The world is fragmenting.
This fracturing had already been underway with the emergence of China as a major economic and geopolitical player and Western governments’ skeptical stance toward China. The war in Ukraine and the responses to it are widening these geopolitical fractures and could accelerate the move from a unipolar world to a bipolar or multipolar world.
In our 2022 Secular Outlook, “Reaching for Resilience,” we discuss these and other key trends affecting the global economy, markets, and fiscal and monetary policies that inform our five-year outlook and portfolio positioning. This blog post summarizes our views.
Medium term: elevated recession risks
We see an elevated risk of recession over the next two years, reflecting greater potential for geopolitical tumult, stubbornly high inflation that reduces households’ real disposable income, and central banks’ intense focus on fighting inflation first, which raises the risk of financial accidents on top of the sharp tightening of financial conditions already seen.
Moreover, if and when the next recession arrives, we expect the monetary and fiscal responses to be more reserved and arrive later than in the last several recessions when inflation was not a concern and when government debt levels and central bank balance sheets were less bloated.
While for many reasons our view is that the next recession is unlikely to be as deep as the Great Recession of 2008 or the COVID sudden stop of 2020, it may well be more prolonged and/or the following recovery may well be more sluggish due to a less vigorous response by central banks and governments.
Secular theme: reaching for resilience
In a more fractured world, we believe governments and corporate decision-makers will increasingly focus on searching for safety and building resilience:
- With the risk of military conflict more real following Russian aggression toward Ukraine, many governments – especially in Europe but also elsewhere – have announced plans to increase defense spending and invest in both energy and food security.
- Many corporate decision-makers are focused on building more resilient supply chains through global diversification, near-shoring, and friend-shoring. These efforts were already underway in response to U.S.–China trade tensions and because the COVID pandemic demonstrated the fragility of elaborate value chains, and are likely to be intensified given the more insecure geopolitical environment.
- Moreover, in response to climate-related risks and the COVID crisis, most governments and many companies have already increased efforts to mitigate and adapt to global warming and to improve health security for their citizens and employees.
Looking forward, rather than reaching for yield, we believe that investors will be reaching for resilience in their portfolio construction, looking to build more robust asset allocation in the face of a more uncertain environment for macro volatility, market volatility, and central bank support. For our part, we will look to build resilience into the portfolios we manage on behalf of clients and seek to benefit during periods of market volatility.
Starting valuations – even following the weakness we have seen in asset markets in recent months – and our expectations for a more volatile macroeconomic and market environment call for low and realistic expectations for asset market returns over the secular horizon.
That said, the yield on core bond benchmarks has recovered from COVID-era lows, and in our baseline outlook, we think that forward markets either price in or are close to pricing in what is likely to be the secular high for policy rates across different countries.
We anticipate positive returns on most bond benchmarks over the secular horizon, and fixed income investments, at higher yield levels, should play an important role in building resilience into diversified portfolios.
We believe private credit strategies can be an attractive complement to public credit allocations, though we are seeing excesses in some parts of these markets. We expect to favor higher-quality corporate credit, and will seek to provide liquidity, not to demand liquidity, during periods of credit market stress.
Amid higher inflationary pressures, we see U.S. Treasury Inflation-Protected Securities (TIPS), commodities, and select global inflation-linked investments as providing a reasonably priced hedge. Real estate can also serve as an inflation hedge, particularly in sectors such as multifamily and self-storage, where leases are generally shorter than one year.
We believe equity markets are likely to deliver lower prospective returns than investors have experienced since the global financial crisis, reinforcing our focus on quality and the importance of careful selection.
We expect emerging markets to offer good opportunities, while we stress the importance of active investment to sort between the likely winners and losers in a difficult investment environment.
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. Equities may decline in value due to both real and perceived general market, economic and industry conditions. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Diversification does not ensure against loss.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.
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