Don’t trip on a fat tail
In our baseline forecast for 2020, the low-growth period of vulnerability from 2019 gives way to a moderate recovery in global growth. However, our conviction in this baseline economic narrative is lower than usual, given our expectations of an environment of heightened uncertainty. In other words, we are wary of the possibility for fat tails in investment outcomes.
Fat tails refer to a probability distribution of outcomes that are skewed towards extreme positive and negative outcomes. We see a number of factors that contribute to this environment.
The first is trade policy. On one hand, a further escalation of the trade war could easily tip an already slowing global economy into recession. On the other hand, a comprehensive trade deal between the U.S. and China that removes a significant portion of the already imposed and prospective tariff increases could produce a synchronized reacceleration of global growth in 2020.
Another factor is global monetary policy. If global central banks under-deliver relative to market expectations, this could result in a left-tail outcome. As the sell-off in risk assets during the fourth quarter of 2018 showed, markets are very sensitive to more-hawkish-than-expected central banks.
Another upside risk to economic growth is that fiscal policy in major economies becomes more expansionary. While our baseline foresees only moderate fiscal stimulus over the cyclical horizon, there is a chance that slowing growth and – in Europe and Japan – negative bond yields and “QE infinity” incentivise governments to become more proactive in supporting growth.
In this environment of potential fat tails, we think it’s prudent to focus on capital preservation, to be relatively light in taking top-down macro risk in portfolios, to be cautious on corporate credit and equities, to wait for more clarity, and to take advantage of opportunities as they present themselves.
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This wire is part of the ‘One thing investors can’t ignore in 2020’ series. To download the full ebook please click here.
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Adam is an executive vice president and fixed income portfolio manager in the Sydney office. Prior to joining PIMCO in 2011, he was responsible for global macro research and trading at Tudor Investment Corporation. He was previously a director and...