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CYCLICAL OUTLOOK
March 2017
Scaling
It Back
As the global economy
improves, central
banks are reducing
extraordinary monetary
policy support.
2
March 2017 Cyclical Outlook
AUTHORS
With her speech entitled “From Adding
Accommodation to Scaling It Back” on 3 March
2017, U.S. Federal Reserve Chair Janet Yellen not
only cemented market expectations for the Fed’s third rate
hike in this cycle, subsequently implemented in the Ides of
March. She also unintentionally provided what turned out
to be the leitmotif of PIMCO’s March 2017 Cyclical Forum
– scaling it back. We found ourselves applying the concept
to not just the monetary policy outlook but to a range of
developments across the global economy.
Joachim Fels
Global Economic Advisor
Andrew Balls
Chief Investment Officer
Global Fixed Income
Aided by the participation of our Global
Advisory Board consisting of its chairman
Ben Bernanke, Gordon Brown, Ng Kok Song,
Anne-Marie Slaughter and Jean-Claude
Trichet, and informed by our macro team’s
scenario analysis and our regional portfolio
committees’ presentations, PIMCO’s
investment professionals debated whether
our 2017 cyclical (six- to 12-month) narrative
of radical uncertainty and fatter tails from
last December (see “Into the Unknown”) was
still intact. Our conclusion: Yes, but.
Given the continuing lack of detail on the
Trump administration’s fiscal and trade
policies, the lingering uncertainty about the
upcoming elections in France, Germany and
potentially Italy, and the risks associated
with China’s debt bubble and capital outflow
pressures, we reconfirmed our “Stable But
Not Secure” secular (three- to five-year)
framework and generally also our “fatter
tails” cyclical outlook. (“Fatter tails” refers to
the distribution curve of potential outcomes
in which we see a generally lower-than-usual
probability of the central or baseline scenario
coming to pass and correspondingly higher
probabilities of the tail-risk scenarios, both to
the downside, or left tail, and to the upside,
or right tail.) However, given what we learned
in the three months since our December
forum, our cyclical story has become
slightly more nuanced in several ways.
Here’s how and why:
First, we scaled back the expected size of
fiscal stimulus in the U.S. and now
anticipate a fiscal package to be finalized in
Congress only in early 2018 – thus its impact
would occur beyond our cyclical horizon.
Repealing and replacing Obamacare will
keep Congress busy for a while, and
comprehensive tax reform will take time and
is hard to do given the rising opposition to
the border adjustment tax from the adversely
affected importing industries and in the
Senate. Thus, any fiscal boost is likely to be
smaller and come later. Viewed in isolation,
this somewhat reduces the probability of a
right-tail (positive) outcome for economic
growth, at least over our cyclical horizon,
even though expectations of an eventual
fiscal package should continue to support
consumer and business sentiment.
Second, it also seems appropriate to scale
back the left-tail risk of a full-blown trade
war sparked by aggressive U.S. trade policy
changes. To be sure, the rhetoric coming out
of the administration on trade continues to
be antagonistic. However, the reported
March 2017 Cyclical Outlook
debate within the White House
between moderate “globalists” and
more aggressive “nationalists”
suggests that the rhetoric shouldn’t
be taken at face value. It would have
been easy for the Trump
administration to impose trade
sanctions early on via executive
orders. The fact that this hasn’t
happened even though the trade
hawks were already operating in
the White House early on in this
administration while the more
moderate voices were still awaiting
congressional confirmation
suggests that President Trump’s
statements on tariffs may be more
symbolic than real. To be sure, this
was our base case all along, but the
left tail of a ferocious trade war
looks less likely now.
Third, and partly related to the
previous item, we are scaling down
the risk of a major China
“accident” this year. Both our
internal and external experts at the
forum emphasized the will and the
wherewithal of the Chinese
leadership and central bank to
maintain financial and (relative)
exchange rate stability ahead of the
19th National Party Congress in
the fourth quarter of this year.
