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CYCLICAL OUTLOOK

March 2017

Scaling
It Back
As the global economy
improves, central
banks are reducing
extraordinary monetary
policy support.
2 March 2017 Cyclical Outlook

AUTHORS With her speech entitled From Adding


Accommodation to Scaling It Back on 3 March
2017, U.S. Federal Reserve Chair Janet Yellen not
only cemented market expectations for the Feds third rate
hike in this cycle, subsequently implemented in the Ides of
Joachim Fels March. She also unintentionally provided what turned out
Global Economic Advisor
to be the leitmotif of PIMCOs March 2017 Cyclical Forum
scaling it back. We found ourselves applying the concept
to not just the monetary policy outlook but to a range of
developments across the global economy.

Andrew Balls Aided by the participation of our Global in the three months since our December
Chief Investment Officer Advisory Board consisting of its chairman forum, our cyclical story has become
Global Fixed Income Ben Bernanke, Gordon Brown, Ng Kok Song, slightly more nuanced in several ways.
Anne-Marie Slaughter and Jean-Claude Heres how and why:
Trichet, and informed by our macro teams
First, we scaled back the expected size of
scenario analysis and our regional portfolio
fiscal stimulus in the U.S. and now
committees presentations, PIMCOs
anticipate a fiscal package to be finalized in
investment professionals debated whether
Congress only in early 2018 thus its impact
our 2017 cyclical (six- to 12-month) narrative
would occur beyond our cyclical horizon.
of radical uncertainty and fatter tails from
Repealing and replacing Obamacare will
last December (see Into the Unknown) was
keep Congress busy for a while, and
still intact. Our conclusion: Yes, but.
comprehensive tax reform will take time and
Given the continuing lack of detail on the is hard to do given the rising opposition to
Trump administrations fiscal and trade the border adjustment tax from the adversely
policies, the lingering uncertainty about the affected importing industries and in the
upcoming elections in France, Germany and Senate. Thus, any fiscal boost is likely to be
potentially Italy, and the risks associated smaller and come later. Viewed in isolation,
with Chinas debt bubble and capital outflow this somewhat reduces the probability of a
pressures, we reconfirmed our Stable But right-tail (positive) outcome for economic
Not Secure secular (three- to five-year) growth, at least over our cyclical horizon,
framework and generally also our fatter even though expectations of an eventual
tails cyclical outlook. (Fatter tails refers to fiscal package should continue to support
the distribution curve of potential outcomes consumer and business sentiment.
in which we see a generally lower-than-usual
Second, it also seems appropriate to scale
probability of the central or baseline scenario
back the left-tail risk of a full-blown trade
coming to pass and correspondingly higher
war sparked by aggressive U.S. trade policy
probabilities of the tail-risk scenarios, both to
changes. To be sure, the rhetoric coming out
the downside, or left tail, and to the upside,
of the administration on trade continues to
or right tail.) However, given what we learned
be antagonistic. However, the reported
March 2017 Cyclical Outlook 3

debate within the White House Fourth, recent polls as well as the
between moderate globalists and outcome of the Dutch election last
more aggressive nationalists week suggest somewhat lower
suggests that the rhetoric shouldnt odds of success for nationalist,
be taken at face value. It would have anti-European candidates and
been easy for the Trump parties in the upcoming elections
administration to impose trade in France and Germany. In fact, as
sanctions early on via executive we discussed at the Forum, the
orders. The fact that this hasnt momentum for Emmanuel Macron We are scaling back
happened even though the trade in France and Martin Schulz in our assessment of
hawks were already operating in Germany increases the probability
the White House early on in this of a more rather than less Europe near-term
administration while the more outcome, which could benefit inflationary pressures
moderate voices were still awaiting assets in the peripheral countries.
congressional confirmation Overall, however, we remain in the U.S. We think
suggests that President Trumps cautious on Europe given the near- longer-term risks to
statements on tariffs may be more term political event risk and also
symbolic than real. To be sure, this our secular concerns about the inflation are skewed to
was our base case all along, but the viability of the euro in its present the upside, but at the
left tail of a ferocious trade war form, as redenomination risk
looks less likely now. albeit very remote has resurfaced same time the
Third, and partly related to the
in the eurozone. momentum behind the
previous item, we are scaling down Fifth, we are scaling back our recent reflation trade
the risk of a major China assessment of near-term
accident this year. Both our inflationary pressures in the U.S.
is likely to ebb
internal and external experts at the following the recent run-up in temporarily in the
forum emphasized the will and the headline inflation (which we had
wherewithal of the Chinese anticipated). One reason is that
near term.
leadership and central bank to labor force participation has
maintain financial and (relative) increased in recent months, which
exchange rate stability ahead of the is likely to damp wage inflation for
19th National Party Congress in now. Another reason is that oil
the fourth quarter of this year. prices have recently declined in
While capital outflow pressure and response to fears of an expiration of
rising debt pose serious risks over last years OPEC deal on supply
the secular horizon, the cyclical constraint just at a time when more
outlook for China appears to be for U.S. shale supply is coming to the
relative stability. Note, however, market. To be sure, we think
that the lowered official growth longer-term risks to inflation are
target of around 6.5% for 2017 and skewed to the upside, but at the
the heightened focus of the same time the momentum behind
authorities on financial stability the recent reflation trade is likely to
imply a waning of the Chinese ebb temporarily in the near term.
credit impulse for the global
economy in the course of this year.
4 March 2017 Cyclical Outlook

