PIMCO Cyclical Outlook: "As Good As it Gets"

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.

Regional economic forecasts: around the globe in five minutes

And here’s our 2018 outlook for the major economies:

US

Investment implications

As previewed above, in an environment in which the macro climate is about as good as it is going to get and where valuations are tight, we will emphasize capital preservation in our portfolios. The considerable uncertainty in the outlook, including the aging U.S. expansion, tapering of central bank balance sheet support and China-related risks we think necessitates a cautious approach to portfolio construction, generating income and grinding out alpha with a broad set of small trades rather than taking large concentrations in generic corporate credit.

While the baseline for the Fed’s balance sheet unwind and the ECB’s ongoing tapering – and broader central bank tightening – should be broadly priced in, the fact remains that full valuations and low volatility leave little margin for error. In the later stages of the corporate credit cycle, as active managers, we think it makes sense to emphasize portfolio liquidity and to avoid less liquid positions as a rule and focus on those bottom-up opportunities where we are truly paid for the risk.

While staying fairly close to home in the overall positioning versus the benchmark, we can aim to generate above-market return from a range of positions:

• U.S. non-agency mortgages
• U.S. agency mortgages
• Other select structured product opportunities
• Curve positioning
• Instrument selection
• Bottom-up credit positions
• Emerging markets (EM) foreign exchange positions
• EM local rate and external bond positions
• Optimization of bottom-up positioning with a high quality/income-focused bias more generally across specialist sectors

Duration

We expect to be slightly underweight duration overall, anticipating fairly range-bound markets but with the potential for a shift higher in yield across market levels that are low even in the context of our New Normal/New Neutral framework. In the U.S., as discussed above, we think the Fed is likely to hike more often than the extremely shallow path priced in by the market.

That said, while U.S. duration is in the lower part of our expected range, it continues to look attractive versus most other global alternatives. We continue to favor Japan duration underweights based on the asymmetric return profile at current levels. Over the medium term, we expect the BOJ to adjust the yield cap on 10-year bonds higher and see only modest risk of significantly lower yields. Moreover, while our baseline is for global duration to be broadly range-bound, we see Japan duration underweights as a low-cost hedge against rising global rates. In the event that we see yields rising in the U.S. and elsewhere, we would expect this to force the BOJ to relax its yield curve targeting regime over time.

Spread

We reduced corporate credit risk already across our portfolios and will continue to avoid generic investment grade and high yield corporate credit, looking to our credit specialist teams for bottom-up analysis, with a focus on high quality “bend-but-don’t-break” credit positions. U.S. non-agency mortgages and other high quality securitized assets where we see remote default risk offer defensive qualities in addition to reasonable risk premia for liquidity, complexity and uncertainty over the timing of cash flows. While we see a more balanced outlook for European macroeconomic and political risk, we do not see European peripheral sovereign spreads as offering compelling risk/reward at current levels.

Currencies

We do not see significant imbalances at present in G-10 currency markets. We will continue to favor a diversified basket of EM currency overweights to generate income where it makes sense within our overall portfolio construction, alongside other income-generating opportunities.

Equities

In asset allocation portfolios, we expect to be broadly neutral on equities and commodities. Global equities have had a good year supported by a robust synchronized recovery in earnings. While fundamentals at the global level broadly underpin performance, valuations are full. Japanese equities stand out, screening as relatively “cheap” among developed markets, with the possibility of earnings upside versus relatively subdued expectations.

Commodities

In commodities markets, while fairly neutral overall in terms of the broad beta of the asset class, we will continue to exploit bottom-up opportunities. We expect oil prices to be fairly range-bound with natural stabilizers on both the upside and downside thanks to OPEC spare capacity and the relatively quick responsiveness of shale production to price changes.