As a turbulent year for the global economy, financial markets, and politics recedes in the rearview mirror, we look ahead into 2020, mapping out both the likely path and the potential roadblocks for the economy and investors.
Last year was not for the fainthearted: Global growth was “synching lower” and entered a “window of weakness,” the U.S.–China conflict and Brexit uncertainty provided dark mood music, climate concerns took center stage amid extreme weather around the globe, and protests against the political establishment reverberated through Hong Kong, Lebanon, Chile, Ecuador, and many other places. And yet, spurred by global monetary easing led by the U.S. Federal Reserve’s dovish pivot in early 2019, both equities and bonds had a year of stellar returns.
Looking ahead, we don’t pretend to know what 2020 will bring in terms of economies, politics, and markets – nobody does. But in order to invest, we must couple our rigorous bottom-up portfolio process with taking an educated guess on the most likely baseline and, even more importantly, the skew of risks and opportunities around that baseline compared with what is priced into markets. That’s why we spend much time at our quarterly forums mapping out different scenarios with the help of data, models, and premortems in order to check our biases, challenge our own and others’ consensus views, and generate investment ideas that will help us manage the risks and target the opportunities we identify.
Based on the discussions, here are our key macro themes for 2020 and how we position portfolios for each of them.
#1. ‘Time to recession’ has increased
Recession risks, which had been elevated during the middle part of 2019, have diminished in recent months, helped by additional global monetary easing, a trade truce between the U.S. and China, better prospects for an orderly Brexit, and early signs of a rebound in the global purchasing managers’ indices (PMIs). This assessment is corroborated by an easing of the 12-month-ahead recession probabilities for the U.S. estimated by our various U.S. recession models.
As a consequence, we are now more confident in our baseline forecast that the current window of weakness for global growth will give way to a moderate recovery during 2020.
World GDP growth, which has been slowing over the past two years, has yet to bottom. However, PIMCO’s World Financial Conditions Index, which tends to lead output growth, has been easing (rising) in recent months, pointing to a moderate cyclical growth recovery in the course of this year (see Figure 1).
Another factor underpinning a likely pickup in global growth this year is the supportive stance of fiscal policy in major economies such as China, Europe, and Japan. With fiscal and monetary policy now working in the same direction – further easing – in almost all major economies, the outlook for a sustained economic expansion over our cyclical horizon has improved. For snapshots of our economic outlook in the major economies, see the section on our regional forecasts further below.
We expect to run a little less duration in our portfolios, with duration close to flat as our starting point and adjusted from there depending on the balance of risk positions in the portfolio. We want to have a constructive approach, with positive carry versus benchmarks, in order to seek to generate income and outperform in the baseline scenario. But we will do this with a bias toward higher-quality positions, a very close focus on portfolio liquidity, and a preference for a diversified approach to generating income. We prefer not to rely excessively on generic corporate credit given concerns over valuations and market liquidity, and the potential for poor performance amid a worse macro outcome than we are expecting or in the event of an overall rise in market volatility in which investors demand a higher risk premium for investing in corporate credit. Within credit, we expect to favor financials over industrials. In asset allocation portfolios, we expect to have a modest overweight to equities, with profit growth likely to provide support in spite of fairly elevated valuations.
#2. But ‘loss given recession’ has likely increased, too
Yet again, the Fed and other major central banks have helped to extend the global expansion by adding stimulus in response to rising recession risks. However, last year’s easing of monetary policy comes at a price: Whenever the next economic downturn or major risk market drawdown hits, policymakers will have even less policy capacity to maneuver, thus limiting their ability to fight future recessionary forces. Thus, while “time to recession” has likely increased with last year’s monetary easing, so has “loss given recession.”
To be sure, this is not a criticism of central banks’ easing actions last year. Hoarding rather than using the policy toolkit is usually not a good idea in the face of rising recession or deflation risks. Rather, these call for aggressive and preemptive action early on to nip them in the bud. This is what both the Fed and the European Central Bank (ECB) attempted last year in response to rising risks and uncertainties, and the first indications are that they were successful in countering these risks.
Still, an inevitable consequence of cutting rates further toward the effective lower bound is that there is now less monetary policy space available for future action.
A common response to the above is that while monetary policy has less space, fiscal policy can and should step in and save the day whenever the next recession looms. After all, low interest rates coupled with central banks’ ability and willingness to purchase (more) government bonds create more fiscal space for governments. In theory, we agree and have in fact argued for some time that fiscal policy is likely to become more proactive in the future. In practice, however, it is unlikely that governments and parliaments are able to diagnose recession risks early enough and, even if so, implement fiscal easing in time to prevent a recession, given the slow way in which political processes usually work. Thus, central banks will still have to be the first responders in the next crisis and, again, will be more constrained than they have been in the past.
