24/7 Wall St.

It’s pretty hard to find anyone outside the White House who does not believe that global economic growth is slowing and that the next recession is on its way, perhaps as soon as the second half of 2019. Investment advisory firm Pimco is no exception.

[in-text-ad]

In a new cyclical outlook, “Synching Lower,” Pimco’s Joachim Fels and Andrew Balls note that the global economic expansion that started in 2009 has passed its peak growth in the cycle as central banks end their easy money programs and political risks increase.

Given the current state of the economy, here’s what Pimco concludes:

These trends support our relatively cautious positioning and intense focus on liquid assets, which will allow us to respond either to specific opportunities or generic spread widening and higher volatility.

Pimco’s analysis follows an early December meeting of its investment committee to discuss five key macro debates that likely will “shape the cyclical and market outlook for 2019.” Here are the five debate topics and a bit of color on each.

How late it is in the cycle. According to a Pimco quantitative model, the probability of a U.S. recession over the next 12 months is about 30% and higher than at any point in the nine-year-old economic expansion. Some of the meeting’s attendees argued that rather than macroeconomic factors like an overheating economy or overleveraging, a derating of financial assets may lead to the next recession.

The end of U.S. economic exceptionalism. The growth gap between the United States and the rest of the developed world is expected to narrow next year. Pimco expects U.S. GDP growth of 2.0% to 2.5% next year as growth “synchs lower” with tight money replacing easy money and lower oil prices providing more benefits to Europe, Japan and China that to the United States. U.S. equities are projected to outperform foreign stocks, and while dollar bulls have been harnessed somewhat, no major weakening of the greenback is anticipated.

Will inflation ever return? Pimco has lowered its inflation estimate based on lower crude oil prices and core inflation that is mostly flat or slightly higher in the United States, Europe and Japan but still below target.

The Fed pauses, then what? Pimco expects the Federal Reserve to raise its policy rate only one or two times in 2019 and notes that a pause in the first half of the year “looks increasingly likely” because tighter financial conditions and the Fed’s balance sheet runoff are doing some of the heavy lifting. And given the likelihood of recession, a resumption of rate hikes is relatively unlikely following the Fed’s pause.

U.S. vs. China: Truce or peace? The recent agreement between the U.S. and Chinese presidents is not expected to solve all the conflicts between the two countries, and those conflicts would “continue to be a source of uncertainty and volatility even if there were a deal on trade.”

Overall, Pimco favors liquid instruments, except in specific instances where investors are paid to be illiquid. As for specific tips, the firm believes that underweight Japanese issues are a good hedge against a possible, but unexpected shift upward in the range for global duration, the sensitivity of a bond’s price to a change in interest rates. U.S. Treasury Inflation-Protected Securities (TIPS) are also “attractively priced and … [offer] a hedge against possible inflation upside surprises” in the United States.

More recommendations and regional economic forecasts are included in the full report available at the Pimco website.