Dealing with an inflation head fake
Our baseline view is for a strong recovery across the world and inflation that – in spite of all the reflationary talk – is likely to remain below central bank targets over the next one to two years, notwithstanding a temporary spike over the next several months.
In our spring 2021 Cyclical Outlook, we discuss what our outlook for global growth, inflation, and central bank policy will likely mean for markets and investors over the next year. This blog post is a distillation of our views.
Global growth looks set to rebound even more strongly in 2021 than we’d anticipated in our January Cyclical Outlook. Governments have stepped up fiscal support significantly, and the accelerating vaccine rollout should permit a ramping up of economic activity in COVID-constrained service sectors over the next couple of quarters.
However, this is a very different economic cycle, coming out of a recession driven by lockdowns and voluntary social distancing, rather than underlying economic and financial strains, and there is a higher-than-usual amount of uncertainty in the outlook.
The path for inflation
Over the next several months, a combination of base effects, recent increases in energy prices, and price adjustments in sectors where activity ramps up is likely to push year-over-year inflation rates significantly higher. However, we forecast that much of this rise will reverse later this year as full employment remains elusive, despite the expected strong labor market recovery. Overall, our baseline foresees core inflation remaining below central banks’ targets in all major developed economies in 2021 and 2022.
That said, we need to be mindful of upside inflation risks from a variety of sources, such as an upside surprise in economic growth and employment gains. Conversely, downside risks to inflation could materialize if companies accelerate automation and digitalization in response to the pandemic, or if the ongoing boom in asset prices turns into a bust.
Investors should look to maintain portfolio flexibility and liquidity to be able to respond to events in what is likely to be a difficult and volatile investment environment. We believe that bonds continue to serve as both a store of value and a potent hedge for risk assets in terms of overall asset allocation.
We expect to be fairly close to home in terms of duration, with interest rates at more reasonable levels after the recent market moves. Given the steepening we have already witnessed in the U.S., there is also a good case for global diversification in expressing this curve-steepening view across the U.K., Europe, and Japan.
In our view, U.S. non-agency mortgage-backed securities (MBS) and some other global structured products, including U.K. residential MBS, offer good valuations versus generic cash corporate bonds, as well as good defensive qualities.
In corporate credit, we see the valuation and liquidity offered by credit default swap indices as attractive versus cash corporate bonds in most cases. We see attractive opportunities in COVID-recovery sectors, housing, industrial/aerospace, and select banks and financials, and we will likely maintain a focus on these opportunities in credit-focused strategies.
In asset allocation portfolios, we expect to maintain an overweight to equities, with a preference for cyclicals over defensive stocks. Sector and security selection remain critical, and we favor securities exposed to fiscal stimulus, the cyclical recovery, and secular disruptions in technology. We also continue to favor equity markets in the U.S. and Asia, regions that appear likely to emerge from the pandemic earlier and that should benefit from fiscal support measures.
We see modest upside for commodities, driven by accelerating global growth, investment in infrastructure, and generally tight levels of current inventories. However, we expect aggregate price gains to be limited. We do not believe that we are at the start of a new commodity supercycle because we do not see broad tightness across the majority of markets.
For more details on our outlook for the global economy in 2021 and the investment implications, please read the full Cyclical Outlook, “Dealing With an Inflation Head Fake.”
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Joachim is a managing director and global economic advisor based in the Newport Beach office. He is a member of the Investment Committee and leads PIMCO's quarterly Cyclical as well as the Secular Forum process.