CYCLICAL OUTLOOK

Balancing Risks and

Opportunities in the
Multi-Speed World
The past several months have
investors and policymakers
reassessing global economic
prospects amid elevated
concerns over emerging
market growth models
and policy effectiveness.
In the midst of these global
uncertainties, PIMCO
investment professionals
gathered recently for our
September Cyclical Forum.

AUTHORS

Richard Clarida
Global Strategic Advisor

Andrew Balls
Chief Investment Officer,
Global Fixed Income

September 2015 Cyclical Outlook

At our previous Cyclical Forum in March 2015, we

concluded (as detailed in our post-forum essay)
that the global economy was Riding a Wave of
Accommodation Carefully. Since then, while
the wave of global monetary accommodation
has if anything expanded in scale and in scope
and may well deepen further over our cyclical
horizon to date it has been insufficient to stave
off a decline in commodity and equity prices or
to discourage renewed fears of disinflation amid
concerns that China will not be able to navigate
the New Normal trajectory for growth and global
financial integration they have set for themselves.
Although the turbulence in global markets that followed the bursting of the Chinese equity
bubble in June and the fallout from the devaluation of the Chinese yuan in August was the
major financial event that has occurred since our March forum, our goal at the September
forum as at every forum was to look ahead from initial conditions so as to formulate a
baseline view for the global economy as well as to identify and assess the balance of risks to
that baseline view. Our forum discussions benefited enormously from the active participation
of and valuable contributions from PIMCO senior advisors Ben Bernanke, Mike Spence and
Gene Sperling. Drawing on superb presentations from our Americas, European, and AsiaPacific portfolio committees, as well as from our emerging market (EM) team, and following
a very robust and wide-ranging internal discussion, we coalesced on a baseline view that
global economic prospects over the next 12 months remain broadly unchanged from where we
saw them in March and are consistent with global GDP growth in the range of 2.5% to 3% and
global inflation of 2% to 2.5%.
While this is our baseline cyclical view, the averages it represents mask significant and in
some cases widening divergences among the worlds major economies. As we shall discuss
further below, our baseline view for GDP growth in the U.S., eurozone, U.K. and Japan over
the next year is actually consistent with a modest increase in the pace of growth for this group

September 2015 Cyclical Outlook

GROWTH OUTLOOK FOR THE NEXT 12 MONTHS (GDP RANGE)

ABOUT OUR FORUMS

United States

United Kindgom

China

2.25% to 2.75%

2.25% to 2.75%

5.5% to 6.5%

BRIM

Eurozone

Japan

2.0% to 3.0%

1.5% to 2.0%

1.25% to 1.75%

BRIM is Brazil, Russia,

India, Mexico

FORECAST

REAL GDP

HEADLINE INFLATION

Current*

Q315Q316

Current*

Q315Q316

United States

2.7%

2.25% to 2.75%

1.8%

1.75% to 2.25%

Eurozone

1.5%

1.5% to 2.0%

0.2%

1.0% to 1.5%

United Kingdom

2.6%

2.25% to 2.75%

0.0%

1.25% to 1.75%

Japan

0.8%

1.25% to 1.75%

0.6%

1.0% to 1.5%

China

7.0%

5.5% to 6.5%

1.5%

1.5% to 2.5%

BRIM**

0.3%

2.0% to 3.0%

8.4%

5.0% to 6.0%

World***

2.7%

2.5% to 3.0%

2.1%

2.0% to 2.5%

*Current data for real GDP and inflation represent four quarters ending Q2 2015
**BRIM is Brazil, Russia, India, Mexico
***World is the GDP-weighted average of countries listed in table above
Source: Bloomberg, PIMCO calculations.

PIMCOs 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 going forward. 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. 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.

September 2015 Cyclical Outlook

of countries versus the past year.

On the other side of the ledger, we
concluded that prospects for
growth in China are clearly
deteriorating, though we note the
market consensus view is
converging toward PIMCOs more
bearish forecast published in
March, which in fact remains
roughly unchanged. Finally, other
major emerging economies such as
Russia and Brazil find themselves
at present in recession with at best
uncertain prospects for recovery
over our cyclical horizon.

pass-through of lower oil prices

and in the case of the U.S., the
stronger dollar on price indexes
fades. By contrast, in Brazil and
Russia, where inflation well
exceeds target, recession and (in
Brazil) tight monetary policy are
expected to bring inflation lower
over our cyclical horizon.

