Good investment opportunities remain, but investors must be compensated for growing and heightened uncertainty and risks of policy exhaustion.
How stable is the global economy, and what are the risks to that stability?
Critical questions like these drove vigorous debate when PIMCO’s investment professionals gathered in May for our 35th annual Secular Forum. As always, our focus was to identify the key secular forces that will drive the global economy, monetary and fiscal policy, and financial markets over the next three to five years. To help us develop and refine our views, we heard from a stellar lineup of invited speakers, were briefed by our newest class of MBAs, and engaged with members of our Global Advisory Board, who actively participated in the forum discussions. The goal of the Secular Forum is to provide the concept, the construct and the compass to help us navigate global markets over the next three to five years. Crucial to this objective are the baseline, left tail and right tail scenarios we consider for the global economy and economic policy over that timeframe.
To set the stage for this year’s forum discussion, we briefly reviewed the baseline scenario that emerged from last year’s forum.
In May 2015, our baseline secular outlook saw central banks constrained by lofty leverage and sluggish growth to set policy rates at levels well below those that prevailed before the crisis, a continuation of our New Neutral thesis from 2014. For the eurozone and Japan, we expected equilibrium real policy rates would remain negative over most, if not all, of our secular horizon. For the U.S., we foresaw a gradual liftoff trajectory for the federal funds rate also fully consistent with The New Neutral, a liftoff trajectory that a year ago – and today – is (more than) priced in to financial markets. We also saw a potential conflict between the Fed’s desire to allow its balance sheet to shrink over time and its dual mandate objectives of supporting growth and pushing up inflation toward its 2% target, and observed that the Fed balance sheet was not on autopilot. Our baseline secular scenario last year saw a world of economies converging to modest trend growth trajectories, with output gaps narrowing – in some cases only very gradually – and with inflation rising toward target. We also identified key tail risks to the baseline scenario that, if realized, would produce a far different trajectory for the global economy. For example, we noted that, were the world economy to tip into a global recession, few countries outside the U.S. and China would have ample room to maneuver to deploy aggressive countercyclical policy. We also specifically cautioned that there “remains a tail risk of political polarization in the eurozone and/or a British exit from the European Union. In China, the planned reforms are ambitious, but success is not assured, and capital account liberalization in particular will be challenging to accomplish in the timeframe announced.”
This year’s questions
As we gathered in Newport Beach for the 2016 Secular Forum, we knew that our New Neutral thesis was now more than fully priced in to financial markets. In fact, Fed officials themselves have discussed U.S. monetary policy in terms of a time varying “neutral” policy rate, which is currently and is expected for several years to remain (well) below its pre-crisis old neutral level. So an important goal of this forum was to develop a new secular framework appropriate for a world in which The New Neutral is expected to prevail and is fully reflected in asset prices. We also realized that we confronted many of the same questions that we did the year before: How robust is the global expansion in developed and emerging economies? What are the limits of unconventional monetary policy, and do the costs of such policies exceed the benefits? Are China’s prospects for growth, exchange rate policy and capital account liberalization on track? We confronted new questions as well, about the prospects and risks for political polarization and fragmentation in Europe and the U.S., and the downside to negative interest rate policy in Japan and elsewhere.
But while many of the questions might remain the same, a lot – to say the least – has happened since our last forum in May 2015, and we needed to decide based on what we learned from our invited speakers, our Global Advisory Board members and our first-year class of MBAs whether and to what extent we needed to reassess our baseline scenario as well as recalibrate the likelihood and rethink the particular consequences of different tail scenarios. We organized our agenda into four broad topics, also the four essential questions to frame our discussion:
- The global economic outlook: Is last year’s left tail this year’s baseline? (See Figure 2 for IMF’s view on this.)
- China: Is the journey as important as the destination?
- Monetary policy: Diminishing returns or dead end?
- Political populism and polarization: Flash in the pan or secular reality?
To read a full Outlook, click HERE