Yield Advantage

Authorities will almost surely face more constraints when looking to discretionary fiscal policy to limit the damage from future business cycle downturns. Our baseline is not a sudden financial crisis, but recurring episodes of market volatility when focus shifts to fiscal issues.

Despite these fiscal pressures, we believe that the U.S. dollar will remain the dominant global currency, in no small part due to the lack of a viable challenger. A U.S debt reckoning could eventually come about, but it’s not likely imminent given U.S. advantages in immigration, productivity, and innovation; U.S. Treasuries being a global reserve asset; and the general dynamism of the U.S. economy. An elevated demand for U.S. Treasury securities as a “safe haven,” liquid store of value has, to date, limited the bond market’s concerns about fiscal sustainability. That suggests the timeline for fiscal reforms may be super-secular.

The U.S. may still be the “cleanest dirty shirt” compared with other economies. China’s outlook is challenged by property sector recession, an aging population, and less-open export markets. In Europe, fragmented politics will make it difficult to build a comprehensive growth strategy in the face of regional conflict, energy insecurity, and more direct competition from China on higher-value manufactured goods.

Moving to a multipolar world

The geopolitical landscape is increasingly defined by tensions between a dominant superpower (the U.S.) and its rising rival (China). Both China and Russia have clear long-term visions that are at odds with Western ideals. The peace dividend realized over the past three decades is becoming a conflict outlay.

This underscores a shift toward a multipolar world order, where cooperation seems limited and new middle powers may emerge. The shift will likely also lead to changing correlations across markets and increased divergence in potential growth and policy responses. Business cycles will likely also be less synchronized. We expect the underlying forces will lead to greater macroeconomic and financial market volatility than pre-pandemic.

Risks to financial stability have also increased and could become problematic should these conflicts begin to materially alter cross-border financial flows or create conditions for capital impairments. We believe the risk premium for credit investment in China is too low to be attractive given potential risks.

We expect China’s growth to continue slowing without stalling. Notably, China is re-globalizing. Its new growth model, focused on production and infrastructure to counterbalance a property sector collapse, is driving a rise in manufacturing exports. This pivot requires reevaluating China’s role in the global economy, especially its impact on commodity markets and inflation, as well as its integration into the global financial order.

Major emerging markets (EM) have displayed remarkable resilience this cycle. The typical combination of factors that often trigger EM crises – capital flight, tighter financial conditions, and a collapse in commodity prices – is not currently evident, nor does it appear likely to emerge over the secular horizon. Debt levels in EM countries are increasing but so far remain at sustainable levels compared with DM.

Roughly 60% of the world by GDP weight will be voting in a major election this year. With early signs of populist parties gaining support – particularly in Europe – global elections have scope to change both economic and geopolitical policy priorities. We see risks that elections increase trends toward fragmentation, multipolarity, and protectionist measures, favoring friend-shoring investments. Countries such as India, Indonesia, and Mexico are positioned to benefit.

Turning to the U.S. presidential election, we believe trade, tax policy, immigration, regulation, and environmental policy have the greatest scope for disruption. U.S. fiscal deficits are likely to remain near historic highs regardless of the election outcome. Both political parties are also focused on remaining tough on China.

AI effects coming into focus

Generative AI has the potential to transform labor markets and democratize access to decision-making tasks, enabling more of the workforce to make informed decisions.

But many organizations will face challenges as they seek to leverage AI effectively. Dramatically enhanced productivity and efficiency may not be evident in the macro data over the next five years. This is because maximizing the payoff from AI at the macro level will require not only adoption of the technology itself, but also the reconfiguration of work streams and the rethinking of production processes at the micro level of individual organizations.

Similar to the experience with other new technologies over the past few decades, there may not be much of an incremental impact on productivity from modest enhancements of existing work practices. But there is a chance of breakthrough changes that could have a larger impact on productivity growth in certain specific areas, such as healthcare and science.

While our base case is that the full impact of new AI large language models manifests gradually over the secular horizon, it’s possible that disruptions may occur more quickly. The capital spending boom in computing, data centers, and green energy technology increases availability of these resources for applications beyond AI, while AI investment makes AI-supported breakthroughs in other fields increasingly plausible. Downside surprises are possible as well, especially if misuse of AI models for surveillance, manipulation, or security threats results in innovation-stifling restrictions.

For now, capital spending can lead to a shorter-term sugar high. Ultimately, efficiency gains will be needed to generate longer-term sustainable growth.

