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, Josh Thimons, chairman of PIMCO’s Americas Portfolio Committee, discusses PIMCO’s outlook for the U.S. over the next six to 12 months.
Q: How do you think the political wrangling over the so-called fiscal cliff will play out, and how important is the result of the upcoming election to some kind of a deal? Thimons: PIMCO expects that the debate over the fiscal cliff will end in fiscal consolidation, but not a fiscal catastrophe. Of the $700-billion-plus in potential fiscal contraction on the table we expect around $200 billion to $250 billion to actually materialize.
While there are clearly differences in views between the parties, there is actually more agreement than disagreement between Democrats and Republicans on the fiscal cliff issues. For instance, Democrats and Republicans generally agree that the Bush-era tax cuts should be extended for those who earn less than $250,000 a year.
At the same time, the biggest area of disagreement is whether to extend the Bush income tax cuts for those earning more than $250,000. The Democrats are determined not to extend them, although there is some indication they would be willing to compromise on dividend and capital gains taxes; the Republicans obviously support an extension. Still, we think a compromise is likely before the end of the year, which certainly has recent political precedent.
With this in mind, we believe the results of the presidential and congressional elections will not significantly affect the fiscal situation. While the makeup of any agreement will likely be different under different election outcomes, we expect the size of the fiscal contraction to eventually be similar.
Q: The Federal Reserve recently announced its third round of quantitative easing, with an even more explicit commitment to keeping rates low and additional asset purchases. What does this mean for the U.S. economy? Thimons: With all of its policy measures, the Fed is attempting to influence asset prices and stimulate the appetite for risk. Low interest rates and outright purchases of mortgage-backed securities are intended to both lower mortgage rates for homebuyers, hopefully making credit more accessible, and increase investor interest in risk asset classes that offer higher return potential than the artificially low yields on Treasury and agency securities. The idea is that investors will be encouraged to take more risk in order to achieve return objectives.
Additionally, the extension of their guidance on a near-zero federal funds rate into 2015 is intended to reduce uncertainty about future monetary policy. By reducing uncertainty and even market concern about a future misstep down the road, the Fed is attempting to ignite animal spirits. Again, investors are encouraged to take more risks as term premiums and volatility in the markets decline.
Unfortunately, while the Fed’s monetary policy actions have been, by and large, successful in achieving its intermediate-term goal of increasing asset valuations, they have not been effective in influencing real economic outcomes. So while we believe that QE3 will continue to have a favorable effect on asset prices over the cyclical time frame, we are skeptical as to whether monetary policy alone will achieve its ultimate goal: a lower level of unemployment and a higher level of nominal and real GDP growth.
Q: What does the modest recovery in the U.S. housing market mean for the U.S. economy as a whole? Thimons: PIMCO has certainly become more bullish on activity in the U.S. housing market relative to our previous pre-crisis and post-crisis views. We expect a moderate increase in home prices over the next 12 to 18 months, and we expect the market to continue to benefit from a supportive tailwind particularly in light of the Fed’s monetary policy.
That said, a housing recovery is unlikely to have a significant direct impact on overall economic growth. This is in part because the role of the housing market as a primary driver of the U.S. economy has been dramatically diminished. Even if we were to see a double-digit increase in residential investment spending, that would translate to just a quarter- to a half-percent contribution to real GDP growth. So while housing will itself be a tailwind for the economy it will not have a critical impact.
To put that in perspective, our forecast for the drag on GDP from the fiscal cliff in the coming year is roughly negative 1.5%. Improvement in the housing market will only fill a small part in that hole. But it will have a multiplier effect through increased spending in other housing-related sectors, so the housing story will overall be a plus for the economy.
Q: How sensitive is the U.S. economy to an external shock? Thimons: We see three potential sources for an external shock to the U.S. economy over the cyclical horizon: further political and economic deterioration in Europe, a geopolitical crisis in the Middle East or a significant slowdown in economic growth in China and emerging economies in general. Multiple transmission mechanisms would allow each of these scenarios to affect economic conditions in the U.S.
The first, a breakdown in the European situation, would largely be transmitted through the global financial system and, in the U.S. specifically, the banking sector. Of course there would be a direct impact on growth due to decreased trade, but by and large it would spiral from disruption to financial services companies to volatility in the markets, decreased asset values and reduced investor confidence. However, our cyclical view on Europe is that the recent actions taken by the ECB have reduced, but not eliminated, the probability of a left-tail event.
The second potential shock, a geopolitical event in the Middle East, would likely lead to an increase in oil prices due to a disruption to supply. Given U.S. dependence on oil, higher prices would act as a tax on consumers, directly reducing GDP growth. Secondarily, adding a spike in oil prices to the already inflationary monetary policy in place in the U.S. could be potentially disruptive as well. A geopolitical event would also be a significant hit to investor confidence, with a similar ripple effect through the global economy as the situation in Europe.
Lastly, a sharp slowdown in China and the emerging economies would likely disrupt real economic growth in the U.S. because these economies are currently one of the main drivers of global growth.
Q: What is PIMCO’s outlook on inflation over the cyclical horizon? Thimons: While we are not expecting runaway inflation in the U.S. economy in the cyclical horizon, there are longer-term inflationary risks associated with the Fed’s extremely accommodative monetary policy. The Fed is in unchartered waters from a monetary policy perspective, and we are less convinced than the Fed that it can withdraw accommodation and excess reserves from the system as quickly as would be necessary should inflation manifest itself. Along with financial repression, inflation appears to be part of the policy prescription to both resuscitate the economy and reduce the impact of the U.S. debt burden. This prescription is a dangerous one. It took the Fed decades to establish its credibility in fighting inflation, and we fear that current policy measures threaten that credibility.
In this type of environment, we believe investors should look to real assets, such as real estate, hard commodities or inflation-protected securities, which are likely to outperform nominal financial assets.
Q: How should investors position their portfolios for the “muddle-down-the-middle” scenario PIMCO has forecasted for the U.S.? Thimons: Over the cyclical horizon, we think there are opportunities to position for our base case scenario for the U.S. economy, which is for neither a drastic recovery nor a massive recession. Among the areas where we see value are intermediate-term U.S. Treasuries. Intermediate maturities, in our opinion, are favorable versus very short-dated securities, which are yielding close to zero, as well as longer-dated securities, which are more at risk due to potential inflation and debt dynamic concerns.
If you believe the Fed will continue to be extremely accommodative, as we do, Treasuries in the five- to 10-year maturity range should continue to provide relatively decent risk-adjusted return potential. While the yields are certainly not at levels to get excited about, they do offer the opportunity for reasonable appreciation as they roll down the yield curve.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. 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. 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. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.
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.
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