The recession warnings are growing louder.
Earlier this week we reported that according to JPMorgan's latest "real-time quant monitor", the risk of a recession has spiked to a no longer trivial 35%, the highest in series history (and up from 16% back in March)...
... while the probability that the next presidential election will take place during a recession (i.e., odds in two years) has now surged to more than double that, or over 70%, virtually assuring that the US economy will be contracting in November 2020.
Now, in a new research report by PIMCO, the world's largest bond manager with $1.7 trillion in AUM, warns that "while the expansion has been ageing gracefully", the global economy is well past its peak growth phase, and the fund's recession models are "flashing orange."
In "Syncing Lower", PIMCO strategists Joachim Fels and Andrew Balls argue that while the global economy is past peak growth in the cycle, "central bank support continues to be reduced and political risk looms large across countries."
As a result, "the probability of a U.S. recession over the next 12 months has risen to about 30 percent recently and is thus higher than at any point in this nine-year-old expansion,” Fels and Balls write, although even with the threat of a recession now higher than any time in the past decade, "the models are flashing orange rather than red."
In the report, which is based on discussions at a forum this month of economists and portfolio managers to guide investments for the coming six to 12 months, the PIMCO duo lay out five key macro debates that will likely shape the cyclical and market outlook for 2019, and include:
- Debate #1: How late is it in the cycle?
- Debate #2: The end of U.S. economic exceptionalism?
- Debate #3: Will inflation ever return?
- Debate #4: The Fed pauses, then what?
- Debate #5: U.S. versus China: Truce or peace?
On Thursday, Pimco CIO Dan Ivascyn warned in a Bloomberg Radio interview Thursday that next year will be as rocky as this one.
"The last few months have given us a sense of the types of risks that are out there, that both the economy and markets are going to face in 2019,” Ivascyn said. “At a minimum, like we have seen this year, expect ongoing volatility and that’s true across all segments of the financial markets."
While PIMCO is growing increasingly cautious on developed markets, the CIO still sees attractive opportunities for 2019 in emerging markets - echoing Gundlach's recent assessment according to which US vs EM markets will converge in the coming months.
"Along with fear being reduced, spreads have tightened and prices have gone up,” Ivascyn said. “We continue to be active in emerging markets."
Here are the key highlights from the PIMCO report, courtesy of Bloomberg:
- U.S. growth will slow to less than 2 percent in the second half of 2019, converging downward with other developed nation economies
- A pause in Federal Reserve interest rate hikes is likely in the first half of 2019, but tightening will persist as the Fed continues reducing its balance sheet holdings
- Investors should stock up on lower-risk, liquid assets to defend against rising volatility and widening credit spreads, saving cash for opportunities ahead
- One opportunity is U.K. financials, where values have fallen amid concerns of a chaotic no-deal Brexit from the European Union, which is “a very low probability”
- U.S. non-agency mortgage-backed securities are a defensive alternative to investment-grade corporate credit. Agency MBS also offer attractive income.
Focusing on a specifically topical question in recent weeks, namely what would happen if and when the Fed Pauses "then what", Pimco writes that it expects the Fed to raise rates only one or two times more in 2019, and therefore "a pause in the first half of 2019 thus looks increasingly likely as financial conditions and the central bank’s balance sheet runoff are doing some of the tightening for the Fed." If and when the Fed pauses, however, will this be followed by a resumption of rate hikes, or will the next move after a shorter or longer pause be down in rates?
At the forum, PIMCO said it "reckoned it would be difficult to communicate a pause without markets jumping to the conclusion that this is the end of the rate cycle and the next move will be down" and adds that "as Ben Bernanke reminded us, his attempt to signal a pause in the previous rate cycle led to significant volatility. While central banks such as the Bank of England might get away with a pause and continued tightening, this is more difficult for the Fed given its global importance."
Against this backdrop, most of us believed that with the probability of recession likely to rise over time, a resumption of rate hikes after a pause was relatively unlikely.
The forum also discussed the biggest geopolitical quandary du jour, namely the US vs China conflict, asking if a "truce or peace" is possible. Here is the response:
Some participants argued that the worst of the trade conflict was now behind us, as both sides wanted a deal before the negative economic consequences of higher tariffs would be felt.
However, most of us believed the conflict between the U.S. and China is more deep-rooted and about much more than trade alone, and would thus continue to be a source of uncertainty and volatility even if there were a deal on trade. Mike Spence’s description of the conflict as a “clash of systems” resonated with the audience and reminded us of our discussions at the Secular Forum in May about the “Thucydides trap,” which describes the risks of a confrontation between an established and a rising power.
And while we urge readers to skim the full report, here is what PIMCo believes are the key investment implications as we head into another volatile year:
- Modestly underweight duration, overweight TIPS (While our base case calls for continued modest inflation, Treasury Inflation-Protected Securities (TIPS) breakevens have repriced lower, and we see TIPS as relatively attractively priced)
- Curve: Long the belly, short the long end (We see global curve-steepening positions as a structural source of income generation and, in the current environment, have a preference for the belly of the curve versus the long end of the curve based on valuation) - also explains the recent inversion in the 2s5s and 3s5s.
- Cautious on generic corporate credit (Credit valuations have moved closer to long-term averages, but we don’t see credit as cheap, while volatility is rising and the slowing economy could reveal underlying weaknesses in terms of leverage.)
- Relative value in financials and MBS (We continue to see non-agency mortgages as offering a defensive alternative to investment grade (IG) credit, with a better downside risk profile in the event of weaker macro/credit market outcomes. We also see agency mortgage-backed securities (MBS) as an attractive and relatively stable source of income in our portfolios)
- Underweight European peripheral risk (We remain cautious on European peripheral sovereign credit risk and corporate risk given the immediate challenges in Italy and the longer-term risks to the eurozone more generally in the next recession.)
- Opportunities in EM FX and bonds (In a world in which growth is synching lower across countries, we have a balanced view on the U.S. dollar versus other G-10 currencies)
- Equities: Focus on high quality defensive growth (we expect downward pressure on profit growth expectations... We believe equity markets will remain volatile, favoring high quality defensive growth and minimal exposure to cyclical equity beta. We continue to favor more profitable U.S. equity markets to the rest of the world)
- Commodities: Modestly positive on oil (OPEC’s recent announcement of a cut in production suggests the desire to support oil prices in the low $60s, avoiding the very low levels of 2014, but not tightening markets enough that it causes more market share losses to shale.)
More in the full report here.