In terms of policy, although more

than 40 central banks have eased
monetary policy thus far in 2015,
the odds for additional monetary
easing by the European Central
Bank (ECB) and the Peoples Bank
of China (PBOC) are material, and
further easing by the Bank of Japan
(BOJ) is certainly possible. As for
the Federal Reserve, while our
baseline view remains that it will
commence a rate hike cycle
sometime over our one-year
cyclical horizon, the pace of liftoff
is likely to be even more gradual
than we expected in March.
Moreover, as our new and already
valued colleague Joachim Fels
reminded us, there is a chance that
the Fed, like a number of central
banks in recent years, may find it
impossible to escape the effective
lower bound to which policy rates
were cut during the dark days of
the crisis some seven years ago.
As for global inflation, we see
prospects for a modest pickup in
inflation in many countries as the

In short, we find ourselves today

and for some time are likely to
remain in a multi-speed world for
growth, inflation and economic
policy; a multi-speed world that is
indeed one of the key elements of
PIMCOs secular New Neutral
thesis. Below is our more detailed
economic outlook for this multispeed world over the next 12
months, and then a discussion of
some of the key investment
implications that flow from it.
U.S. Outlook

For the U.S., our baseline view sees

economic growth in the range of
2.25% to 2.75% over the next four
quarters and CPI inflation of 1.75%
to 2.25%. This baseline represents a
modest pickup in growth and
inflation relative to the pace
recorded in the first half of 2015,
and it is slightly below the pace of
GDP growth over the most recent
four quarters. Projected
employment and labor income
gains should support consumption,
while historically low mortgage
rates and a pent-up demand for
housing driven by household
formation and demography should
boost residential construction. In
contrast to robust consumption

and housing, business investment

confronts the headwinds from low
oil prices and cutbacks in drilling
and exploration, while exports will
be challenged by the delayed effects
of a stronger dollar and slower
growth in emerging economies. As
for the Fed, one consequence of the
summer sell-off triggered by
surprise devaluation of the
Chinese yuan (CNY) on August 11
has been to lower the odds that we
get a hawkish mistake from the
Fed. While the Yellen put
analogy is imprecise if there is a
put, then where is the strike, and
is this Fed really prepared to
deploy its balance sheet to defend
it? it is clear from their
statements that this Fed is alert to
the state of financial conditions
and is inclined to go slow once it
starts to hike so as to avoid
tightening too much.
Eurozone and U.K. Outlook

For the eurozone, our baseline sees

economic growth of 1.5% to 2.0%
over the next four quarters with
inflation in a range of 1% to 1.5%.
This baseline also represents a
modest pickup in growth and
inflation relative to the paces
recorded in recent quarters. Unlike
the U.S., the eurozone has
benefited from a weaker currency
and from low oil prices, and the
tailwinds from low oil prices and
the weaker euro currency should
support aggregate demand in the
year ahead. And for the first time
in several years, fiscal policy is no
longer projected to be a drag on
eurozone aggregate demand.

Moreover, the ECB is gaining

traction in transmitting the thrust
of accommodative monetary
policy to easier credit conditions.
On ECB policy, we see a significant
probability that the current
quantitative easing (QE) program
gets expanded before its scheduled
conclusion in September 2016. As
for the U.K, we are projecting GDP
growth of 2.25% to 2.75% with
inflation running in a range of
1.25% to 1.75%. The U.K. economy
is supported by a strong labor
market and the wealth effect from
robust house prices benefiting
from low interest rates. With
prospects for the eurozone
improving, U.K. exports should
also contribute to growth. As Mike
Amey (sterling portfolio manager
on our European portfolio
committee) reminded us, this is a
typical U.K. business cycle, and
one that is not threatened by
above-target inflation. If the Bank
of England does hike during our
horizon, it will almost certainly be
after the first Fed hike, and not
until sometime in 2016.
China Outlook

