Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the outlook for the global economy and financial markets. Paul McCulley, managing director and portfolio manager, leads these forums. In the following interview, he discusses PIMCO's cyclical economic outlook for the next six to 12 months.
Q: What are the key points in PIMCO's cyclical outlook?McCulley: Three themes dominated our conversation at this month's Forum.
First, the world economic outlook is fraught with unusually high uncertainty. This reality, in itself, is a headwind to global growth because uncertainty stifles risk appetites. Uncertainty and risk are hallmarks of the New Normal environment, which also has the global economy facing increasing regulation and private sector deleveraging.
Second, we are living in a multi-speed world, with a stark and widening divergence between the outlook for growth in the developed world and developing worlds, thanks to differences in initial conditions, policy flexibility and policy effectiveness. In the developed world, the cyclical outlook has deteriorated in recent months, with growth limping along and hope for escape velocity remaining just that, hope, rather than reality. And the risk remains that the faster-growing developing world may not continue to rebound powerfully enough to resist the drag from the developed world.
Third, "old normal" policy actions aimed at boosting global aggregate demand "“ notably efforts to induce increased public and private leverage "“ will be much less effective in the New Normal. Global policy coordination is weak. Paradoxes of thrift and liquidity traps, in the absence of structural global realignments, will see the tailwinds of leverage give way to headwinds of self-insurance and de-risking. Developed economies must consequently spend an extended period undergoing balance sheet repair. There are no easy answers, only tough political choices and diminished prospects for prosperity in the developed countries.
Q: What's the outlook for the United States? What, if anything, can the U.S. do to trigger a stronger recovery?McCulley: It's a tricky situation. Household sector deleveraging and de-risking remain enduring realities, fueling a paradox of thrift: What is rational for the individual is deleterious to the community of individuals, because one person's spending is another person's income, the fountain from which all savings flow.
The nonfinancial business sector sees little reason to hire or invest due to heightened economic, regulatory and political uncertainty, even though larger businesses have very sturdy balance sheets together with positive cash flow, access to the capital markets and bank credit.
The housing market continues to aggravate the situation; it's bolstered by patchwork loan modification programs of limited effectiveness, but to date there has been no visible political will to pursue more comprehensive reforms.
In concept, fiscal and monetary authorities, acting in concert, could lever up even faster than the private sector is deleveraging "“ yet greater fiscal expansion financed by yet greater money creation. But it's highly uncertain how effective that would be in reviving animal spirits. Such a policy is also hostage to the political reality of the public's increasing distaste for further fiscal largesse. What might "“ stressing the word, might "“ be economically desirable is simply not politically feasible. Indeed, a swing to fiscal drag is already on the cyclical horizon, even if some or all of the Bush era tax cuts are extended.
So the heavy policy lifting probably falls on the monetary authority, and a new round of quantitative easing (call it "QE2") is likely over our cyclical horizon. While QE2 may help incite higher valuations for liquid risk assets, notably stocks, it probably won't do much to help lift illiquid risk asset valuations, notably property, and it is likely to be of limited effectiveness in stimulating aggregate demand, given the reality of liquidity trap pathologies.
Thus, the bottom line for the U.S. is a growth trajectory so slow you'd nearly call it stalled, in the context of a huge output gap, implying further disinflation from an already too-low level for inflation. And the balance of risk is skewed to the downside: The paradox of thrift and a liquidity trap are a noxious cocktail.
Q: What are we likely to see over the cyclical horizon in Europe and the U.K., notably given the continued challenges facing the peripheral countries?McCulley: We think front-loaded fiscal austerity is likely, and the stronger countries are embracing it proactively in hopes of a boost to private sector animal spirits. True, Germany's export machine is powerful, but remember that prior to the financial crisis, Germany and northern Europe were exporting heavily to the peripheral countries.
Expect further disinflation in Europe, keeping the European Central Bank (ECB) on hold. The ECB's hurdle for full-blown quantitative easing remains high, but if the (likely) launch of QE2 in the U.S. were to put downward pressure on the dollar vs. the euro, and if QE2 were to induce meaningful upside to stock prices "“ the ECB's hurdle would probably fall.
In the U.K., fiscal austerity will take hold on a cyclical horizon. Fortunately, U.K. housing prices have held up remarkably well. Unfortunately, headline inflation has also held up well, which may limit, at the margin, the Bank of England's appetite for further QE. That said, if the U.S. launches QE2, the U.K. would likely follow as well.
