Pimco investment committee member talks markets, positioning, and the eurozone ‘endgame
As Pimco investment professionals gather in the US to discuss the outlook for the global economy and financial markets, managing director, generalist portfolio manager and member of Pimco’s investment committee Saumil Parikh discusses the firm’s cyclical economic outlook for the next six to 12 months.
Q: Before discussing near-term factors, could you provide an overview of Pimco’s secular (long-term) outlook?
Parikh: We have been investing under a hypothesis we designated the New Normal, a worldview of the next three to five years, in which we see global aggregate demand continually falling short of global aggregate supply. We see the world’s ability to consume goods and services at today’s prices below the world’s ability to produce them, in large part because of the rapid speed of globalization.
Also, we see developed economies and emerging economies facing very different economic destinies over the secular horizon. The developed world continues to grapple with large debt overhangs, required deleveraging in the private sector and now in the public sector, and the reversal of financial deregulation in the aftermath of the financial crisis of 2008. We believe emerging economies, while not immune to the developed world’s problems, should be better positioned for secular growth, with their healthier balance sheets and potential for greater domestic consumption.
Q: How do these long-term factors apply to what may happen over the next 12 months?
Parikh: Our near-term outlook incorporates the acceleration of certain New Normal factors: Europe’s debt deleveraging, the U.S. debt ceiling debate and ratings downgrade, and stubborn cyclical inflation in Asia and Latin America. Over the next 12 to 18 months, we expect the global economy to expand at a very modest real rate (the rate after inflation) of 1% to 1.5%. That compares with our estimations of 2.7% to 3% in 2011 and 4.1% in 2010. We are more bearish than the consensus outlook of 3% to 4% growth for 2012.
Essentially, we see three things draining the global economy. First, global imbalances are rising and have continued to rise in the post financial crisis environment. Consumer economies driving global aggregate demand are displaying sluggish income growth and also struggling with high debt stocks, private or public or both. So the countries that the global supply chain depends on as consumers of last resort are showing signs of rapid cyclical slowdowns.
Second, global policymakers continue to fail in their coordination efforts on fiscal, monetary and trade policy. The G-20, which is responsible for policy coordination across the 20 largest economies in the world, has not achieved a favorable coordinated policy since the first quarter of 2009.
Third, deleveraging and reregulation continue to be predominant macroeconomic forces within our cyclical horizon.
Q: How are these dynamics playing out in the US?
Parikh: In the US, imbalances remain high. The US economy together with European economies ex-Germany account for about 40% of global income and slightly more than 50% of global consumption. Consider the US as the consumer of last resort in the global economy. We forecast the US economy will produce no real growth in 2012, literally a rate of 0% real growth, while consensus expectation is 1.5% to 2%.
The debt ceiling debate and secular issues in the US have brought forward in time a lot of the deleveraging that we had expected to occur over a longer secular horizon. The very public and polarizing deficit debate has arguably resulted in a loss of consumer confidence and we believe is likely to cause a rise in precautionary private savings. Any acceleration in savings produces a loss of aggregate demand and, therefore, of economic momentum.
So while the US economy is not suffering from some of the acute sovereign and financial sector issues plaguing Europe, private deleveraging continues and now fiscal policy is moving from an expansionary phase to a contractionary one. The transition from macroeconomic balance (expansionary fiscal policy compensating somewhat for private contraction) to a contractionary scenario is the predominant driver of our 0% to 0.5% U.S. growth projection for 2012.
Q: What do you think this environment means for US policymakers?
Parikh: It is quite apparent to us that polarization in Washington is nearing a post-WWII high, including the divide in ideologies and in economic vision for the role of fiscal policy. Because of these differences, we believe fiscal policy is not going to be very stimulative at all. In fact, if no new policies get enacted in the next two to three months, then fiscal policy will probably be a drag on the US economy to the tune of 1.5 to 2 percentage points of GDP.
