The global economy is likely to make good progress along the path to recovery over the cyclical horizon, especially in the second half of 2021. However, much of this growth is already priced in to markets. Investors should also beware of several macro risks that command careful portfolio construction to weather renewed bouts of volatility in financial markets.

In our January 2021 Cyclical Outlook we discuss the outlook for global growth, policy, and inflation in 2021, together with the implications for markets and investors. This blog post is a distillation of our views.

Baseline outlook: growth rebound, elusive inflation

Following an outsized contraction of economic activity in 2020, global output and demand are likely to rebound strongly this year. We expect the current renewed weakness due to lockdowns in major economies to give way to accelerating gross domestic product (GDP) growth from around the second quarter, driven by the broadening rollout of vaccines and continued fiscal and monetary policy support. Coming off a low base, world GDP growth in 2021 is expected to be the highest in more than a decade.

Consumer price inflation is likely to creep up only moderately during this year and generally remain below central banks’ targets in all major economies.

Monetary and fiscal policy support growth

Central banks will likely keep borrowing costs low in order to enable ongoing fiscal support for years to come. Policy rates are likely to remain at present levels in the foreseeable future or could even be reduced further in some countries. Asset purchases are likely to continue throughout, and likely well beyond, 2021.

Fiscal policy remains a key swing factor in our cyclical outlook. Most governments are likely to keep propping up household incomes via transfers and supporting companies via loan guarantees, subsidies, and tax breaks.

Three key risks to the baseline outlook

An onset of fiscal fatigue (in which governments return to a more cautious stance) would be a significant risk to the expected economic recovery, particularly in the second half of this year and more so in 2022.

Also, with China exhibiting strong growth momentum coming into 2021, we expect policymakers to refocus on deleveraging in the course of this year. We see a risk of overtightening, which could cause a sharper-than-expected growth slowdown.

The greatest uncertainty in the economic outlook stems from potential scarring effects that could inhibit or even prevent a swift return to pre-pandemic levels of consumer spending as well as corporate investment and hiring decisions.

Investment implications

We see both upside and downside risks to government bond yields in the near term, reflecting the push and pull between lockdowns and reduced activity and vaccine rollout. In most of our portfolios, we anticipate being fairly neutral on overall duration. We may employ curve-steepening positions in our core bond portfolios, given our view that while central banks will anchor front ends, over time markets will likely price greater reflation into the longer ends of curves.

Though we see little inflation upside risk over the cyclical horizon, we continue to see U.S. Treasury Inflation-Protected Securities (TIPS) offering a reasonably priced hedge against higher inflation in the U.S. over the longer term.

We expect to favor agency and non-agency mortgages and other structured product positions, carefully selected corporate credit overweights, and hard-currency-denominated emerging market sovereign credit exposures. We will be careful to avoid generic tight corporate credit positions, preferring to rely on the active picks of our credit teams. On currencies, we expect to maintain a modest U.S. dollar underweight.

While risk markets can continue to perform well over the coming months in response to broadening vaccine rollout and policy stimulus, investors may have become too complacent in light of the risks. We see this as a time for careful portfolio positioning and not for excessive optimism or risk-taking. Given the overall low level of yields, tight spreads, and low volatility, we plan to place significant emphasis on capital preservation and careful liquidity management.

Once the easy pandemic recovery trades have played themselves out, we expect a difficult market environment. As active managers, we will look to add value with security selection across credit sectors, with a focus on high quality sources of income, and seek to find the best global opportunities.

For more details on our outlook for the global economy in 2021 and the investment implications, please read the full Cyclical Outlook, “Bounded Optimism on the Global Economy.”

Joachim Fels is PIMCO’s Global Economic Advisor and Andrew Balls is CIO Global Fixed Income.