The demand for chips, data centers, and the generation capacity that will power them is expected to be explosive, and these trends will have immediate sectoral consequences.

Neutral policy rates to remain low

Today’s elevated policy rates are the result of cyclical forces, namely an inflationary spike. Once inflation stabilizes near central bank targets, we expect neutral monetary policy rates in advanced economies will likely settle at levels below those that prevailed before the global financial crisis.

We believe the neutral nominal policy rate in the U.S. over our secular horizon will likely remain in the range of 2%–3% (implying a long-run neutral real rate of 0%–1%). By contrast, current pricing indicates markets expect the neutral rate may not fall far below 4%. That can present further opportunities for bond investors, as yields today already embed cushion in the form of positive real rates and term premium.

We expect central bank balance sheets, which are currently contracting under quantitative tightening (QT) programs, will remain substantially larger than before the era of quantitative easing (QE). DM central banks will likely continue to use asset purchase programs to ensure the smooth functioning of sovereign debt and repurchase markets, and to act as lenders of last resort. Examples include the U.S. Federal Reserve’s 2023 Bank Term Funding Program and the Bank of England’s 2022 operation to support the U.K. gilt market.

However, we think it is less likely that central banks deploy open-ended QE asset purchase programs in response to future economic downturns. The financial strain of maintaining large securities portfolios, where the costs of funding exceed the returns from these assets, has become increasingly apparent.

Monetary and fiscal puts – or expectations of government relief in the event of downturns – are further out of the money today. That constrains the government’s ability to stimulate flagging economies and provide support to dampen shocks. We expect additional volatility as markets trade more on fundamentals and less on the expectation that governments will come to the rescue.

Investment implications: Fixed income resurgence

Our 2024 Secular Outlook favors a renewed focus on public fixed income markets, which we believe are poised to generate competitive returns and lower risk compared with other asset classes. Today’s yields and a stabilizing inflation outlook are enabling bonds to reassert their fundamental advantages in portfolios: providing potential for attractive income, downside resilience, and stability through reduced correlation with equities.

Many sophisticated asset allocators have moved well beyond the traditional 60% stocks / 40% bonds paradigm. Even so, it remains an oft-cited rule of thumb that frames many investment conversations. We believe we are entering an era that warrants a rethinking and a reversal of that concept.

The post-pandemic inflation shock and subsequent central bank rate-hiking cycle reset bond yields sharply higher. Historically, starting yields are highly predictive of bond returns over a multiyear horizon (see Figure 2). The yields on the Bloomberg U.S. Aggregate and Global Aggregate (hedged to U.S. dollar) Indexes, two common benchmarks for high quality bonds, are about 5.31% and 5.41%, respectively, as of 30 April 2024.

Using that as a baseline, active investment managers can seek to enhance the yields investors earn. By identifying attractive opportunities in high quality areas – such as agency mortgage-backed securities – active managers can currently construct portfolios yielding about 6%–7% without taking on significant interest rate, credit, or illiquidity risk.

As a result, a diversified bond allocation offers the potential for long-term equity-like returns with a more favorable risk-adjusted profile, especially given what may be stretched valuations in stock markets (see Figure 3). Markets don’t appear to price significant recession risk, meaning bonds may be an inexpensive means to hedge that risk.

Bonds today also embed a term premium that offers a cushion. We expect yield curves to steepen as policy rates decline and the term premium builds (for more, read our February PIMCO Perspectives, “Back to the Future: Term Premium Poised to Rise Again, With Widespread Asset-Price Implications”), and we have a curve steepener as a structural trade.

In the wake of its longest-ever inversion, the U.S. yield curve remains relatively flat. That means investors do not need to take a lot of interest rate risk. We currently find value at the 5-year part of the yield curve and are wary of potential underperformance of the long end due to fiscal concerns. Active fixed income is positioned to perform well if there are no recessions over our secular horizon and to perform even better if there are, with the potential for price appreciation if yields decline, which makes bonds attractive compared with cash, in our view.

Global bond markets offer particularly attractive and diverse opportunities that investors might be overlooking as a way to enhance yield without significantly increasing risk. Global yields – across DM and EM – have returned to attractive levels. Many economies outside of the U.S. face more fragility yet enjoy better starting fiscal conditions, both supportive of bonds.

We expect business cycles will be less synchronized, which will lead to lower correlations across financial markets. The differentiation in central bank policies and market conditions across regions presents unique opportunities for active, global investment platforms to capitalize on these discrepancies and potentially further enhance returns through country and security selection. Industrial subsidies and trade policies promoting onshoring, friend-shoring, and the energy transition will likely create both sectoral and national winners and losers, presenting further opportunities for active investors.