In previous forums, weve

concluded that China possesses the
will and the wallet to deal with the
policy challenges it faces as it
transitions from a development
model based on running huge
current account surpluses with
a closed capital account to a
model based more on domesticdemand-supported growth and a
more internationally open capital
market. While this continues to be

September 2015 Cyclical Outlook

true, recent events require us to ask

if will and wallet continue to be
sufficient. This assessment is a task
that will take us (and the markets)
some time to complete, and at the
September forum we only just
began the process. Clearly, the
challenges facing China today are
substantial. The economy confronts
a property bust, a collapse in equity
prices, falling exports and an overlevered shadow banking system.
Hot money capital is fleeing
China, and the central bank
(PBOC) is losing reserves in an
effort to prevent a further
uncontrolled depreciation of the
CNY exchange rate. Under these
circumstances, our baseline sees
GDP growth in China in a range of
5.5% to 6.5% over the next four
quarters, which is little changed
from our March forecast but
remains well below consensus. We
see inflation in the range of 1.5% to
2.5%. In the face of such challenging
economic circumstances, we expect
to see a significant monetary policy
response from the PBOC, with 75
basis points in deposit rate cuts, a
200 basis point cut in the required
reserve ratio and devaluation of the
CNY to a level of 6.80 to the dollar.

third arrow of Abenomics (the

first two arrows were fiscal
stimulus and monetary easing;
structural reform is the third). The
Bank of Japan remains extremely
accommodative with its massive
Quantitative and Qualitative
Monetary Easing (QQE) program
in place, yet inflation is projected
to rise only modestly. Our baseline
view is that GDP growth in Japan
should rise from an outright
decline in the second quarter, but
only up to a range of 1.25% to 1.75%
over the next four quarters. Under
this scenario, we see a possibility
that over our cyclical horizon the
BOJ expands yet again the QQE
program, as there is a limited
prospect that inflation reaches the
2% target desired by BOJ Governor
Haruhiko Kuroda.

Japan Outlook

The Japanese economy has suffered

from the slowdown in China and
the continuing drag from the 2014
hike in the VAT. Corporate profits
are healthy due to the weaker yen
and the labor market is robust, but
Japan faces significant structural
headwinds to trend growth that
have not yet been offset by the

Brazil and Russia Outlook

In Brazil, the macro outlook will

largely be a derivative of domestic
politics as the gridlock in Congress
continues. We are forecasting the
recession to deepen throughout
this year with meaningful
downside risks as business
confidence and investment remain
weak. At the same time, we expect
inflation will remain high but start
to noticeably decline in the first
quarter of 2016. Potential upside
risks to inflation could arise from
the outcome of wage negotiations
in the fall, a weaker currency and
further fiscal slippage; downside
risks could arise from a deep
disinflation from the recession and
lower energy prices. Given this
backdrop, we expect only a modest

September 2015 Cyclical Outlook

rate-cutting cycle in 2016 as long as

the political backdrop is stable and
currency pressures are contained.
In addition, we expect to see
pressures on Brazils sovereign
external ratings following S&Ps
downgrade to high yield (with
negative outlook) as the political
dysfunction continues and nearterm prospects of fiscal
consolidation and circuit breakers
remain slim. In Russia, the
recession continues unabated and
is set to peak in the third quarter of
2015 (in year-over-year terms) on
the back of a negative terms-oftrade shock and amid the weight of
Western sanctions. PIMCO
expects Russias GDP to contract
between 3.5% and 4% this year,
and around 0.5% in 2016.
Domestic demand remains the
main drag to growth, with
household spending in particular
being hit under a sharp contraction
in real wages. Capital expenditures
are set to become the main
detractor to growth going forward
once the pressure on real wages
subsides. Meanwhile, the
disinflation trend is set to continue
as the impact from the rubles
weakness has been relatively
contained, i.e., not validated by
wage growth. We expect Russias
central bank to continue to cut
interest rates but to moderate the
pace of easing going forward. The
mirror image (and the silver
lining) of the recession in domestic
demand has been the improvement
in Russias external balance sheet.

