Editor’s Note: A longer version of this report, along with charts and graphics, is available on the Pimco Website.
Pimco’s quarterly Cyclical Forum was held earlier this month to evaluate and assess the state of the global economy, to reach consensus on the macroeconomic outlook for the next 12 months, and to explore the tail risks to that outlook. The key question for the global economy in 2015, as in each year since the great global recession of 2008–2009, can be posed as follows: Given that the world has since 2007 faced a chronic shortage of global aggregate demand relative to abundant and growing aggregate supply, have prices (can prices?) — of commodities, credit and currencies — adjusted by enough to generate a robust rise in global aggregate demand to close the gap with global supply?
Richard Clarida
We have before characterized the post-crisis global economy as operating in a New Normal, and our framework for cyclical analysis is anchored in that secular view. On hand at the forum to help us try to answer these and other questions were Pimco advisors A. Michael Spence and Gene Sperling, who was attending his first forum. We were also honored again to have former Federal Reserve chair Ben Bernanke with us, sharing his insights about the outlook for the U.S. economy and for Federal Reserve policy.
The baseline macroeconomic forecasts that emerged from these discussions can be summarized as follows.  
• We see somewhat stronger global growth in 2015 than was recorded in 2014, but our views for global growth have not increased materially since our December 2014 forum.
• While we see somewhat faster growth in the euro zone, U.S. and Japan in 2015, we have marked down our growth outlook for China.
• Lower oil prices and a wave of monetary policy accommodation in the rest of the world are a net positive for the global economy, but there are losers as well as winners, especially in some emerging market (EM) economies.
• Global inflation is projected to remain stable in the aggregate, but with many central banks easing monetary policy as an insurance policy against deflation.
So this is our bottom line. How did we arrive at these baseline forecasts?
As is the case at any Pimco forum, we have three choices: to reaffirm our macroeconomic views laid out at the previous forum, to refine those views, or – if circumstances warrant – to replace those views. At our December 2014 forum, we concluded that, for the global economy, “A Rising Tide Lifts Most Boats.” This outlook was based on the fall in oil prices that had occurred in the second half of 2014, our inference that most of that decline reflected positive supply factors and not negative demand factors, and our view that the European Central Bank (ECB) was likely in 2015 to announce a substantial quantitative easing program that would complement the QE program already in place in Japan.  
Andrew Balls
Since the December forum, there have been several macroeconomic developments that could potentially impact the outlook for the global economy in a material way, and we discussed those at length. For example, since December a parade of more than 20 central banks from around the world – including all the major central banks save the Fed, which is still expected to commence hiking policy rates sometime in 2015 – have eased monetary conditions by slashing policy rates toward zero or even below zero. Moreover, the ECB in January announced a €1.1 trillion QE program that was much larger and more open-ended than the markets expected. Together these actions have produced a wave of global monetary policy accommodation – largely unforeseen in 2014 – that, in and of itself, should be supportive of growth and inflation expectations in those countries.
Another material development since the December forum has been a further decline in oil prices relative to what was projected at the time. Oil prices are now $20 per barrel lower than they were in December and a full $40 lower than the average oil price in 2014. As we discussed at length in December, falling oil and, more broadly, commodity prices create both winners — in commodity importing countries — as well as losers — in the exporting countries. The net impact on global aggregate demand is expected to be positive since lower commodity prices are a transfer from commodity exporters with high saving rates (state oil companies, sovereign wealth funds) to consumers with lower saving rates.
A third supportive development for global aggregate demand — exemplified by Prime Minister Shinzo Abe’s decision in late 2014 to “postpone” a scheduled second VAT tax increase in Japan — is the accumulating evidence that over our cyclical horizon the impulse of global fiscal policy is likely to be neutral and not, as in recent years, negative and thus no longer subtracting from global aggregate demand.

Given this context, our forum discussion appropriately focused not only on what is a relatively positive baseline scenario for the global economy – one that calls for a stabilization of global inflation and a modest rise in global growth that could surprise on the upside – but it also considered left tail risks to this baseline. These tail risks include (1) a negative, potentially disorderly market reaction – with macroeconomic consequences especially for EM countries – to what would be the first Fed rate hike in nine years, (2) the related risk that what is now a global currency “skirmish” descends into a currency war and (3) uncertainty about the exposure of the global economy and markets to geopolitical risk as well as the fragility of the economies that lose out from the end of the commodity supercycle.  