Given potential volatility around inflation, U.S. Treasury Inflation-Protected Securities (TIPS), commodities, and real assets offer inflation-hedging properties and higher real rates than pre-pandemic levels.

Prioritize credit selection and liquidity

While credit spreads appear broadly fair overall, credit and sector selection are poised to become more important over our secular horizon. Growth in both public and private credit markets should give active investors with flexible capital more opportunities during periods of volatility.

Many stronger, more resilient companies generate significant cash and don’t rely heavily on financing. Many weaker companies tend to need greater ongoing access to credit. The more productivity-enhancing AI technologies are, the more disruptive they are likely to be across companies and industries, creating more winners and losers. In the past, the advent of new technologies has often been followed by boom-bust cycles, creating volatility but also presenting bottom-up active investment opportunities.

We expect increased regulation for banks, which should lead to more disintermediation and more money flowing through private markets. Our focus remains on liquidity gaps arising from banks being pressured to manage capital and meet regulatory requirements. For example, this bank retrenchment will likely create opportunities for flexible capital in CRE debt, as we expect large-scale capital needs for asset owners facing a wall of loan maturities.

Asset-based lending is a prime example of what we see as an attractive and less crowded investment opportunity. Middle-market corporate lending appears to be in favor within private markets, but we believe areas such as consumer lending offer outstanding long-term fundamentals and value as U.S. household leverage has declined (see Figure 4) and housing markets remain well-supported.

We would contrast that with the amount of capital now concentrated in corporate lending. We are very concerned about the rapid growth within private, floating-rate markets that may not have been tested through prior default cycles. These conditions increase the risk of excesses building in areas such as technology and direct lending to companies with high leverage and lower credit ratings. Challenges could emerge during our secular time frame.

Given the high potential for returns in the more liquid segments of the bond market, investors should have a high hurdle – in the form of attractive return potential and strong lender covenants – for giving up liquidity. At today’s yield levels, the risk-adjusted return potential of broadening exposure to public fixed income markets – such as increasing allocations to high quality DM and EM bonds – also compares favorably with the trade-offs involved in extending into less liquid areas of credit markets.

¹ According to Newmark Research calculations, as of 12 February 2024. Return to content↩

Tobias Adrian

Financial Counsellor and Director of the Monetary and Capital Markets Department, International Monetary Fund

Anima Anandkumar

Bren Professor of Computing and Mathematical Sciences, Caltech

David Autor

Ford Professor of Economics, MIT

Jason Furman

Aetna Professor of the Practice of Economic Policy jointly at Harvard Kennedy School and the Department of Economics, Harvard University

Kevin Hassett

Brent R. Nicklas Distinguished Fellow in Economics, Hoover Institution; former Chair of the White House Council of Economic Advisers

John H. Cochrane

Rose-Marie and Jack Anderson Senior Fellow, Hoover Institution

Carmen Reinhart

Minos A. Zombanakis Professor of the International Financial System, Harvard Kennedy School

Brad Setser

Whitney Shepardson Senior Fellow at the Council on Foreign Relations

Wendy R. Sherman

Former U.S. Deputy Secretary of State

PIMCO’s Global Advisory Board

World-renowned experts on economic and political issues

About our forums

PIMCO is a global leader in active fixed income with deep expertise across public and private markets. Our investment process is anchored by our Secular and Cyclical Economic Forums. Four times a year, our investment professionals from around the world gather to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. In these wide-reaching discussions, we apply behavioral science practices in an effort to maximize the interchange of ideas, challenge our assumptions, counter cognitive biases, and generate inclusive insights.

At the Secular Forum, held annually, we focus on the outlook for the next five years, allowing us to position portfolios to benefit from structural changes and trends in the global economy. Because we believe diverse ideas produce better investment results, we invite distinguished guest speakers – Nobel laureate economists, policymakers, investors, and historians – who bring valuable, multidimensional perspectives to our discussions. We also welcome the active participation of the PIMCO Global Advisory Board, a team of world-renowned experts on economic and political issues.

At the Cyclical Forum, held three times a year, we focus on the outlook for the next six to 12 months, analyzing business cycle dynamics across major developed and emerging market economies with an eye toward identifying potential changes in monetary and fiscal policies, market risk premiums, and relative valuations that drive portfolio positioning.