Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the outlook for the global economy and financial markets. In this interview, Andrew Balls, head of European portfolio management and a member of PIMCO's Investment Committee, discusses the firm's cyclical economic outlook for the eurozone and U.K. over the next six to 12 months, along with the implications for investment strategy.
Q: PIMCO has upgraded its cyclical growth forecasts for the U.S.; are you also revising your growth outlook for the eurozone and the U.K.?Balls: Our forecasts for the eurozone and the U.K. remain broadly the same as at the time of our September 2010 Forum "“ and this in spite of the upgrade to our U.S. forecasts. We expect real growth in the eurozone this year of 0.5%"“0.75% and growth in the U.K. of 1.0%"“1.25%.
The upgrade to the U.S. growth forecast was primarily the result of further fiscal stimulus in the U.S., in the form of extension of previously enacted tax cuts and importantly a one-year reduction in the payroll tax. This will likely boost household spending power over the next 12 months. The improvement in the short-term outlook for the U.S. has some benefits for Europe, in terms of providing a boost to animal spirits and risk assets globally.
But while the U.S. is doing yet more fiscal stimulus, in the eurozone and in the U.K. we are going to see sizable fiscal tightening this year. The picture in the eurozone remains a twin-speed recovery where core countries, particularly Germany, are experiencing faster growth relative to peripheral Europe, where the outlook is for weaker growth. But while Germany is doing very well, it is not likely to grow strongly enough to significantly boost growth in the peripheral countries. And the ongoing crisis in the eurozone peripheral countries is a source of risk for the European banking system and for growth across the continent. Hence, we expect subdued growth in the eurozone overall.
We have slightly revised up our U.K. forecast, relative to the eurozone, in part owing to better recent U.K. data. However, we remain below consensus in our U.K. forecast due to the impact of the U.K.'s fiscal tightening on growth. A worse than expected impact of the fiscal tightening and the slowing housing market are the main risks to our outlook for ongoing, moderate growth.
Q: Does this affect your longer-term recovery expectations for the eurozone and the U.K.?Balls: When looking beyond the next six to 12 months into the medium term, we have significant concerns over the eurozone countries' ability to maintain austerity programs over multiple years. We have the problem of all countries trying to tighten fiscal policy at once, in the core as well as in the periphery. This suggests that fiscal multipliers "“ the impact of fiscal policy on growth, either stimulating or hindering "“ may be greater than the standard historical rules of thumb. In addition, the threat of a banking crisis in the event of one or more European government defaults remains a significant source of macroeconomic risk.
One of the key characteristics of PIMCO's New Normal thesis is that we are living in a world with a flatter distribution of possible outcomes and fatter tail risks rather than a single, dominant baseline scenario, and Europe exemplifies this view. It is possible that European countries will make successful fiscal adjustments, helped in part by stronger external growth. We may see the successful quarantining of Greece, Ireland and perhaps Portugal via European Union (EU) support and International Monetary Fund (IMF) rescue packages, or perhaps the restructuring of some sovereign debt over time to prevent full-blown contagion to larger peripheral countries, namely Spain and Italy. But at the other end of the spectrum we have to take seriously the risk of one or more disorderly defaults and the possibility that countries may exit the eurozone.
In the case of the U.K., the depth of the fiscal cuts and the uncertainty over the inflation outlook characterize the fatter distribution and greater tail risks. Should the government's fiscal policy tightening program lead to significantly weaker growth than forecast, it is not clear how the government would react "“ other than probably relying on the Bank of England (BoE) to provide further monetary stimulus. The BoE in turn may be constrained by the persistently high inflation figures.
Q: Can Europe avert a European banking crisis or a default in one or more countries given the coordination challenges facing eurozone member states?Balls: As previously mentioned, we see a wide range of possible outcomes for the eurozone. Part of the explanation lies in fundamental questions about debt dynamics and the ability to sustain significant austerity programs while also transitioning to higher growth. Part of the problem lies in the challenges that some eurozone countries face when it comes to policy and currency flexibility. And part of the reason for the wide range of potential outcomes is down to the uncertain eurozone policy response given the big coordination problems within the single currency area.
To simplify, the eurozone's policy response to date has been to provide liquidity support for Greece and Ireland, to take them out of the market for three years and possibly longer, in the hope of buying time for them to try to grow into more sustainable debt dynamics. Last month, the European leaders agreed on a permanent approach crisis resolution mechanism starting in 2013.