We also continue to believe that monetary policy is losing effectiveness. Financial conditions as best we can judge them are quite good for large corporations and healthy household balance sheets. However, the transmission mechanism from financial markets and from healthy balance sheets to small businesses and younger or indebted households remains broken. Only deleveraging can take care of this over time – it is really a secular healing process, not something that monetary policy can address over a cyclical horizon.
In any case, monetary policy directed at interest rates is on hold for an extended period. In our view, it is quite conceivable that the Fed will keep short-term interest rates near 0% for well beyond its commitment to two years, perhaps even as long as five years from today, depending on what happens in Europe and in the emerging markets with respect to global imbalances.
Q: Investors are clearly focused on what happens in Europe. What is Pimco’s outlook for the region?
Parikh: From a cyclical perspective, Europe is clearly the most important economy to focus on. Unfortunately, our base case outlook for Europe in 2012 is an economic recession: We think the European economy will contract 1.0% to 0.5% in real terms, with significant downside risk that has negative implications for the global economy.
What is occurring in Europe is a classic feedback loop. A large part of the European economy is suffering from a significant loss of competitiveness, high debt loads and negative demographics. Aggregate supply in the eurozone is much greater than aggregate demand at current prices. To address this large output gap, both fiscal and monetary policies ought to be expansionary, but both have actually been contractionary. With external demand weakening, and domestic demand contracting, fiscal austerity measures will cause European aggregate demand to contract even further over the next 12 months or so. And because so many countries are enacting contractionary fiscal policies at the same time, we expect deficit targets to be missed, credit rating downgrades for systemically important banks and sovereigns to continue, which in turn will force another round of deleveraging and austerity.
To break this feedback loop, Europe is desperately in need of an external balance sheet and an external source of demand. We think there are really only two options. We believe the European Central Bank has the ability to act as a lender of last resort; however, its willingness is questionable, mainly because of philosophical differences between member countries on the role of the central bank.
Instead, we think the International Monetary Fund, which has almost $1 trillion in lendable resources, will likely play a very important role in stabilizing the feedback loop in Europe over the next 12 to 18 months. However, we believe it will play a critical role not in the pre-emptive phase of the crisis but in the stabilization phase, when certain systemically important balance sheets of sovereigns and banks within Europe need to be recapitalized. Unfortunately, that means we argue things will get worse before they get better.
Q: What is Pimco’s view on what will happen to the eurozone – the endgame?
Parikh: We cannot help but think that the eurozone economies have invested too much at this point to go back. Ultimately, in our view, the eurozone will become a stronger, though possibly smaller, union, involving not just currency and monetary policy union but also true fiscal union. The journey to that endgame is fraught with danger, and how the euro area engages with the rest of the world on a policy basis will determine whether the transition is orderly or disorderly. Unfortunately, right now, the lack of policy coordination suggests a disorderly path. However, this could change easily, depending on a few policymakers’ decisions.
Q: What are our expectations for the UK?
Parikh: In our view, the UK economy will fare somewhere between the US and Europe. In many regards, the UK benefits from being a more open economy than either the US or Europe. From a policy perspective, the UK and US are fellow travelers. UK monetary policy, one could argue, is even more independent than it is in the US, and fiscal policy is on a path that the US is now moving toward: one of measured policy actions with an eye toward a secular balance in terms of structural deficits. So the UK is a much more flexible economy but has some of the same deleveraging pressures as the US.
Q: Shifting the geographic focus, what are Pimco’s expectations for emerging markets?
Parikh: We expect that emerging economies (including China, India, Brazil and Mexico) will grow at a 4.5% to 5% real GDP rate over the next 12 months. While this sounds quite high relative to our expected 0% to 0.5% growth in the US, it would represent the slowest growth rate for emerging markets in a decade, with the exception of 2009.
