I have many fond memories from 25 years ago of St. Joseph High School's track and field team, particularly of our away spring track meets throughout southwestern Michigan. During most of our weekly events, my coach counted on my participation in six events: 100-yard dash, 200-yard dash, 4x100-yard relay, 4x200-yard relay, the shot put and the discus. This busy schedule turned out to be nearly logistically impossible in our away track meets because our coach had less control of the scheduling of each event and organizers almost always scheduled the start of the 100-yard dash and shot put as well as the start of the 200-yard dash and discus at roughly the same time. The away track meet schedules were made up on the basis that most shot putters and disc throwers aren't known for their speed and most sprinters aren't known for their upper-body strength. While logical, this schedule didn't work for our team and as a result every week our coach would have to bargain with event organizers and attempt to modify the timing of when each of our various track events started.
My teammates and friends who participated in the shot put and discus were different from my teammates and friends who ran sprints; however, both groups shared one joy: the thrill of watching our coach turn into a logistics manager each week combined with the rush of seeing if I would make it from one event to the next. "Hurry up!" "Get over here!" "You're up next!" "Where is Mark?" I heard these words every week each spring. My teammates had numerous laughs as my coach and I became the source of many jokes and pranks. Running fast was something I had to do "“ both in the actual events and between them.
Despite everyone's good-natured fun and effort to turn our weekly logistical issues into a source of entertainment, we managed to pull off all the events back-to-back-to-back-to-back-to-back-to-back. This left me exhausted and my coach needing a beer. My teammates got great pleasure on our bus rides back home from the away track meets coming up with a new joke each week to describe the team's predicament and most recent experience. One of the best ones came from one of my 4x100 and 4x200 relay buddies, who said, "If you ran as fast in our relay as you did between events, we would have won the race." Unfortunately, he was right. I wasn't known for my endurance and the additional running from one event to the next probably tired me out as my desire to run fast in all the events proved to be unsustainable.
The sustainability, speed and health of the global economy are of great interest these days to both policymakers and investors. As it turns out, several regions and countries around the globe from a cyclical perspective are set to "run fast" next year, while others "run slow." Globally, economic growth and inflation is set to experience significant differentiation next year, with strong growth and rising inflationary pressures in developing countries offset by relatively weak growth in most developed economies, particularly in peripheral Europe. This cyclical divergence in growth and inflation has significant implications for global investors, particularly in the credit markets.
Economic Outlook Favors Emerging Markets and the U.S.Economic growth in the emerging markets will likely continue to run fast due to rising consumer wealth, negative real interest rates and extremely accommodative monetary policy, strong capital inflows and rising wages and asset prices. In addition to a positive near-term cyclical outlook, there are additional longer-term structural factors in the developing world that remain constructive for economic growth in the region and should allow these countries to continue to run fast both near-term and over a longer-term secular period. The emerging markets' secular advantages in most of these countries include the ability to sustain high economic growth rates due to favorable demographics, competitive cost structures, productivity catch-ups, solid fiscal positions (Chart 1), healthy current account balances, rising reserves, growing pent-up consumer demand and low relative aggregate debt levels. As an example, aggregate debt levels of government, household, non-financial and financial debt are significantly lower in emerging market countries relative to developed economies (Chart 2). This is one of many structural advantages that should support the emerging markets and allow them to run fast relative to most developed countries.
While one would not characterize the recent performance of the U.S. economy as that of a sustainably fast runner, the experience of running fast, or at least running faster, is something the U.S. economy is finally set to do from a near-term cyclical perspective after a few years in hibernation. U.S. real GDP should pick up toward 3%"“3.5% in 2011 due to the support of healthy corporate profits; rising stocks, wealth and animal spirits; improving labor market conditions; consumer confidence and income; a banking sector set to gradually extend more credit and the Fed's commitment to reflate through quantitative easing (QE2). The extension of the Bush tax cuts as well as additional fiscal stimulus measures (payroll tax cut, jobless benefits and business tax credit for capital spending) are likely to add roughly 1% to growth next year.
While not in a sprint, the U.S. economy has turned the corner from a cyclical perspective due to the combination of accommodative monetary policy and increased near-term fiscal stimulus along with gradually improving trends in underlying economic fundamentals. Corporate profits, typically a good leading indicator of employment growth, remain strong (Chart 3). While most business executives remain cautious on hiring, we should see a gradual improvement in the labor market given healthy corporate profit and cash flow trends (Chart 4), which should support capital spending and the U.S. economy.
