In the following interview, Andrew Balls, managing director and head of European portfolio management, highlights the conclusions from PIMCO’s quarterly Cyclical Forum in September 2012 and how they influence the firm’s European investment strategy, including the unique challenges of forecasting for the coming months given recent European Central Bank (ECB) policy actions and dramatic long-term changes underway in the eurozone’s periphery.
Q: With the ECB announcing an unlimited bond-purchase programme and the German Constitutional Court issuing a “green light” for the European Stability Mechanism (ESM), have we reached an inflection point in Europe?
Balls: I believe we have arrived at a critical junction in Europe. More than three years into this crisis, the ECB has signaled its willingness to be a lender of last resort for eurozone sovereigns. This development follows commitments by European governments to build the institutions and make the political commitments to create a more stable union. ECB President Mario Draghi has worked hard to establish the case for eurozone intervention and its consistency with the ECB’s monetary policy mandate, including the attempt to restore the functioning of the monetary transmission mechanism across the eurozone and to address “convertibility”, i.e., break-up risk. Although the German Bundesbank has publicly opposed the ECB plan, we have fairly clear support from the German government for the ECB’s bond buying plans.
The German Constitutional Court verdict represented another piece of important event risk in Europe in terms of the creation of the ESM. This was important – not least because Mr. Draghi has made it clear that the ECB will only buy the bonds of a country that has ESM/European Financial Stability Facility (EFSF) support.
The ECB’s potential engagement as lender of last resort has had a significant impact on Spanish and Italian spreads in the front end of the yield curve. However, there remains a significant event risk on the part of the ECB and on the part of the eurozone fiscal agencies, representing very difficult coordination challenges.
First, we have to observe how the process of Spain, and potentially others, applying for ESM support will work. Second, we need to see how the ECB’s intervention will function and how the process will be different to the ECB’s previous bond buying initiative under its Securities Market Programme (SMP), which proved to be ineffective. Third, we need to see if eurozone governments will be able to overcome their coordination problems and make real progress in building a banking union and a closer fiscal union to ensure the medium-term stability of the eurozone. The ECB has a vital role to play in helping to build the bridge and provide necessary financing; however, it is Europe’s governments, and particularly the big four, i.e., Germany, France, Italy, and Spain, that have to construct a more stable eurozone to complement the ECB’s policy actions.
Q: Is the ECB providing sufficient long-term firepower to stabilise yields in the eurozone’s peripheral countries?
Balls: In terms of the recently announced Outright Monetary Transactions (OMT) programme, the ECB hasn’t actually implemented anything at this point. The OMT will only be enacted when a country asks for support. We have to see how resolutely the ECB will act. The key challenge for the eurozone is in crowding-in private and foreign official investors to buy eurozone sovereign debt. To date, European interventions have chiefly financed the exit of investors, rather than crowding-in investors. The conditional nature of the ECB’s potential support for sovereigns stands in contrast to the unconditional support the ECB has provided to the European banking sector. The fact that it will limit its sovereign purchases to the one- to three-year part of the yield curve makes the challenge more difficult. The bottom line is that we need to see how determinedly and predictably the ECB will act.
For now, market anticipation of the ECB to act as a lender of last resort has been very powerful in cutting off the left tail risk of a near-term collapse in the eurozone, such as Italian or Spanish sovereign yields spiraling out of control over the coming 12 months. In addition to the political and institutional challenges of building a more stable eurozone, the other significant cyclical and secular challenge is one of achieving growth in the region. The ECB has a vital role to play in maintaining stability; however, in the medium-term, stabilising the eurozone and the debt dynamics of key countries will require economic growth.
Q: Has the ECB reduced the lingering risk of a Greek exit, or potentially the exit of other peripheral eurozone countries?
Balls: I would make a clear distinction here between the planned OMT programme and the challenge of Greece. The OMT is aimed at supporting countries that maintain market access. Greece has already defaulted on its debt while its programme with the Troika (European Commission, ECB and International Monetary Fund (IMF) representatives) is very far off-track. The ECB continues to provide support for the banking system and for the Greek government. Rather than addressing Greece’s fundamental problems and the exit risk, such support merely serves to buy time. The decisions will have to be made by eurozone governments and by Greece, not by the ECB.
This strategy has allowed Europe to build potentially more effective firewalls and for both Ireland and Portugal to achieve progress with their own fiscal adjustments. Very little has been achieved toward stabilising Greece. Eurozone governments face the choice of committing new resources to keep Greece afloat, either in the form of new money or by writing down Greece’s official sector debts. Even then, external support is no guarantee for stability given the extent of the political and social rejection in Greece for the Troika’s initiated programme and ongoing austerity measures. By their nature, the political dynamics are hard to forecast. Over time, it appears likely that Greece will end up exiting the eurozone by resorting to printing some form of new currency, in effect cutting itself off from ECB support. The only way to prevent this outcome from occurring might be if creditor countries are prepared to replace existing austerity programmes with very generous aid. At this stage, such a change in approach seems quite unlikely.
