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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 2014.
Q: What is driving PIMCO’s forecast for an acceleration in U.S. economic growth to 2.25%–2.75% from 1.8% in 2013? Mittal: The biggest source of the increase between realized growth in 2013 and expected growth in 2014 comes from the fiscal side. Recall, 2013 was the year of significant fiscal drag: We saw approximately $85 billion in sequestration-related cuts in government spending, roughly $120 billion in incremental taxes from the expiration of payroll tax cuts and about $85 billion in additional taxes, including increases on higher earners, increases related to the Affordable Care Act and the expiration of other provisions. Finally, we had a two-week government shutdown. Altogether, we estimate that fiscal drag detracted about 1.3% from U.S. GDP (gross domestic product) in 2013.
Looking ahead, while we think some elements of fiscal drag will remain, the aggregate incremental impact in 2014 should be much smaller, detracting about 0.6% from U.S. GDP. This 0.7% reduction in fiscal drag should boost growth from 1.8% in 2013 to a range of 2.25%–2.75% in 2014.
There is also the possibility of improved consumer spending in 2014 due to improved wealth effects, as well as the possibility of improved corporate capex (capital expenditure) due to high corporate profits and continued easy financial conditions. And on the flip side, there is risk that a reduction in monetary stimulus in 2014 (through tapering of the Federal Reserve’s quantitative easing (QE) purchases) dampens the housing recovery, which remains sensitive to interest rates.
The Fed and market consensus see approximately 3% growth in 2014. PIMCO’s forecast is a little lower because we do not expect wealth effects to contribute as much, and we also think corporations will be more inclined to return cash to shareholders instead of increasing capex.
Q: The Federal Reserve announced it will begin to “taper” bond purchases in January. What measures can it take to keep markets and the economic recovery on track? Mittal: The Fed definitely has a difficult path ahead of it. It wants to taper because the marginal benefit of QE purchases is diminishing as the Fed buys more bonds. However, it does not want interest rates to move significantly higher, because higher rates could hinder the recovery in interest-rate-sensitive sectors like housing and autos.
In order to offset the effect of tapering, the Fed will likely try to focus the market’s attention on short-term rates, which hover around 0% and will likely remain there for a while. Through forward guidance, the Fed can communicate targets for unemployment and inflation rates that must be reached before it raises the policy rate. The Fed can also offset some of the impact of tapering by cutting the interest on excess reserves (IOER) – the interest rate (currently 0.25%) paid to banks for excess reserves held at the Fed. The idea behind cutting IOER would be to push banks into using more of the reserves to make loans to the economy, spurring growth.
In its recent meetings, the Fed has discussed and evaluated these tools, and we would expect it to use one or more of them in 2014. QE is one of the stronger forms of monetary intervention in the markets today; forward guidance or cuts in IOER (or both) will not completely offset the impact of tapering QE, but they should be a step in the right direction toward convincing markets about the Fed’s intentions of keeping rates low for longer. At the December meeting, the Fed mentioned that it will keep rates low well past the time that unemployment drops below 6.5% if projected inflation is low. This is another form of forward guidance.
Q: How do you see political developments in Washington affecting the U.S. recovery? Mittal: As I mentioned earlier, fiscal drag in 2014 will be smaller relative to 2013. Thus, by reducing the drag, D.C. is – in a sense – contributing positively to U.S. growth in the coming year. Additionally, the recent budget agreement as conceived by Rep. Paul Ryan and Sen. Patty Murray is a pleasant change from the complete dysfunction we saw throughout 2013, even though this budget increases discretionary spending in 2014–2015 and, like essentially all other things in D.C., uses longer-dated revenue increases and spending cuts to offset that spending. Also, Congress seems to be reaching an agreement on legislation to help President Obama win approval on trade deals.
We think these developments suggest that following the shutdown, political parties’ willingness to work together seems marginally higher. Nonetheless, we must recognize that even if the Ryan/Murray budget deal is approved by Congress, and even if the fiscal situation is less of a drag in 2014 relative to 2013 (though still a drag), we still face several policy complications: the ongoing sequester, the expiration of unemployment benefits, and the potential for another debt ceiling debate as the February deadline approaches, for a few examples. These could create further negative surprises to growth next year.
Q: Many emerging markets (EM) were rattled over the summer but have largely stabilized. What is PIMCO’s outlook for growth in the major economies of Latin America? Rahman: We are cautiously constructive on Latin America in 2014. The improvement in U.S. growth momentum that Mohit mentions, as well as broader economic stabilization in Europe and China, should be supportive of the region. We expect growth in the 3%–4% area on average, but with large dispersion across countries given increasing differentiation in trade openness, commodity dependence and policy frameworks.
