Global inflation is expected to slow to 2% to 2.5% as developed world inflation falls to 0.75% and emerging market inflation decelerates to around 5%. PIMCO expects that weaker global growth will lead to lower energy prices and wider output gaps in developed markets.
PIMCO has been a strong advocate of a secular multi-speed characterization of the post-crisis global economy. This is a world where structurally impaired developed economies continue to experience sluggish growth and high unemployment, and systemically important emerging economies continue to advance their growth while entering into a middle-class transition. Emerging Asia has been one of the front-runners in our multi-speed global economy with its favorable initial conditions, in terms of both private and public balance sheets. Developed Asia (i.e., Japan and Australia) has been a major beneficiary of the high-speed growth in emerging Asia.
As I mentioned, even though we expect emerging Asia to outperform the rest in the global economy, we think its growth rates will moderate considerably. PIMCO’s real GDP growth forecasts over the next 12 months for China and India are both around 6.5% to 7.5%. These forecasts are still considerably higher than those for developed economies, but when compared to what others in the market predict, these are very conservative numbers and are indeed at the lower end of the market consensus. When it comes to China, we think its initial conditions are still favorable, particularly compared to large developed economies, which will likely facilitate more effective policy responses. In our view, however, China will likely focus more on “rebalancing” of the investment-focused domestic economy this time, than on “reflating” of the economy to engineer higher growth as it has done in 2008 to 2009. This shift in its policy focus stems from the legacy of post-crisis reflationary policy responses as a domestic constraint and political considerations as an external constraint.
Q. Could you explain further your views on the Chinese economy and what you expect to be the most likely policy responses there? How will domestic political dynamics affect China’s economic policy responses?
Meng: Economic momentum in China has further moderated during 2011 under sustained monetary tightening, waning central and local public investment and restrictive property controls. Despite double-digit household income growth durable goods consumption has also slowed following the conclusion of fiscal stimulus programs. Although exports have held up well so far, the outlook is dimming due to European sovereign and banking stress and the fragile U.S. recovery. As Tomoya indicated, we remain more cautious than the market consensus, which remains around 8.5%, and we expect the Chinese GDP to moderate from 9.1% to 6.5% to 7.5% in the next 12 months.
Despite signs of commodities inflation peaking, policymakers continue to stress price stabilization as their first priority. Until CPI dips below 5%, which we may see sometime in the first half of 2012, we expect China’s monetary policy will maintain its tight stance. PIMCO projects the China CPI to be around 4% to 5% in the next 12 months, which leaves little room to cut the 3.5% benchmark rate. However, it is possible to see the People’s Bank of China (PBOC) ease tight liquidity by cutting the Reserve Requirement Ratio (RRR) and provide some credit easing for Small and Medium-sized Enterprises (SMEs). In the medium term, we expect accelerated interest rate deregulation and migration to a more flexible exchange rate regime.
Chinese political leadership succession, expected around the fourth quarter of 2012, will influence policy bias, whereby continuation and stabilization will likely dominate. Barring a repeat of the 2008 financial crisis and collapsing global trade, policymakers will likely tolerate growth moderation to 7% in 2012. As noted earlier, we believe their focus will be on structural reform via rebalancing the economy toward domestic consumption rather than cyclical reflation. Policymakers will continue to seek to mitigate systemic risks, as required, in the property and shadow banking sectors and with rising local government debt, while fiscal support should be available to boost public housing, social spending, tax cuts and SME credit, if necessary.
Q. Could you share your views on this new form of shadow banking within China?
Meng: Recent headlines of shadow banking stress in China have triggered market worry. The shadow banking system, by which we are referring to any credit-creation channel outside the traditional bank lending, is estimated at CNY8 trillion to 10 trillion (15%-20% of GDP according to PIMCO estimate based on various regulatory and other surveys), and has grown 50% over the last two years. The typical lenders/investors are wealthy households but also include cash-rich corporates. Shadow banking has been funding investment in working capital, capital goods, real estate, infrastructure, commodity and private equity. Reflecting its largely unregulated and risky nature, the funding cost fluctuates from low teens to 30% to 50 % according to a survey conducted by China Banking Regulatory Commission and PBOC Wenzhou office.
