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Mohit Mittal, Ed Devlin, Lupin Rahman
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, Ed Devlin and Lupin Rahman discuss PIMCO’s cyclical outlook for the Americas over the next 12 months.
Q: PIMCO’s outlook for the U.S. economy in the year ahead has improved slightly from December to a range of 2.5% to 3% growth in real GDP. What is spurring the more optimistic forecast? Mittal: After being below consensus for 2013, PIMCO’s outlook for the U.S. economy for the next 12 months, at 2.5% to 3%, has moved closer to the consensus view.
The main source of the improvement in outlook comes from a reduction in fiscal drag. Recall that in 2013, we saw significant fiscal drag from the payroll tax hike, Affordable Care Act taxes and sequestration. The incremental drag from these measures will decline in 2014. Additionally, public sector revenues have improved, helped by higher asset prices and improvement in consumption. As a result, the fiscal deficit will decline to around 3.5% of GDP in 2014, which is near the long-term average, thereby eliminating the need for additional fiscal restraint on the economy.
In addition, we expect to see improvement in consumption driven by rising consumer optimism, easing credit conditions and steady job growth.
Finally, conditions are also ripe for modest improvement in corporate capital expenditures (capex) given high cash levels, favorable financing conditions and the high market value of equity relative to book value.
However, not all is in the clear. Monetary policy, at the margin, will be restrictive in 2014 relative to 2013 as the Federal Reserve looks to end quantitative easing (QE) over its next few meetings. Additionally, in spite of favorable conditions for capex, corporates are still choosing to do share buybacks and dividend distributions instead of engaging in long-term capex programs. Finally, the quality of job creation and income inequality remain concerns and could jeopardize the recovery in housing by delaying household formation.
Q: What are the risks to the positive U.S. outlook? Mittal: We think the biggest risk to the U.S. outlook comes from the ongoing tapering. During the last four years, whenever the Fed has tried to end QE, we have seen growth begin to falter. The end of QE can lead to higher interest rates that can hurt many of the rate-sensitive sectors of the economy like housing, auto lending and other forms of credit. The Fed will try to offset the impact of tapering through forward guidance – essentially providing details on the conditions it will look for before considering rate hikes. But words are a weak form of monetary easing relative to QE, and the market is at risk of pricing potential rate hikes pre-emptively, thereby leading to higher rates, which are a drag on growth.
Other risks to the U.S. outlook stem from the slowing growth trajectory in China. We see higher downside risks to achieving the official growth target of 7.5% in China as Chinese authorities try to manage the shadow banking system. Slowing Chinese growth has an impact on broad emerging markets growth as well as on U.S. corporate sector profits.
Q: What is the outlook for Canada? Do you think it will benefit substantially from the strengthening U.S. economy? Devlin: We see real growth in Canada of about 2% to 2.5%, while we expect core inflation to increase to the 1.25% to 1.75% range. Since the U.S. is Canada’s largest trading partner, accounting for three-quarters of total exports, Canadian growth should be helped by the recovery in the U.S. And as the recovery becomes more firmly entrenched in the private sector and less dependent on public policy, this will be a positive for Canadian exporters.
While the external sector will be a tailwind to growth, the economy faces headwinds from housing and the consumer. Canada has experienced a multiyear boom in housing that we believe will come to an end in 2014 as valuations have become stretched. In addition, over-indebted Canadian consumers will start to be more prudent with their borrowing and consumption. In our view, this will translate into lower growth in consumption than forecast by the Bank of Canada.
The wild card for growth in 2014 is business fixed investment. Globally, the recovery in capital expenditures by businesses has lagged what models would normally predict at this point in an economic recovery, and this has been a problem in Canada, too. The disappointment in capital expenditures makes sense to us as CEOs faced a severe shock to their businesses in 2008. It is tough to predict when animal spirits will engage, but as long as the system does not face another shock, the nature of a business cycle points to increased capital expenditures at some point. Also, given that Canada faced a smaller shock than other developed countries, it makes sense that capital expenditures in Canada may lead the G7 in this cycle. So we are cautiously optimistic.
Q: Is a housing correction in Canada imminent? Devlin: We expect a multiyear housing correction in Canada, and we forecast it will start in the second half of 2014 for a number of reasons. First, house price valuations look stretched, especially in Toronto and Vancouver where house prices are six to 12 times median family income. Second, Canadian consumers are over-extended as debt loads are at all-time highs − household debt is over 160% of disposable income. Third, we see mortgage rates heading higher in 2014, which will make housing less affordable; the Fed’s tapering should put upward pressure on bond yields both in the U.S. and Canada, and new banking regulations should increase the cost of funding for banks, making mortgages less attractive. Expect the Canadian banks to pass along these higher costs to their mortgage customers. Finally, CMHC (Canadian Mortgage and Housing Corporation) has increased its mortgage insurance premiums, which should decrease demand for houses.