While capital outflow pressure and
rising debt pose serious risks over
the secular horizon, the cyclical
outlook for China appears to be for
relative stability. Note, however,
that the lowered official growth
target of around 6.5% for 2017 and
the heightened focus of the
authorities on financial stability
imply a waning of the Chinese
credit impulse for the global
economy in the course of this year.
Fourth, recent polls as well as the
outcome of the Dutch election last
week suggest somewhat lower
odds of success for nationalist,
anti-European candidates and
parties in the upcoming elections
in France and Germany. In fact, as
we discussed at the Forum, the
momentum for Emmanuel Macron
in France and Martin Schulz in
Germany increases the probability
of a “more rather than less Europe”
outcome, which could benefit
assets in the peripheral countries.
Overall, however, we remain
cautious on Europe given the nearterm political event risk and also
our secular concerns about the
viability of the euro in its present
form, as redenomination risk –
albeit very remote – has resurfaced
in the eurozone.
Fifth, we are scaling back our
assessment of near-term
inflationary pressures in the U.S.
following the recent run-up in
headline inflation (which we had
anticipated). One reason is that
labor force participation has
increased in recent months, which
is likely to damp wage inflation for
now. Another reason is that oil
prices have recently declined in
response to fears of an expiration of
last year’s OPEC deal on supply
constraint just at a time when more
U.S. shale supply is coming to the
market. To be sure, we think
longer-term risks to inflation are
skewed to the upside, but at the
same time the momentum behind
the recent reflation trade is likely to
ebb temporarily in the near term.
3
We are scaling back
our assessment of
near-term
inflationary pressures
in the U.S. We think
longer-term risks to
inflation are skewed to
the upside, but at the
same time the
momentum behind the
recent reflation trade
is likely to ebb
temporarily in the
near term.”
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March 2017 Cyclical Outlook
A strengthening and
broadening global expansion
Putting it all together, we are now more confident in our baseline view that the nearly eight-year-old
global economic expansion will be strengthening and broadening over our cyclical horizon. In fact,
both world GDP growth and consumer price inflation for 2017 are now likely to come in a quarter
percentage point higher than previously expected, reflecting: 1) generally supportive fiscal policies (or
expectations thereof) in most developed market economies, 2) easier financial conditions since the start
of the year, 3) more positive animal spirits as evidenced by consumer and business confidence data and
4) a rebound in global trade in recent months. While back in December we forecast 2017 world GDP
growth averaging 2.5%–3.0%, we now expect growth to be in a 2.75%–3.25% range this year, up from
2.6% in 2016. More specifically (and also see the forecast table), here are our baseline scenario estimates
for growth and inflation in major economies around the world in 2017:
U.S.
GROWTH
EUROZONE
GROWTH
2%-2.5%
1.5%-2%
We expect U.S. GDP to grow in an above-trend 2%–2.5%
channel through 2017 as business investment recovers,
particularly in the energy sector, and consumer spending is
supported by a further decline in unemployment, higher
consumer confidence and expectations of personal income
tax cuts in 2018. Meanwhile, we forecast core inflation to
hover sideways this year, but that the Fed will feel
encouraged by above-trend growth to raise interest rates
two more times during 2017 on top of the March rate hike.
Also, we expect the Federal Open Market Committee to
discuss and eventually agree on a plan to taper reinvestment
of maturing bonds starting in 2018 and thus organically
shrink the Fed’s balance sheet.
We now expect the eurozone economy to grow in a 1.5%–2%
range in 2017, revised higher from our December forecast to
reflect the stronger momentum into the year. While political
uncertainty remains elevated ahead of crucial elections in
France, Germany and potentially Italy, both fiscal policy and
monetary policy are expansionary and the recovery in global
trade growth supports exports and investment. We anticipate
core inflation at just below 1%, making little headway toward
the European Central Bank’s (ECB) “below but close to 2%”
objective and that the ECB will keep buying bonds at the
recently announced reduced pace of €60 billion per month
through December 2017, before tapering and eventually ending
its purchases from early next year.