FOR THE U.S.: Our baseline view remains that the U.S. is on track for solid if not spectacular above-trend growth in the range of 2.5% to 3% (2.75% midpoint shown in graphic). This outlook reflects our expectation for robust consumption growth supported by a strengthening labor market and the boost to real income from low commodity prices. However, against this positive outlook for consumption, we must weigh the potential negatives of sluggish export growth held back by the stronger dollar as well as the likelihood that capex spending will be held back by a slowdown in investment in the energy sector. While headline inflation may briefly turn negative due to the year-over-year decline in oil prices, we expect core inflation to bottom out near current levels and to rebound later in the year, and overall we expect inflation over the next four quarters to be close to the Fed’s 2% target. In terms of our Fed call, we believe that, for a variety of reasons to be discussed below, the Fed will likely commence a rate hike cycle later this year. That said, we see the Fed as operating with a New Neutral for the policy rate, and as a consequence, this hiking cycle will in important respects differ from previous Fed rate hike cycles both in terms of pace – slower – and in terms of the destination – lower.
FOR THE EURO ZONE: As the blues song declares, “Been down so long it looks like up to me.” We see low oil prices, a weak euro and ECB QE as a trifecta of tailwinds for the euro zone. And yet, when we add all this up, we can only credibly forecast growth of around 1.5% over the next 12 months. The challenges are familiar: too much debt, too little structural reform and too many political challenges that weigh on confidence and animal spirits. We expect growth of around 2% in Spain and Germany and 1% or so in Italy and France. While modest, the pace of growth we envision is a significant improvement from the prior year, when euro zone GDP grew less than 1% on average. Weak demographics and poor productivity suggest that the economy will grow above potential, but only marginally so. Slack will therefore remain ample, which – together with the pressure to recover competitiveness in the periphery – will put a cap on wage growth and therefore inflation. We think that inflation will move back up from around -0.5% currently to +1% or so in a year’s time, but this will be due almost entirely to a normalization in energy price inflation, helped by a weaker euro. Core inflation is likely to remain fairly steady at just above 0.5%. While improving, the outlook still points to a subdued macro picture, with an economy that grows only 2.5% or so in nominal terms over the next year. This pace of growth remains modest and challenging given the need for both public and private sectors to deleverage in several countries. In this environment, the ECB may well have to adjust its QE program higher. The challenges to European growth in the medium term mean that unstable debt dynamics remain an important secular risk.
FOR JAPAN: Our views on Japan have changed little since December. Recall that the Bank of Japan (BOJ) surprise shock-and-awe announcement to double down on QE and Abe’s decision to “postpone” the VAT increase were already factored in to our December forecast. We still see growth of around 1.5% and core inflation running at about 1%. This baseline reflects the consensus view that consumption growth will be solid in the absence of the second VAT hike and that capital spending will be supported by easier financial conditions. Net exports are expected to improve to a large degree because of a decline in the oil import bill. Our views of the BOJ have not changed. As demonstrated by the October surprise expansion of the existing ambitious QE program, the BOJ is all in and won’t fail for lack of trying to reflate Japan’s economy. BOJ Governor Haruhiko Kuroda’s strong commitment to achieve 2% inflation in about two years appears unwavering. There is no change to our base case that the BOJ will continue its current QE2 program, with the possibility that additional easing may be forthcoming in the second half of 2015 if economic recovery falters. As in Europe, unstable debt dynamics remain a secular concern in the context of low nominal growth.
FOR CHINA: Pimco has consistently held below-consensus views on Chinese growth prospects, and we continue to do so. Chinese officials themselves now refer to a “new normal” for the Chinese economy of “around” 7% growth, and we continue to think that GDP growth in China will fall short of that. For 2015 we see growth in the low 6% territory. China is dealing with a property bust and deleveraging of the shadow banking system, and can no longer rely on low wages to undergird an endless export boom. The People’s Bank of China has begun to ease rates and reserve requirements aiming for a soft landing, and we expect more easing to follow. We discussed at some length the left tail risk that China enters a currency war and engineers (or blesses) a large competitive devaluation of the yuan. We concluded that scenario is unlikely because Chinese officials seem genuine in their desire to transition to a more domestic-consumption-based growth model and for the yuan to become a global currency and are obviously aware of the intense political backlash that would ensue.
