Russia’s invasion of Ukraine, the response to sanctions and fluctuations in commodity markets have cast an even thicker layer of uncertainty on what was already an uncertain economic and financial outlook before this horrible war.
In our March 2022 Cyclical Outlook, “Anti-Goldilocks,” we discuss the wide range of possible scenarios and the potential for nonlinearities and abrupt regime shifts in the economy and financial markets. This blog post summarizes our views.
Economic outlook: a radically uncertain environment
Despite the many unknowns, we draw five main conclusions regarding the 6-12 month cyclical outlook that we believe are most relevant to investors at this point.
1) An « anti-Goldilocks » economy – The global economy and policy makers are facing a stagflationary supply shock which is negative for growth and will tend to drive up inflation further. Admittedly, this “anti-Goldilocks economy” – an economy that will be both too hot in terms of inflation and too cold in terms of growth – is not part of our provisional base scenario, which still calls for higher growth. on trend. and a gradual easing of inflationary pressures from higher peaks across developed market economies. However, the risks of higher inflation and weaker growth or even a recession have increased.
2) More likely nonlinear responses to growth and inflation – The outlook for growth and inflation is clouded by potential nonlinearities related to already fragile initial conditions. Supply chain disruptions were already widespread due to COVID-19, weighing on production and driving up costs and prices in many sectors. Russia’s war in Ukraine and sanctions responses have led to further disruption. Additionally, recent COVID-related lockdowns in parts of China have the potential to create new bottlenecks in the global supply chain.
3) An asymmetric shock leads to greater divergence – The war in Ukraine is likely to lead to greater dispersion of economic performance and inflation across countries and regions. Europe will be the most affected, while the American economy seems relatively isolated from the direct effects of the war in Ukraine. China and most other Asian economies have more limited direct trade ties with Russia, but will likely be negatively affected by rising energy prices and slowing growth in Europe. In emerging markets (EM), commodity exporters should benefit, although rising commodity prices tend to add to already high inflationary pressures in most emerging economies.
Investment implicationsIn this difficult and uncertain environment, a key element of our investment strategy will be to emphasize the flexibility and liquidity of the portfolio to react to events and possibly take advantage of opportunities.
We plan to target modest duration underweights given current levels, upside inflation risks and the prospect of further central bank tightening.
We expect to de-emphasize curve positions, with the broad global tightening cycle underway. We continue to view US Treasury Inflation-Protected Securities (TIPS) as a reasonably priced way to mitigate upside inflation risks.
Credit positioning in portfolios should focus on resilience, liquidity and preservation of principal for a wide range of scenarios. We will seek to underweight generic corporate credit, as we believe that several segments of the securitized product markets offer higher credit quality or more default alternatives to corporate credit. Within corporate credit, we expect to continue to favor senior financials. In credit markets, we are likely to maintain a US bias against Europe and emerging markets.
Currencies and Emerging Markets
On the currency side, in portfolios where these risk positions align with our clients’ guidelines and expectations, we plan to overweight select G-10 and emerging market currencies relative to the US dollar and euro, with a focus on commodity beta and cheap valuations. We will keep these positions quite small in the current uncertain environment. In emerging markets more generally, we expect to have limited exposure but continue to look for attractive opportunities in a challenging environment.
Given the importance of energy in the production costs of other commodities, the impact on general inflation of events in Ukraine could cause prices to rise significantly, with commodity buyers generally seeking to reduce their dependence on Russian exports. With commodity indices showing positive carry at levels rarely seen, we believe commodities can also play a role in mitigating upside inflation risks.
We expect to be broadly neutral on overall equity beta risk in our asset allocation portfolios. We are now firmly in the late phase of the cycle, with underlying growth momentum still strong but increasingly vulnerable to downside risk. We believe the current environment favors high quality, less cyclical companies. Our asset allocation portfolios – and our fixed income portfolios – will tend to emphasize keeping the powder dry in order to take advantage of stock market disruptions when they occur.
Joachim Fels is PIMCO’s Global Economic Advisor and Andrew Balls is CIO Global Fixed Income.