Emerging economies are in a very different cyclical position relative to developed economies. In our view, they will play two important roles going forward. First, we expect emerging economies will continue to be the source of savings for developed markets. When it comes to potential contagion in and from Europe and deleveraging in the developed world, we believe emerging economies will determine what parts of the capital structure receive incremental investments.
Second, we expect emerging economies to transition from being producers and investors of last resort to being consumers of first resort over the secular horizon. As emerging economies struggle with asset and commodity inflation and attempt to transition to a more balanced split between investment and consumption, the EM growth rate will likely slow to somewhere around 5% from our estimate of a midpoint of 7%. The aggressiveness with which they transition their economies will have important ramifications for the health of the global economy as a whole.
Q: What is Pimco’s current thinking on China’s role?
Parikh: China’s role in the global economy is rising very rapidly; it has almost $3.2 trillion in foreign reserves that it can deploy as it wishes in global markets (as of June 30, 2011). The big question for us over the next 12 to 18 months, as with other key emerging economies, is whether China moves its economy from being investment-focused to being consumer-focused and over what time frame.
We believe Chinese policymakers recognize the importance of this shift for both internal and external reasons. We view income inequality becoming a rising issue in China with an increasing desire at the household sector level to share in the wealth of the nation. We argue this will cause Chinese policymakers to expedite the transfer of wealth via more rapid privatization, more rapid wage gains in real terms and more broadly sharing the fruits of labor’s productivity.
If the process is accelerated, it would also benefit the European and US economies significantly because demand for global goods and services would rise rapidly over the cyclical horizon. The G20 could help convince China to play a greater role as a consumer, given that the consumers of last resort have large debt stocks and will likely not be able to grow their rate of consumption.
Q: Amid these global growth dynamics, what should we expect with regard to inflation?
Parikh: Given our growth outlook for the next 12 months, we believe global inflation will certainly moderate and perhaps even turn toward disinflation in the latter half of our cyclical horizon. We forecast world inflation, which is currently running at about 3% to 3.5% on a headline basis, should slow to 2% to 2.5% a year from now. But we also think inflation will go up before it goes down. So we have likely not seen the peak in global inflation yet, but when we speak a year from now, we expect global inflation will be on a downward trajectory.
Q: Finally, how does Pimco’s cyclical outlook translate into investment strategy?
Parikh: We are transitioning into a world where we believe the incentives of policymakers and the divisiveness of politics will become the predominant drivers of investment returns and economics. This is a time when old frameworks and classical economics have to be reconsidered.
What we have to try to determine not only over the next 12 months but also over the next three to five, or perhaps even 10, years is: What are the incentives of policymakers in different countries? How are those incentives likely to change? And what policy actions are likely to dominate the investment outlook? PIMCO has never been more focused on policies and on trying to determine social incentives in the major economies of the world.
Further, given our outlook for slow growth globally and recession in Europe, we are focusing on protecting portfolios against downside risk. We are particularly concerned about the lack of leadership and coordination in Europe and the risk of a disorderly deleveraging process. In terms of credit, we have been focused on minimizing our exposure to weaker credits and financial institutions in Europe, although we anticipate remaining positive on the financial sector as a whole. We favor strong emerging market credits, both corporates and sovereigns, as well as US municipals and US agency and non-agency mortgages.
And because the global yield curve up to about seven years has flattened and yields are about as low as they can go, we are focusing further out on the curve, between about seven and 15 years, where we see the potential for price appreciation through falling yields. We are very selective about the countries in which we are currently extending duration, choosing those with independent monetary policy and low credit or inflation risk.
We continue to like Canada, Australia, Brazil and Mexico and find opportunities to add duration in the US, Germany, France, the UK and Japan attractive. We also prefer global inflation-protected securities with maturities of 10 years or more.
In terms of equities, we find valuations attractive in the emerging markets but plan to remain underweight in the developed markets. Finally, given the volatility in currencies, we look to reduce currency exposure in general. Still, we see attractive opportunities in the currencies of China and other emerging Asian countries.