The global investment landscape is set to be transformed in the months ahead as the trajectories of major economies diverge more noticeably. Central banks, which tightened policy in unison to curb the pandemic inflationary spike, will likely follow varied paths when cutting interest rates. While many large, developed market (DM) economies are slowing, the U.S. has maintained its surprisingly strong momentum, with several supportive factors poised to persist.

Larger pandemic-related fiscal stimulus and still-elevated federal deficits have bolstered U.S. demand relative to other regions, while other economies are proving more sensitive than the U.S. to higher interest rates. Moreover, Europe and Southeast Asia appear less insulated than the U.S. from Chinese import competition, though U.S. companies are at the forefront of AI technologies, creating significant wealth effects even before productivity gains are realized. It is also worth considering that the balance of risks for the outcome of the U.S. presidential election leans toward policies that would be marginally supportive of U.S. growth and potentially detrimental elsewhere.

These growth drivers could keep U.S. inflation lingering above the Federal Reserve’s 2% target over our six- to 12-month cyclical horizon. We still expect the Fed to start normalizing policy at midyear, similar to other DM central banks. However, the Fed’s subsequent rate-cutting path could be more gradual.

Although a soft landing that avoids recession appears within reach across regions, significant uncertainties remain. A positive shift in economic supply, decelerating inflation, and falling rates have been key characteristics of past soft landings, according to our analysis of central bank rate-hiking cycles from the 1960s to today. All of these elements gained traction in 2023. Indeed, market pricing for both equities and the Fed’s terminal policy rate appears to largely rule out the possibility of a recession. Yet we believe risks in both directions – from recession to rekindled inflation – remain magnified in the aftermath of unprecedented global shocks to supply and demand.

Investment implications

Amid this uncertainty, bonds offer attractive nominal and inflation-adjusted yields, plus the potential to weather a variety of economic conditions. We expect a more normal pattern of negative correlation between bonds and equities to reassert itself, with the potential for fixed income to outperform in the event that the pricing of recession risk rises again.

Intermediate maturities offer attractive yields along with potential price appreciation if bonds rally. They also appear compelling at a time when cash yields are poised to fall if central banks cut rates from current elevated levels. We maintain a slight duration underweight in U.S and global core bond portfolios, reflecting a recent market rally, but our focus remains on strategies related to global relative value and yield curve positioning. We have an underweight view toward the long end of the U.S. curve due to concerns about fiscal policy and Treasury supply.

Regional diversification

We see bond markets outside the U.S. as particularly attractive, based on our view that inflation risks are less pronounced in the rest of DM while recession risks loom larger. In Australia, the central bank has removed its policy-tightening bias. Yet the path of rate cuts priced into the forward curve looks relatively shallow versus other markets, especially given Australia’s elevated household leverage and floating mortgage rates that foster more direct transmission of monetary policy changes into the economy.

We see U.K. duration as attractive given current valuation, an improving inflation picture, and the potential for the Bank of England to deliver more cuts than are currently priced into markets. Similarly, in Canada, we see the balance of risks skewed toward greater central bank easing compared with current market pricing given an improved inflation outlook.

European markets look somewhat less attractive but offer important benefits such as liquidity (market depth and the ease of buying and selling assets) and diversification. They could also perform well if upside U.S. economic risks or downside European risks are realized.

In the eurozone, we see expectations for the European Central Bank (ECB) and the level of 10-year yields as broadly fair versus the U.S. in our baseline economic scenario. Yet we see the balance of risks as leaning toward weaker economic performance and more easing from the ECB. We also prefer the U.S. dollar over the euro and other European currencies such as the Swiss franc and the Swedish krona, anticipating further U.S. economic exceptionalism.

We continue to favor U.S. agency mortgage-backed securities and other high quality assets for their attractive yield and return potential. With interest rates elevated, we see greater pressure on both corporate borrowers and traditional lenders such as banks. Within private markets, we see increasing opportunities in asset-based and specialty finance.

Today’s environment underscores the importance of global diversification, prudent risk mitigation, and constructing resilient portfolios through active management. We expect the traditional inverse correlation between stocks and bonds to resume, with the potential for fixed income investments to appreciate if the pricing of recession risk rises again.

Read the full outlook here

For Professional Investors Only. PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. PIMCO Europe Ltd services are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. ©2024, PIMCO Past performance is not a guarantee or a reliable indicator of future results.