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Click here for Mike Amey's biography. In May PIMCO held its annual Secular Economic Forum, where the firm assesses the three-to-five year outlook for the global economy and markets. In this interview, Mike Amey highlights the conclusions from the Forum and specifically discusses the outlook for the U.K. Q: What do the key conclusions from the Secular Forum suggest for PIMCO's outlook for U.K. growth over the next three to five years? Amey: The conclusions from the secular forum point to the New Normal, where global growth will be constrained, growth in the industrialized countries will continue to trail its pre-Lehman levels and emerging markets will account for an increasingly large slice of global growth. The secular themes of de-leveraging, higher regulation and looser levels of globalization will be particularly pertinent to much of the industrialized world. Whereas the significantly better initial conditions of many emerging markets will help insulate the emerging world. As we move forward, we think we will go through bouts of volatility, particularly in the industrialized world where a lot of balance sheet flexibility has already been sacrificed. This outlook is particularly applicable to the U.K., which will be weighed down by the combined balance sheet stress across the personal, banking and public sectors. We expect U.K. growth to be positive but constrained over the next three-to-five years. Real economic growth rates are likely to come in consistently below the 2.5% to 3% levels we saw for the decade running into 2008. Q: PIMCO expects inflation to accelerate at different speeds in different parts of the world. What is your outlook for inflation in the U.K. over the secular horizon? Amey: U.K. inflation starts from a higher level when compared with many other parts of the industrialized world. This is owing to the effects of the pound's previous weakness and the rise in value added tax (VAT), which reverted to 17.5% at the beginning of the year. As these effects pass through to the consumer price index, inflation should come back down below the 2% government target over the course of 2011. When we look out past the 12-to-18 month period we see further upward risks to inflation. In particular, the consistent overshooting of the 2% target, risks inflation expectations becoming unhinged at some point. Meanwhile, the Bank of England (BoE) will face a significant challenge in judging when to withdraw the current monetary stimulus. Given that the cost of withdrawing the stimulus too early greatly outweighs the cost of withdrawing it too late, we think the medium-term risks to inflation are on the upside.
Q: How do you expect interest rates to move given this inflation outlook? Amey: We expect the Monetary Policy Committee (MPC) and the BoE to act cautiously when raising rates. The economy is still highly leveraged and the Bank will want to see the recovery firmly entrenched before hiking rates. This is all the more likely as we expect the government to embark on a multi-year programme of fiscal austerity. As such, we expect tight fiscal and loose monetary policy over the secular horizon. Q: When and how should investors adjust their inflation hedging strategies? Amey: The dominant risk for the short term remains lower inflation due to the technical factors mentioned before. For the longer term, the problem with hedging against inflation in the U.K. is that real yields in the U.K. index-linked market are very low, and therefore not necessarily the best way to hedge against longer-term inflation risks. Instead, for U.K. investors looking for an effective inflation hedge, we think, we think international index-linked markets with similar longer-term inflation profiles and higher real yields are more attractive.
