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 the following interview, members of the Asia-Pacific Portfolio Committee – Robert Mead, Isaac Meng and Raja Mukherji – discuss PIMCO’s cyclical economic outlook for the region over the next six to 12 months.
Q: Before we focus on the Asia-Pacific region, could you summarize PIMCO’s global cyclical outlook?
Mead: PIMCO expects the global economy to grow by 1.0%-1.5% in 2012, which is significantly slower than 2.5% growth in 2011 and 4.1% in 2010. Despite that, we believe the risks to our forecast remain to the downside. Global balance sheet deleveraging will become a much more dominant force over the next year. In this environment, it is crucial to analyze global linkages, especially to Europe.
Q: What are the implications of global deleveraging for the Asia-Pacific region?
Mead: Over the next 12 months, we believe emerging Asia will continue to perform well and remain a contributor to global economic growth. But we expect emerging Asia growth below the market consensus; in our view, Asia will not be the world’s savior due to its less aggressive policy responses compared to 2008-2009.
Asia-Pac is less affected than other regions by eurozone turmoil, but nevertheless, contagion risks remain. In addition to direct trade linkages, the regional production chains that characterize Asia’s export-oriented economies mean the loss of a very large customer, like the eurozone, will have a negative ripple impact on growth in the region.
That said, European banks have provided less financing to Asia-Pac than to other emerging regions, especially Eastern Europe. The Asian banking sector is generally better prepared than its global peers: capital ratios are adequate and quality of capital is relatively high; non-performing loan ratios are still at historically low levels and banks have built up high reserves. Most Asian banks are fully funded by domestic deposits, with exceptions including Australia and South Korea. But even Australia and South Korea have materially reduced their reliance on wholesale funding sources since 2008.
*Current data for real GDP growth and inflation represent 12-month actual figures from Q3 2010 to Q3 2011** Excluding estimated impact of carbon tax introduction. The Australia forecast was formulated by PIMCO's Australian portfolio management team, not in the Forum
*** Brazil/Russia/India/Mexico
**** The CPI range for China has been adjusted to 3.5%-4.5% from 4%-5% as published in December, which reflects continuted weakness in the property market and softening labor market.
Source: Bloomberg, PIMCO
Q: What are the key risks to China’s growth in 2012?
Meng: China’s economy faces significant downside risk, which is openly acknowledged by Chinese policymakers. PIMCO forecasts that GDP will slow to around 7% on the year by the fourth quarter of 2012, which is 1.5 percentage points below the consensus. Aside from pressure on exports, particularly to the eurozone, the strong credit expansion which drove property and investment demand for the past three years began rolling over in the second half of 2011. Burdened by past excess investment, both property and private capital expenditure face negative adjustment pressures in 2012. On the financial side, banks are under asset quality and capital constraints, while the shadow banking system, which historically funded private sector property investment, also faces deleveraging pressure. As growth slows and commodity and property prices soften, we expect inflation to slow sharply, potentially piercing the lower bound of the 3.5%-4.5% forecast range, leaving room for stabilization policies to be implemented, eventually.
Q: What policy responses are we expecting from China, and how will they differ from those in 2008?
Meng: In December, China laid out its 2012 economic work objectives focusing on “growth stabilization, price stability and structural adjustment.” Heading into the critical political succession in October this year, Chinese policymakers will be seeking to strike a fine balance between sustaining growth of around 7% to ensure benign inflation and pushing medium-term structural reform. With inflation having peaked, the first reserve requirement ratio (”RRR”) cut in December 2011 suggested a clear shift to a more pro-growth stance.
However, unlike 2008, there is no aggressive public investment program or credit stimulus, and despite heavy property price pressures, property tightening measures have been largely kept in place.
PIMCO expects the People’s Bank of China (PBOC) to gradually loosen financial conditions with some 200 basis points of cuts in the RRR in 2012 and eventually a cut in the benchmark rate. On the Chinese yuan, we expect policymakers to maintain the current gradual appreciation stance, and even in a situation of global economic turmoil, we don’t expect the PBOC to either re-peg or devalue the yuan on a sustainable basis. As the yuan approaches its equilibrium level and growth risk intensifies, we project a more gradual appreciation rate of 2%-3% annualized, with the possibility for increased two-way flexibility.
On the fiscal side, despite rising local government debt, there is still room for expansionary policy in China. Fiscal stimulus will likely be focused on tax cuts and supporting household spending. There is no political support for the aggressive investment and property reflation policy we saw in 2008. Lacking robust physical demand pull, limited and muted policy response may arrest the downward growth momentum by the second half of this year, but it will be difficult to combat the confluence of credit cycle, property price pressures and European export recession.