March 2017 Cyclical Outlook
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UK
GROWTH
CHINA
GROWTH
1.75%-2.25%
6%-6.5%
In the UK, we forecast growth to stay in a 1.75%–2.25%
range in 2017 (above market consensus) despite Brexit,
reflecting robust momentum so far and supported by higher
government spending and a positive contribution of net
trade on the back of the 15% fall in the pound in 2016. We
forecast CPI inflation to exceed the Bank of England’s 2%
target, but that the Bank will keep policy rates unchanged
throughout 2017.
China’s public sector credit bubble and its private sector
capital outflows will likely remain under control this year,
and we anticipate growth will slow into a 6%–6.5% band in
2017 as policymakers prioritize financial stability over
economic stimulus ahead of the 19th National Party Congress
in the fourth quarter of 2017. Any trade war with the U.S. will
likely be engaged via words (and tweets) rather than action,
and we expect the yuan to depreciate gradually by some
4%–5% against the U.S. dollar.
JAPAN
GROWTH
EM*
GROWTH
0.75%-1.25%
5%-5.5%
Japan’s fiscal stimulus and a weaker yen will likely propel
2017 GDP growth into a 0.75%–1.25% zone while inflation
remains subdued significantly below the 2% target. We expect
the Bank of Japan to keep targeting the overnight rate at
−0.1% and the 10-year bond yield at 0% and thus continue its
standing invitation to the government to engage in additional
fiscal expansion, which we expect to happen later this year.
In emerging markets, we expect Brazil and Russia will see
moderate growth returning as their deep recessions end.
With inflation dropping from elevated levels, both countries’
central banks can cut rates multiple times. Meanwhile,
Mexico’s Banxico will likely tighten policy further (following
the Fed’s lead) to support the peso and quell inflation. As a
consequence, growth in Mexico will likely slow into a 1.25%–
1.75% band in 2017.
* Aggregate GDP growth for China, Brazil, Russia, India, Mexico
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March 2017 Cyclical Outlook
GROWTH OUTLOOK FOR 2017 (GDP RANGE)
Developed Markets
Emerging Markets
1.75% to 2.25%
5.0% to 5.5%
REAL GDP GROWTH (% YOY)
CPI INFLATION (% YOY)
2015
2016
2017
FORECAST
2015
2016
2017
FORECAST
DM1
2.1
1.6
1.75-2.25
0.2
0.8
1.75-2.25
U.S.
2.6
1.6
2.0-2.5
0.1
1.3
2.0-2.5
Eurozone
2.0
1.7
1.5-2.0
0.0
0.2
1.25-1.75
UK
2.2
1.8
1.75-2.25
0.0
0.7
2.5-3.0
Japan
1.2
1.0
0.75-1.25
0.8
-0.1
0.25-0.75
EM2
4.7
4.8
5.0-5.5
3.8
3.5
3.0-3.5
China
6.9
6.7
6.0-6.5
1.4
2.0
2.25-2.75
Brazil
-3.8
-3.6
0.5-1.5
9.0
8.8
4.0-5.0
Russia
-2.8
-0.2
0.75-1.75
15.6
7.1
4.0-5.0
India
7.2
6.9
7.0-8.0
5.9
4.9
4.0-5.0
Mexico
2.6
2.3
1.25-1.75
2.7
2.8
5.0-5.5
World3
3.0
2.6
2.75-3.25
1.3
1.7
2.25-2.75
Note: All data for real GDP and headline inflation are year-over-year (YOY) percentage changes.
DM is the GDP-weighted average of U.S., eurozone, UK and Japan.
EM is the GDP-weighted average of China, Brazil, Russia, India and Mexico.
3
World is the GDP-weighted average of all countries listed in table above.
Source: Bloomberg, PIMCO calculations
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March 2017 Cyclical Outlook
Scaling back
accommodation
But here is the catch, and it’s a big
one: With improved growth and
inflation prospects, exhausted
central banks are likely to move
closer to the exit from ultraaccommodative monetary
policies. And it’s not certain
whether highly leveraged private
and public borrowers around the
world will be able to keep dancing
when the music stops.
