Following the longest expansion on record, the coronavirus pandemic has plunged the global economy into what could be one of the deepest but also shortest recessions in modern times. However, as we discuss in our latest Cyclical Outlook, any outlook now is more uncertain than usual.
Unlike previous recessions, usually caused by the interplay of economic and financial imbalances, interest rate hikes, or oil price spikes, the trigger of the present crisis is an exogenous shock. The severity of the COVID-19 health crisis has led governments around the world to lock down populations and aggressively curtail economic and social activity, causing a sharp drop in aggregate output and demand. We are seeing the first-ever recession by government decree – a necessary, temporary, partial shutdown of the economy aimed at preventing an even larger humanitarian crisis.
Economic policy response
What is also different this time is the unprecedented speed and size of the monetary and fiscal response, as policymakers and monetary authorities try to prevent a recession turning into a lasting depression.
Central banks have stepped up as lenders of last resort not only for banks, but also for other financial intermediaries and even nonfinancial companies. Their support has come via a range of lending and asset purchase programs (for details, see our blogs, “The Fed: Avoiding a Depression,” and “In Europe the Crisis Policy Response Is Substantial, But More Is Likely Needed”).
On the fiscal front, many governments have offered guarantees for bank loans to businesses, tax payment delays, backstops for central bank lending programs, direct income transfers to households, and subsidies for businesses. In many countries, the fiscal response already exceeds that during the 2008–2009 global financial crisis, and we may see further support in the near future.
Our cyclical base case: from hurting to healing
Given the sheer size of support measures and the absence of major real economic imbalances, we expect the global economy to transition from intense near-term pain to gradual healing over the next six to 12 months, once the spread of the coronavirus is under control and restrictions are lifted.
However, our base case remains a U-shaped rather than a V-shaped recovery (see figure) because these restrictions will likely be lifted only gradually and at different speeds in different sectors and regions. Also, repairing broken global supply chains will take time. As a consequence, following the nosedive in economic activity that is currently underway (the downward I in the U), we expect the bottoming process to last a few months after the virus is under control (the L in the U), before output and demand ramp back up, helped by fiscal and monetary support and the eventual easing of the acute health crisis.
The risks: longer stagnation, or recovery and relapse
Our base case forecast, however, could be challenged if the pandemic lasts longer than expected, or if there is an increase in corporate defaults above expectations. We see two downside risk scenarios: a prolonged L-shaped trajectory or a recovery interrupted by a relapse – call it a W.
A V-shaped recovery is in theory possible, but it’s a remote upside risk, in our view. Such a trajectory could be the result of successful macroeconomic policy, medical breakthroughs, and an increase in the capacity of health systems and governments to deal with the current crisis.
A glimpse into the post-COVID world
We believe this crisis is likely to leave three long-term scars:
- Globalization may be dialed back: Firms may try to reduce the complexity and risk of global supply chains, and governments may use health concerns to curb trade, travel, and migration. Companies, sectors, and countries that are highly dependent on trade and travel may see a lasting hit to their business models.
- More private and public debt: This could challenge central bank independence as central banks become more involved in providing support to companies (essentially a fiscal act), and also keep rates low to help finance deeper fiscal deficits. If governments continue their fiscal expansions even after the crisis, the dominance of fiscal over monetary policy may lead to higher inflation than markets currently price in. But with central banks capping the rise in nominal yields that would normally result from higher inflation, real rates would tend to fall as inflation rises.
- Shift in household saving behavior: Rising unemployment and higher levels of personal debt may make households more cautious, lifting demand for low-risk assets such as bonds and cash. In addition, homeowners may be keen to pay down their mortgages faster. Thus, with the private sector saving glut likely to rise further, investors should brace themselves for a New Neutral 2.0 of even more depressed real interest rates over the secular horizon.
Investment implications: caution first
Investors should brace themselves for a very different investment landscape as the weakest areas in the global credit spectrum will be exposed over the next several months. While this should create more attractive entry points in higher-risk segments of the investment universe over time, we remain patient and focus on opportunities that we see as high quality, default-remote assets for now. We believe a caution-first approach is warranted in an effort to protect against permanent capital impairment.
In our view, this approach includes a focus on U.S. duration; despite significant relative outperformance, we still see room for U.S. rates to drop further if stabilization takes longer than our baseline outlook. We see U.S. agency mortgage-backed securities (MBS) and U.S. Treasury Inflation-Protected Securities (TIPS) as attractive high quality assets despite recent volatility.
We have for some time been cautious on corporate credit, due in part to valuation and market functioning issues, but we now see some opportunity to add long-dated, high quality exposures that we believe compensate us for the risk taken. In private credit, we anticipate opportunity to seek attractive liquidity premiums. We remain cautious on the weaker segments of the investment grade, high yield, and loan markets.
We will take a cautious approach on European sovereign debt and will continue to watch closely any monetary and fiscal action. Emerging markets (EM) are heading into this recession with few major macro imbalances, but also limited monetary and fiscal capacity. This, plus a persistent negative shock to oil prices, suggests taking a cautious approach to EM while also assessing select opportunities.
Read PIMCO’s latest Cyclical Outlook, “From Hurting to Healing,” for detailed insights into the 2020 outlook for the global economy along with takeaways for investors.
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest 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 durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
Duration is the measure of a bond’s price sensitivity to interest rates and is expressed in years.
All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2020, PIMCO
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