recession. This could come in different flavours: income and wealth redistribution from the winners to the losers of the games of globalisation and digitalisation: more aggressive protectionism; nationalisation of major firms or even industries; or attacks on central bank independence, to name just a few.

If left-wing populism were to take hold in the US, UK or Europe, weaker growth and higher inflation would probably result.

Note, however, that there is also a potential (if not very likely) upside for the economy if sensible redistribution policies support real incomes and provide training and jobs for those left behind by digitalisation and globalisation.

Investment implications
Since the 2008 crisis, bad news for the economy has typically been interpreted as good news for financial assets, as policymakers have been quick to respond. But this “buy the dip” mentality may not endure. Financial assets have significantly outperformed the real economy over the past decade but, over the next decade, the opposite may very well be the case.

In this environment we can focus on maintaining portfolio flexibility to respond in the face of downside and upside risks, or surprises. It may mean giving up some portfolio yield potential in exchange for this flexibility, for example by holding more highly liquid short-term investments.

While interest rates have moved higher, likely driven in large part by the prospect of wider fiscal deficits and increased supply in the US, we continue to expect The New Neutral framework of low equilibrium policy rates anchoring global fixed-income markets to be a useful guide.

Demographics, high existing debt levels, low productivity and the global savings glut would work against significantly higher real and nominal interest rates. As a result, we expect to maintain durations that are close to benchmark, given our forecast for fairly range-bound global fixed-income markets and what we see as generally balanced upside and downside risks to the forward yield curves.

We expect that higher volatility over time will lead to the re-establishment of higher-term premiums and risk spreads, leading to steeper yield curves. Higher inflation pressures, whether perceived or realised, could also lead to global curve steepening.

We believe investors should be much more selective on credit as we approach the end of the post-GFC recovery. Our overall caution is bolstered by the large flows we have seen into the asset class, the increase in corporate leverage, and the fact that many asset allocators who were pushed into credit by the low yields available in short-term, liquidity-focused markets in the past decade, may find those short-term investments more enticing in the coming years.

Sectors that have seen a significant increase in regulation, including commercial real estate and the financial sector, as well as housing, will probably show resilience in a more difficult market environment, while other segments of the corporate universe may be more volatile than current valuations appear to anticipate.

Starting valuations across sectors mean that we expect overall an environment of lower nominal returns compared with the post-2008 recovery period.

Although we anticipate a difficult investment environment, it is one where we expect active managers to find good opportunities.

About the author

Joachim Fels is Global Economic Advisor at PIMCO. Andrew Balls is the firm’s Chief Investment Officer (CIO) for Global Fixed Income and Daniel Ivascyn, Group CIO.

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. 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. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Management risk is the risk that the investment techniques and risk analyses applied by an investment a manger will not produce the desired results, and that certain policies or developments may affect the investment techniques available to manager in connection with managing the strategy. Diversification does not ensure against loss.
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