Recent growth momentum has been even better than expected across many economies, providing a strong ramp into 2018. It would seem in many ways that the stars are aligned for a continuation of the “Goldilocks” environment that we saw last year, with above-trend global growth and low but gently rising inflation. Easier financial conditions (reflecting buoyant markets for risk assets and still-low interest rates) imply sustained near-term tailwinds, including fiscal stimulus in the U.S. and elsewhere in the advanced economies. Meanwhile, China keeps suppressing its domestic economic and financial volatility while fundamentals in many other emerging market economies continue to improve.
But here’s the catch as described by my PIMCO colleagues: This Goldilocks-extended scenario seems to be pretty much baked into the consensus and into asset prices. At PIMCO, we believe that 2017–2018 could well mark the peak for economic growth in this cycle and that investors should start preparing for several key risks that lie ahead in 2018 and beyond.
Reasons for caution
First of all, the U.S. is depleting its fiscal tool kit with tax cuts and spending increases that appear more dictated by the political cycle than the economic one. Unfortunately, that’s not exactly what is needed at this stage of the cycle and could have detrimental longer-term economic consequences.
Arguably, the last thing an economy operating at close to full employment in the ninth year of an economic expansion needs is a shot in the arm from fiscal policy. Adding around US$1 trillion to the public debt over 10 years without adding much to potential growth and thus future tax revenues could come back to haunt the public coffers if rates rise in the future. With higher debt levels and higher fiscal deficits, it will be politically much more difficult to add more fiscal stimulus if and when the next downturn comes. It might have been better, instead, to keep the powder dry.
A second major risk that we are watching is a potential inflation overshoot. With fiscal stimulus in the U.S., globally synchronized growth, rising commodity prices and a weaker U.S. dollar, the risks of an inflation overshoot in 2018 are rising. Global structural forces are still weighing down inflation, but the cyclical pressures are clearly on the up.
The third risk relates to the end of central bank balance sheet expansion. Central bank balance sheets have expanded pretty dramatically over the past 10 to 15 years, but all major central banks are now contemplating the reduction of monetary accommodation. It may well turn out, however, to be too onerous for economies and asset markets that have become used to and addicted to easy monetary policies, low interest rates and depressed term premia across the yield curve.
This turn in the tide of global central bank policies will not necessarily affect global growth, but the uncertainty does pose potential risks to markets, particularly as the new and still-evolving U.S. Federal Reserve leadership is untested.
Within this global economic backdrop, the Australian economy is at a fragile inflection point which we expect to keep the Reserve Bank of Australia (RBA) on the sidelines until there is some clarity on the net economic impact. Mining investment is contributing to growth for the first time in five years, yet China’s economic trajectory will continue to slow at the margin. Business conditions have improved, which has led to a pick-up in hiring, but this has not flowed through into higher wages or consumption. Public infrastructure investment is increasing while dwelling investment and housing prices are declining. At the same time, the Australian dollar has strengthened and the RBA’s most transparent metric for policy setting, inflation, continues to hover just below their 2% to 3% target band.
In this synchronised phase of global expansion, markets are currently placing a very low probability on a growth slowdown or change in economic momentum. Our concern is that global markets are more susceptible to shocks from any sort of slowdown or surprise given high asset valuations. The recent spike in volatility should be a warning signal for investors that are heavily overweight risk assets. In this environment, fixed income’s role in a portfolio – to diversify risk, preserve capital, provide steady income and offer a hedge against equity market downturns – remains as important as ever. In fact, for those Australian investors that hold an underweight to fixed income, we believe that now is the time to be increasing, not reducing, their bond allocation.