Q: Do you expect the Bank of England to extend its quantitative easing further? What effect have these programs had on its independence? Amey: We don't expect the BoE to extend its quantitative easing (QE) program as it has largely achieved what it set out to do. It was successful in stabilizing the economy after Lehman's collapse by stemming asset price volatility and providing a bridge during a period of extreme market pressure. Given that the U.K. economy has stabilized, the threshold to trigger more QE would be quite high in our opinion. The BoE will be reluctant to significantly increase the size of its balance sheet any further; it has already expanded by a factor of 2.5 times and it already owns over 25% of the nominal gilt market. The larger the BoE's balance sheet becomes, the greater its reliance on the Treasury, which in turn calls into question the degree of independence with which the Bank can conduct monetary policy. This has implications for bond investors, if inflation is likely to be tolerated at a higher level than would otherwise be the case. Fiscal authorities typically have multiple mandates, one of which is to stabilize inflation but others may include the social requirements of low unemployment and stable growth. Therefore, the inflation targeting focus of the central bank becomes impaired in a world where the central bank grows increasingly reliant on the Treasury. Q: PIMCO has identified sovereign risk as a key theme for 2010. How significant is this risk for the U.K. relative to the eurozone? Amey: Sovereign risk is a key risk for the U.K. but in a slightly different way to the economies of continental Europe. The U.K. government deficit, which is currently running at around 11% of GDP, is one of the highest both on record and within the developed world. That creates a potential risk as regards to the ability of the government to finance its debt. However, unlike countries within the eurozone, the U.K. has the advantage of an independent floating currency, making it highly unlikely it will suffer the problems currently besetting parts of the eurozone. With its own currency, the U.K. will always have the ability to repay its debts, but it may devalue the debt in real terms when viewed in non- GBP terms. Therefore, U.K. sovereign debt risk will continue to be an issue as long as U.K. debt levels remain high, which in turn will put pressure on the currency and the inflation rate, and potentially erode the longer-term value of government debt. Separately, the eurozone accounts for just over 60% of U.K. trade. If the eurozone's debt problems result in a protracted period of economic weakness, it will be harder to sustain positive U.K. growth. That is one of the reasons why we expect U.K. growth to remain materially weaker than it has been over the last decade. Q: PIMCO has begun to talk about "state capitalism" "“ what is in store for the U.K. financial markets under a coalition government? Amey: The new coalition government is keen to focus on the role of the banking system within the broader economy. This is likely to lead to greater regulation of the financial sector, especially the banks. As long as the government maintains a large stake in the U.K. banks, there is the risk of state-directed lending. However, we believe the government's primary focus will be aimed at addressing the level of leverage in the banking industry. As a result, we think banks will be forced to run lower levels of leverage and operate safer business models to prevent a repeat of the last few years. This trend towards greater regulation and government intervention is what we at PIMCO refer to as "state capitalism". This government intervention will be designed to lower the risk of another severe banking crisis, and if the price paid is lower growth, then so be it. From a bond investor's perspective this is likely to result in lower growth rates going forward and potentially higher inflation as productivity in parts of the economy is reduced. Q: Has the risk of a double-dip recession in the U.K. increased or decreased under a Conservative- Liberal Democrat coalition? Amey: At the margin, the risk of a double-dip recession has decreased. While we have yet to see the full scope of the new government's deficit reduction plan, early signs seem to indicate it has been well received by the BoE. This might suggest that short-term interest rates in the U.K. will remain low for a number of years, which will support the private sector as it de-leverages. In our opinion, the coalition government has demonstrated their intent to tackle the deficit immediately and we think that is generally good news. Q: What is your outlook for the pound? Amey: We think the British pound remains vulnerable, not least because it is the primary mechanism used to reflect U.K. sovereign risk. While we are pleased to see the deficit reduction plans being enacted, there remains execution risk. The U.K. is still vulnerable to the de-leveraging in the banking system and the consumer balance sheet. As long as that persists, the pound is likely to be susceptible to further bouts of weakness, primarily against currencies of emerging markets that are in better economic health and where we expect stronger growth.
Q: How does PIMCO's U.K. secular outlook translate into investment strategy? Amey: The current outlook for the U.K. is one of low short-term interest rates for a multi-year period with some longer-term inflation risks. The economy will remain weighed down by the extended process of de-leveraging and the primary focus will be on maintaining economic growth. This speaks to a world in which the U.K. yield curve stays steep and low short-term interest rates support front-end valuations. In such a world, we believe short maturity bonds will likely be the best place to invest on a total return basis. Given the risk to the pound and the medium-term upside risk to inflation, we think there is relatively less value in longer-term U.K. bonds. Furthermore, the pound is likely to remain under pressure relative to emerging market currencies, which is why we prefer to overweight currencies of high quality emerging markets. However, we do not expect the U.K. to fail in meeting its commitments. The bulk of the U.K. liabilities are in GBP and the U.K. maintains a fully floating exchange rate. As such, we believe exposure to the U.K. in the credit default swap market offers a valuable opportunity for sophisticated investors. Finally, we would favor inflation hedging in the inflation-linked markets of other industrialized countries rather than the U.K., where real yields are relatively lower. Thank you, Mike.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government; obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
This article contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2010, PIMCO.
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