A strengthening and
broadening global expansion
Putting it all together, we are now more confident in our baseline view that the nearly eight-year-old
global economic expansion will be strengthening and broadening over our cyclical horizon. In fact,
both world GDP growth and consumer price inflation for 2017 are now likely to come in a quarter
percentage point higher than previously expected, reflecting: 1) generally supportive fiscal policies (or
expectations thereof) in most developed market economies, 2) easier financial conditions since the start
of the year, 3) more positive animal spirits as evidenced by consumer and business confidence data and
4) a rebound in global trade in recent months. While back in December we forecast 2017 world GDP
growth averaging 2.5%3.0%, we now expect growth to be in a 2.75%3.25% range this year, up from
2.6% in 2016. More specifically (and also see the forecast table), here are our baseline scenario estimates
for growth and inflation in major economies around the world in 2017:

U.S. EUROZONE
GROWTH GROWTH
2%-2.5% 1.5%-2%

We expect U.S. GDP to grow in an above-trend 2%2.5% We now expect the eurozone economy to grow in a 1.5%2%
channel through 2017 as business investment recovers, range in 2017, revised higher from our December forecast to
particularly in the energy sector, and consumer spending is reflect the stronger momentum into the year. While political
supported by a further decline in unemployment, higher uncertainty remains elevated ahead of crucial elections in
consumer confidence and expectations of personal income France, Germany and potentially Italy, both fiscal policy and
tax cuts in 2018. Meanwhile, we forecast core inflation to monetary policy are expansionary and the recovery in global
hover sideways this year, but that the Fed will feel trade growth supports exports and investment. We anticipate
encouraged by above-trend growth to raise interest rates core inflation at just below 1%, making little headway toward
two more times during 2017 on top of the March rate hike. the European Central Banks (ECB) below but close to 2%
Also, we expect the Federal Open Market Committee to objective and that the ECB will keep buying bonds at the
discuss and eventually agree on a plan to taper reinvestment recently announced reduced pace of 60 billion per month
of maturing bonds starting in 2018 and thus organically through December 2017, before tapering and eventually ending
shrink the Feds balance sheet. its purchases from early next year.
March 2017 Cyclical Outlook 5

UK CHINA
GROWTH GROWTH
1.75%-2.25% 6%-6.5%

In the UK, we forecast growth to stay in a 1.75%2.25% Chinas public sector credit bubble and its private sector
range in 2017 (above market consensus) despite Brexit, capital outflows will likely remain under control this year,
reflecting robust momentum so far and supported by higher and we anticipate growth will slow into a 6%6.5% band in
government spending and a positive contribution of net 2017 as policymakers prioritize financial stability over
trade on the back of the 15% fall in the pound in 2016. We economic stimulus ahead of the 19th National Party Congress
forecast CPI inflation to exceed the Bank of Englands 2% in the fourth quarter of 2017. Any trade war with the U.S. will
target, but that the Bank will keep policy rates unchanged likely be engaged via words (and tweets) rather than action,
throughout 2017. and we expect the yuan to depreciate gradually by some
4%5% against the U.S. dollar.

JAPAN EM*
GROWTH GROWTH
0.75%-1.25% 5%-5.5%

Japans fiscal stimulus and a weaker yen will likely propel In emerging markets, we expect Brazil and Russia will see
2017 GDP growth into a 0.75%1.25% zone while inflation moderate growth returning as their deep recessions end.
remains subdued significantly below the 2% target. We expect With inflation dropping from elevated levels, both countries
the Bank of Japan to keep targeting the overnight rate at central banks can cut rates multiple times. Meanwhile,
0.1% and the 10-year bond yield at 0% and thus continue its Mexicos Banxico will likely tighten policy further (following
standing invitation to the government to engage in additional the Feds lead) to support the peso and quell inflation. As a
fiscal expansion, which we expect to happen later this year. consequence, growth in Mexico will likely slow into a 1.25%
1.75% band in 2017.

