The world is watching Europe, but the political and economic choices being made in Asia are also critical for the future of the global economy.In the following interview, portfolio managers Tomoya Masanao, Robert Mead and Ramin Toloui survey how the major economies of Asia are adapting to – and influencing – evolution in the global economy.
Q: What is PIMCO's secular outlook for Asia? Will the region influence global developments in the years ahead, or react to them?
Masanao: All regions have active roles to play in the massive global transitions that are taking place, even as they are affected by developments elsewhere. This interdependence is clear when we look at how Asia relates to the ongoing deleveraging in the industrialized world. Yes, household deleveraging in the U.S. is reducing demand for exports from Asia. And, yes, the fiscal crisis in Europe is causing financial institutions to pull back and transmit volatility to Asian markets.
But unlike in the past, when Asia was economically smaller and financially more fragile, the region is not a passive player in this process. The choices made by governments, households and businesses in Asia will determine whether we bring about a world where emerging market domestic demand helps fill the vacuum left by retrenchment in the U.S. and Europe.
Q: Is PIMCO concerned that China's economic growth will slow down sharply? What effect will China's growth trajectory have on the rest of Emerging Asia and the world?
Toloui: Nowhere is the transition just described more difficult – or more important – than in China. The key drivers of net exports and investment that powered the 10% to 11% growth rate that China has achieved over the past decade have reached their limits.
The key question is whether China can pivot to a growth model that emphasizes domestic demand – specifically consumption. This requires significant changes in government policy, including reform of tax policy, distribution of the profits of state-owned enterprises and other structural changes affecting the markets for labor and energy. These changes are not easy. PIMCO’s view is that a process of incremental reform, supported by the financial wherewithal to protect against a massive contraction, is likely to produce average growth over the secular horizon in the 7% range – below what is predicted by optimists, but not the severe hard landing predicted by pessimists.
Moreover, the changing composition of Chinese growth is likely to produce winners and losers in the global economy. The big winners of recent years – commodity exporters like Australia – are likely to enjoy less of a boost in the next few years, as China de-emphasizes commodity-intensive investment. In contrast, countries in the supply chain feeding domestic Chinese demand are in a position to benefit.
Q: Is there substantial inflation risk in Asia, and, if yes, how should investors deal with that risk?
Mead: Many cross-currents are affecting the path of inflation, including aggregate supply, aggregate demand, central bank policy and expectations. In the near term, our view is that inflation is unlikely to be a predominant concern globally, and is therefore likely to retreat as a concern in Asia.
As we move further out in the secular horizon, the risks of inflation become greater. One factor is central bank policy, which in the core industrial economies is clearly geared toward generating inflation over deflation. Second, the longer the economic crisis continues, the more the productive base of the global economy erodes, undermining aggregate supply. Workers experiencing long-term unemployment lose their skills, and plant and equipment deteriorates. As aggregate supply recedes, the risks of inflation begin to rise.
For this reason, we believe that inflation hedging remains a key component of any well-balanced portfolio for the secular horizon. This can be achieved through allocations to inflation-indexed bonds, commodities, select equities or emerging market assets.
Q: What is PIMCO’s secular outlook for Japan? How does it inform your view on Japan’s sovereign risk?
Masanao: Japan’s growth will continue to be challenged by secular dynamics, both internal and external, and, importantly, by the country’s inability to respond to them.
Internally, the deteriorating demography is the most powerful secular driver in Japan. Potential growth is already low but will likely further decline closer to zero. The labor force, and even capital stock, are decreasing and should decrease further. Young people are unlikely to become more enthusiastic about spending as taxes and social security payments will likely be raised. Reform is needed to moderate a widening of “inter-generational” wealth inequality, but the probability of such reform seems very slim. Traditional monetary policy alone will remain ineffective since the policy rate has been at a nominal zero bound for so long.
Externally, slower growth and a bumpy macro-rebalancing of the Chinese economy would likely have mixed effects on Japanese growth. China moving toward a higher-income economy could be an opportunity for Japan’s high-end consumer goods. However, China rebalancing with less investment could adversely affect some of Japan’s main exports to China, which are production goods.
Japan’s growth outlook is weak, but its net external creditor status and ability to print its own currency are important advantages compared to European peripheral countries. Also, to be clear, Japan’s fiscal problem is not external solvency but rather inter-generational solvency. Inter-generational transfers may reach a limit in the future, but probably not, at least, in the next three to five years.
Q: You mentioned China's impact on Australia. How will Australia adapt to the changing global landscape?
Mead: PIMCO has previously dubbed the Australian economy as experiencing “Dutch Disease-Lite” and recent experience suggests the economic symptoms are intensifying.
China is Australia’s largest trading partner, and China’s historical focus on infrastructure building has amplified the divergence in Australia’s two-speed economy, in which the natural resources sectors significantly outpace the consumer and manufacturing sectors. Many non-mining sectors are no longer globally competitive – manufacturing, for example, has seen a significant drop as a share of the Australian workforce – but these non-mining sectors are much more influential on employment prospects. Over the secular horizon, with less Chinese policy support, the tailwinds that Australia has been experiencing since 2008-09 will turn into headwinds via declining terms of trade.
Despite the fact that Australia has been a significant beneficiary of China's growth and demand for commodities since the crisis began, Australia has run large fiscal deficits. One lesson learned from the developed world is that running permanent fiscal deficits is not sustainable, so migrating back to surplus is sensible secular policy. The appropriate timetable for reaching budget balance is debatable. Given the 3% fiscal drag embedded in the 2012-13 federal budget and the expectation that ongoing fiscal austerity will be the mantra, a weaker Australian dollar and lower interest rates will be the only escape valves for the economy.
Q: What are the investment implications of PIMCO’s secular outlook for Asia?
Toloui: A defining feature of PIMCO’s outlook is the unusually broad range of plausible outcomes over the secular horizon. Preparing for this means thinking about portfolio diversification in a non-traditional way. Analysis of narrow, backward-looking correlations is likely to be less relevant than a scenario-based approach to diversification. This may be achieved by mapping the potential ways the global landscape could evolve and working to ensure that the overall portfolio’s asset allocation is robust against these contingencies.
To take one example: PIMCO’s base case is for a world of low growth in industrialized countries and higher but still historically modest growth in emerging market countries. This is an environment where emerging market currencies may continue to appreciate and outperform against industrial peers to facilitate global rebalancing.
Income-producing investments in emerging markets – such as emerging market local currency bonds – are poised to be the sweet spot in this scenario, offering some of the best potential risk-adjusted returns globally. Unfortunately, the portfolios of most global investors are disproportionately allocated to industrialized country securities.
We expect that the reallocation of global investor portfolios toward more balanced allocations to emerging market bonds – the “Great Migration” – will be a major theme in the coming years. This will mean more investor flows into Asia. It will also mean more flows from Asian investors into other global emerging markets. We believe investors who participate in the leading edge of this process are in the best position to potentially benefit from a “first-mover” advantage, since their portfolios may own assets poised to gain from future investment flows.
On a related note, the increased focus on sovereign creditworthiness is also likely to benefit Australian fixed income markets. As Australia’s federal budget moves back into surplus and bond issuance declines, we are likely to see continued interest from offshore investors.