At our fully virtual 2020 PIMCO Investment Summit, we were delighted to be joined by clients from across Asia Pacific to provide our insights into the short- and long-term outlook for the world’s major economies and financial markets in the wake of the COVID-19 crisis. PIMCO investment professionals were joined by Global Advisory Board members Dr. Ben Bernanke and Ng Kok Song. The sessions ranged from uncovering value in credit markets to the investment implications of central bank policy. One message was consistent throughout: Investment success over the secular horizon will continue to be defined by being prepared for disruption and by actively pursuing the opportunities that arise when volatility occurs.
Here are our four major takeaways from the wide-ranging discussion:
1. The road to recovery will be long and arduous
The global economy has commenced its long climb from the sharpest but also shortest recession of modern times. In the near term, there will be a sharp, mechanical bounce in economic activity following the lifting or easing of lockdown measures. But our panelists agreed that the recovery will be drawn out for four main reasons:
- Social distancing remains in place ahead of effective vaccines and treatments becoming available, meaning many sectors will remain depressed for the foreseeable future.
- Supply chains will remain impaired because reopening will be uneven across countries, regions and sectors.
- Reallocation of labor and capital from losing to winning sectors will take time and could even be hampered by government policy that results in "zombie" firms being kept alive, leading to a decline in overall economic productivity.
- Debt overhangs in the corporate and household sector will likely hinder consumer and investment spending for years to come.
One of the common questions we hear from clients is why do financial markets seem to be faring well despite the current state of the economy?
Our panelists noted that it is important to remember the stock market and economy are different. Stock markets comprise large firms, including tech firms and multinationals whose operations have remained robust despite the pandemic. Meanwhile, small businesses, especially in the service sector, that have been hit hardest are far less represented in the world’s stock exchanges. In addition, despite the current environment of low interest rates, markets are taking a longer-term view, looking beyond the near-term effects of COVID-19 to a period when an effective vaccine is in place.
We believe investors should keep an eye on two crucial swing factors. The first is the road to recovery from COVID-19, and how quickly we see effective vaccines or succumb to subsequent waves of infection. The second is fiscal policy, which could either expand or retreat in response to political factors, such as the U.S. presidential and congressional elections. We are also likely to see fiscal policy disparity between countries over the coming years.
In this more uncertain environment, our panelists felt that it is important to construct portfolios that take into account a variety of potential outcomes – to take advantage of opportunities should there be an upside surprise and to provide protection from downside scenarios. One example would be in private markets. In areas such as commercial real estate and specialty finance, panelists noted that investors can deploy capital over time opportunistically, as companies face significant stresses, to access attractive higher returning opportunities. And alternatives, such as insurance-linked securities and absolute return driven strategies, can offer attractive diversification benefits to portfolios.
2. Economic scarring could weigh on growth and hold back inflation
As we noted in PIMCO’s latest Secular Outlook, the COVID-19 crisis is likely to leave some long-term economic scars that investors should be aware of.
The first is longer-term unemployment. It takes time for workers that have been out of work for a while to become productive again. Longer spells of unemployment typically imply an erosion of skills and labor productivity. This will be exacerbated by the deferment and scaling back of business investment in response to the prevailing economic uncertainty. There will also be further interruptions to global supply chains, which have already been scaling back in response to trade wars and geopolitics. More broadly, some governments might use health concerns to curb trade, travel and migration. This could have long-term consequences for companies, sectors and countries that are dependent on trade and travel.
In addition, debt levels are likely to remain significantly higher after the crisis. This could erode central bank independence as monetary policy becomes increasingly involved in allocating resources to the nonfinancial corporate sector and dominated by the need to keep the cost of servicing government debt low. If governments continue to engage in more expansionary policies even after the crisis, fiscal dominance of monetary policy may eventually lead to significantly higher inflation rates than markets currently price in. While panelists saw very little upside risk to inflation in the near term, they noted that over time it will likely make sense to hedge against a rise in inflation using Treasury Inflation-Protected Securities (TIPS), yield curve strategies, real estate, and potentially exposure to commodities.
Many households are also likely to come out of the crisis with higher levels of debt. This could increase the demand for precautionary saving in relatively low-risk instruments such as cash and bonds. This potential rise in the private sector saving glut could lead to even more depressed real interest rates over the longer term.
3. Disruption will be amplified, so prepare for further volatility
With markets having to grapple with the longer-term consequences of the pandemic shock and the policy responses, our panelists agreed that investors need to be prepared for disruption and further volatility.
In the wake of the pandemic, four macroeconomic disruptors are likely to become even more pronounced:
- China’s rise as a higher-value-added producer and superpower vying with the U.S. for geopolitical dominance will be hastened by its earlier and stronger rebound from the COVID-19 crisis and its strengthened focus on its strategic plan. That rise will come at the expense of producers from other countries and could serve to erode U.S. influence abroad.
- Populism, along with protectionism and nationalism, could be strengthened by the exacerbation of inequality brought about by the pandemic. At PIMCO's annual Secular Forum in September, we concluded we have yet to reach “peak populism” around the world.
- Climate-related risks have become even more apparent and acute this year. Whereas climate change is often spoken of as a super-secular consideration, it is increasingly impacting day-to-day business and life, with devastating fires in Australia and California, hurricanes in the U.S. and typhoons in Asia. Apart from these physical risks, the effort to contain climate change by moving to a greener economy brings its own transition risks. Corporates are also likely to face more burdensome regulation, reporting requirements and carbon taxes. This will create winners and losers, calling for active management of credit and default risks.
- Technology and its adoption have been turbo-charged by COVID-19, which has accelerated the move from physical to virtual. To a significant degree, the shift in work and consumption patterns brought about by the pandemic is likely to persist even after the crisis subsidies. The short-term boost to the fortunes of established and new technology companies during the crisis will likely make them an even greater disruptive force going forward. The ability to sort the winners and losers from digitalization will be another important source of investment success over the longer term.
These and other disruptions will cause higher volatility and PIMCO expects lower returns across asset classes going forward. This calls for a patient, global, flexible approach to pursue the best risk-adjusted opportunities and the lower return environment means that alpha is likely to be an even more important part of total return.
4. Asia should provide attractive opportunities for investors
Economies in Asia, and China in particular, have bounced back much faster than those in the U.S. and Europe. To capture these opportunities, PIMCO has been adding exposure across Asia, in both high yield and investment grade credit. Even ahead of that, cognisant of the opportunities in the region and increasingly attractive relative value, we have been bolstering our Asia credit capabilities.
Investors at large remain underweight Asia, suggesting there will be substantial rebalancing toward the region in coming years. There is, of course, considerable divergence within Asia. Countries such as China, Korea, Japan and Australia have managed COVID-19 relatively well, while the likes of India and Indonesia are struggling. Investors in credit markets need to closely monitor not only individual economies and ratings, but also how the pandemic impacts individual companies.
Given its resilience during the pandemic and enormous market potential, China was a major focus of discussion for our panelists. They believe the domestic consumption theme in particular is compelling, with the e-commerce, automotive, infrastructure, utilities and property sectors expected to be the major beneficiaries over the coming year.
Asian credit markets are currently trading at much wider spreads than their U.S. peers: Asian investment grade credit at around 70 basis points wider and high yield credit at about 230 basis points wider. This provides some pockets of opportunity for investors, but careful and active credit selection is vital as we navigate the aftermath of the pandemic. Panelists also noted that over time, Asia’s expected stronger growth should see its companies improve their credit profile, which would lead to spread compression relative to their U.S. counterparts.
For more insights on the road to recovery from COVID-19 read PIMCO’s latest Secular Outlook, “Escalating Disruption.”