* Aggregate GDP growth for China, Brazil, Russia, India, Mexico


6 March 2017 Cyclical Outlook

GROWTH OUTLOOK FOR 2017 (GDP RANGE)

Developed Markets Emerging Markets


1.75% to 2.25% 5.0% to 5.5%

REAL GDP GROWTH (% YOY) CPI INFLATION (% YOY)


2017 2017
2015 2016 FORECAST 2015 2016 FORECAST

DM1 2.1 1.6 1.75-2.25 0.2 0.8 1.75-2.25

U.S. 2.6 1.6 2.0-2.5 0.1 1.3 2.0-2.5

Eurozone 2.0 1.7 1.5-2.0 0.0 0.2 1.25-1.75

UK 2.2 1.8 1.75-2.25 0.0 0.7 2.5-3.0

Japan 1.2 1.0 0.75-1.25 0.8 -0.1 0.25-0.75

EM2 4.7 4.8 5.0-5.5 3.8 3.5 3.0-3.5

China 6.9 6.7 6.0-6.5 1.4 2.0 2.25-2.75

Brazil -3.8 -3.6 0.5-1.5 9.0 8.8 4.0-5.0

Russia -2.8 -0.2 0.75-1.75 15.6 7.1 4.0-5.0

India 7.2 6.9 7.0-8.0 5.9 4.9 4.0-5.0

Mexico 2.6 2.3 1.25-1.75 2.7 2.8 5.0-5.5

World3 3.0 2.6 2.75-3.25 1.3 1.7 2.25-2.75

Note: All data for real GDP and headline inflation are year-over-year (YOY) percentage changes.
1
DM is the GDP-weighted average of U.S., eurozone, UK and Japan.
2
EM is the GDP-weighted average of China, Brazil, Russia, India and Mexico.
3
World is the GDP-weighted average of all countries listed in table above.
Source: Bloomberg, PIMCO calculations
March 2017 Cyclical Outlook 7

Scaling back
accommodation
But here is the catch, and its a big potential for fiscal expansion at a
one: With improved growth and time of full employment raises the
inflation prospects, exhausted uncertainty about the Feds future
central banks are likely to move monetary policy reaction function
closer to the exit from ultra- (i.e., its targeted if-this-then-that
accommodative monetary response to new economic data
policies. And its not certain and conditions a function that
whether highly leveraged private itself can change over time along
and public borrowers around the with the Feds policy approach).
world will be able to keep dancing
In Europe, we expect the ECB to
when the music stops.
change its forward guidance on
As we learned in recent weeks, policy rates around midyear and
Janet Yellen and her colleagues at to scale back its asset purchases
the Fed are now more confident further starting in early 2018,
that the time for scaling it back which raises the specter of sharp
has come. The Fed will likely hike adjustments in euro area sovereign
its policy rate twice more in the yield levels and peripheral
remainder of this year and looks sovereign spreads over Bunds.
set to allow assets to roll off its
One final note, and as mentioned
balance sheet gradually in 2018 by
earlier, with the Chinese
tapering reinvestment. Moreover,
authorities focus shifting from
the likely replacement of almost
growth to stability, the strong
the entire Board of Governors
Chinese credit impulse that
(including the chair and vice
supported global reflation in 2016
chair) over the next year and the
and into 2017 is likely to wane in
the course of this year.

Needless to say, we will revisit


and thoroughly discuss the
longer-term risks associated with
many of these issues in our
annual Secular Forum in May.
With improved growth and
inflation prospects, exhausted
central banks are likely to
move closer to the exit from
ultra-accommodative
monetary policies.
8 March 2017 Cyclical Outlook

Investment implications
Turning to our investment conclusions, financial markets have priced in the stronger baseline
growth outlook, somewhat reduced left-tail (downside) risks and the faster path for Fed rate
hikes, which we had anticipated. At current valuations we see it as appropriate to moderately
scale back our credit exposures in our fixed income portfolios, while we expect to be broadly
neutral on equities in our asset allocation portfolios. (For details on our asset allocation views
and strategy, please visit our Asset Allocation Outlook page.)
The U.S. economy may indeed be graduating from multiple years of recovery following the
global financial crisis, and there is some potential for the Fed to proceed on a more traditional
tightening path (though that is not our baseline outlook). However, this is set against the
combination of still muted growth in the rest of the developed world and the prospect of central
banks moving closer toward the exit in Europe, the UK and Japan. One significant source of
uncertainty is the prospect for U.S. dollar strengthening and the Trump administrations words
and actions in response to further dollar appreciation.
March 2017 Cyclical Outlook 9

