Shorter duration bonds and defensive stocks could help investors prepare their portfolios for a global economic slowdown in 2019, according to PIMCO’s Joachim Fels and Andrew Balls.
Fels, PIMCO’s global economic adviser, and Balls, chief investment officer for global fixed income, said that after synchronised growth last year a synchronised slowdown could be on the horizon.
“The much-hyped synchronised global expansion of 2017 has long receded in the rear-view mirror as global growth reached its zenith around the turn of the year,” they said.
“But growth has not only plateaued, it has also become more uneven across regions this year.”
Synchronised global growth coincided with strong returns for global markets last year, but this year the US has outstripped its peers.
Performance of indices YTD
Source: FE Analytics
Indeed, during 2018 there have been signs of increasing economic divergence and differentiation between and within asset classes, “both of which are typical of an ageing expansion”.
Several “rude awakenings” for the global economy – such as an intensifying US-China trade dispute, turmoil in emerging markets, and a showdown between the EU and a populist Italian government – have already manifested during the past few months.
The pair noted that these “rude awakenings” are relevant to the cyclical outlook because they have tightened global financial conditions and increased political and economic uncertainties.
They are also likely to dampen corporate and consumer ‘animal spirits’ around the world and lead to a “growing but slowing” outlook.
“Against this backdrop and with the fiscal stimulus in the US starting to fade next year, our cyclical baseline sees this year’s economic divergence – with US growth accelerating but the rest of the world slowing – giving way to a more synchronised deceleration of growth in 2019,” the pair noted.
“In our forecasts, the big three – the US, the eurozone and China – should all see lower GDP growth in 2019 than this year.”
The UK, they said, will grow by 1.5-2 per cent in 2019, based on expectations that a ‘hard’ Brexit will be avoided – helping to spur domestic demand.
However, Balls and Fels emphasised that while the major economies might slow in 2019 they will continue expanding at an above-trend pace with unemployment likely to fall.
As such, central banks will also likely continue to remove the accommodative measures – such as quantitative easing and low interest rates – employed since the onset of the global financial crisis.
The biggest risks to the expectation of a slowing global economy are the burgeoning trade war, as US president Donald Trump continues to pursue more favourable trade deals with allies and rivals alike.
As the below chart shows, China and emerging markets broadly have struggled in 2018 as the Trump administration has imposed tariffs worth $200bn as part of a tougher negotiation.
Performance of indices YTD
Source: FE Analytics
In a more adverse trade war scenario, the pair said if Trump were to impose tariffs on all Chinese imports and on autos and parts from other countries, then trading partners retaliated in kind and China devalued its currency there could be a sharp slowdown in US and global growth.
If trade peace breaks out, however, and recently imposed tariffs are reduced, global growth may be maintained, according to Fels and Balls.
As such, the pair stand by their late-cycle thesis although they have warned that it may yet to be “too early to run for the hills”.
“Indeed, a recession next year is not our base case and so we expect to remain in the late-cycle stage for some time,” they said.
“So far, none of the domestic imbalances that typically precede recessions have developed: over-consumption, over-investment, a housing bubble or excessive wage growth.
“However, much will depend on whether or not the Fed will push rates significantly above neutral.”
The pair said the Fed is likely to raise rates three more times by the end of 2019, in line with the longer-run neutral rate.
While the pair anticipate a growth slowdown, there is the potential for higher macroeconomic uncertainty and volatility.
“This macro and market volatility comes at a time when, in many markets, volatility is low and valuations are fair-to-stretched,” they noted.
“While the growth cycle may continue, we see risks of more difficult market environments ahead and the testing of market liquidity and structure, notably in credit markets.”
In terms of portfolio construction, Fels and Balls said caution should be emphasised and flexibility necessary to respond to any shocks.
Within global fixed income, the pair have maintained a modest underweight in its duration positioning given the higher probability of a significant rise in yields.
“The level of yields in the UK is very low relative to history and relative to the US, in particular,” they said. “Given our expectation for an orderly Brexit process – in spite of both headline and real tail risk – we think it makes sense to be underweight UK duration.”
Elsewhere, global duration remains close to benchmark weights, although it is underweight Japanese duration as a hedge against an unexpected rise in global yields.
Fels and Balls are also cautious on corporate credit, where they expect to be modestly underweight given “fairly tight valuations, concerns about market liquidity and crowded positioning after multi-year flows into credit”.
“It is quite likely that credit will continue to perform well over the cyclical horizon, but we think it is prudent to operate from an underweight position given highly uncertain liquidity in any flight to quality and steadily deteriorating underwriting standards,” they said.
“When the credit cycle turns, we want to be in a position of strength as liquidity providers and not forced sellers.”
The pair instead prefer a range of shorter-dated “bend, but don’t break” positions they expect to perform well even in a more challenging environment.
In equities, defensive companies are favoured over cyclical stocks given the stage of the cycle, the expectation of further policy tightening, and upward pressure from inflation.
Performance of indices over 3yrs
Source: FE Analytics
“This ‘growing but slowing’ cyclical view suggests reduced return expectations,” they said. “It makes sense in this environment to shift toward greater defence by upgrading portfolio quality, with a focus on growth durability and scaling back exposure to cyclical beta.
“We favour less cyclical, more profitable US equity markets to the rest of the world and prefer high quality large-cap equities at this stage in the cycle.”