In the following interview, Andrew Balls, managing director and head of European portfolio management, highlights the conclusions from PIMCO’s quarterly cyclical forum in March and how they influence the firm’s European investment strategy, including the unique challenges of forecasting for the coming months given the dramatic long-term changes underway.
Q: The two Long-Term Refinancing Operations (LTROs) auctions seem to have improved liquidity conditions and asset prices. Is this a short-term fix, or has the European Central Bank (ECB) done enough to change the course of the eurozone economic outlook on a sustainable basis?
Balls: The LTROs are an important source of support for eurozone markets and have succeeded in buying more time for the Europeans as they try and address their problems. The ECB introduced the LTROs at a time when France and the Netherlands, two countries at the core of the eurozone, were suffering significant contagion from the peripherals crisis – owing in part to the pressure on the banking sector in those countries.
The LTRO provides unlimited funding to European banks on generous terms against a wide array of collateral. While it has helped to truncate the risk of a banking sector collapse in Europe, there have been spillover effects into some sovereign markets, notably Italy and Spain and more broadly into credit markets. Partly due to political divisions, the ECB may not be in a position to act as a predictable lender of last resort to European governments. But it is an active and generous lender of last resort to the banking sector and has encouraged the recycling of liquidity into sovereign debt markets.
As a result of the ECB’s intervention, the European system has undergone a slower and more orderly deleveraging compared with the race to shed cross-border assets that we saw in the second half of 2011. It also sends the important signal that, amid Europe’s myriad coordination and political problems, the ECB is a competent actor in this drama. However, there are three main problems:
First, while this is an inefficient way to intervene, via the banks rather than directly focused on the sovereigns at the heart of the crisis, the ECB balance sheet is now at 33% of the eurozone’s gross domestic product (GDP) compared with about 20% each for the Federal Reserve and the Bank of England, meaning more deterioration of the balance sheet and risk of collateral damage in the ECB’s case. Ongoing commentary and leaks from the Bundesbank, in particular, suggest that institutions’ unease with the ECB’s interventions, itself a source of instability.
Second, the ECB is not removing risk from the market but rather providing funding. As well as the larger overall size of its balance sheet increase, this also means that in the event of renewed stress in eurozone sovereign markets, the banks that have increased their sovereign holdings – notably weaker banks in weaker countries – will likely be sources of stress.
Third, liquidity provision buys time but it does not deal with the twin underlying problems of too little growth and too much debt in the countries at the center of the crisis. While the ECB is a credible actor, there are still huge challenges for the eurozone to overcome to help it restore stability and address the big unanswered questions about how they will get there. The ECB can provide the bridge financing but it needs to be a bridge to somewhere, not a bridge to nowhere.
Q: What is your outlook for growth in eurozone over the next six to 12 months and how does the ongoing crisis impact your outlook for the U.K. economy?
Balls: We expect the eurozone to fall into recession, with the weakest growth stemming from peripheral countries that are undergoing big fiscal retrenchments and weak growth overall. The main question is just how deep and just how prolonged the recession will be. Our baseline expectation is for the economy to contract at a pace of -0.5% to -1.5% over the four quarters to Q1 2013.
In the U.K. we expect the economy to be flat to slightly negative over the four quarters. The eurozone crisis does not help of course, given its role on the important export market for the U.K. and the impact on confidence. But the bigger factor contributing to the U.K.’s lack of growth is the extent to which the fiscal tightening, which was a big drag on U.K. growth in 2011, will continue to be a big drag in 2012 as the government attempts to implement unprecedented peacetime spending cuts.
Q: What can the eurozone sovereigns do to ensure long-term stability?
Balls: The eurozone faces a daunting set of challenges, including technical and economic challenges but highest on the list are politics and coordination.
Greece’s default, the biggest in history, demonstrates the inadequacy of liquidity provisions to address solvency problems. It also demonstrates the self-defeating nature of piling austerity on top of austerity in an economy that is not growing.
Now, after its default, Greece has been more effectively quarantined, although the default we have seen is likely not the end of the story and not the end of the contagion risk. In particular, Greece’s exit from the eurozone remains a significant risk and one that could lead to contagion across the eurozone as investors reassess the potential currency risk if the currency union is proven not to be one of fixed but adjustable exchange rates. It is also far from clear that Portugal is on a sustainable path.
Q: What are some of the challenges facing the eurozone and how should they be addressed?
Balls: The first thing that needs to be done is to make clear the firewall to protect countries that are essentially solvent but facing liquidity problems from the spillover of smaller countries facing real solvency challenges. This is likely to involve the ECB as well as the fiscal authorities, to provide a credible lender of last resort function for governments that the ECB is currently providing liquidity or funding for the banks.
There should also be agreement on a credible plan for deeper fiscal union and which countries will be in that union. Europe’s leaders have said that only Greece will default. Yet, 18 months ago, the mantra was that no country would ever default.
Countries need credible medium-term plans to reduce debt levels but equally crucial are credible medium-term plans for nominal growth. While Italy has taken steps to try and improve its tax collection and budget management, reforms are needed, including labor market reforms to promote growth in an economy that has essentially stagnated for the past decade.
Debt sustainability is a function of the level of debt, the county’s growth rate and also the funding cost for the debt. Rates need to drop to a level low enough to make debt burdens sustainable even at economic growth rates below the eurozone’s full potential. Again, this highlights the importance of the ECB’s role as the lender of last resort or of a credible partnership with the fiscal authorities to achieve that goal.
Q: What are the potential risks that may derail your outlook for the eurozone?
Balls: The key risk at the moment is that Greece’s ongoing challenges, including the probability that its forthcoming elections in early May will usher in a government that is more hostile to the eurozone and the International Monetary Fund’s (IMF) demands for fiscal austerity. Greece’s exit from the eurozone in turn is a key risk.
Second, Portugal‘s need for another EU/IMF program is brought forward by Greece’s crisis. European governments have been more supportive of Portugal, but it remains to be seen how an off-track program will be handled. Moreover, it is the IMF‘s job to call for Plan B when it is clear that Plan A is not going to work.
Third, France has presidential elections in late April/early May, with potential important implications for the Franco-German alliance at the center of the political response to the eurozone crisis. It is often said that Germany and/or the ECB does not want a credible and predictable policy framework for dealing with the crisis in order to keep up the pressure on Italy or Spain to adjust. That same point can be applied to France and it would therefore be a challenge if a new French government were to take a radically different approach in terms of domestic or European policy.
More fundamentally, the key challenges for the eurozone revolve around overcoming their coordination problems and achieving adequate nominal growth. Given the difficulties facing the eurozone in terms of growth, coordination and politics, this is going to continue to be a bumpy journey.
Q: How will PIMCO’s cyclical outlook affect European investment strategy in the year ahead?
Balls: At the global level, the eurozone crisis remains the biggest risk to global activity and global markets. We will continue to monitor the developments very closely and the implications not only for eurozone markets but all the markets that we operate in along with other key global risks, such as the rising tensions in the Middle east and the resulting unwelcome pressure on oil prices. That means an overall cautious approach in terms of investment strategy at a time when risk spreads have narrowed significantly but where significant risks remain to the outlook.
In Europe, specifically, we will continue to avoid Greece, Ireland and Portugal and to be cautious overall on eurozone sovereign risk, not only in the case of Italy and Spain but also France and other countries closer to the core.
And we will continue to position our European portfolios with exposure outside of the eurozone to access better growth prospects and stronger balance sheets, including investing in emerging market countries that offer a combination of the two.