The most important new development to consider when setting the global macroeconomic outlook for 2015 is the 40 per cent drop in spot oil prices over the last three months. Oil price drops of similar or greater magnitude have occurred several times over the past 30 years, coinciding with major economic recessions in some cases (1991, 2001, 2008) and faster global growth in other cases (1993, 1998). So, what does the current drop in oil prices mean for global growth in 2015?
To answer the question, we must first determine whether the current bear market in oil is a demand-driven bear market or a supply-driven bear market.
Generally speaking, demand-driven bear markets in oil tend to be harbingers of real economic stress and downside macroeconomic risk, whereas supply-driven bear markets in oil tend to presage higher productivity growth and upside macroeconomic risk.
Further, demand-driven bear markets occur much more frequently than supply-driven bear markets, which has conditioned financial market participants to associate declining oil prices with real economic stress and downside macroeconomic risk, in turn propagating a conditional correlation to other indicators of stress and downside risk that might not be warranted.
All that said, the conclusion reached at our recent cyclical forum (the quarterly gathering where PIMCO investment professionals develop the firm’s outlook for the global economy) suggests that today’s bear market in oil is predominantly supply-driven. During the forum, Greg Sharenow and other PIMCO energy market experts presented research that guided debate and informed our view that 70 per cent of the drop in oil is being driven by upside surprises in supply growth, and some 30 per cent to 40 per cent of the reduction in demand growth is coming from increased energy productivity, such as via fuel-efficient vehicles, as opposed to slower economic growth.
US crude oil production has surprised significantly to the upside in 2014 compared to prior expectations, and while this is not without precedent -- US crude oil production has been surprising on the upside for a few years now -- the impact on oil prices has been greatest recently because both the sheer size of production growth has reached meaningful levels and some of the temporary “Arab Spring” shutdowns from 2012–2013 have coincidentally reversed in 2014.
On the demand side, there is evidence to suggest that real demand out of China and Europe has slowed in 2014, adding to the downward price pressure; however, global oil demand has still increased on the year, reinforcing the assertion that the 2014 bear market is primarily a supply-driven development.
PIMCO expects global growth to accelerate in 2015, from around 2.5 per cent (year-over-year) this year to 2.75 per cent next year -- an incrementally rising tide, we could say. The majority of this improvement comes from our view that supply-driven declines in oil prices serve as a fundamentally positive terms of trade shock for a majority of global economies, and further, the transfer of incremental petrodollar cash flows from producers to consumers will result in the acceleration of money velocity, which will also support higher economic growth next year.
On the inflation front, declining oil prices will have a clear downside impact on global inflation readings next year. In most developed economies, headline inflation will likely go into negative readings in the early part of 2015, only to bounce back toward positive core inflation readings as we go into late 2015 and early 2016.
While global growth is likely to surprise on the upside in 2015, there will be large differences in growth dynamics between net consumers and net producers of oil. Among the major economies, the biggest beneficiaries from a decline in oil prices are expected to be Japan, the eurozone, China, India and the US. On the other end of the spectrum, Russia and to a smaller extent Brazil stand to suffer from oil price declines next year.
Another factor driving PIMCO’s forecast for faster global growth in 2015 is the fact that fiscal and monetary policies in most major economies around the world are tilted marginally toward promoting faster growth in 2015: In Japan and China, we expect both fiscal and monetary policy will contribute marginally to faster growth next year. In the eurozone, we expect monetary policy in particular will contribute marginally to faster growth. And in the US, we expect fiscal policy will contribute marginally to faster growth, even as monetary policy is scheduled to become more restrictive.
One key question on our minds for 2015 is whether the decline in oil prices today, which will lead to negative headline inflation prints early next year, is sufficient to change the baseline outlook for monetary and fiscal policies we have already embedded in our growth forecasts. Nowhere is this question more important than in the U.S., where our baseline expectation remains for the Federal Reserve to raise policy interest rates sometime between June and September next year, a view that is widely embedded in market prices and expectations of economic divergence between the U.S. and other major developed market economies in 2015.
To help answer the question, PIMCO invited Dr. Ben Bernanke, former Chairman of the Federal Reserve, to the December Cyclical Forum to present his baseline view for the U.S. economy and monetary policy. During an engaging question and answer session with Dr. Bernanke, PIMCO investment professionals explored various macroeconomic scenarios in an effort to gain a better understanding of the veteran policymaker’s reaction function to various growth and inflation outcomes in 2015.
Dr. Bernanke affirmed PIMCO’s view that the outlook for the U.S. economy in 2015 is incrementally positive, reflecting improving household finances and confidence as well as increasing evidence that the economic recovery is becoming self-sustaining and broad-based. Even as the output gap closes, the economic expansion looks to have room to run, reflecting remaining slack in the labor market and a housing recovery still in its early stages. Further, Dr. Bernanke suggested that monetary policymakers are likely to remain deliberate. They will look past the drop in headline inflation in the U.S. next year, and will remain focused on the level and momentum of real growth as well as the progress of core inflation toward target in determining the proper future course of monetary policy.