Another way last year’s monetary easing may increase “loss given recession” is that the combination of a longer expansion and a longer period of even lower rates and “QE infinity” (i.e., central bank asset purchases, or quantitative easing, with no clear end date) incentivizes companies and households to increase leverage, which could come back to haunt them and their creditors in the next downturn.
We will tend to favor U.S. duration over global alternatives, given the relative value and potential for capital gains in U.S. Treasuries and the scope for further Fed easing in the event of a weaker-than-expected macro outcome. While we are broadly neutral on the U.S. dollar versus other G10 currencies, we generally will favor long yen positions in accounts where currency exposure is appropriate, reflecting the combination of what we believe is cheap valuation and the risk-off nature of a long yen position (which can be a proxy for duration exposure). In credit, as well as the overall cautious stance on generic credit risk, we expect to favor short-dated, default-remote “bend but don’t break” corporate exposures, being extra cautious in the current stage of the credit cycle of what fits into this category.
#3. Potential cracks in the corporate credit cycle
As part of our forum discussions and following the suggestion by Richard Thaler, we engaged in a couple of premortems – exercises in “prospective hindsight” intended to mitigate groupthink and overconfidence in a particular baseline scenario. For one of the premortems, we asked our U.S. team to assume that the economy falls into recession in 2020 and suggest a plausible narrative of how and why this happened. The team zoomed in on vulnerabilities in the riskier segments of the corporate credit market that could exacerbate a further slowdown of growth and turn it into a recession. The story goes as follows:
Back in 2017 and 2018, due in part to a notable increase in nonbank loans to U.S. small and midsize firms that couldn’t get credit from banks, the corporate credit impulse (i.e., the change in overall credit flows, which is highly correlated with GDP growth – see Figure 2) accelerated dramatically. These firms benefited from strong global growth and U.S. fiscal stimulus and were driving the acceleration in private sector job growth. However, when GDP growth decelerated during 2019 from 3% to 2%, private credit lending activity ground to a halt and, in addition, banks tightened standards on commercial and industrial loans.
According to Federal Reserve data, private credit is a roughly $2 trillion market, or 9% of U.S. GDP, which makes a slowdown in this engine of credit growth seem manageable in the context of a robust labor market and healthy consumers. However, if growth slows further in 2020 rather than picking up during the year as in our baseline, the riskier segments of the credit market would seem vulnerable. Private credit, leveraged lending, and high yield debt have been concentrated in businesses that are highly cyclical and have riskier credit profiles. Moreover, despite solid bank equity positions, post-crisis regulation creates incentives for banks to ration credit when heading into a downturn. With speculative grade lending currently around 35% of GDP, stress across these sectors would be more than enough to contribute to a recession.
Again, our base case is that growth picks up in the course of 2020 and thus the “financial accelerator” does not kick in to propagate a default cycle and recession (note that the term was introduced by current PIMCO advisor Ben Bernanke and co-authors in 1996). However, in our view, these corporate credit vulnerabilities warrant close attention especially if growth should fall short of our and consensus expectations this year.
This theme reinforces the case for a defensive stance on generic corporate credit. In addition, in asset allocation portfolios, we will look to be overweight large cap over small cap equities.
#4. Home sweet home
We expect the housing market to be an area of strength in the U.S. economy this year and beyond. The decline in mortgage rates in 2019 has brought buy-to-rent and payment-to-income affordability ratios back to November 2016 levels. Moreover, credit score requirements for new mortgages have eased year-over-year.
Meanwhile, the excess homes built pre-crisis have finally been digested (see Figure 3) and we are now entering a period of overall scarcity across the U.S. Housing vacancy and inventories are at their lowest levels since 2000, while household formations are once again picking up, arguing for an increase in investment needed to grow the housing stock. Our mortgage team expects U.S. home prices to appreciate by some 6% cumulatively over the next two years.
We favor both U.S. agency mortgage exposures and non-agency exposures. We believe agency mortgage-backed securities (MBS) offer attractive valuation, reasonable carry, and an attractive liquidity profile in comparison with other spread assets. We see non-agency mortgages as offering relatively attractive valuation along with a more defensive source of credit and carry and better market technicals than generic corporate credit exposure. We will also look to have select commercial MBS (CMBS) exposures. U.K. residential MBS (RMBS) also looks attractive on a relative valuation basis.
#5. The world leads, the U.S. lags
Just as the U.S. cycle lagged behind the global cycle during 2018 and 2019 with the U.S. economy slowing later and by less than the rest of the world, we expect global growth to trough out and rebound earlier than U.S. growth this year.