On one end of the spectrum, you have Mexico, which is undertaking an ambitious structural and energy reform program, and is well poised to benefit from U.S. growth given its strong linkage with the U.S. On the other end, you have Argentina, where the government’s unorthodox policies are resulting in growing economic imbalances and increasing macroeconomic uncertainty, which is hampering productivity and growth. In the middle, you have Brazil, where growth has disappointed for the second year in a row as structural constraints start to bind and where the government seems unlikely to adjust policies meaningfully ahead of the October presidential elections. Nevertheless, supportive commodity prices due to a turn in global growth momentum will still be a tailwind for Brazil.
Q: What policy constraints do central banks in Latin America face? Rahman: Central banks in Latin America face the challenging task of navigating the various external cross-currents facing the global economy in 2014. Top of the list is the possibility of rapid currency depreciation due to Fed action and/or global risk-off moves in markets. In particular, if a move by investors to reduce risk is sharp and volatile, then central banks are most likely to react by intervening to smooth the overshoot and/or by providing U.S. dollar liquidity to the onshore market.
The good news is that most Latin American economies have built up large war chests of currency reserves to comfortably cover imports and short-term debt payments. At the same time, external debt ratios have fallen dramatically over the last decade, which means the negative balance-sheet effects of currency depreciation are more contained than before. The bad news is that the sheer size of potential capital outflows could be large given the foreign ownership in local bond markets and the scale of inflows into emerging markets since the financial crisis. In our view, several Latin American central banks ‒ Mexico, Brazil, Colombia, Peru and Chile, for example ‒ are well positioned to handle these cross-currents effectively with a combination of currency intervention, U.S. dollar liquidity provision and rate hikes if needed.
Q: In Canada, do you expect the economy to follow the U.S. higher in 2014? And does PIMCO expect any major shifts in the Bank of Canada’s (BoC) monetary policy under the new governor? Devlin: Canada should benefit from the U.S. recovery, which we expect to lead to higher exports, but similar to other developed countries, Canada is waiting for business investment to kick in, and so far, the animal spirits have been disappointing. Over-indebted consumers and over-valued housing markets should lead to lower consumption and residential investment, which means that Canadian growth is likely to lag U.S. growth in 2014: We expect real growth in the 2%–2.5% range.
So our baseline is unchanged, but in our view, the tail risks have changed under new BoC governor Stephen Poloz, who seems more dovish than former governor Mark Carney. While Carney was keen to raise rates above the 0.25% lower bound and was reluctant to get close to that level of monetary accommodation (barring an economic shock), Poloz seems to be open to using rate cuts to spur growth, if necessary.
Q: What are the investment implications of PIMCO’s cyclical outlook for the Americas? Mittal: First and foremost, we expect 2014 will be a year of continued uncertainty. While economic growth is likely to improve in the U.S., tapering could reduce market liquidity and also have negative consequences for EM countries. Hence, we focus on areas where there is a high degree of certainty.
In duration space, we find that certainty in two- to three-year U.S. rates. We do not think the Fed will begin to raise rates until late 2015 or possibly early 2016. Thus, front-end rates look attractive in the U.S. Similarly on the credit side, short maturity credit as well as credit sectors tied to the housing recovery offer value, given the improving growth outlook and the Fed remaining on hold. Finally, because liquidity will likely deteriorate as the Fed tapers and banks implement new regulations (for example, the supplementary leverage ratio and the liquidity coverage ratio), investors should focus on maintaining a high degree of liquidity.
Rahman: For Latin America, country selection will be important ‒ economies whose initial macro conditions and policy buffers offer more immunity against currency and interest-rate volatility should be favored over those whose policy responses to current external developments are not adequate.
Across the EM asset class, external debt spreads in Brazil are attractive, while in interest-rate space the front-ends of local yield curves look attractive. For example, Mexico is likely to keep interest rates on hold for longer, while in Brazil, current prices reflect the potential for excessive rate hikes versus our expectations.
Devlin: We expect that Fed tapering will lead to somewhat higher U.S. bond yields, and this should drag Canadian rates modestly higher, but at a slower rate than in the U.S. Provincial budget deficits continue to improve (albeit modestly), and so we think provincial bonds are a good source of high-quality carry for portfolios. As Canada’s economic performance lags that of the U.S. in 2014, we see room for further declines in the Canadian dollar, but we would be looking to buy the dips based on Canada’s strong secular economic fundamentals.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk. 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.
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