Calmer C’s Ahead? China, Commodities And Central Banks Dominate The Global Outlook by Joachim Fels, Andrew Balls – PIMCO
Navigating an environment of tepid nominal growth and near-zero or negative interest rates was never going to be easy. Still, the events that have unfolded since the Federal Reserve’s first rate hike in almost 10 years last December easily surpassed the imagination of most central bankers, observers and investors alike.
And so there was much to talk about when PIMCO’s investment professionals gathered at our Newport Beach office in early March for our quarterly Cyclical Forum to deliberate and update our economic and market outlook for the next six to 12 months. In addition to hearing from PIMCO’s regional portfolio committees from around the globe, we were fortunate to benefit from the perspective of PIMCO’s newly created Global Advisory Board, consisting of its chair Ben Bernanke, Gordon Brown, Anne-Marie Slaughter, Ng Kok Song and Jean-Claude Trichet, which held its inaugural meeting on the day before our forum.
Much has occurred since our December 2015 forum. Investors seemed underwhelmed with the Fed’s first rate hike, which had been well-telegraphed, but China’s leadership allowing faster currency depreciation in the first few days of this year – which may in part have been a reaction to the Fed rate hike – sparked another major risk-off move in financial markets resulting in a considerable tightening of global financial conditions. We are all familiar with the rest of the story: Oil plummeted to new lows, the Bank of Japan (BOJ) surprised markets by taking its interest rate on excess reserves negative for the first time ever, and a further massive sell-off in bank equity and debt, and in risk assets more broadly, ensued. The European Central Bank’s (ECB) suggestion that it would cut rates further into negative territory contributed to European banking sector underperformance. This sent a strong signal that markets were losing faith in central banks’ ability to further prop up asset prices, growth and inflation, as they had been doing over and over again since the 2008 financial crisis.
Lowering our sights on global growth and the Fed
Equity markets, credit indexes and oil prices have rebounded from their mid-February lows, helped by more stable daily fixings of the Chinese yuan (CNY), expectations of a slower-moving Fed and signs that the ECB and the BOJ may have had second thoughts on the relative merits of negative rates after discovering their dark sides. But notwithstanding the recent calmer tone in markets, we concluded at our investment forum that the weaker global economic momentum at the end of 2015/start of 2016 and the significant, though temporary, tightening in global financial conditions in January/February meant that 2016 economic growth and inflation would likely come in at or below the ranges we had forecast in December for most major economies.
The general sense at our forum was that while the almost seven-year-old “BBB economic expansion” has been underwhelming all along, this year it would likely feel even more BBB: bumpy, below-par and brittle. And so we lowered our forecast for calendar year 2016 global real GDP growth by a quarter-point to a range of 2% to 2.5%. Actual global GDP growth was 2.8% in 2014 and 2.6% last year; our forecast sees the slowdown continuing. Moreover, with central banks discovering the limits of monetary policy divergence, which became apparent in the form of excessive U.S. dollar strength, and U.S. monetary policy to some extent being “made in China” given the negative impact of CNY depreciation on financial conditions, we concluded that the Fed would likely only hike rates once or twice this year. In fact, at the Federal Open Market Committee (FOMC) meeting in March, which took place after our Forum, the median FOMC participants’ forecast came down from the four hikes by the end of 2016 (as projected in December) to two hikes in 2016, and thus is much closer to our forecast. And, in line with our analysis, the Fed cited global developments as a major risk to the U.S. outlook.
More headwinds for the multi-speed global economy
Beneath the surface of slow overall global growth, this is still a multi-speed, multi-faceted global economy. Economic and policy divergence will continue to create a plethora of tensions, volatility, risks and opportunities. However, wherever one looks around the globe, nominal and real GDP growth and, therefore, interest rates are likely to stay well below historical norms, very much in line with our time-tested secular New Normal concept of a world economy transformed after the global financial crisis of 2008. The New Normal is characterized by both weak potential output and a lack of aggregate demand, reflecting high debt levels and an excess of global desired saving over investment – the global savings glut. This continues to provide significant headwinds for growth not only on our secular (three- to five-year) horizon but also over the cyclical (six- to 12-month) timeframe. It underpins our expectations for low “neutral” central bank policy rates – along with The New Normal, we have described The New Neutral, referring more explicitly to central bank policies converging to lower neutral rates than in previous economic cycles.
Complicating things are the additional headwinds emanating from rising political uncertainty in multiple constituencies: the U.S. presidential election, rising populism in Europe, the refugee crisis, Brexit risk in the UK and unstable governments in Brazil and beyond. While political risks are difficult to quantify, they have the potential to dent consumer confidence and corporate animal spirits further, and their impact may be non-linear especially when desired saving is high and desired investment is low for other, more secular reasons. One very seasoned observer even suggested that “zombie governments” around the world were the main reason why the global economy is in the doldrums.
The good news? No recession!
However, after weighing all the factors, we decided that this is not the time to despair. Despite the multiple headwinds to the BBB, multi-speed global expansion, we agreed that the risk of a U.S./global recession on our cyclical six- to 12-month horizon remains relatively low, and certainly lower than equity and credit markets had come to price in during the first couple of months of 2016. Both our forecasting models and our forum deliberations suggest a recession probability of at most 20%. While the economic expansion is aging, it is important to remember that expansions don’t die of old age – they are usually ended by a combination of serious imbalances and significant central bank tightening. Right now, none of the typical signals of imminent collapse are flashing: no over-consumption, no over-investment, no over-heating, and no monetary overkill. In short, we expect this expansion to last (for more detail, please see our Macro Perspectives, “The Recession of 2020”).
The three “C’s”
However, in an uncertain world with plenty of potential economic, financial and political tail risks, we will not focus only on a particular baseline forecast. Rather, it pays for investors to explore the risks around the baseline, thinking hard about the distribution of probabilities over a range of conceivable outcomes.
To that end, we concluded that there are three main swing factors for the global economic and financial market outlook this year: China, commodities and central bank policies. Depending on different