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Mohit Mittal, Lupin Rahman, Ed Devlin
Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the firm’s outlook for the global economy and financial markets. In the following interview, portfolio managers Mohit Mittal, Lupin Rahman and Ed Devlin discuss PIMCO’s cyclical outlook for the Americas in 2013.
Q: Starting with the U.S., PIMCO expects the economy to grow 2.0%–2.5% over the next year. Why is PIMCO’s forecast lower than market consensus expectations? Mittal: One reason is continuing weakness on the consumer side. Real wages are growing at less than 0.5%, and aggregate consumer income growth is around 2%, according to the Bureau of Labor Statistics, while the Bureau of Economic Analysis pegs the U.S. savings rate at only 4.6%, so people cannot use their savings to fund consumption, either. And while the unemployment rate is declining, much of it is due to shrinking labor force participation.
Also, while many are expecting corporate capital expenditures to grow 7%–8%, PIMCO expects them to remain subdued. Balance sheets are healthy and companies have easy access to the capital markets. However, nonfinancial earnings growth is stalling as of 2Q.
Finally, higher rates since the Federal Reserve first started talking about tapering quantitative easing (QE) will weaken credit-sensitive sectors. Home affordability has declined 25% since January, according to the National Association of Realtors, and housing starts have plateaued. The Treasury’s cost of funding debt is also drifting higher.
With all that said, we have become cautiously optimistic due to reduced fiscal drag, improved wealth effects, higher energy production and pent-up demand in durable goods like autos. However, if the government shutdown continues, we expect a 0.1% to 0.2% drag for each week it goes on. That is relatively manageable for now, but the longer the shutdown lasts, the bigger the negative effect on growth will be.
Q: How does the Fed’s decision not to begin tapering affect PIMCO’s view? Mittal: PIMCO’s view has been that the Fed needs to keep rates lower for longer because higher rates were threatening the recovery. Moreover, the economy still faces headwinds: weak earnings growth, subdued credit creation and slowing corporate capital expenditure.
We believe interest rates will remain low for a very long time – particularly if Janet Yellen becomes the next Fed Chair. The Fed’s median forecast stands at 1% for 2015 and 2% for 2016. And the Fed further demonstrated its commitment to a data-driven approach. Once data start to recover, it would look to taper QE.
Q: What is PIMCO’s view of the U.S. housing market recovery and the effect of rising mortgage rates? Mittal: We think housing is set to recover another 5%–10% in the next 12–24 months. Affordability is still 20% above pre-bubble levels, while the Department of Commerce reports low inventories of only five months of sales. Nonetheless, higher rates are a drag. A $1,000 mortgage payment could buy a $225,000 house in May, but now it only buys a $195,000 home.
Q: When might inflation become a concern again? Mittal: We do not see inflation as a short-term concern in the U.S. given the excess capacity in the labor market and capital stock. We expect headline inflation to stand at 1.5%–2% for the next year. However, medium to longer term, we see two possible sources of inflation – besides commodity price spikes. One is the labor market: Further tightening there could lead to higher wages and inflation. The second is increased credit creation. Banks have about $2 trillion in excess reserves at the Fed. As the economy recovers, they may find it profitable to lend despite higher capital requirements. But for now, credit creation is growing modestly at 4% year-over-year, according to Bloomberg.
Q: In Latin America, what drove investors to the exit this summer, and was their reaction in line with fundamentals? Rahman: In our view, this summer’s moves were largely technical in nature affecting all emerging markets (EM). Fundamentally, many Latin American economies are robust, with strong balance sheets and cushions to withstand external shocks. Essentially, investors were reacting to the prospects of Fed tapering as well as the potential for a more hawkish Fed chair in Larry Summers. As a result, bond prices fell and volatility spiked, leading to some forced risk asset sales.
There are several reasons why emerging markets were harder hit than other credit sectors. First, EM is a relatively long duration asset class and one where currency exposures and local positioning are highly correlated, resulting in technicals in one sector of the asset class quickly affecting others. Second, since 2009 EM had seen strong inflows from crossover investors searching for yield, which reversed when U.S. duration prospects began to look more negative. Third, valuations in EM were relatively tight, with local nominal yields and EM spreads at recent lows. Finally, EM’s lower market liquidity meant that small changes in flows resulted in large price adjustments and market moves that were delinked from economic/credit fundamentals, with investors tending to sell more liquid positions.
On the positive side, Mexico can allow its currency to weaken and actually cut policy rates as markets are selling off, since its external indebtedness is relatively low. And because Brazil has an arsenal of foreign exchange (FX) reserves, it can intervene and offer U.S. dollars to its exporters.
Q: What is PIMCO’s outlook for the major economies and markets of Latin America? Rahman: We see growth picking up over the next 12 months to 3.0%–3.5%, but the outlook varies. Mexico should fare well given its strong institutional framework and structural reform progress, which could catapult it into stronger medium-term growth. Brazil’s story is more mixed given the challenging macroeconomic backdrop and next year’s presidential elections. We think credit will remain relatively strong amid cautious monetary policy focused on balancing inflation, FX and growth concerns. In Colombia, Peru and Uruguay, the improved outlook means navigating calmer waters with lower FX volatility and reasonably modest growth.
Inflation has been declining overall, and we expect it to remain contained around 5%. On the domestic front, the key factors to watch for are the impact of FX weakness and upcoming wage negotiations. On the global side, trends in commodities are key, particularly oil prices and the impact on metals, mining and soft commodities from stronger-than-expected growth in the U.S. and China.
Q: Turning to Canada, a number of investors seem to be pessimistic on its economy. Why isn’t PIMCO expecting a substantial correction? Devlin: Canada’s housing market is certainly heading down, but I do not think the correction will be as severe as many market participants are predicting. Overall, on the negative side, consumers are overindebted and consumption is going to be a drag on Canadian GDP, while the housing market will have to face the consequences of overbuilding. But on the positive side, net exports to the U.S. should improve due to the effects of the Fed’s ongoing expansionary monetary policy. Moreover, we do not expect interest rates to increase meaningfully in Canada anytime soon, and employment remains steady.
Overall, we expect Canada’s GDP to grow 1.5%–2.0% over the next year, a bit slower than U.S. GDP. The housing market is facing more of a growth issue than a stability issue. Residential construction is currently about 7% of GDP right now, according to Statistics Canada, which we expect to gradually drop closer to the historical average of about 5.5%.
Q: What are the investment implications of PIMCO’s cyclical outlook for the Americas? Devlin: We think credit spreads on Ontario and Quebec provincial bonds are relatively attractive, particularly at the 10-year part of the curve.
Rahman: A lower-for-longer Fed rate means favoring positions in Brazil and Mexico local rates and external credits (sovereign and corporates) in high quality balance sheets, which will be able to withstand global shocks.
Mittal: For the U.S., favor front-end rates since we think the Fed will very gradually take its foot off the accelerator. Also, certain credit sectors look attractive, like those tied to housing recovery, energy production and distribution, as well as certain short maturity, high quality credits. Finally, focus on liquidity for when the taper is back on the table.
A word about risk: Past performance is not a guarantee or reliable indicator of future results. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. All investments contain risk and may lose value.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
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