Duration Credit
While there is the potential for a rise in the level We have moderately scaled back corporate
of global interest rates, it remains the case that credit exposures but generally expect to remain
higher yields will be limited by still high levels of overweight in credit. We expect to continue to
public sector debt and in some cases private reduce generic investment grade and high yield
sector debt, as well as demographic influences positions in our portfolios, and focus instead on
and slow growth in both productivity and credit bend but dont break credits: defensive, high
availability. The greater normalization we have quality, short-dated and default remote credit
seen in U.S. rates compared with Europe, the UK exposures. Financials continue to provide some
and Japan and historically wide spreads mean good opportunities, but we will be careful on
that there is the potential for global yields to scaling of these positions. As always, rigorous
reprice closer to the U.S., and this also leaves the credit research is paramount.
U.S. as the most attractive source of hard
We expect to be overweight non-agency
duration in the event of a shock.
mortgage-backed securities (MBS), which again
Given valuations and the ongoing uncertainties offer defensive qualities in the event of weaker-
in the global outlook, we continue to see the than-expected growth outcomes in addition to
current environment as one in which we should attractively priced risk premia for liquidity,
avoid big calls on macro trades and instead look complexity and uncertainty over the timing of
to grind out alpha, take advantage of cash flows. U.S. agency MBS also offer
mispricings and relative value opportunities, and reasonable valuations and a source of income,
respond to new information. Maintaining a although we will carefully monitor the prospects
sufficient level of liquidity (or dry powder) for the Fed reducing the reinvestment of
should allow us to respond as active investors to coupons and the market impact.
market volatility and high conviction
We remain cautious on eurozone peripheral risk,
opportunities when they present themselves.
based upon the challenging secular outlook for
We expect to keep portfolios fairly neutral on the eurozone, political risks and the ECBs
overall duration, with a preference for the U.S. decision to scale back its quantitative easing (QE)
over European, UK and Japanese duration and program and the prospect for further tapering
to maintain a bias toward curve steepening, later in the year. The ECBs tapering at a time
based on the opportunity to generate income, when core inflation is a long way from target in
expectations of a still measured pace for the Fed the eurozone has called into question the extent
and other central bank tightening and the to which the ECB will support both reflation in
prospect that markets will price in greater risk the eurozone and peripheral sovereigns in the
premium at the longer end of global curves. event of political or economic shocks. We also
expect to be underweight European corporate
In our view, U.S. Treasury Inflation-Protected
credit at current valuations.
Securities (TIPS) continue to offer reasonable
valuations and an attractively priced hedge
against higher-than-expected inflation outcomes
particularly given the uncertainty over the
extent of U.S. fiscal expansion at a time when
the economy is at full employment.
10 March 2017 Cyclical Outlook

PIMCOs Global Advisory Board meets regularly


to provide PIMCO with an outside perspective Equities
about key variables that could affect markets.
We expect to be neutral on overall equity risk in
our asset allocation portfolios. Equity markets
have continued to rally, driven by the earnings
recovery and the stronger global growth
outlook. But we do not see significant upside
potential for U.S. equities at current valuations in
the absence of a breakthrough on corporate tax
reform in the U.S. The stronger global expansion
has the potential to boost cheaper cyclical
markets, notably Europe, but this remains
subject to eurozone political risk.

Commodities
Returns in and prospects for the commodity
markets have improved materially since last year
Currencies
due to a combination of improved
While we see some potential for modest U.S. macroeconomic activity as well as material
dollar strengthening versus other major advances in the supply-side adjustment. We
currencies, this is subject to significant believe commodity allocations should be broadly
uncertainty over the Trump administrations at benchmark weight, as an expected increase in
response to a stronger dollar. Higher-yielding global GDP supports commodity demand. The
emerging market currencies offer attractive correlation of commodities to other asset
income-generating potential, but we will be classes, as well as correlation within the
careful in terms of the scaling of these positions. commodity space, has returned to historical
norms, pointing to the likely return of
commodities as a portfolio diversifier. The
positive correlation to inflation and inflation
surprises also points to the benefits commodities
may offer a portfolio, especially as infrastructure
spending increases globally and austerity
Emerging markets declines, as we anticipate.
More generally on emerging markets, while we
do not anticipate running large risk positions at
current valuations, we will continue to look for
good opportunities to add diversified positions
to our portfolios.
March 2017 Cyclical Outlook 11

ABOUT OUR FORUMS


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.
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. Every Secular Forum,
we invite distinguished guest speakers Nobel laureate
economists, policymakers, investors and historians who
bring valuable, multi-dimensional perspectives to our
discussions. We also welcome the active participation of
the PIMCO Global Advisory Board, a team of five world-
renowned experts on economic and political issues.

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.
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