We see the multiyear correction in housing as being relatively orderly, and we do not expect a “crash.” Our baseline forecast is for national house prices to be flat to down 10% over the next five years. This makes real estate a fairly unattractive investment because adjusting for inflation, we expect a decline of 10% to 20%. We are not more bearish on the housing market because Canadians are still broadly employed − the unemployment rate of 7% is below the 20-year average − and wages are growing, generally more than 2% annually. Also, while we see mortgage rates going higher, it should be a modest increase of about 1% over the next year or so. Banks are well capitalized, and we do not see a U.S.-style drying up of mortgage credit that would lead to sharply higher mortgage rates.
Q: Turning to Latin America, how is the region faring amid the volatility in emerging markets overall? Rahman: The region as a whole is performing relatively well so far this year. In the past three months, Latin America has strengthened along with other emerging markets, posting modest single-digit returns in external debt (+3% for the J.P. Morgan EMBIG) and local rates (+2% GBIEMGD), while currencies are generally weaker (-1.6% ELMI+) as of late March. This is very much in line with emerging markets as a whole, Latin America being in the midrange compared with other EM regions.
Of note, the theme of increased differentiation across credits and markets is continuing to play out. On the positive end of the spectrum, Mexico’s ambitious structural reforms look to be on track, with the focus now on the details of the secondary legislation and implementation. In the middle ground is Brazil, where attention remains on the government delivering fiscal consolidation, containing inflation and tackling the energy rationing issue given low reservoir levels. At the other end of the spectrum are Argentina and Venezuela, which have both seen increasing demand for U.S. dollars and where there appear to be some corrective policy actions to release some of the imbalances that are building up.
The political calendar has eased up somewhat: Elections in several countries are out of the way (for example, Costa Rica, El Salvador and Chile), but Colombia’s and Brazil’s presidential elections in May and October are still to come.
Q: What is PIMCO’s forecast for Latin America over the next 12 months? Rahman: We forecast growth of 2.5% as economic activity remains tied to both the U.S. and the outlook for the commodity sector. For Mexico and Brazil, economic momentum is turning positive with the worst behind us, although we don’t expect a sharp rebound in growth. On the inflation front, prices are likely to be sticky, with Mexico and Brazil Consumer Price Indexes hovering close to the upper bounds of their inflation targets. In Argentina and Venezuela, which have seen large de facto currency depreciations, inflation is expected to be elevated − in the high double-digits − as the currency pass-through feeds into prices.
Looking ahead across the region, we expect to see further economic adjustments to a world with the Fed taper and a slowing China. These will likely include improvements in monetary policy communication, efforts to consolidate fiscal accounts and further current account adjustments as weaker currencies start to affect the trade balance.
Q: What are the implications of PIMCO’s cyclical outlook for investors? Mittal: The odds of the U.S. economy maintaining another year of tranquility have increased. But the Fed must convince markets of its credibility as it exits QE. If it succeeds, risk assets should do well. However, investors should also recognize that valuations in most asset classes have risen given ongoing global QEs. In duration, investors should focus on short maturity U.S. rates instead of longer maturity rates, given the improving economic trajectory and the risk of the Fed raising rates around mid-2015. Similarly on the credit side, short maturity credit and credit sectors tied to the housing and consumer recovery offer value, provided companies are using that growth to de-lever instead of re-lever.
Finally, because liquidity will likely deteriorate as the Fed tapers and banks implement new regulatory requirements (for example, the supplementary leverage ratio and the liquidity coverage ratio), investors should focus on maintaining a high degree of liquidity.
Devlin: We expect overall returns in Canadian bonds to be modest and possibly negative as the process of market normalization continues on its bumpy journey in 2014. There are some strategies that investors can employ to boost returns. As inflation increases, we expect real return bonds to outperform nominal bonds. We continue to view the spreads embedded in provincial bonds as attractive, although, with the rally of the past couple of years and provincial elections coming, investors should expect volatility, and selecting good entry points will be important. Finally, “rolling down” the yield curve (realizing gains when a bond’s price increases as it nears maturity) will be another way to generate capital gains. To take advantage of roll down, investors should focus on the steepest part of the Canadian yield curve, which is the five- to 10-year sector.
Rahman: In Latin America, the combination of a modest pickup in growth, EM geopolitical risks and uncertainty over the success of the Fed’s forward guidance suggest focusing on strong balance sheet economies, which have the flexibility to deal with both external and domestic shocks. In external credits, we favor investment grade quasi-sovereigns and corporates, which widened in last year’s sell-off and now offer value versus fundamentals; in local rates, the long end of the yield curves in Mexico and Brazil offers value given the steepness of the curves and the vulnerability at the front end due to potential interest rate hikes by the Fed. However, in currency markets, we remain cautious on long positions versus the U.S. dollar given the potential for further bouts of risk-off sentiment in the markets.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. 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. Investors should consult their investment professional prior to making an investment decision.
The JPMorgan Emerging Markets Bond Index Global (EMBIG) is an unmanaged index which tracks the total return of U.S.-dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady Bonds, loans, Eurobonds, and local market instruments. JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (BGIEMGD) is a comprehensive global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure. JPMorgan Emerging Local Markets Index Plus (ELMI+) tracks total returns for local currency-denominated money market instruments in 24 emerging markets countries with at least U.S. $10 billion of external trade. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. 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. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
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