Despite the limited and localized stress so far, shadow banking has alerted top policymakers and has resulted in decisive policy responses. We believe the strong public balance sheets and high household saving will prevent systemic contagion. A variety of policy tools provides considerable flexibility for authorities to reregulate and contain financial and economic contagion. Liquidity and monetary easing, fiscal support for growth and re-engaging the public balance sheet should help ensure an economic soft landing rather than the devastating deleveraging that some fear.
Q. Is Japan likely to follow a similar policy path to its Asian neighbors or its Western counterparts? How do you assess Japan’s budget and funding for the post-quake reconstruction?
Masanao: Japan’s near-term policy focus will be on reconstruction from the March earthquake. Fiscal policy will need to be expansionary to facilitate reconstruction efforts, in contrast to fiscal contraction that is underway in the U.S. and Europe. As such, PIMCO forecasts Japan’s GDP growth to outperform other G4 members over the next 12 months.
But PIMCO’s forecast for Japan’s GDP growth at 1% to 1.5% is actually at the low end of the market consensus range of 0.9% to 2.9%. We are worried about spillover effects of deteriorating external demand from both Western developed countries and emerging Asia. Bank of Japan’s tankan surveys indicate that Japanese corporates still generally maintain healthy capital expenditure plans, but those plans will likely be cut back if PIMCO’s pessimistic outlook in the global economy materializes. We are also worried that political instability in Japan could further delay implementation of a large fiscal package for reconstruction.
There is good news and bad news with regard to funding plans for the reconstruction budget that is under discussion. The good news, from a near-term economic growth perspective, is that while the government plans to finance the reconstruction budget essentially by tax hikes, the government doesn’t intend to implement major tax hikes until 2013. The bad news, from a longer-term perspective, is that the planned tax hikes for reconstruction are failing to address structural problems in Japan’s tax systems. The tax hikes through income and corporate taxes that the government is currently proposing seem less controversial. But without widening a narrow tax base – a fundamental problem in Japan’s tax system – tax hikes alone would not likely help resolve Japan’s long-term fiscal problem. It’s clear Japan needs more tax revenues. If this is a good opportunity to discuss tax hikes, why not debate more broadly about expanding its super narrow tax base at the same time? After all, that is what Japan needs for long-term fiscal austerity.
Q: What do you expect the Bank of Japan (BOJ) to do? Will the BOJ follow the Federal Reserve’s policy?
Masanao: As for monetary policy, Japan will likely take a different path than countries like the U.S. and the U.K. While the world has been debating the effectiveness of monetary policy in this post-crisis world, the BOJ seems to be on the cautious side of the policy effectiveness debate in the current state of the developed world where a major balance sheet adjustment or deleveraging is continuing. Balance sheet adjustments tend to reduce natural interest rates (or trend growth rate per capita) and at the same time, policy rates are stuck at a zero nominal bound, limiting policy effectiveness. Also, in stark contrast to what the Federal Reserve Board and Bank of England claim, the BOJ has expressed publicly its concerns regarding central banks’ ability (or inability) to control the government bond yield. We do not expect the BOJ will implement aggressive quantitative easing in the near future.
Q. What are the implications specifically for Australia and, more generally, for commodities?
Mead: The nature of China’s policy response, as Isaac mentioned, directly impacts real capital formation and consequently steel production, which in turn is key to iron ore demand. PIMCO expects capital formation and associated steel production to trough in 2012 and only grow moderately from 2013 onward, which should directly impact Australia, Brazil and India, the top three iron ore exporters to China. Of these countries, Australia arguably has the most advantageous position, with the lowest mining cost per ton and less political and regulatory interference. This is supportive for the mining components of the Australian economy, especially considering that iron ore accounts for 36% of Australia’s commodity exports.
In many ways, Australia finds itself in a unique position. It is experiencing similar characteristics to that of an emerging economy, as it tends to benefit significantly from economic growth in emerging Asia, but it is also seen as a highly stable, advanced economy. Australia has a two-speed economy, with the high demand for natural resources and the associated capital expenditure needed to expand capacity in mining and liquefied natural gas (LNG) on the one hand, and the subdued consumer and manufacturing sector on the other. The non-mining sector has been squeezed via tight monetary policy settings, the high Australian dollar, and the reality that direct employment by the mining sector only represents around 2% of the workforce.
