Every year, PIMCO organizes a forum, which brings together top people from its 12 world-wide offices and outside finance and economics thought leaders to debate global financial markets. These investment professionals and thought leaders discuss and identify major trends that will be in play for next three to five years. Outcomes of these forums provide medium term guidance for where and how PIMCO invests its funds.
After this year’s forum, Mohamed A. El-Erian, PIMCO’s CEO and co-CIO, laid out the result of this collective effort for its clients in a report.
El-Erian calls PIMCO’s next three to five years forecast of the global economy to be “Unusually Uncertain“, a term that Ben Bernanke, Chairman of the Federal Reserve Board, used in July 2020 to characterize United States’ cyclical outlook. The basic framework used to analyze and forecast global trends involves “knowns” and “known unkonwns“.
In such a world, we believe that it is particularly important to differentiate well between what one knows with a high degree of both foundation and conviction (the “knowns”), and where sufficient knowledge and confidence can only be built through additional data and analysis (“known unknowns”). This should be combined with enough intellectual agility to change the composition as more information become available; and also with the operational responsiveness required to evolve investment strategies accordingly.
The Knowns
El-Erian notes that presently too many developed economies – many in Europe – are seeing too little growth and are saddled with too much debt and too high unemployment. Growing political polarization and growing calls for greater social justice in Europe lead him to believe that there is a greater probability that eurozone will evolve into a smaller and less imperfect entity – closer political union of countries with more similar conditions. Most likely it will be dominated by the big four: France, Germany, Italy, and Spain.
He forecasts that how this will come about – saving the European project and avoiding major disruption to the global economy – will be both expensive and uncertain.
He believes that United States will look good relative to Europe, outperforming in terms of growth and financial stability. Overall, the developed economies will see a growth that will be around 1% as compared to 2% that the last forum forecasted.
The emerging economies will continue to outpace both Europe and the US and would account for 50% of the global GDP in term of purchasing power parity. However, they still will not be able to compensate for the problems elsewhere globally. They will see an average growth of 5% over the next three to five years compared to 2011’s forecast of 6% growth.
Inflationary pressures will slowly build in the global system and most central banks will maintain a highly accommodative policies for too long.
The Known Unkonwns
El-Erian states that there are many factors which may impact the global economy unpredictably, either negatively or positively.
- Political uncertainties
- Governments could deliver the “Sputnik moment” that acts as a catalyst for a series of beneficial grand policy bargains and their impact could be amplified by the crowding-in of significant private capital that is now on the sidelines
- Unpredictable sociopolitical reactions
- Technological innovations that may create disruptions or enable leapfrogging of structural impediments or could be used negatively
Implication
PIMCO has some recommendations about how to navigate these “Unusual Uncertainties“. It suggests that investors:
- Need to retain a claim of the upside, while protecting against the downside
- Maintain highly differentiated, positioned portfolios for the knowns, while also maintaining the right level of optionality in the face of the unknowns
- Supplement careful bottom-up security selection with macro and deep understanding of the implications of the different policy approaches being used to deal with over-indebted economies generating insufficient growth
- Keep a sizeable quality bias for sovereign and company exposure, the latter both in corporate credit and equity space by focus on names with high cash balances, low financial leverages, high operating margins and exposure to growth areas
- Maintain higher quality sovereign exposure only in parts of the yield curve that offer meaningful roll down and are anchored by credible central bank policies focusing on sovereign with a lower risk of inflation and also utilizing inflation-protected securities
- Supplementing higher quality equity exposure, where possible, with a dividend dimension as a means of de-facto shortening duration.
- Consider real assets when thinking of the range of responses to minimize the multi-faceted risk of financial confiscation, especially as inflationary pressures slowly mount
El-Erian maintains that in this environment, currencies are hardest to call. He notes that:
- Emerging market currencies will likely be supported by continued productivity gains, strong balance sheets and capital inflows.
- Policy makers will be hesitant to see their currencies strengthen in a world that is so uncertain, especially if the appreciation is turbo-charged by leakages from what they view as excessive liquidity creation in the US
- US dollar will continue to be the main recipient of the flight-to-quality capital, at least for the first part of the secular horizon
Bottom Line
El-Erian’s bottom line advice to clients is: Wherever you are in the capital structure ad in geopolitical space, be very alert to situation where valuations do not reflect the confiscation risk, which is not just default but also a function of poor protection against inflation, nationalization and the large preemption of company and currency earnings by governments.