On the other hand, the challenges in Portugal and Ireland are not as difficult as in Greece, as eurozone governments have shown much greater enthusiasm for providing support for these two countries. Regardless, the challenges of growth loom very large. In Portugal’s case, weak growth has resulted in the government’s operating deficit overshooting its target, something that has been obscured in the published fiscal deficit data due to one-off transfers of banks’ pension assets. Although Ireland has to date successfully hit its fiscal targets, the slow pace of the economic recovery in Europe will result in downward revisions to official growth forecasts over the next few years. The result in both cases, when compared with initial expectations, is either a higher level of required austerity in the coming years or fiscal deficit and debt targets will be missed – or the targets will have to be significantly revised.
With that in mind, a Greek exit would put particular pressure on Portugal and Ireland. Faced with large-scale capital flight should it exit the euro, it is highly likely that Greece would introduce retail deposit and capital controls. While this would affect confidence in all eurozone countries, the contagion would be greatest in the most vulnerable economies of Portugal and Ireland. The economic shock would further undermine these countries’ attempts to first stabilise and then lower relatively high government debt levels (in the order of 120% of gross domestic product), increasing the political attractiveness of solvency relief.
Big questions remain on the extent to which creditor governments will permit greater official sector burden-sharing – in the form of potential write-downs of official sector debts in Portugal to address the debt overhang problem, and similarly in Ireland, by taking on some of the burden of debt that resulted from Ireland’s support of its banking system.
Q: How have these recent ECB policy developments and positive news for German and UK manufacturing sectors in July influenced your outlook for sustained growth in the eurozone, as well as for the UK economy?
Balls: As discussed, the ECB policy actions have helped to cut off the left tail risk of Spanish and Italian yield spreads spiraling out of control over the cyclical horizon. However, it will do little to improve the growth outlook in the longer term. We forecast a deep recession in the eurozone over the next four quarters, with the overall eurozone economy set to shrink in the range of -1% to -1.5%. At the national level, the burden is uneven, with much deeper recessions in eurozone countries attempting to make very large fiscal adjustments. Germany is doing relatively better, as the manufacturing data shows; however, we anticipate an ongoing slowdown in German activity owing to the weakness of its eurozone trading partners and slower growth in Asia, especially China.
For the UK, there is some volatility in the Purchasing Managers Index (PMI) data, reflecting the additional public holiday in the second quarter 2012. Given the underlying weakness, we expect UK economic activity to be essentially flat over the next four quarters, reflecting the impact of fiscal austerity on UK growth and weakness in the eurozone, the UK’s biggest trading partner. Overall, there has been nothing in the short-term indicators to warrant adjustments to our view of the anemic UK growth and eurozone outlook.
Q: How about inflation?
Balls: We expect a moderation of inflation in the eurozone and the UK over the cyclical horizon, with inflation coming in at, or a bit below, the ECB’s 2% target for Europe and at, or a little above, the Bank of England’s (BOE) 2% inflation target for the UK. With further quantitative easing (QE) action by the BOE, increased use of the ECB balance sheet in Europe, QE3 in the US and more quantitative easing by the Bank of Japan (BOJ), a broad effort at reflation is underway on the part of the world’s leading central banks. It remains to be seen whether there will be a significant impact on the underlying fundamentals of growth and employment.
Over the secular horizon, we need to be vigilant and guard against a potential upside risk for inflation. This is particularly true in the case of the Anglo-Saxon countries, where central banks have displayed great policy activism and potentially greater willingness to accept higher inflation as part of the attempt to maintain overall nominal growth while supporting the difficult deleveraging process in these economies.
Q: How will PIMCO’s cyclical outlook inform your European and global investment strategies in the coming year?
Balls: The level of core government yields leaves little room for further capital appreciation, except in the event of renewed systemic pressures in the eurozone. At a time when central banks are attempting to peg the front ends of yield curves, we see the potential for earning relatively safe income from rolling down the steep end of the curve, favouring the intermediate parts of the yield curve and underweighting the long ends.
As a firm, we have moved broadly to a neutral-to-overweight position on Italy and Spain, after a period of three years in which we have been underweight European peripherals. This reflects our expectation of the ECB’s extended engagement buying government bonds and expectation that Spain will apply for ESM/ECB support in the coming weeks. It also reflects the relative value that Italian and Spanish sovereign bonds and select private sector credit opportunities offer versus European and global credit alternatives.
While we have targeted our exposure on Italy and Spain under the ECB bond-buying umbrella of one to three years, we have also extended out our exposure to the five-year sector, beyond the ECB umbrella, where the curve is steepest. It is important to note that Italy and Spain offer relatively attractive sources of credit risk, not interest rate risk. We continue to take a cautious approach, scaling our Italy and Spain positions as credit risk, and reflecting the extent of execution risk surrounding the plans of the ECB and eurozone governments in building a more stable eurozone. We will continue to monitor the process very closely and adjust portfolios accordingly.
In summary, we see the survival of the eurozone as depending on the big four countries – Germany, France, Italy and Spain – sticking together and, with the support of the ECB, forging a more stable currency union. Reflecting the systemic importance of these countries, and the ECB commitment to support market access for these countries, we also view Italy and Spain as safer forms of credit risk than Portugal and Ireland, which we plan to continue to avoid, together with Greece.
More broadly, global credit spreads have exhibited a compressed range to the risks and the weaker growth we forecast, including eurozone industrials and financials.
Therefore, we expect to take a very cautious approach and be underweight in European credit risk and European financials in general, looking for specific opportunities rather than broad exposure. In terms of corporate exposures, we will continue to look for better global alternatives.