But neither the short-term nor the longer-term plan addresses decisively and clearly the very real solvency concerns. It is far from clear that the strategy of trying to buy time for growth to improve the situation is going to be successful. With investors concerned about default risk in eurozone countries, there is the danger that the demand curve for European government debt shifts inward, and that contagion from the weakest countries spreads to Spain and Italy and even further.
While the prospect of default or restructuring in the smaller eurozone countries is a significant source of risk for the European banking system, it is a more manageable one than that of a larger economy facing significant default risk.
In the event that we do see further significant contagion to Spain and Italy, we think it is likely that fiscal and monetary authorities will provide large-scale support. But this support would most likely be reactive "“ as a result of significant spread widening and contagion to the banking system "“ not pre-emptive. Moreover, as noted earlier, there is a huge amount of uncertainty.
A key issue in all this is whether Germany is prepared to use its balance sheet and also allow the ECB's balance sheet to be used even more. There are political problems and policy coordination problems across countries, not to mention the extent to which countries with weaker fiscal positions are prepared to give up fiscal sovereignty in addition to monetary sovereignty. Thus, there are fat tail risks of disorderly defaults and of countries leaving the eurozone, not just debtor countries that find the austerity too much to bear but creditor countries that find the demands on their own balance sheets too great.
Q: Inflation in the U.K. is running above the 2% target rate of the Bank of England. Is inflation a risk in the U.K. over the cyclical horizon? What about the rest of Europe?Balls: Inflation in the U.K. is indeed running above the BoE's 2% target rate, but when we take out the impact of taxes (value added tax, or VAT), U.K. inflation does not look very different from inflation rates in the eurozone or U.S. The problem, however, is that we have had a long period in which U.K. inflation has tended to overshoot the target rate, and we now face the prospect of another year of above-target inflation owing to the impact of VAT increases. As a result, we could see a rise in inflation expectations in the U.K. and increased concerns about the BoE's inflation targeting regime. But our baseline case is for weaker inflation over time with inflation falling back to or a bit below the BoE's inflation target over the next 12 months or so. Nevertheless, it is certainly an uncomfortable time for the BoE, with inflation remaining stubbornly above target and throwing into question the central bank's credibility. The bar for further stimulus from the BoE is certainly high.
In the eurozone, the risks are more balanced as the area is starting from a low level of inflation and the fiscal adjustment programs of the smaller peripheral eurozone countries will be disinflationary, if not deflationary. The impact of high commodity prices in the eurozone, as with the U.K., could present inflationary pressure, but overall our expectation is for disinflation in continental Europe over the next year.
Q: What is your outlook for the euro in 2011?Balls: The euro could weaken in 2011, especially given the risk premium emanating from the eurozone peripheral crisis. This view also reflects our outlook for weaker growth in the eurozone relative to the U.S.
The eurozone's single currency prevents countries like Greece and Ireland from depreciating their currencies, one of the measures that could make the adjustment less painful overall in terms of growth. The depreciation of the euro against the U.S. dollar and particularly against Asian currencies would benefit the eurozone as a whole, but the adjustment on a trade-weighted basis is also frustrated by the fixed exchange rate regimes in Asia.
Q: How will PIMCO's cyclical outlook affect European investment strategy in the year ahead?Balls: Our European investment strategy remains similar to the strategy we have been pursuing over the last 12 to 18 months. We continue to underweight European peripheral sovereign and credit risk given possible restructuring and contagion issues. We are cautious on German duration, given the potential for the peripheral countries to contaminate the German balance sheet, that of other core countries, and the ECB.
We remain underweight European senior bank debt, reflecting concerns that the peripheral crisis could lead to more contagion in the banking sector. We believe that U.S. senior financials offer better risk/reward characteristics and valuations relative to their European counterparts.
As with other PIMCO portfolios, a key part of our current strategy across European and U.K. portfolios will be to target "safe" spread investment opportunities: securities we believe are able to earn a spread relative to sovereign debt across a range of possible economic scenarios.
Our focus is skewed toward investment grade credit and select high yield opportunities, covered bonds and asset-backed securities. Given the contrast in fundamentals and growth opportunities, we will continue to favor emerging market securities and currencies.
Thank you, Andrew.
"Safe Spread" is defined as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios. All investments contain risk and may lose value.
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. 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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.. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations.
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. ©2011, 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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