Signs of a rebound already started to show up late last year in the global PMIs, particularly in emerging markets, and in other business surveys that are sensitive to global trade and manufacturing, such as the German Ifo survey. Meanwhile, in the U.S. our leading indicators suggest that GDP growth could slow further to around 1% annualized in the first half of this year before picking up again (Figure 4). Moreover, potential temporary production cuts in the U.S. airline industry could shave off another 0.5 percentage points from first-quarter annualized GDP growth, though this would likely be largely recovered assuming production resumes in the second quarter as is widely expected.
Another factor that could hold back U.S. animal spirits and growth this year would be a possible increase in political uncertainty ahead of the U.S. elections, particularly if progressive high-tax, high-regulation Democratic candidates gain more support during the primaries. This would most likely weigh on business sentiment and investment spending and could lead to a tightening of financial conditions via lower expected equity returns.
Taken together, U.S. growth momentum may lag global growth momentum at least for some time during the first half of 2020.
We expect to favor U.S. duration over other global sources of duration. In currency strategy, we look to be overweight a basket of emerging market currencies versus the U.S. dollar and the euro. We will watch closely for other opportunities to be long G-10 currencies versus the U.S. dollar if we see more evidence of a relative shift in momentum from the U.S. to the rest of the world.
#6. Inflation: The devil they prefer
While our baseline forecast is for benign inflation in the advanced economies over our cyclical horizon, we believe medium-term upside risks outweigh downside risks, especially given how little inflation is priced into markets.
One reason is that labor markets have continued to tighten, and wage pressures, though still very moderate given the low level of unemployment, have been picking up recently. If unemployment falls further as economic growth recovers this year, wage pressures are likely to intensify over time, and firms will find it easier to pass on cost increases as demand improves.
Also, with fiscal policy likely to become more expansionary over time, in line with our view that “fiscal is the new monetary,” nominal demand should be better supported, especially if central banks play ball and don’t aim to offset fiscal easing with monetary tightening as the Fed did in 2018.
Last but not least, after many years of missing their inflation targets on the downside, virtually all major central banks seem to prefer inflation (the devil they know) over deflation (the devil they don’t know).
While any changes resulting from the Fed’s ongoing and the ECB’s upcoming strategic review are likely to be evolutionary rather than revolutionary, we expect a nod toward average inflation targeting in the U.S., and a more symmetric 2% inflation target or target band centered around 2% in the euro area, implying a higher tolerance by two major central banks for potential inflation overshoots.
Against this backdrop, and despite the expected global growth recovery this year, we see the major central banks largely on hold this year and expect the bar for tighter policy to be generally higher than the bar for further easing. While discomfort with negative interest rates in Europe is rising given the unpleasant side effects, the ECB is very unlikely to exit until well beyond our cyclical horizon.
We will tend to favor curve steepening positions in the U.S. and in other countries, reflecting valuations but also reflecting the combination of front ends anchored by central banks – that will be reluctant to tighten policy – and the potential for higher inflation expectations to be priced in further out the curve. Curve steepening positions should also provide our portfolios with some cushion given the rise in U.S. government deficit and debt and the possibility that, over time, markets will demand more term premium in the event of further deterioration in the fiscal outlook. U.S. Treasury Inflation-Protected Securities (TIPS) look attractive on a valuation basis and, given the high bar for the Fed to hike rates, even in a somewhat stronger environment. While the outlook for inflation is subdued, the balance of risks is toward a higher inflation outlook than the relatively depressed level priced into TIPS breakevens.
#7. Dealing with disruption
While our baseline economic outlook of a moderate pickup in global growth amid supportive monetary and fiscal policy is relatively benign, we remain cognizant of the potential for significant bouts of volatility caused by geopolitics and national politics around the world.
While a limited Phase 1 trade deal between China and the U.S. is in the making, relations between the established power U.S. and the rising power China remain fragile and tensions could easily erupt again during this year.
Another area of focus this year will be the U.S. elections in November. Risk markets will pay close attention as the field of Democratic candidates for the presidency narrows during the primaries.
Moreover, the recent wave of protests against the political establishment across many emerging market economies may spread further, especially as potential growth in many of these economies has downshifted, which increases the dissatisfaction with governments and sharpens the focus on income and wealth inequality.
Thus, as we pointed out in our 2019 Secular Outlook, investors will have to get used to “dealing with disruption” and position their portfolios accordingly.
While the baseline outlook for 2020 looks positive, we also recognize risk premia has been compressed by central bank action, leaving little cushion in the event of disruption. We see a range of political and geopolitical risks in addition to the potential for macro surprises, central bank exhaustion, and rising volatility.
As well as a close focus on liquidity management, careful scaling of investment positions, and caution on generic credit, we will look to have somewhat lower weight on top-down macro trades, to keep powder dry and potentially go on the offensive in a more difficult investment environment.
This wire is an extract from PIMCO's cyclical outlook for 2020. You can read the full version here
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