Joachim Fels, PIMCO Global Economic Advisor
This week, PIMCO’s investment professionals from around the globe will convene in Newport Beach for our quarterly Cyclical Forum, followed by two Strategy Days and a concluding review and update of the IC model portfolio by the Investment Committee. Forum week has been an integral part of PIMCO’s investment process for nearly forty years.
Once a year, at the May Secular Forum, we try to look three to five years ahead to establish the broad guardrails that guide our strategy, and three times a year we refine our outlook and positioning for the next six to 12 months at the Cyclical Forum.
In the past couple of weeks, our portfolio managers, economists, strategists and quantitative and credit analysts have been busy updating their assumptions, models, and forecasts and preparing a wealth of background material. This coming week is when the rubber meets the road and we discuss and debate the outlook with a view to formulating the implications for our positioning.
Following our September Forum, we agreed that a Growing, But Slowing economy had entered the later part of the cycle and that the ongoing removal of monetary accommodation called for a cautious and defensive positioning aimed at keeping portfolios liquid and flexible in order to be able to take advantage of bouts of volatility and potential dislocations. While this served us well during the last higher market volatility witnessed in October and November, the task at hand is now to update our outlook, compare it to what is currently priced into markets, and reassess valuations given that many markets have repriced.
Since September, initial conditions for the macro outlook have changed in more than just subtle ways.
First, global growth momentum continued to deteriorate during the third and early in the fourth quarter, as witnessed by the global PMI, thus further confirming our Peak Growth thesis from December of last year. Importantly, economic growth in the US, which defied the global slowdown during H1 2018 thanks to massive fiscal stimulus and tailwinds from last year’s easing in financial conditions, peaked in the second quarter and has started to decelerate, albeit still running at an above-trend pace.
Second, financial conditions have tightened considerably as interest rates rose (initially), credit spreads widened, equities sold off and the dollar appreciated further. This should start to impact growth adversely over the next several quarters. Some offset may result from the beneficial impact of the recent sharp decline in oil prices for consumers and oil importers, provided prices remain soggy beyond the OPEC meeting next week.
Third, geopolitical and national political crosscurrents continue to muddy the outlook in several ways, with two-sided risks. In the US, a divided Congress as a result of the mid-term elections could spell gridlock in Washington, but there is also an outside chance of a deal on infrastructure. In Europe, the conflict between Italy and the rest of the Eurozone on fiscal policy remains unresolved and the decision by Angela Merkel to stand down as CDU party chair after 18 years (though not as chancellor) has increased political uncertainty – we’ll know more -- though perhaps not much more -- after the CDU delegates have elected their new leader next Friday. Meanwhile in Brazil, the election of a new President has raised hopes that pro-market reforms to promote growth and address fiscal issues will follow, though doubts remain.
Regarding trade policy, the USMCA deal (or NAFTA 0.8 as some in Washington D.C. call it) was signed this past week but is facing a difficult ratification process in the new Congress with an uncertain outcome. Most importantly, however, China – US trade tensions will continue to simmer and be a source of uncertainty for several months even following the Trump-Xi agreement tonight to start negotiating a deal over the next 90 days during which tariffs will be frozen at current levels.
Against this backdrop, we will discuss on Tuesday how these changed initial conditions affect our cyclical outlook. Here’s a sneak peek of what we plan to focus on -- although you never know where the discussions will lead us at this highly interactive event that brings together a large number of strong-minded PIMCO investment professionals from around the globe.
With several of our trusted advisors attending the Forum, we’ll kick it off with brief presentations by and discussions with Ben Bernanke, who chairs our Global Advisory Board, Mike Spence, the 2001 Nobel Laureate in Economics, and Gene Sperling, the former Director of the National Economic Council to Presidents Clinton and Obama. We will also be joined by special guest Richard H. Thaler, the 2017 Nobel Laureate in Economics. Professor Thaler is director of the Center for Decisions Research (CDR) at the Unversity of Chicago Booth School of Business, which recently engaged in a partnership with PIMCO in support of CDR’s behavioral science research, including behavioral economics and finance. Professor Thaler will share his views on how to avoid the pitfalls of groupthink and how to mitigate some of the conscious and unconscious biases that many investors may hold. At PIMCO, we constantly thrive to evolve and improve our own process and are excited about the opportunity to engage with CDR researchers on this and many other topics relevant for our clients and us.
Next, our regional portfolio committees will present their update baseline forecasts for growth, inflation and policy in the major economies over the next six-to-12 months, with a focus on what’s changed, where they differ from consensus, and the risks around their baseline. All PIMCO participants already received a detailed sneak preview of the forecasts last week to facilitate a deeper discussion at the Forum.
As part of the discussion of the growth outlook, we will also thoroughly test our thesis from earlier this year that we have entered the later stage of the cycle. While slowing growth, rising inflation, removal of monetary accommodation and increased market volatility would seem to support the late cycle thesis, we still feel it is important to revisit and challenge it with the help of quantitative and qualitative analyses aimed at measuring the ‘distance to recession’.
A related area of focus will be the inflation outlook, given that one way how expansions have ended in the past was through an acceleration inflation that provoked a significant tightening of monetary policy. We’ll revisit the relationship between economic slack and wage and price inflation to figure out whether the so-called Phillips curve describing that relationship is still flat like a pancake of could start to display a late-cycle kink with wages and/or inflation tilting higher.
We’ll also explore a somewhat unconventional theory of inflation – the Fiscal Theory of the Price Level – which predicts that, under certain circumstances, a constellation of rising interest rates and expansionary fiscal policy could lead to an inflationary spiral. In addition, we’ll discuss the impact of the Amazon effect and growing monopolization in important industries on the inflation process (see also The Art of Monetary Policy). Needless to say, we’ll also have to assess if, and if so how, the plunge in oil prices changes the inflation outlook beyond the immediate impact on headline inflation.
Another way how expansions have died has been through the build up of asset bubbles and/or credit booms that turned into busts – memories of the global financial crisis still loom large ten years after. How different are things this time? To assess potential risks, we will engage in a discussion with Professor Alan M. Taylor from the University of California, Davis, one of the leading experts on the history and the genesis of credit booms and busts based on a unique data base spanning more than 140 years of data and 14 countries. What are the key drivers and characteristics of credit booms? How do we diagnose them? Are there critical thresholds beyond which they turn into busts? And what do they do to the volatility and the skew of the business cycle? Following this, our regional portfolio teams will present on potential credit excesses across the globe and across economic sectors to pinpoint potential leverage hotspots.
Last but not least, before the general discussion that concludes our first Cyclical Forum day, we will zoom in on Emerging Markets, which have seen heightened volatility this year. Our EM team will present on what the continued rise in the dollar, the plunge in oil prices, US-China trade tensions and, importantly, recent domestic political developments in several large EM countries imply for the EM macro outlook and the asset class.
If all of this sounds like a lot, keep in mind this is only the first day of our deliberations. As I explained above, it will be followed by several days of strategy discussions based on our macro outlook and other (equally important) bottom-up, valuation, quantitative and technical considerations. In short, it’ll be a long but certainly interesting week for all of us at PIMCO. And as I’ll have to digest and synthesize our discussions for the Cyclical Outlook that we aim to publish in mid-December, the Signposts will pause next week.