The current stance of monetary and fiscal policy as well as a floating currency give Australia’s policymakers ample flexibility to cut interest rates and provide liquidity support for banks, if necessary. There is also space to delay the return of the budget to surplus given the low level of net government debt. Growth, however, will likely be impacted by moderation in the emerging world and ultimately the demand for Australia’s natural resources.
Our forecast for Australia’s GDP is moderately below consensus, reflecting our similarly below-consensus forecast for Chinese growth. On the inflation front, the Reserve Bank of Australia (RBA) explicitly targets CPI within a 2%-3% band and it has continued to focus on ensuring its forecasts for inflation move back within its target range. According to PIMCO’s proprietary inflation model, inflation should come in slightly below consensus. We believe the RBA will maintain its pragmatic approach to monetary policy settings in the face of global economic weakness and financial market stress.
Q. How does PIMCO’s Asia-Pacific Portfolio Committee (APC) contribute to the firm’s cyclical outlook and the development of Asian portfolio strategy?
Mead: PIMCO created the APC in June of 2009 as a step in the devolution of our global investment process to capture alpha by making investment decisions and managing risks locally. The APC oversees Asian strategy and trading, and acts as the central point for local economic analysis and idea generation. At the same time, it interacts directly with PIMCO’s Investment Committee, global and emerging market teams, as well as the European Portfolio Committee (EPC) and Americas Portfolio Committee (AmPC). The APC is in charge of making a formal presentation of its macro forecasts and key themes at PIMCO’s cyclical forum, accompanied by recommendations for strategic portfolio implementation. Current members of the APC are presented below.
Q. Finally, how does PIMCO's cyclical outlook translate into investment strategy in the Asia-Pacific region?
Masanao: As our colleague Saumil Parikh mentioned in his latest Economic Outlook, PIMCO believes that policies and politics will dominate the investment outlook in coming years. In this regard, over the next 12 months, China (and Europe) will be our primary focus for our global investment strategies. Both domestic and external political considerations will drive China’s economic policies, which we believe, as a base case scenario, will likely help China achieve a gradual slowdown and avoid a hard landing for its economy. But we also need to be aware that there is an increased risk that China’s policies could further destabilize the global economy, especially given increased uncertainties stemming from the sovereign debt crisis in Europe.
Against this backdrop, our investment strategies in the Asia-Pacific markets are focused on preparing portfolios for increased downside risks while seeking upside potential from secularly sound investment opportunities. Key factors to consider when evaluating strategy selections should be balance sheets and cash flows in both private and public sectors.
For interest rate strategies, Australian government bonds look attractive. Australia maintains sound fiscal conditions and has greater flexibility in monetary policy than most developed countries in this cycle. We therefore view Australian government bonds as high-beta duration, meaning that they have the potential to outperform U.S. Treasuries on a local currency basis, particularly in a left-tail global economic scenario where global bond yields decline further. Japanese government bonds, in contrast, are viewed as low-beta duration, which have the potential to outperform U.S. Treasuries when the global bond yields rise from here. We also believe weak external demand and increased energy imports (as a result of the nuclear power plant accident) is the recipe for a smaller trade surplus for Japan. Yet, Japan’s current account will likely still be cushioned by its healthy income balance, which should continue to enable Japan to finance its deficits domestically.
In emerging Asia credits, we see sovereign, quasi-sovereign, and low-beta/high-quality corporates as the best source of risk-adjusted returns in this environment, but relative value considerations are key factors used to determine weights and exposure in our portfolios.
In terms of currency strategies, we prefer low-beta currencies such as the Chinese yuan and Singapore dollar in this environment. Price dynamics in these two currencies reflect their active role as a policy tool in combating inflation. They also command a lower credit premium supported by fiscally sound sovereign balance sheets and sufficient dry powder, in the form of foreign exchange reserves, to help reduce "risk off" correlations with the broader asset class.