We expect the global expansion to continue in 2018. Yet investors should prepare for both the consequences of policy shifts and the
opportunities presented in more difficult market conditions.
Barring a sudden spontaneous collapse in asset prices, the current Goldilocks environment of synchronized, above-trend global economic growth and low but gently rising inflation will likely persist in 2018. PIMCO’s baseline forecast is for world real GDP growth in a 3% to 3.5% channel in 2018, about the same as in 2017.
However, during our December Cyclical Forum we zoomed in on the potential consequences of synchronized global growth, fiscal stimulus in the U.S. and the reduction of monetary accommodation by central banks. In a nutshell, we concluded that 2017–2018 could well mark the peak for economic growth in this cycle and that investors should start preparing for several key risks that lie ahead in 2018 and beyond. Here’s why:
Borrowing from the future
First, the prospective U.S. fiscal expansion in 2018 appears dictated by the political cycle rather than the economic cycle. Fulfilling last year’s presidential election campaign promises and delivering tax cuts and spending increases ahead of next year’s congressional midterm elections makes political sense but could have detrimental longer-term economic consequences.
Arguably, the last thing an economy operating at close to full employment in the ninth year of an economic expansion needs is a shot in the arm from fiscal policy. Also, adding around $1 trillion to the public debt over 10 years could come back to haunt the public coffers if rates rise in the future. And most importantly, depleting the fiscal toolkit while the economy is good comes at a price. Higher fiscal deficits and debt levels imply that the room for fiscal stimulus in the next recession will be more limited.
Bend it like A.W.H. Phillips?
A second major risk related to the 2018 outlook is that wage and/or price inflation may finally inflect higher as employment overshoots its natural level. There are good reasons why this hasn’t happened so far and why the Phillips curve describing the link between (falling) unemployment and (accelerating) wages/prices has thus remained fairly flat.
However, the risks of an inflation overshoot in 2018 are rising given the globally synchronized nature of the expansion, additional fiscal stimulus, recent rises in commodity prices and super-easy financial conditions. Global structural forces are still weighing down inflation, but the cyclical pressures are clearly on the up.
The risk of monetary overkill
A third risk for 2018 is that the reduction of monetary accommodation – well-intentioned as it may be – turns out to be too onerous for economies and asset markets that have become addicted to low short rates and depressed term premia across the yield curve. With markets having become addicted to easy monetary policies, this turn in the tide of central bank policies poses significant risks to markets and economies.