Investment management giant PIMCO believes the probability of a recession sometime in the next five years is around 70%, if history is any guide. This is one of the warnings contained in its just-published Secular Outlook.
The paper is a product of PIMCO's 36th annual Secular Forum held on 8-10 May in Newport Beach, California. It is by Richard Clarida, global strategic adviser, Andrew Balls, chief investment officer global fixed income and Daniel J Ivascyn, group chief investment officer.
It is a consideration of the issues that will drive the global economy over the next three to five years. “Over our secular horizon, we see rising downside risks to the outlook for Chinese growth and eurozone stability,” say the authors.
Four key takeaways
- Monetary policy: We expect Federal Reserve balance sheet normalisation, but less than many think, with a new neutral destination for the Fed Funds rate
- Fiscal policy: We expect US Congress to pass a package tilted to tax cuts, but light on reform; we see limited fiscal space in Europe
- Trade policy: We expect the US to focus on bilateral deals (eg, China, NAFTA) and aggressive use of existing authority within the WTO (World Trade Organisation)
- Exchange rate and geopolitical policies: Amid populist movements in Europe and beyond, we expect the euro to survive and Italy to remain in the eurozone. The Chinese yuan is likely to grind weaker
Global economy surprised on the upside
“Since our last forum, the global economy has surprised on the upside, markets have shrugged off and indeed rallied after Brexit and the US Presidential election. Risk appetite has been robust.”
This has resulted in lofty equity valuations, tight credit spreads, and low realized volatility, they note. They believe that markets now look too relaxed and medium-term risks are building.
In this environment, they advise that investors should use cyclical rallies to build cash to deploy when markets correct and risks are re-priced.
Recommended portfolio responses
- Focus on valuation – lots of “good news” is priced in to markets
- Maintain focus on capital preservation
- Seek relative value in rates and credit
- Look to a global opportunity set, including emerging markets
Macroeconomic risks…roughly balanced for the US
“In our view, downside and upside risks are roughly balanced for the US; downside risk to growth in both Europe and China is rising over the secular horizon. We see a significantly lower tail risk of global deflation.
“We see a risk the Fed Funds rate lands to the downside of new neutral levels,” the authors continue. “We are monitoring the global economy’s “driving-without-a-spare-tyre” risk in the next recession, whenever it happens.”
The probability of a recession, remember, is 70% in the next five years, they believe.
Andrew Balls, chief investment officer global fixed income, PIMCO