Prior to the COVID shock, we had anticipated a difficult investment environment subject to a range of long-term disruptors, including China’s rise, populism, technology, and climate-related risks. The pandemic has amplified these disruptors and created an even more challenging landscape for investors.
In our latest Secular Outlook, we discuss the importance of being prepared for a variety of disruptions and actively pursuing opportunities that arise when volatility occurs. As always, our outlook derives from our annual Secular Forum (this year held in September), which included PIMCO’s global investment professionals and Global Advisory Board as well as distinguished guest speakers. This blog is a distillation of our outlook and investment implications.
The economic outlook
We forecast above-trend growth for a couple of years as the global economy emerges from the COVID recession. However, we think concerns voiced at our forum that “economic scarring” will weigh on potential output growth are warranted.
Three factors are likely to weigh on longer-term productivity growth: Longer spells of unemployment typically imply an erosion of individuals’ skills, higher uncertainty will likely depress business investment for a long time, and an increasing “zombification” of the corporate sector is expected due to massive government and central bank support.
The two key swing factors that could produce upside or downside surprises are the state of the pandemic and the degree to which fiscal policy stays active or retreats. While more stimulus is already on the horizon in Europe, the outcome of the U.S. election in November will (hopefully) provide more clarity on the scope and nature of continued fiscal support.
Given the difficult near-term and longer-term economic backdrop, and with disruption likely to lead to repeated bouts of volatility in financial markets, we expect monetary policy rates in most advanced economies to stay low or go even lower for much or all of the next three to five years.
We view negative rates as a desperate tool with adverse side effects that become larger the longer rates stay negative (see “A Negative View on Negative Rates”). However, with bond yields already low or negative and yield curves flat, more central banks are likely to venture into negative (or more deeply negative) territory in response to future adverse shocks, along with further purchases across a wide spectrum of financial assets.
Starting valuations in bond markets and equity markets make it difficult to envision the ongoing inflation of asset prices as the byproduct or the intention of policy interventions, including with the best efforts of central banks to offset the effects of future negative shocks.
While we see very little upside risk to inflation in the near term, we think that over time it will make sense to hedge against a rise in inflation, using Treasury Inflation-Protected Securities (TIPS), yield curve strategies, real estate, and potentially exposure to commodities.
Opportunities in credit
Credit spreads are close to their tights, but we will seek to add value with active name and security selection. This is not an environment where we want exposure to generic credit.
We continue to see U.S. agency mortgage-backed securities as a relatively stable and defensive source of income in our portfolios. In addition, U.S. non-agency mortgages and the broader set of U.S. and global asset-backed securities offer seniority in the capital structure and a favorable downside risk profile in the event of negative macro or market surprises.
Private credit and private real estate strategies offer the potential for attractive returns, including harvesting illiquidity premia for investors who are able to commit long-term capital and bear the heightened risks associated with private investments.
Opportunities in many regions
We expect to find good investment opportunities in Europe if the current greater stability of the euro area is maintained or – as active investors – in the event that Europe continues the more familiar pattern of one step forward followed by two steps backward.
We also expect to find good investment opportunities in Asia, a region that thus far has demonstrated somewhat greater stability during the COVID crisis, including active opportunities for corporate credit selection.
We believe emerging markets generally offer the potential for higher returns than developed countries, given initial valuations, but also the potential for yet more significant disruptions that will lead to a range of winners and losers.
Emerging market currencies also offer the potential for higher returns given initial valuations, but are subject to local and global disruption risk. While the short-term cyclical outlook for a global recovery from the COVID shock raises the possibility of further U.S. dollar weakening, repeated disruptions over the secular time frame will likely lead to periods of flight to the dollar, which many investors believe remains the safest haven even in a more multipolar world.
The prospect of a more difficult investment environment and the potential for a rise in economic and market volatility mean that we will put significant emphasis on capital preservation and avoiding the risk of exposure to absolute losses. We also think this is likely to be an investment environment that calls for a patient approach, a global approach, and a flexible approach to utilize a wide as possible set of investment instruments and pursue attractive risk-adjusted opportunities across jurisdictions.
For more details on our outlook for the global economy and investment implications over the next three to five years, read the full Secular Outlook, “Escalating Disruption.”
Joachim Fels is PIMCO’s Global Economic Advisor, Andrew Balls is CIO Global Fixed Income, and Dan Ivascyn is Group CIO.