Building Resilience Amid Global Risks
The members of PIMCO’s Global Advisory Board, a team of world-renowned macroeconomic thinkers and former policymakers, recently joined the discussion at PIMCO’s annual Secular Forum, where they addressed critical factors likely to shape the global economy over the five-year horizon. The board’s insights constitute a valuable input into PIMCO’s investment process, and the views they presented helped inform the latest Secular Outlook, “Reaching for Resilience.” The discussion below is distilled from their far-ranging conversation.
Q: What are the longer-term implications of the Russia-Ukraine war?
A: In Ukraine, whatever the outcome of the war, an enormous and costly reconstruction effort will be required. And in Russia, the economy is likely to be severely weakened and less integrated into the global economy, and Russia is likely to be more isolated diplomatically. President Putin will remain a pariah in the eyes of the U.S. and Europe (though not necessarily the rest of the world), and some sanctions will likely remain in place as long as he is in power. Given the reputational risk, few American and European businesses are anticipated to return to Russia. How this ultimately plays out for Putin is being watched closely by China’s President Xi Jinping and will likely influence his calculus regarding Taiwan.
NATO, for its part, should emerge larger, stronger, and more focused on deterring Russia. Defense spending in Europe is likely to increase substantially. Ultimately, Putin does not want to take on NATO: He knows how costly that would be for Russia.
The war has had a major impact on European energy supply and policy. We’re seeing the beginning of Europe’s long-term effort to reduce reliance on Russian oil and gas. In the near term, that means shifting to alternative suppliers. In the medium to longer term, we can expect increased investment in energy resilience, including infrastructure and alternatives such as wind, solar, and nuclear. A key question: Will individual countries look to secure their own energy sources, or will the EU pull together a regionwide strategy with greater synergies and efficiencies?
Q: What is the high-level outlook for U.S. foreign policy?
A: Along with investing in the drivers of economic and technological competitiveness, the Biden administration will continue to focus on restoring U.S. leadership among allies. Inconsistencies in the approach to Europe and the greater Middle East under the Trump administration raised doubts about U.S. credibility – doubts that deepened under the Biden administration following the Afghanistan withdrawal. Now, after the invasion of Ukraine, U.S. policy will likely emphasize strengthening NATO, security assistance to help allies build capacity to defend themselves, and bolstering deterrence vis-a-vis Russia and China.
U.S.–China relations are likely to continue to deteriorate, with intensifying competition across political, economic, technological, and military domains. China is likely to deepen its economic and strategic relationship with Russia, while taking care to avoid triggering U.S. sanctions. In the next year or more, President Xi’s primary focus will continue to be on getting COVID-19 under control, getting the Chinese economy growing again, and consolidating his power and position in the Chinese Communist Party at the 20th Party Congress.
In U.S. foreign policy, there remains a tension between values and national interests. This is particularly evident in the Middle East and in China, where U.S. economic interests often clash with values-based concerns around human rights and authoritarian leadership. It can make it challenging to craft a consistent and credible policy.
Q: Which geopolitical trends are likely to affect the global economy and international institutions over the secular horizon?
A: Three simultaneous seismic geopolitical shifts are creating challenges and uncertainty for the global economy. The first is the breakup of the unipolar order: Consider the large number of countries that did not take actions or enact sanctions against Russia following the Ukraine invasion, and this suggests a fragmented multipolar world.
The second seismic shift is, if not deglobalization, a globalization-lite reflected in not just reshoring and ally-shoring but a new emphasis on resilience – guaranteeing supplies – taking precedence over efficiency, securing the lowest price.
The third shift is in the economic paradigm – specifically, the role of government. For three decades economics determined political decision-making (and for a decade central banks were the only game in town). Now politics is determining economic decision-making. We now must factor in not just the protectionism of “America first,” “China first,” etc., and the retreat into national self-sufficiency strategies, but also the weaponization of trade policy via sanctions, the politicization of financial policy (for example, expelling countries from the SWIFT platform), and the securitization of economic policy – namely, military concerns dictating financial policy decisions.
In light of these shifts, the international institutions we’ve relied on to ensure global coordination are diminished, and it is becoming hard to imagine the widespread cooperation that fostered the creation of these institutions decades ago.
The secular consequences of these shifts and the resulting upsurge in populist-nationalist movements are likely to mean less global trade (though perhaps more regional trade agreements) and as a result lower growth, along with more fiscal pressures on governments (to fund increased defense, immigration, energy subsidies, and a faster energy transition) and consequential inflationary pressures.
Explosive advances in technology – e.g., in digital, life science, and environmental industries – should compensate by driving up growth, but they will occur mainly in regions capable of harnessing them.
Q: What is the longer-term outlook for China’s relationship with the U.S.?
A: The U.S.–China relationship continues to deteriorate, and given the tone of leadership on both sides, it is hard to imagine the situation will improve. President Xi Jinping’s leadership is secure and China’s population tends to unite in the face of challenges.
For years, China has enacted policies to strengthen its economy and reduce its vulnerability to external forces, such as an increasingly hostile U.S. China’s leaders may need to dial back some of those policy efforts – such as the dual circulation economic model and the common prosperity social program – in the near term as China addresses significant growth challenges (including the impact of COVID lockdowns and the struggling property market). But these policies are likely to remain priorities over the longer term.