As we learned in recent weeks,
Janet Yellen and her colleagues at
the Fed are now more confident
that the time for “scaling it back”
has come. The Fed will likely hike
its policy rate twice more in the
remainder of this year and looks
set to allow assets to roll off its
balance sheet gradually in 2018 by
tapering reinvestment. Moreover,
the likely replacement of almost
the entire Board of Governors
(including the chair and vice
chair) over the next year and the
With improved growth and
inflation prospects, exhausted
central banks are likely to
move closer to the exit from
ultra-accommodative
monetary policies.
potential for fiscal expansion at a
time of full employment raises the
uncertainty about the Fed’s future
monetary policy reaction function
(i.e., its targeted “if-this-then-that”
response to new economic data
and conditions – a function that
itself can change over time along
with the Fed’s policy approach).
In Europe, we expect the ECB to
change its forward guidance on
policy rates around midyear and
to scale back its asset purchases
further starting in early 2018,
which raises the specter of sharp
adjustments in euro area sovereign
yield levels and peripheral
sovereign spreads over Bunds.
One final note, and as mentioned
earlier, with the Chinese
authorities’ focus shifting from
growth to stability, the strong
Chinese credit impulse that
supported global reflation in 2016
and into 2017 is likely to wane in
the course of this year.
Needless to say, we will revisit
and thoroughly discuss the
longer-term risks associated with
many of these issues in our
annual Secular Forum in May.
7
8
March 2017 Cyclical Outlook
Investment implications
Turning to our investment conclusions, financial markets have priced in the stronger baseline
growth outlook, somewhat reduced left-tail (downside) risks and the faster path for Fed rate
hikes, which we had anticipated. At current valuations we see it as appropriate to moderately
scale back our credit exposures in our fixed income portfolios, while we expect to be broadly
neutral on equities in our asset allocation portfolios. (For details on our asset allocation views
and strategy, please visit our Asset Allocation Outlook page.)
The U.S. economy may indeed be graduating from multiple years of recovery following the
global financial crisis, and there is some potential for the Fed to proceed on a more traditional
tightening path (though that is not our baseline outlook). However, this is set against the
combination of still muted growth in the rest of the developed world and the prospect of central
banks moving closer toward the exit in Europe, the UK and Japan. One significant source of
uncertainty is the prospect for U.S. dollar strengthening and the Trump administration’s words
and actions in response to further dollar appreciation.
March 2017 Cyclical Outlook
Duration
Credit
While there is the potential for a rise in the level
of global interest rates, it remains the case that
higher yields will be limited by still high levels of
public sector debt and in some cases private
sector debt, as well as demographic influences
and slow growth in both productivity and credit
availability. The greater normalization we have
seen in U.S. rates compared with Europe, the UK
and Japan and historically wide spreads mean
that there is the potential for global yields to
reprice closer to the U.S., and this also leaves the
U.S. as the most attractive source of hard
duration in the event of a shock.
We have moderately scaled back corporate
credit exposures but generally expect to remain
overweight in credit. We expect to continue to
reduce generic investment grade and high yield
positions in our portfolios, and focus instead on
“bend but don’t break” credits: defensive, high
quality, short-dated and default remote credit
exposures. Financials continue to provide some
good opportunities, but we will be careful on
scaling of these positions. As always, rigorous
credit research is paramount.
Given valuations and the ongoing uncertainties
in the global outlook, we continue to see the
current environment as one in which we should
avoid big calls on macro trades and instead look
to grind out alpha, take advantage of
mispricings and relative value opportunities, and
respond to new information. Maintaining a
sufficient level of liquidity (or “dry powder”)
should allow us to respond as active investors to
market volatility and high conviction
opportunities when they present themselves.
We expect to keep portfolios fairly neutral on
overall duration, with a preference for the U.S.
over European, UK and Japanese duration and
to maintain a bias toward curve steepening,
based on the opportunity to generate income,
expectations of a still measured pace for the Fed
and other central bank tightening and the
prospect that markets will price in greater risk
premium at the longer end of global curves.
