Is President Trump about to start a major trade war? Will goldilocks give way to a more challenging late-cycle mix of slowing global growth and rising inflation? Is the untested Powell-Fed about to step up the pace of rate hikes? Could the neutral rate of interest r* be heading higher? Will Emerging Markets continue to shine? Are we now in a bear market for bonds? Is the new-found volatility in financial markets a taste of things to come or will it blow over soon?
These are some of the macro questions we will discuss this week when PIMCO’s investment professionals from around the globe come together in Newport Beach for the March Cyclical Forum. Together with our credit analysts’ detailed bottom-up work and our quantitative analytics research, the quarterly forums are a central element of PIMCO’s investment process. Everybody gets a chance to speak up at the forum. We try to put all arguments and plausible scenarios on the table and find out where we agree and, importantly, disagree. Needless to say, we frequently go at each other in the debates. At the end of a long week, our Investment Committee then decides on how to position our clients’ portfolios along the key macro risk factors over the cyclical six-to-12 month horizon. And with the gyrations in the global economy, politics and financial markets since the start of the year, this forum promises to become the most exciting since December 2016, shortly after the U.S. elections.
At our previous forum three months ago, we coalesced around a baseline economic scenario of continuing synchronized global growth and only moderately rising inflation in 2018 – basically ‘Goldilocks extended’. However, with markets fully priced for such a benign outcome and investors seemingly unperturbed by several macro risks that we identified in our discussions, we decided in early December to position more defensively for rising rates and bouts of volatility in risk assets, while focusing on bottom-up, relative value and global cross-market opportunities.
Regarding the economic outlook, while we saw a low risk of recession in the near term, we concluded that the global economy would reach ‘peak growth’ this year and titled our December 2017 Cyclical Outlook accordingly. Our concerns centered around three related macro risks: First, that fiscal stimulus in the U.S. comes at the wrong time of the cycle and eats up policy space that had better been saved for the next downturn. Second, that for the first time in this expansion, there is a risk of an inflation overshoot in the U.S. And third, that with the Fed keen to keep removing stimulus and other central banks inching closer to the exit this year while markets and economies have become addicted to ultra-low rates, there is a rising risk of monetary overkill.
Looking back at the past three months, it appears that many investors have started to worry that these risks could indeed materialize, driven by economic data and developments on the fiscal and monetary policy front. The main economic news were (i) upside surprises in U.S. CPI and wage inflation and (ii) downside corrections in (still elevated) global purchasing manager index (PMI) readings, including in China, Europe and the U.S. this past week (peak growth?). Our regional economic and portfolio teams will present in more detail at the forum what these data imply for the outlook.
Regarding fiscal policy, concerns about an ill-timed sugar high for the economy were fueled earlier this year by the Congressional budget deal that provides for a nominal $300 billion federal spending this and next fiscal year, on top of the $1.5 trillion (over 10 years) corporate and personal income tax cuts enacted in December. Moreover, the Administration proposed an infrastructure plan that includes a cumulative $200 billion federal spending aimed at sparking an additional $1.3 trillion of state, local and private infrastructure investment. We’ll discuss at the forum with our experts and advisors how likely it is that the plan will be enacted anytime soon and, if so, whether it is realistic to expect state and local governments and private investors to leverage federal spending by such a large amount.
Last but not least, concerns about potential monetary overkill – one of the risk we highlighted in December – contributed to recent bond and equity market volatility as the Powell-Fed appears to contemplate upping the pace of rate hikes in response to a strengthening expansion, upside inflation surprises and fiscal profligacy. Will they or won’t they change the current game plan of three hikes in the Fed funds rates this year and two more next year as early as the March FOMC meeting? And how will this interact with the Fed’s accelerating balance sheet runoff and possible moves by other central banks to dial down monetary stimulus? This will be another focal point in our discussions this coming week.
Of course, my colleagues and I all have views on all of these issues, and we debate them not only at our quarterly forums but almost daily on the trade floor, in the Investment Committee and in the regional portfolio committees. However, our forum is where the rubber meets the road once every quarter, based on thorough prep work by our research teams and portfolio managers. And once the dust settles, we’ll let you know what we conclude, as always.