The current account surplus has

been improving, and the
deleveraging by the corporate
sector has been impressive, if only
out of necessity.
Risks to the Baseline View

All probability distributions have

right as well as left tails. Today, the
most significant left tail risk to the
global economic outlook is for a
hard landing in China, which in
the extreme could trigger a
currency war and could increase
the odds of outright global
deflation. This is not our base case,
in no small part because we project
significant policy easing by the
PBOC over the next year as they
seek to clip this left tail risk.
On the optimistic side, thus far the
positive stimulus to global
aggregate demand from low oil
prices has been less than projected
by the Organisation for Economic
Co-operation and Development,
the International Monetary Fund
and other experts. If in fact the
stimulus from low oil prices
has only been delayed, not
overestimated, global growth
in the year ahead could surprise on
the upside.
Overall, we see the balance of risks
to the global economy tilted
somewhat to the downside, in part
because of diminishing returns of
unconventional monetary policy
and also the market volatility
stemming from developments
in China.

September 2015 Cyclical Outlook

INVESTMENT IMPLICATIONS
While our baseline views on the
global macro outlook have not
changed significantly, we see
somewhat higher macro and in
particular market risk. To the extent
that there is an impact on macro
variables from the market volatility,
we expect that central banks will
respond over the cyclical path,
including a slower pace of hikes by
the Fed and increased QE from the
BOJ and the ECB. As the Federal
Reserve noted in its statement
following its September meeting
just after our Cyclical Forum
while most of the FOMC
members expect to raise interest
rates before the end of this year,
global developments have raised the
risks to the U.S. outlook for growth
and inflation in the near term.
At the same time, we see central
banks migrating from being a
source of endogenous stability in
markets to being a source of some
exogenous instability. The
willingness to attempt to suppress
volatility is there, but the ability to
do so is diminished. Over-reliance
on central banks (versus fiscal/
structural policy) has led to a wedge
between market valuations and
fundamentals that requires a careful

We see central banks

migrating from being a
source of endogenous
stability in markets to
being a source of some
exogenous instability.

approach to portfolio construction

and close attention to correlated
risk positions and stress tests.

appropriate new issue premiums

are on offer before adding in
primary markets.

In broad terms, we see global fixed

income markets as anchored by our
New Neutral secular framework for
interest rates. Lower central bank
policy rates over the next three to
five years mean that fixed income
markets look fair to somewhat rich
but not grossly mispriced.

We continue to see value in

non-agency mortgages given
housing market strength, broadly
range-bound rate markets, and the
fairly defensive nature of the
securities due to seniority in the
capital structure.

In terms of portfolio positioning,

this translates into modest duration
underweights for the most part. We
expect markets to price more risk
premiums into developed country
curves, starting with the U.S. and
the Fed rate hike cycle.
We think that markets are probably
pricing insufficient tightening by
the Fed, based upon our baseline
forecast of above-potential growth
and inflation getting back to the
Feds 2% target over the next four
quarters. Globally, we see the same
pattern of forward rates that look
fair to slightly rich in nominal
duration. In U.S. Treasury
Inflation-Protected Securities
(TIPS), we see valuation as
attractive, given our expectation
for gradually rising inflation.
We continue to expect to maintain
broad credit spread overweights in
our portfolios, with some
increased uncertainty in the
outlook compensated for by more
attractive valuations following
recent market weakness. We
continue to see investment grade
and high yield credit industrials
and financials as attractive. We will
be vigilant on liquidity and ensure

On currencies, we will maintain an

overweight to the U.S. dollar,
reflecting macro and policy
divergence at a time when the U.S.
economy is outperforming and the
Fed is set to tighten policy, while
we expect ongoing policy
loosening outside the U.S. We will
favor a diversified basket of
funding currencies, G-10
currencies and Asian emerging
market currencies.
We will be cautious on emerging
markets holdings, reflecting macro
and market risks, but will continue
to look for select opportunities to
add risk at attractive valuations.
On global equities, we are broadly
neutral overall. At a time of
peaking U.S. profits and a
stronger U.S. dollar, we will
continue to favor European and
Japanese equities based on
earnings growth momentum and
supportive central banks.
On commodities, we expect to see
supply and demand as broadly
balanced over the next 12 months
and have a neutral outlook at
current prices.

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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
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