The Aftershock Economy.

Key Takeaways

The first few years of the 2020s have seen a number of acute economic, financial, and geopolitical disruptions on a worldwide scale, and it will take time for the ultimate consequences of these shocks to be fully felt. At PIMCO’s latest Secular Forum, we discussed how recent short-term cyclical dynamics are likely to have longer-lasting secular consequences.

The global economy is exiting a period of massive fiscal and monetary policy interventions that are unlikely to be repeated over our secular horizon. After the post-pandemic surge in global inflation, central bankers are starting to recognize that unconventional monetary policies bear costs as well as deliver benefits, while surging sovereign debt levels will likely limit fiscal capacity to address future downturns.

With the era of volatility-suppressing policies possibly over, markets are likely in for a period of heightened volatility, with an unusually large array of potential aftershocks. We believe the risks to global growth are skewed to the downside over our five-year secular horizon, and that returns across asset classes are likely to be more differentiated in this new era.

We expect central banks to maintain their existing inflation targets and to prioritize keeping longer-term inflation expectations anchored at those target levels. We believe that neutral long-run real policy rates in advanced economies will remain anchored in a range of 0% to 1%. With rising government debt and the possible return of an inflation risk premium, we expect the yield curve to steepen as investors demand more compensation on longer-term bonds over the secular horizon.

Our expectations of low neutral rates and a return to near-target inflation reinforce a positive outlook for core and high quality fixed income. After rising sharply last year, starting yield levels – historically strongly correlated with future returns – for high quality bonds are close to longer-term averages for equity returns, potentially with significantly less volatility and more downside protection than equities. This may help investors to construct prudent, resilient portfolios without relinquishing upside potential. We have a bias toward high quality, more liquid investments and remain cautious about more economically sensitive areas. We expect increasingly attractive opportunities across private markets over time, particularly in light of the changing banking landscape.

A new era of geopolitical tension between an established superpower and a rising rival will likely create global economic implications. We continue to believe that the U.S. dollar will retain its status as the dominant global currency, despite a widening U.S. fiscal gap and growing indebtedness, but that there are investment opportunities to be found elsewhere.

Secular theme: The aftershock economy

Ongoing disruption – to the global economic and financial order, to the geopolitical balance, and to the scale and scope of government policy interventions – has defined the first three years of this decade and will, we believe, remain a new reality that investors need to recognize over the next five years. This has been a trend we’ve noted in recent PIMCO Secular Outlooks and one we revisited at our latest annual Secular Forum in May.

Our Secular thesis last year, “Reaching for Resilience,” argued that in a more fractured world, governments and businesses would increasingly prioritize safety over short-term economic efficiency. We flagged potential inflationary pressures as companies friend-shore supply chains and as governments boost spending on energy initiatives and national defense.

While that thesis broadly continues to hold, our outlook for the next five years must incorporate and assess a number of major developments since our May 2022 forum, including

• Hawkish monetary policy pivots in response to the largest sustained surge in global inflation in 40 years

• A debate over the destination for neutral monetary policy rates once (or if) central banks return inflation to target levels

• Three of the largest bank failures in U.S. history and the collapse of Credit Suisse in Europe

• The passage of an ambitious U.S. fiscal trifecta – the Infrastructure Investment and Jobs Act, the Inflation Reduction Act, and the CHIPS and Science Act – in support of a newly assertive American industrial policy push, which will serve as a cyclical and secular tailwind as funds are released into the economy

• Conflicting signals on the economic and geopolitical direction of China amid President Xi Jinping’s “third act”

Our secular views also build upon our latest Cyclical Outlook, “Fractured Markets, Strong Bonds,” which anticipated modest recessions across developed markets, with tighter credit conditions raising downside risks. We said major central banks are near the end of their rate-hiking cycles, although not yet close to normalizing or easing policy, while future fiscal responses may be constrained due to high debt levels and the role of post-pandemic stimulus in fueling inflation.

In this environment of ongoing and multiple disruptions, short-term cyclical dynamics are having more long-lasting secular consequences, ushering in what we’re calling “the aftershock economy.” Here we share some key economic and investment implications we took away from our 2023 Secular Forum.

Macroeconomic volatility and geopolitical tension likely to persist

It’s worth remembering how unusual the first three years of this decade have been in comparison with the 2010s.

The world faced a once-in-a-century pandemic, which authorities countered by locking and shutting down big chunks of the global economy and providing massive monetary and fiscal stimulus. In time, that stimulus, along with the cost of reopening the global economy and restoring supply chains, fueled the sharpest sustained surge in global inflation in 40 years. Central banks eventually responded with the most aggressive global rate-hike cycle in decades, with consequences that included a financial market rout in 2022, a banking crisis, tighter credit conditions, and widespread forecasts of a recession this year or next (see Figure 1).