The world has lived through an eventful three years. A global pandemic that triggered an economic recession, geo-political disruptions, as well as massive fiscal and monetary policy interventions have rattled investors. Added to this, inflation has become more than just transitory, and businesses and consumers are faced with the highest borrowing costs in more than a decade.
On 19 July, LGT Crestone met with Dr Richard Clarida, Global Economic Advisor at PIMCO and former Vice Chair of the US Federal Reserve. Dr Clarida provided his insights on US monetary policy, as well as some of the secular trends that are likely to shape the world in coming years. Dr Clarida was accompanied by Rob Mead, Managing Director and Head of Australia and Co-Head of Asia-Pacific Portfolio Management at PIMCO and Sam Watkins, Executive Vice President and Head of Business for Australia and New Zealand at PIMCO. The session was facilitated by LGT Crestone’s Chief Investment Officer, Scott Haslem.
The world has lived through several acute economic, financial, and geo-political shocks in the first few years of the 2020s. Dr Clarida believes that the full extent of these disruptions is yet to be felt, and in the coming three to five years investors will need to navigate what he calls the “aftershock economy”. In addition to this, PIMCO is identifying potential future disruptions that will be relevant over a three to five-year horizon.
Among these disruptions are several geo-political events. “The outcome of the US presidential election in 2024 could be very critical for thinking about things like onshoring, geo-political relationships, and even the independence of the Federal Reserve.”
Other potential future disruptors include large language models and artificial intelligence, which have the potential to make businesses more productive. Dr Clarida explained that game-changing innovations often take years or decades before they are widely assimilated. However, he feels there is reason to believe that artificial intelligence could see a much faster adoption rate.
As the world navigates these aftershocks, macro-economic volatility will likely remain elevated. Dr Clarida explained that we are living in a world where there are not only shifts in demand, but also changes in supply dynamics as businesses rethink their supply chains and governments facilitate the transition to net-zero carbon emissions.
Dr Clarida believes that global central banks will do whatever is necessary to keep inflation expectations anchored to their long-run targets. Over a five-year horizon, he sees US monetary policy rates returning to the vicinity of where they were previously, and yield curves could eventually become steeper than they were prior to the pandemic. In this world, investors will once again be able to earn a positive term premium for taking on duration risk.
“Many governments have issued a lot of debt to finance the fiscal deficits generated during the pandemic. We also think we’re in a world where global central banks are beginning to suffer from QE fatigue”.
Dr Clarida explained that the US Federal Reserve (Fed) has signalled that there is still more work for it to do, with some of the more “dovish” members indicating that the risk of doing too little on rates exceeds the risk of doing too much. “The Fed wants to resist “mission accomplished” declarations and then have to resume hiking”.
Dr Clarida feels there could be another hike following the July meeting, but that this will not necessarily take place in September. Following this hike, the Fed should have reached the end of its current rate-hiking cycle. We will then begin to see some consistently positive news on inflation in the second half of the year, with housing estimates likely putting downward pressure on official numbers. Dr Clarida explained that PIMCO’s baseline case is for inflation to fall to a level with a 2% handle and that the Fed funds rate will reach 5.5-5.75%. Once in restrictive territory, rates are likely to remain elevated for a while.
"The Fed wants to avoid "mission accomplished" declarations and then have to resume hiking.”
To get inflation down to the 2% range on a sustainable basis, Dr Clarida feels there will need to be a modest rise in the unemployment rate – perhaps 0.5% or so. He explained that, in the past, when there has been a rise in the unemployment rate of this magnitude, the economy has always tipped into a recession. If this occurs, he does not see the US tipping into a deep recession and places himself in the “soft-ish” landing camp. He said the US is still enjoying one of its lowest unemployment rates of the past 50 years, and the disinflation that has occurred in the US until now has happened without any real softening in the labour market.
Mr Mead added that a very large cohort of US households is well protected, having locked in 30-year debt at 2%. Although renters are less protected, the flow-through of rate rises to US households has been very slow. He explained that this is one of the reasons why the Fed has hiked rates more than the Reserve Bank of Australia.
Mr Mead explained that in Australia, there may be a cohort of investors that are not pricing in the reality of interest rate rises. While households have continued to spend, some of the leading indicators are beginning to suggest that in the past four to six weeks, the nature of consumers’ spending is now changing. Consumer trends are now shifting from brand names to generic names, and some retailers are beginning to see an uptick in consumers buying in bulk.
While Mr Mead believes Australian banks remain well capitalised and are not a cause for concern, he cautioned that investors should be wary of being exposed to discretionary spending. Floating rate borrowers and highly levered corporates also remain at risk.
Dr Clarida explained why now is an excellent time for active management, particularly within fixed income portfolios. Although one year ago investors were not being paid much to hold fixed income in their portfolios, this is no longer the case. He explained that yields are now at much more attractive levels—both in an absolute sense, as well as in inflation-adjusted terms.
“We think there are a lot of opportunities. Now, investors can earn equity-like returns without taking on interest rate risk or credit risk.”