In contrast to the emerging markets and the U.S., Europe appears sick and is set to "run slow" on a relative basis, with subpar economic growth due to headwinds from fiscal tightening in the U.K. and Europe as well as significant uncertainty surrounding the sovereign debt crisis and the health of European banks. So far, policymakers in Europe have not been able to come up with a credible and forceful plan to backstop the borrowing needs of a growing list of peripheral sovereigns. While the European Central Bank (ECB) has recently stepped up its bond purchases of peripheral countries' debt, a longer-term fiscal solution in Europe is needed but yet remains uncertain given the lack of policy coordination and a growing distaste for bailouts, particularly among German citizens. This backdrop has caused sovereign credit spreads to remain under pressure, particularly in the peripheral regions (Chart 5). Should restructuring of sovereign debt eventually occur in these weaker countries, European banks may need to raise more capital, as many banks have significant ownership of cross-border sovereign credit on their balance sheets. This development would add to what is already a tight credit environment throughout Europe, given the region's high debt levels and integrated banking sector. While EU banking sector stress tests this past summer suggested that Europe's banking sector was sufficiently well capitalized, Ireland last month was forced to require its largest banks to raise additional capital. The lack of credibility of Europe's stress test is leading to significant uncertainty, and will likely soon force regulators to require more stringent tests.
While German economic growth has been supported by a vibrant export sector, weaker growth in peripheral Europe combined with continued deleveraging of European banks and rising political and economic uncertainty will likely constrain credit availability in the region, leading to a more challenging environment throughout Europe in 2011. As a result, from a cyclical perspective, Europe will be running slow next year on a relative basis.
Finally, those regions in the world that are most closely tied to the emerging markets' growth engine will likely continue to be the areas that cyclically outperform next year. Canada and Australia, because of these economies' healthy fiscal positions and large and thriving resource-based export industries, should run fast on a relative basis compared with most developed economies.
Credit Implications of Running at Different SpeedsWhile emerging market, U.S., Canadian and Australian economic growth is set to run fast on a relative basis, European growth, employment and capital spending will likely be constrained as business executives maintain a cautious outlook and governments across Europe and the U.K. implement fiscal tightening. As sovereign credit concerns linger and debt instability fears rise, investors will increasingly view European sovereign and government bond risk as credit risk, as the probability of restructurings, defaults and haircuts increase for the weakest countries in Europe. Without strong European policy coordination and an aggressive policy response, the fundamental trends in Europe will likely lead to heightened risk aversion and contribute to weak economic growth. This outlook, combined with high debt burdens and deteriorating market technicals throughout Europe, will constrain credit fundamentals in the region. In contrast, in the emerging markets, U.S., Canada and Australia, credit trends are improving due to more supportive policy and healthier fundamentals.
The implications of a multi-speed world and particularly of running fast in the emerging markets, U.S., Canada and Australia relative to Europe leads us to continue to overweight credit risk in emerging markets (as well as in countries tied into strong emerging markets growth, such as Australia and Canada) and in the U.S. in companies and issuers with improving credit fundamentals. In addition, we continue to maintain an underweight in credit risk in European peripherals and in a growing list of European corporates due to poor credit fundamentals, rising liquidity concerns and the potential for solvency issues with an expanded list of European sovereigns.
Opportunities in Emerging Market and U.S. CreditAs a result of European sovereign credit concerns, we maintain a cautions approach to credit investing in Europe and remain particularly mindful of the credit risk in companies in the peripheral eurozone countries. In our global credit portfolios, we are being highly selective in our European credit exposure; however, we remain overweight emerging markets and U.S. credit risk given more positive fundamentals. These are a few credit opportunities today:
Running FastGlobal economic conditions and structural factors remain supportive for the emerging markets to "run fast," and for the U.S., Canadian and Australian economies to "run faster" on a relative basis than most other developed economies in 2011. This is in sharp contrast to the outlook in Europe and the U.K., where fiscal tightening and lingering sovereign credit issues suggest these regions are set to "run slow." This large economic differentiation has significant credit implications for investors.
Investors should favor investing in companies tied to economies with the strongest fundamental outlook. Given longer-term structural and near-term cyclical factors, the emerging markets and the U.S., Canada and Australia present the most attractive credit opportunities today for investors.
In terms of specific sectors, investments in emerging market corporate bonds, U.S. banks, secured debt, select municipal BABs and high yield bonds offer compelling opportunities. Investors should take advantage of the improving fundamental trends in select bonds in these sectors as economies in these issuers' regions run fast. Healthy economic growth in emerging markets and solid cyclical growth in the U.S., Canada and Australia should lead to improving credit fundamentals for numerous companies and issuers in these areas as the global economic expansion is extended due to accommodative monetary and fiscal policies in many parts of the globe. Investors who embrace "running fast" and have an appreciation for the near-term positive cyclical implications for credit fundamentals should prosper.
Mark KieselManaging DirectorDecember 13, 2010
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. 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. Build America Bonds issued by state and local governments are taxable issues. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower's obligation, or that such collateral could be liquidated. Bank loans are often less liquid than other types of debt instruments. Some debt instruments may include senior and subordinated and secured and unsecured debt obligations (including investments in the senior, subordinate, hybrid debt instruments, and Collateralized Debt Obligations or CDOs and Collateralized Loan Obligations or CLOs). General market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. Corporate debt securities are subject to the risk of the issuer's inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. 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.
There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.
This material contains the 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 and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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.
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.
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