Q: And Japan?McCulley: Japan remains a paradox within an enigma: It's a very rich country with a shrinking working age population, mired in a deflationary liquidity trap. Japan has limited political willingness to boldly pursue reflationary policies, and they have major doubts as to the effectiveness of such measures, even if tried. The bottom line is that it is difficult to generate growth given Japan's deflationary and demographic realities, particularly in the context of weak and revolving political leadership.
Bright spots include the nation's wealth and its high-valued-added industrial base, which it is wisely using to shake hands with the rest of Asia, notably China. Accordingly, over our cyclical horizon, Japan's authorities are likely to become ever more resistant to further appreciation of the yen.
Q: PIMCO forecasts high growth in emerging markets, especially China, over the cyclical horizon; what are some of the reasons for this sector's continued strength, and what are the main risks it faces?McCulley: The emerging markets are a heterogeneous sector, but taken as a whole, they are blessed with sturdy initial conditions, notably sustainable fiscal positions, increasingly robust institutions and growing middle classes. The sector has many major players in both Latin America and Asia, with China the dominating juggernaut of growth; this benefits the whole sector, especially Asia, which is experiencing an increased volume of intra-regional trade.
Policy efforts to limit overheating and asset price bubbles in China have proven mostly effective, though that is no guarantee of future success. Public investment in infrastructure is key to driving China's growth, but over the longer term, income must be shifted from state-owned enterprises to the household sectors: Wages need to rise more in line with the nation's productivity growth. Social safety nets need to be dramatically enhanced to reduce households' need to self-insure via super-high savings rates. China has both the ability and the will to pursue these developments over the longer term. That said, over the cyclical horizon, China's path is unlikely to sufficiently fill the hole in global aggregate demand.
Unsatisfied with the pace of China's adjustment, the Western world persists in threatening "“ though not yet enacting "“ trade protection. But this is yet another area of unusual uncertainty: The world is no longer in a common foxhole, as was the case after the fall of Lehman Brothers, but in many different foxholes. In other words, the global coordination of one to two years ago, born of mutual fear of total financial meltdown, has broken down. What we have are heterogeneous foxholes with insufficient coordination and weapons with limited effectiveness.
As strong as many of the emerging markets are, they are still tethered to the developed markets by strong global trade linkages. A greater-than-expected fall in developed countries' current account deficits, notably in the U.S., would be a daunting challenge for the emerging market sector.
Q: Could you briefly remark on how the cyclical outlook will inform investment strategy?McCulley: Macroeconomic analysis and forecasts have always been hard-wired into PIMCO's investment philosophy and process, on both secular and cyclical horizons. But, as Bill Gross is fond of saying, we don't invest in GDP futures, but rather in global securities. Thus, our quarterly Cyclical Forums are just the beginning of our strategy formation process, which is an intensive, week-long interactive process between PIMCO's Investment Committee and our world-class specialty desks. Indeed, this quarter, the process stretched two weeks, reflecting the reality that we are indeed living in a world of a flatter distribution of possible outcomes, with fatter tails. Unusual uncertainty demands more, not less, intensity of thought and dialogue, as strategies must be stress-tested over a broader range of possible outcomes.
Our key cyclical conclusion mirrors our secular conclusion: We are living in a world transforming to greater influence from the emerging countries, with retrenchment in the developed countries. If there is one thing that we are most confident about, it is that monetary policy in the developed countries will remain extraordinarily accommodative for a very extended period, with policy rates pinned close to zero and quantitative easing either in motion or at the ready to be in motion. We will position our duration and curve strategies accordingly: overweights in the developed world, concentrated in the "belly" of yield curves. In contrast, an increasing share of our positioning in the "spread sectors" will be allocated to the emerging markets, including their currencies.
Ironically, in our base case, volatility is likely to be suppressed, notwithstanding unusually high uncertainty, because central bank policies in the developed world will be predictably accommodative, with the aim of nurturing increased investor risk appetite. Accordingly, during our strategy sessions, we focused intensely on identifying avenues for maintaining "safe" "carry" in our clients' portfolios. And we define "safe" as sectors that are likely to withstand the vicissitudes of the whole range of possible economic scenarios. In the New Normal, prudent investing is all about recognizing that the patterns and relationships of the "old normal" will give way to new patterns and relationships. Mean reversion is still a valid investing concept, but until the New Normal new means reveal themselves, portfolios must be structured with acute recognition that there are many known unknowns and, yes, unknown unknowns.
Thank you, Paul.
All investments contain risk and may lose value. 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.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material 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 material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
Related Insights Investing in the New Normal 2010 A selection of articles that discuss the origin, causes and trajectory of the New Normal as well as the implications for investors.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
Read Full Article »