We have moved beyond the world once characterised as the new normal

The war in Ukraine and the responses to it are widening these geopolitical fractures and could accelerate the move from a unipolar world to a bipolar or multipolar world.

In the medium term we see an elevated risk of recession over the next two years, reflecting greater potential for geopolitical tumult, stubbornly high inflation that reduces households’ real disposable income, and central banks’ intense focus on fighting inflation first, which raises the risk of financial accidents on top of the sharp tightening of financial conditions already seen.

Moreover, if and when the next recession arrives, we expect the monetary and fiscal responses to be more reserved and arrive later than in the last several recessions when inflation was not a concern and when government debt levels and central bank balance sheets were less bloated.

We think forward markets either price in or are close to pricing in what is likely to be the secular high for policy rates across different countries.

While for many reasons our view is that the next recession is unlikely to be as deep as the great recession of 2008 or the Covid sudden stop of 2020, it may well be more prolonged and recovery may well be more sluggish due to a less vigorous response by central banks and governments.

Reaching for resilience

In a more fractured world, we believe governments and corporate decision-makers will increasingly focus on searching for safety and building resilience.

With the risk of military conflict more real following Russian aggression toward Ukraine, many governments – especially in Europe but also elsewhere – have announced plans to increase defence spending and invest in both energy and food security.

Many corporate decision-makers are focused on building more resilient supply chains through global diversification, near-shoring, and friend-shoring.

These efforts were already underway in response to US/China trade tensions and because the Covid pandemic demonstrated the fragility of elaborate value chains, and are likely to be intensified given the more insecure geopolitical environment.

Looking forward, rather than reaching for yield, we believe that investors will be reaching for resilience in their portfolio construction.

Moreover, in response to climate-related risks and the Covid crisis, most governments and many companies have already increased efforts to mitigate and adapt to global warming and to improve health security for their citizens and employees.

We believe that we have firmly moved beyond the world that we once characterised as the new normal of subpar but stable growth and inflation stubbornly below central banks’ targets.

During that period, many investors were rewarded for reaching for yield and for buying the dip, anticipating central bank action and – during the Covid pandemic – fiscal policy support for risk assets.

However, over the secular horizon we believe that central banks may be less able to suppress market volatility and to support financial asset market returns.

Looking forward, rather than reaching for yield, we believe that investors will be reaching for resilience in their portfolio construction, looking to build more robust asset allocation in the face of a more uncertain environment for macro volatility, market volatility, and central bank support.

For our part, we will look to build resilience into the portfolios we manage on behalf of clients and seek to benefit during periods of market volatility.

Starting valuations – even following the weakness we have seen in asset markets in recent months – and our expectations for a more volatile macroeconomic and market environment call for low and realistic expectations for asset market returns over the secular horizon.

That said, the yield on core bond benchmarks has recovered from Covid-era lows, and in our baseline outlook we think that forward markets either price in or are close to pricing in what is likely to be the secular high for policy rates across different countries.

We anticipate positive returns on most bond benchmarks over the secular horizon, and fixed income investments, at higher yield levels, should play an important role in building resilience into diversified portfolios.

We believe equity markets are likely to deliver lower prospective returns than investors have experienced since the global financial crisis.

Private credit strategies can be an attractive complement to public credit allocations, though we are seeing excesses in some parts of these markets.

We expect to favour higher-quality corporate credit, and will seek to provide liquidity, not to demand liquidity, during periods of credit market stress.

Amid higher inflationary pressures, we see US Treasury inflation-protected securities, commodities, and select global inflation-linked investments as providing a reasonably priced hedge.

Real estate can also serve as an inflation hedge, particularly in sectors such as multi-family and self-storage, where leases are generally shorter than one year.

We believe equity markets are likely to deliver lower prospective returns than investors have experienced since the global financial crisis, reinforcing our focus on quality and the importance of careful selection.

We also expect emerging markets to offer good opportunities, while we stress the importance of active investment to sort between the likely winners and losers in a difficult investment environment.

Daniel Ivascyn is group chief investment officer; Joachim Fels, global economic adviser; and Andrew Balls, chief investment officer of global fixed income at Pimco