Economic and Market Commentary

Three Themes Investors Need to Know

4/20/2023

Tiffany Wilding, Kenneth Chambers

Watch PIMCO experts discuss the three macro themes investors should watch for throughout the rest of 2023.

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Text on screen: Ken Chambers Fixed Income Strategist

Kenneth Chambers: Back in October, we talked about the central banks, the need to fight against inflation, and it was going to make recession more likely. And then at the start of this year, we detailed this idea that inflation was likely to moderate across many developed markets. Central banks were going to remain restrictive at these policy rates, but a shallow recession a bit farther in the future. Maybe could you share some color around how the events of the first couple of months have impacted our outlook?

Text on screen: Tiffany Wilding, Economist

Tiffany Wilding: Sure. Everything was actually looking quite good. Over the turn of the year, we saw much more resilient economic data. Inflation was even looking a bit stickier. But of course, things turned around very quickly. We saw this banking sector stress that happened in mid-March.

FULL PAGE GRAPHIC: TITLE – Fractured Markets, Strong Bonds: Macro outlook. The graphic shows Three Economic Themes Through 2023 Across Developed Markets (DM). The circle on the left shows an hourglass image with the text: Potentially deeper recession, sooner. The circle in the middle shows an image of a government building with the text: Central banks: Less tightening, but slower easing. The circle on the right shows a weighing scale image and the text: Fiscal policy and regulation: Focus on moral hazard?

So overall, just taking a step back given these events, we would just highlight three things that we are really focused on or three themes about the outlook.

the first is that the banking sector stress has resulted in a higher risk of a deeper recession, maybe sooner.

There's various academic studies that suggest when banks perceive a higher cost of capital, or a cost of capital is rising, then they actually pull back on their lending growth. And we do think we are seeing a rising cost of capital in the banking sector.

So, all of that means that we are probably going to see lending growth slow and slower lending growth is just going to slow the economy.

the second thing is that inflation is still elevated. So central banks, they're going to be slower to ease than they have in the past.

Going from four to two, again, it's going to take more time. And part of the reason for that is just labor markets are still very strong, or at least they are coming into this period with relative strength and wage inflation or the wage level adjustment has just taken longer to happen and that's because it's just less flexible than prices. So you're going to have wages that are continuing to catch up with the price level adjustment that we've had. And that's just going to mean that wage inflation looks elevated for longer.

Images on screen: The Federal Reserve building

That means that probably the Federal Reserve, as a result of tighter credit conditions within banks, maybe they don't need to tighten as much because of this. But there might not be as fast or as aggressive in terms of easing either just because they're still having to deal with elevated inflation risks.

Then in terms of actually starting that normalization path back to neutral in the past we've said maybe that starts around the end of this year and the brunt of that happens in 2024. And I think that's still reasonable.

Just on the third theme, you're going to see that kind of behavior from governments as well. They're not going to preemptively ease and we're not going to see the type of aggressive response like we did to the pandemic.

So, the FDIC, the Fed, they still are able to invoke the so-called systemic risk exemption. When a bank does fail, they can come in ex-post and say we're going to guarantee all the deposits. But in terms of a blanket provision ahead of time, that would probably help with confidence, which is so important in these kinds of events. We just don't see that happening. And furthermore, on the regulatory side that could actually tighten in the coming quarters as a result of this.

Kenneth Chambers: Certainly, a lot going on from the macro front. What's your advice for investors today?

Tiffany Wilding: Sure, so I think lags with monetary policy, they are working. The tighter financial conditions are becoming more apparent. Recession risks have elevated. But obviously, this is a good environment for bonds.

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