The Russia-Ukraine war has raised profound questions for China. Seeing the sanctions imposed on Russia, China’s leaders likely feel they should prepare their country for the risk that the U.S. imposes similar consequences for theoretical future actions (related to Taiwan, for example). Such preparations would not be easy. Consider, for example, China’s massive foreign exchange reserves, of which the majority is U.S.-dollar-denominated. It is unrealistic to expect much reduction in USD reserves because there are no practical alternatives. However, China may seek to raise the proportion of international trade settled in renminbi. Finally, if China cannot do much to reduce the risk of its assets, it could build up external liabilities so that if the assets are threatened, the liabilities would also be impaired.
In a sense, China would be preparing for a possible “capital war” by embedding these deterrents. And given the scale of China’s economy, a capital war could have enormous implications globally.
Q: What factors are contributing to inflation in the U.S., and how is the Federal Reserve likely to respond?
A: Broadly speaking, three components are driving inflation in the post-pandemic era: excess demand, traditional supply shocks (such as food and energy), and pandemic-related shocks. In the U.S., the Federal Reserve and to some extent the fiscal authorities can control the first factor – demand – but they have very little control over the second and third.
With tremendous fiscal and monetary stimulus, U.S. policymakers were able to support demand and consumer spending following the pandemic-driven recession. But the 2020 recession was unusual, and Fed stimulus tended to help many areas of the economy that needed it least – housing, manufacturing, and consumer durables – sectors that would struggle in a typical recession. The service sectors needed more support during the pandemic, but these areas don’t tend to be as sensitive to lower interest rates.
Turning briefly to the other two inflation components, which policymakers cannot control: A supply shock caused by the Russia-Ukraine war has exacerbated existing price pressures across a range of commodities, in turn affecting food and energy costs. And pandemic effects persist, including the demand rotation from services to durables, the enormous strain on supply chains, and the overall drop in labor supply.
Looking ahead, there are two scenarios for inflation. In the first, those two factors the Fed does not control moderate over time, which would allow the Fed to bring down inflation with a sustained but perhaps not severe tightening on the demand side. In the other scenario, those two factors get worse, not better – perhaps there’s another oil price shock, or supply chains worsen due to the pandemic or geopolitics. That scenario would leave the Fed with a very difficult decision. If it doesn’t tighten enough, inflation expectations rise, potentially leading to a wage-price spiral. Or the Fed could tighten much more, swiftly pulling the U.S. economy into recession so that the decline in demand offsets the inflationary impact of the factors outside Fed control.
Inflation expectations are key. If they move up in a significant way, Fed officials could feel forced to tighten much more aggressively. And communication is crucial; what the markets expect the Fed to do is an important part of monetary policy.
Q: What is the secular outlook for inflationary pressures in developed economies, and how could climate policy play a role?
A: Among developed markets, the asymmetry of secular risks has shifted toward higher inflation, particularly in the U.K., Europe, and Canada, and somewhat less so in the U.S., which generally imports less inflation. Many government and business leaders are reprioritizing away from efficiency and toward resilience. These decisions to build resilience in national defense, health care, supply chains, and value chains will help mitigate shocks in the future, but they all entail costs that will show up in consumer prices persistently over the longer term.
Add to these the sheer scale of the global transition to net zero carbon emissions, which should offer significant benefits and opportunities in the future, but also entails a range of costs over the secular horizon. Addressing climate change will be critical for a resilient economy and for the resilience of insurers, businesses, communities, and fiscal authorities. Progress on the transition will also likely become a key determinant of economic competitiveness, and from a geopolitical perspective– in China, for example – competitiveness is as much a driver of action as is managing the risks of climate change.
Against this backdrop, individual companies, financial institutions, and governments are increasingly focusing on the net zero transition. The financial sector is essential to the net zero solution, but it cannot address this issue on its own. Government climate policy will be a key determinant of the pace of investment and the scale of price pressures. The more credible and predictable is climate policy, the smoother the economic adjustment will be. Climate policy is becoming a third pillar of macroeconomic policy.
Q: How are major multinational corporations handling the challenges of inflation, geopolitics, and polarization?
A: Most of America’s big companies have expected inflation for some time, and they are facing the challenge with concern but not panic. Labor shortages remain but are beginning to stabilize. Supply chains continue to be a source of stress, exacerbated by lockdowns in China and the war in Ukraine. After the invasion, American and European companies swiftly pulled out of Russia. Most large U.S. corporations, even ones with substantial interests in Russia, showed strong willingness to quickly abandon the Russian market.
However, many of these companies are concerned about what the world’s response to Russia signals for their businesses in China in the coming years. An accelerated decoupling of the U.S. and Chinese economies may be the better-case scenario, with a worse-case scenario of a capital war that could be deeply painful for many major U.S. companies. These risks are prompting many U.S. businesses to invest in more diversified supply chains, building resilience against a more severe decoupling from China. Reshoring may not be realistic in many cases, but nearshoring and friendshoring are prevalent themes.
U.S. businesses are also forced to navigate an increasingly polarized political environment, and this isn’t likely to improve over the secular horizon. Business leaders are addressing many social and political issues because they can’t afford to remain silent, engaging with their employees, investors, customers, and politicians on either side of the aisle. It’s a challenging environment.
For PIMCO’s insights into the longer-term trends shaping the global economy and market environment, please read the latest Secular Outlook, “Reaching for Resilience.” To learn more about PIMCO’s forums and how they inform the firm’s investment process, please watch this behind-the-scenes video.