Q: What do you expect for India?
Mukherji: India faces several challenges over the cyclical horizon: a slowdown in the investment cycle, high inflation with structural underpinnings, and current account and fiscal deficits. We expect a bumpy road for India, with disappointing growth. Our forecast for GDP growth of 7.0% in fiscal year 2012 is below consensus. Slowing growth can be seen in M1 growth, which has historically led corporate revenues by roughly two quarters. High inflation and fiscal slippage leave little room for a quick policy response, although we would not rule out a rate cut later in 2012 if falling demand and growth contain inflation.
Q: Japan remains vulnerable to the external demand shock, but how will this be affected by post-quake construction demand?
Mukherji: Japan’s government spending this year will help produce GDP growth that looks optically OK, despite PIMCO’s pessimistic forecast for private sector demand. Private sector rebuilding of the supply chain was done surprisingly quickly, but the public sector’s reconstruction is just about to start. Next quarter, Japan will implement a large reconstruction budget worth 2% of GDP, which is expected to contribute 0.6% to GDP growth in 2012. The private sector is unlikely to respond positively to the large fiscal stimulus. In other words, it’s a case of classic “Ricardian equivalence” – it suggests that it does not matter whether a government finances its fiscal stimulus with a tax increase or debt, because the effect on the total level of demand in the economy is the same.
We think the consensus forecast of 1.5% real growth for Japan, which includes reconstruction spending, is too optimistic as it assumes consensus growth estimates for both U.S. and China. Under our much more conservative assumptions for the external environment, PIMCO forecasts 0.5%-1.0% for Japan’s growth in 2012. We expect 2013 GDP growth to be even weaker as private sector demand will likely remain weak.
Q: What could the less aggressive Chinese policy response potentially mean for capital formation and accordingly iron ore demand?
Mukherji: China’s current annualized steel production has dropped 19% since September 2011, driven by weak demand from the cooling property sector, seasonality, and lower infrastructure spending. The direct impact of falling steel production can be seen on iron ore prices, which are down more than 25% since their peak in 2011. The future implied spot iron ore price anticipates further declines, and if the sovereign debt crisis in Europe worsens, we would expect iron ore prices to test the lows of 2008.
We expect China’s real capital formation and associated steel production to trough in 2012 and only grow moderately after that. Australia, being the largest exporter of iron ore to China, is the most exposed in Asia-Pacific to falling prices and volume. However, Australia also has the lowest mining cost per ton. So while a worsening sovereign debt crisis in Europe would lead to a sharp contraction in both the volume and price of iron ore, Australian producers would likely be the last to stop production due to their cost advantage.
Q: For Australia, what are the direct implications of these lower regional growth prospects?
Mead: Australia will not be immune to global deleveraging. It will be felt via at least four channels: 1) weaker developed market growth; 2) moderating Chinese demand for core commodities, such as iron ore, as discussed by Raja; 3) retrenchment of foreign banks to their home markets; and 4) higher bank funding costs. In addition to these global factors, for the first three quarters of 2011, domestic policies became increasingly restrictive while underlying inflationary pressures were easing. The Reserve Bank of Australia’s (RBA) recent reduction in policy rates – two 25 basis-point cuts in November and December – reflected this combination of domestic and global factors. Based on PIMCO’s estimates, the current policy rate of 4.25% should be considered “neutral.”
We think the RBA will need to ease further in 2012. With the Australian dollar remaining stubbornly above parity to the U.S. dollar and domestic housing prices declining, broader financial conditions are set to remain tight despite neutral interest rates. Also, the Australian federal government remains committed to further fiscal tightening, aiming for a budget surplus in the 2012-2013 year, despite the likelihood of lower realized revenues resulting from slower-than-expected domestic growth.
Q: Finally, how does PIMCO’s cyclical outlook translate into investment strategy in Asia-Pacific?
Mead: Our investment strategies in the Asia-Pacific markets are focused on preparing portfolios for increased downside risks and seeking upside potential from long-term sound investment opportunities.
For interest rate strategies, Australian government bonds still look relatively attractive given their underlying high credit quality, which is becoming increasingly rare in the sovereign space. Australia maintains sound fiscal conditions and has greater flexibility in monetary policy than most developed countries. 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 if global bond yields decline further in a left-tail global economic scenario.
In terms of currency strategies, we prefer moderate long positions in low-beta currencies, such as the Chinese yuan, and short positions in the Australian dollar at levels above USD parity.
And in credit, we remain focused on sustainable cash flow generation, specifically, corporate issuers that have delevered, termed out their debt maturities and maintain healthy cash balances, and covered bonds and self-liquidating residential mortgage-backed securities.