PIMCO’s three key risks to economic recovery

Global fixed-income manager PIMCO delivered a reasonably positive outlook for the global economy in its 2021 Q4 Cyclical Outlook report, titled ‘Investing in a fast-moving cycle’. On the back of the robust global recovery in 2021, PIMCO remains convinced that the long-term outlook will be more uncertain and volatile, with ‘cycles becoming shorter in duration, larger in amplitude and more divergent across countries’.

PIMCO notes that the economic effects of the pandemic “may well be in the rearview mirror, with peak policy support and peak growth” in the past. In a challenge to the consensus, it expects developed-market inflation to moderate to within central bank targets by the end of 2022.

However, due to “the magnitude and the persistence of the recent inflation overshoot,” the manager also now expects “an earlier start of DM central bank rate hiking cycles.” The result is “above-trend, albeit slowing growth, moderating inflation” but a “gradual tightening of monetary conditions” as its base case.

Of course, there are several key risks to the thesis, being “persistently elevated inflation, virus variants and the potential for financial conditions to tighten more abruptly than expected.” The PIMCO investment committee thinks markets are already priced for a “blue sky” scenario, where the soft landing is delivered and rate hikes aren’t meaningful.

It warns that “stuff happens,” and at this point, “risk premiums and yields don’t reflect potential downside scenarios.” The result is a change in views across the various fixed-income policy levers:

• Duration: PIMCO suggests an under-weighting to duration, primarily due to the “dearth of risk premium in the term structure” of long-dated bonds. “Active duration management” is expected to be a more significant source of alpha in a more volatile environment’.
• Credit: It will seek an overweight to credit, but with a key caveat being that this must be delivered through “diversified sources.” Corporate bonds will see lower allocations due to the limited scope for further contraction in spreads with individual bond selections set to be a key driver of returns.
• Equities: Its remain “constructive” on global equities due to the “positive earnings backdrop” but stresses the importance of security selection given the “late-cycle dynamics.” Large-cap and high-quality companies look set to outperform, along with companies with pricing power and the semiconductor sector. 
• Emerging markets: The sector remains “intriguing” despite a number of risks, with particular focus on well-managed corporates.
• Commodities: Energy prices are likely to be capped by increased US output, but PIMCO remains “constructive.” Particularly attractive is the “cap-and-trade” emissions market, which will be supported by the transformation from brown to green, and the decarbonisation trend.

Drew Meredith

Drew is publisher of the Inside Network's mastheads and a principal adviser at Wattle Partners.