In our forum discussion of the outlook for the level and momentum of real growth and core inflation in the U.S., we concluded that both key inputs in the Fed’s decision-making framework were likely to propel them toward tightening monetary policy in 2015. Therefore, despite the drop in oil prices today likely leading to negative headline inflation in early 2015, we expect the Fed will remain on course to raise official policy interest rates in mid-2015, sometime between June and September.
The outlook for monetary policy tightening in the U.S. next year will likely decouple from the outlook in other parts of the developed world. The European Central Bank (ECB) and the Bank of Japan (BOJ) are likely to continue to ease monetary policy in 2015. In the eurozone, a large output gap is continuing to put downward pressure on core inflation, which is already well below the ECB’s target, whereas in Japan, poorly anchored inflation expectations will be the dominant driver of BOJ activism.
So what is the biggest risk to PIMCO’s cyclical economic outlook for 2015? We focus intensely on financial linkages between falling commodity prices and global banks. The commodity supercycle, which has been a driver of significant increases in global capital spending for the past 10 years, has most likely come around to its last phase, which could last for a few years. Previously, a positive demand shock from China and other emerging market countries between 1994 and 2007 resulted in a positive real price shock between 1999 and 2012, leading to a positive capital spending shock between 2004 and 2013. However, by 2014 the actual production of some important industrial commodities has begun to outstrip incremental demand, leading to the final phase of the commodity supercycle, in which a negative real price shock ultimately drives a negative capital spending shock in the future.
Historically, there have always been some bottom-up casualties of the commodity price cycle. However, given the length and breadth of the commodity-based capital spending boom over the past 10 years, we must pay special attention to where there is both visible and hidden leverage associated with commodity price volatility. There is a tail scenario in PIMCO’s outlook wherein the speed and size of commodity price declines lead to concentrated credit losses on some sovereign or quasi-sovereign balance sheets that are large enough to trigger a systemic financial event, in turn causing tighter financial conditions and a reduction in future global growth. While this is not a baseline view at PIMCO, the opacity of financial linkages between commodity prices and global banks, particularly emanating from emerging market economies, gives us some caution.
Following the macroeconomic discussions and conclusions from our Cyclical Forum, PIMCO portfolio managers presented their views of the many sectors of global markets to the firm’s Investment Committee. The committee then performed a final review that combines our economic forecast with the input from these portfolio management desks, which cover everything from interest rates to equities to commodities, to decide the broad themes that will be expressed in client portfolios. Here we share a selection of these high level themes from the Chief Investment Officers and other members of the committee.
Underweight interest rates
Our discussion of global rates and risk assets was anchored by our secular New Neutral thesis. However, we concluded that this longer-term outlook for lower neutral policy rates is now largely priced into the markets, and thus we see limited upside for high quality duration (other than as a hedge for risk assets) over the cyclical horizon. As such, our preference is to position PIMCO portfolios flat to modestly underweight high quality duration like U.S. Treasuries, UK Gilts or German Bunds.
Elsewhere in Treasury space we find TIPS (Treasury Inflation-Protected Securities) attractively valued given their recent underperformance. Although we expect headline inflation (on a year-over-year basis) to trough below the zero bound in the next few months, this is more than reflected in TIPS valuations. We still expect the underlying steady trend in core inflation to remain robust.
Mixed backdrop for risk assets
For risk assets, we see the combination of a Fed that we expect to be slow-moving and increased policy stimulus from the Bank of Japan and ECB as supportive. But again, there is significant risk of increased market volatility as we approach the start of the Fed tightening cycle.
Picking spots in Europe and Japan
Globally, we remain favourable on eurozone peripheral bonds. Moreover, given expected central bank support, combined with improving earnings in Japan and attractive valuations in Europe, we see room for outperformance in those equity markets. However, we continue to focus on the effectiveness of BoJ policy and the ability of the ECB to deliver versus what are now high market expectations.
Favour non-agency mortgages in the US
Within the US, we continue to favour non-agency mortgages given the outlook for above-trend economic growth accompanied by continued stabilization in the housing and job markets. On the other hand, we feel agency mortgage-backed securities (MBS) are overvalued and expect the end of Fed purchases to weigh on this sector. Moreover, recent widening in credit spreads has created select opportunities in both investment grade and high yield corporate issues.
Overweight US dollar
On currencies, our dominant cyclical view remains the U.S. dollar overweight versus other G-10 currencies as a result of diverging economic growth and, importantly, diverging central bank actions. We expect both the euro and the yen to decline versus the U.S. dollar over the cyclical horizon despite significant weakening already. We feel this decline in their currencies is a primary tool by which these regions can boost economic growth and also solidify inflation expectations.
Select opportunities in emerging markets
Weaker commodity prices, a stronger dollar and a potential shift in Fed policy should weigh on the emerging markets as a whole over the next year. Volatility is likely to remain elevated. However, this should result in attractive investment opportunities for the long-term investor. For example, local rates in Mexico are attractive given the high yields offered in the context of a high quality country with strong linkages to the U.S.
These should be the broad themes that PIMCO clients can expect to see reflected in their portfolios over the coming quarters. Meanwhile, both generalist and specialist portfolio management teams will continue to seek the best possible expressions of these themes in their markets while supplementing them with the bottom-up security selection and quantitative relative value opportunities that we are known for.
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