FOR EMERGING MARKETS: Emerging markets are facing a number of headwinds that are translating into slowing growth, negative output gaps and greater divergence in inflation rates. Our baseline for BRIM (Brazil, Russia, India and Mexico) weighted average growth is around 2% as the commodity tailwind and Fed liquidity unwind, structural constraints start to bind and domestic/geopolitical headwinds come to the fore. This forecast is in line with consensus but with important country differences. Russia and Brazil are projected to undergo recessions as the macro economy adjusts to lower commodities prices, weaker currencies and the fallout from both domestic and geopolitics. Meanwhile Mexico is expected to rebound modestly but with growth still below potential as the country adjusts its ambitious energy reforms to the new realities of a world with lower oil prices for the medium term.
We forecast BRIM inflation in the range of 6% to 7.5%, with our base case closer to 6% but with increasing risks to the upside as weaker currencies pass through to headline inflation. We also expect to see greater divergence across countries within the commodity exporting block – e.g., Russia and Brazil – facing rising price pressures, and the Asia block – primarily commodity importers like India – experiencing disinflation. Mexico sits somewhere in the middle with headline inflation well within the inflation target band of 3% +/- 1%. In addition to these broad macro trends, BRIM economies are also experiencing a number of idiosyncratic themes. In Brazil, 2015 is likely to be another lost year with risks compounded by several negative shocks including the Petrobras crisis and energy rationing. This together with a more difficult political landscape makes the anchoring policies of Finance Minister Joaquim Levy even more critical. In Russia, the ongoing geopolitical crisis together with plummeting oil has increased the tail risks of credit events in the corporate space and runs on the banking sector driven by capital flight. Mexico and India, in contrast, are facing fewer domestic headwinds and instead are focused on progressing on ambitious structural reforms that should provide a boost to potential growth and the investment/business climate in the medium term.
So over the next 12 months we expect the pace of global economic growth to rise modestly, with GDP growth in a range of 2.5% to 3%. Our outlook for modestly stronger growth in the euro zone, U.S. and Japan is offset by the expectation of slower growth in China. As for inflation, 2015 is the year when most global central banks are doubling down on monetary accommodation to stabilize inflation and avoid deflation. We have seen a wave of monetary policy accommodation and we expect more to follow.
Investment implications
Expectations for a low New Neutral policy rate compared with historical experience remain an important anchor for global asset markets. But a challenge in terms of investment strategy is that this expectation is fully priced into global fixed income and equity markets.
In the U.S. and in some other countries there is a strong case that markets need to price in more risk premium compared with a low-for-long baseline. At the current level of yields, we continue to favor an underweight duration position in U.S. rates and expect that solidifying expectations for the Fed rate hike cycle together with the stabilization in oil prices forecast by our commodity specialists will provide support to this valuation-driven investment thesis over the coming months.
Related to this need for greater risk premium, we will be cautious on exposures at the front end of the U.S. curve – a tactical position that stands in contrast to our secular and structural bias in favor of curve steepening positions. We will continue to monitor very closely market positioning and in particular global investment flows driven by emergency policy settings elsewhere.
In Europe, similarly we see little long-term value in core government yields at current levels, but at the same time we are respectful of the technical forces unleashed on the flow of funds by the ECB’s planned €60 billion per month of asset purchases in terms of both core duration and curve positions. We expect the technicals to overwhelm the fundamentals at least in the near term. Core duration levels, which look too low, could be driven yet lower.
European peripheral risk, notably the larger markets of Italy and Spain, remain attractive versus German bunds on a spread basis – with the potential for ECB purchases to drive spreads significantly tighter – and as a liquid source of sovereign credit risk.
The potential for a Fed-driven rise in volatility argues for keeping some dry powder in portfolios in order to leave room to add positions at more attractive valuations. In general, options markets have priced in the prospect of higher realized volatility to a very reasonable extent, such that volatility levels look reasonably attractive at the same time that corporate credit markets have continued to tighten.
Clarida is global strategic advisor with Pimco, and Balls is chief investment officer, global fixed income with the fund firm.