In our view, U.S. Treasury Inflation-Protected
Securities (TIPS) continue to offer reasonable
valuations and an attractively priced hedge
against higher-than-expected inflation outcomes
– particularly given the uncertainty over the
extent of U.S. fiscal expansion at a time when
the economy is at full employment.
We expect to be overweight non-agency
mortgage-backed securities (MBS), which again
offer defensive qualities in the event of weakerthan-expected growth outcomes in addition to
attractively priced risk premia for liquidity,
complexity and uncertainty over the timing of
cash flows. U.S. agency MBS also offer
reasonable valuations and a source of income,
although we will carefully monitor the prospects
for the Fed reducing the reinvestment of
coupons and the market impact.
We remain cautious on eurozone peripheral risk,
based upon the challenging secular outlook for
the eurozone, political risks and the ECB’s
decision to scale back its quantitative easing (QE)
program and the prospect for further tapering
later in the year. The ECB’s tapering at a time
when core inflation is a long way from target in
the eurozone has called into question the extent
to which the ECB will support both reflation in
the eurozone and peripheral sovereigns in the
event of political or economic shocks. We also
expect to be underweight European corporate
credit at current valuations.
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March 2017 Cyclical Outlook
PIMCO’s Global Advisory Board meets regularly
to provide PIMCO with an outside perspective
about key variables that could affect markets.
Equities
We expect to be neutral on overall equity risk in
our asset allocation portfolios. Equity markets
have continued to rally, driven by the earnings
recovery and the stronger global growth
outlook. But we do not see significant upside
potential for U.S. equities at current valuations in
the absence of a breakthrough on corporate tax
reform in the U.S. The stronger global expansion
has the potential to boost cheaper cyclical
markets, notably Europe, but this remains
subject to eurozone political risk.
Commodities
Currencies
While we see some potential for modest U.S.
dollar strengthening versus other major
currencies, this is subject to significant
uncertainty over the Trump administration’s
response to a stronger dollar. Higher-yielding
emerging market currencies offer attractive
income-generating potential, but we will be
careful in terms of the scaling of these positions.
Emerging markets
More generally on emerging markets, while we
do not anticipate running large risk positions at
current valuations, we will continue to look for
good opportunities to add diversified positions
to our portfolios.
Returns in and prospects for the commodity
markets have improved materially since last year
due to a combination of improved
macroeconomic activity as well as material
advances in the supply-side adjustment. We
believe commodity allocations should be broadly
at benchmark weight, as an expected increase in
global GDP supports commodity demand. The
correlation of commodities to other asset
classes, as well as correlation within the
commodity space, has returned to historical
norms, pointing to the likely return of
commodities as a portfolio diversifier. The
positive correlation to inflation and inflation
surprises also points to the benefits commodities
may offer a portfolio, especially as infrastructure
spending increases globally and austerity
declines, as we anticipate.
March 2017 Cyclical Outlook
ABOUT OUR FORUMS
PIMCO’s investment process is anchored by our Secular
and Cyclical Economic Forums. Four times a year, our
investment professionals from around the world gather
in Newport Beach to discuss and debate the state of the
global markets and economy and identify the trends that
we believe will have important investment implications.
We believe a disciplined focus on long-term fundamentals
provides an important macroeconomic backdrop against
which we can identify opportunities and risks and
implement long-term investment strategies.
At the Secular Forum, held annually, we focus on the
outlook for the next three to five years, allowing us to
position portfolios to benefit from structural changes
and trends in the global economy. Every Secular Forum,
we invite distinguished guest speakers – Nobel laureate
economists, policymakers, investors and historians – who
bring valuable, multi-dimensional perspectives to our
discussions. We also welcome the active participation of
the PIMCO Global Advisory Board, a team of five worldrenowned experts on economic and political issues.
At the Cyclical Forum, held three times a year, we focus
on the outlook for the next six to 12 months, analyzing
business cycle dynamics across major developed and
emerging market economies with an eye toward
identifying potential changes in monetary and fiscal
policies, market risk premiums and relative valuations that
drive portfolio positioning.
11
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