Enjoy the strong economy and its accompanying asset returns while you can, because a recession is coming. And when it does, it’s going to be an entirely different animal.
That was the message delivered by Pacific Investment Management Company (Pimco) on Wednesday as the firm published a secular outlook spanning the next several years.
While Pimco doesn’t see a recession posing an imminent threat, it expects to see one sometime in the next three to five years. This has become the consensus view held by many market experts, and Pimco takes it a step further by outlining what will vary from history this time around.
“While all of this is highly speculative, we lean toward forecasting a shallower and longer, call it wok- or saucer-shaped, recession rather than a deeper but shorter V-shaped recession,” Joachim Fels, the firm’s global economic advisor, and Andrew Balls, its chief investment officer of global fixed income, wrote in the report. “Markets do not seem to be pricing in this risk, judging by risk spreads and volatility.”
In order to fully understand where Pimco’s coming from, one has to realize just how anomalous the accommodative conditions enjoyed by investors over the past decade have been. As the firm notes, the global environment following the last crisis has been marked by financial repression, passive fiscal policies, subdued inflation, and low volatility, among other elements.
Pimco expects that to change, and that forecast informs the three ways the firm says the next recession will differ. Fels and Balls say it will be:
1) Shallower — “There are so far no signs of corporate or housing overinvestment or overconsumption in the U.S. economy, and the global financial sector looks steadier than in the past few cycles.”
2) Longer — “Relatively low interest rates, bloated central bank balance sheets and (in the US) larger fiscal deficits limit the policy space to fight a global recession. Moreover, given the widespread trend toward economic nationalism and protectionism, a recession could fuel trade deglobalization and currency wars, thus shrinking the pie further.”
3) Riskier— “Inflation expectations are very low at the outset almost everywhere, the structural weaknesses in the eurozone could be exposed, and a recession would raise the risk of populism aimed at wealth redistribution and confiscation.”
Perhaps even more immediately jarring to investors might be Pimco’s view on one of the stock market’s most reliable strategies: buying the dip. The practice, which refers to using temporary market weakness to add to positions at lower prices, has repeatedly been credited with providing a backstop to equities throughout the nine-year bull market.
While it’s been good while it’s lasted, stock traders had better figure out a new tactic, Pimco says.
“Since the 2008 crisis, bad news for the economy has typically been interpreted as good news for financial assets, as policymakers have been quick to respond,” Fels and Balls wrote. “But this ‘buy the dip’ mentality may not endure. Financial assets have significantly outperformed the real economy over the past decade but, over the next decade, the opposite may very well be the case.”
With that trusted method out the window, what are investors to do if they want to survive the next big downturn?
One option will be to mitigate risk from a credit perspective, which means being more selective about which bonds to own, Pimco says. This would be a big change from current behavior, which has seen the credit-risk premium for CCC-rated bonds— the riskiest of all junk issues — fall to the lowest since 2007.
From a more international perspective, Pimco suggests investors consider scaling back exposure to peripheral nations in the eurozone. According to the firm, issues such as political risk and an overreliance on the European Central Bank could flare up and destabilize the entire region.
“We expect to remain cautious in our positioning while preparing to play offense when rude awakenings present themselves,” Fels and Balls said. “While there’s still a path to a relatively benign outcome for the global economy and markets, it’s a narrow and difficult path, with stretched valuations leaving little room for error.”
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