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Scott A. Mather
As the eurozone crisis escalates, PIMCO’s Scott Mather, managing director and head of global portfolio management, explains its increasingly global impact. He discusses PIMCO’s view on the likelihood of a resolution in the coming months, the role of the European Central Bank (ECB), and finding investment opportunities in the eurozone and abroad.
Q: What is PIMCO’s view on the likelihood of a “silver bullet” resolution to the eurozone crisis?
Mather: At this point, we do not anticipate an immaculate policy solution, or so-called “Grand Bargain,” in 2012. The recent bout of European Union summits fell well short of delivering a solution to the structural problems of the eurozone; what little was agreed fell victim to implementation challenges once policymakers flew home. At this stage of the game, coordinated global policy action to support the eurozone would qualify as a black swan event – but, of course, in this case an extremely positive, right tail event so maybe we should call it a “golden swan” event. Unfortunately, the alternative, a continuation of reactive policy in Europe, is not only insufficient to stabilize the situation but will also likely exacerbate the crisis. The question now is whether the crisis spirals out of control, sending the global economy into something worse than a recession.
Q: Has the situation in Greece stabilized or is there continued risk of default?
Mather: Despite recent efforts – the Private Sector Involvement (PSI) agreed upon at the October EU summit and the €110 billion in stop-gap loans from the IMF and EU – Greece will likely only stave off default until the first quarter of 2012, in our view. The PSI plan is unlikely to get the support necessary to get off the ground, and even if it does, the PSI will not be the end of the story. It will help shrink a portion of Greece’s debt, but the country will continue to have an unsustainable debt load until policymakers can come up with a credible plan to generate economic growth.
Q: Would a default by Greece be a catalyst for other peripheral countries to exit the Economic and Monetary Union (EMU)/EU? What are the implications of a weak country departing?
Mather: It is unclear that Greece or other peripheral countries would voluntarily choose to compound its short-term problems by exiting the EMU (and most likely the EU on a contingent basis). Leaving EMU may ultimately be the right long-term choice for a country, but it would entail significant near-term pain over and above the pain of default.
It is important to remember that European political leaders want to hold the currency union together even in the event of a country default for fear that a country leaving EMU may start in motion a difficult-to-stop process of breakup. However, one should consider other scenarios that may lead to EMU exit: A curtailment of ongoing official lending support brought about by political change, austerity fatigue, or a run on a country’s banking system may also increase the possibility of an uncontrollable exit from EMU.
Any country leaving the EMU – even a peripheral country – would significantly weaken the EMU as a whole. It would create a large uncertainty for the future of the currency union, hinder economic activity between all countries, and raise the risks of uncontrollable breakup. Even if the weak countries left the eurozone first, it is unlikely the currency or remaining countries would be perceived as better off given all the uncertainties this would create. Consequently, the interests of all countries, strong and weak alike, is in maintaining the currency union for the time being.
Q: Many people seem to believe the eurozone crisis could be resolved if the ECB goes “all in.” Why isn’t the ECB acting as the lender of last resort like the U.S. Federal Reserve did in the 2008-2009 financial crisis?
Mather: On some measures, they already have gone all in; today, the ECB’s balance sheet is bigger than the Fed’s and continues to expand. So it is lending quite substantially in the eurozone. Some argue that the ECB should print more money and buy all of the peripheral country debt. But the reality is that the ECB cannot, by treaty or mandate, legitimately monetize this debt. Moreover, printing euros and buying debt is not a long-term solution to the structural challenges underlying the eurozone crisis. The ECB does not want to be a bridge to an unsustainable and adverse economic destination. They would rather force politicians to address the critical problems of the currency union now.There is another limit to ECB intervention: the bank’s historical legacy. The ECB was modeled on the German Bundesbank, which has a strong influence on the ECB, and the German population has vivid memories of the disastrous long-term consequences of debasing currency by printing money. So the ECB is hesitant to monetize the debt for a short-term benefit when doing so would put at risk the credibility they have spent years earning from the markets. In addition, large scale debt monetization may sow the seeds of eventual EMU breakup, albeit by a different path than the advocates of monetization are currently worried about.
Q: What are the investment options for global investors who want to retain exposure to Europe?
Mather: Investors in the eurozone will continue to face difficult choices as credit and economic risks rise. It is likely that very large divergences will continue to develop based on sovereign debt dynamics. Investors will likely continue to focus on better balance sheet countries like Germany and avoid the rising risks associated with weaker countries. German bunds are in relatively scarce supply but we believe represent the lowest risk and most liquid sovereign choice within the eurozone. But there are other high quality alternatives in agencies, covered bonds and corporates. Investors within the eurozone need to remain extremely diligent in analyzing the fluid dynamics within Europe in order to navigate the crisis; the risks and opportunities will look substantially different as the crisis response unfolds.
Q: Looking beyond the eurozone, how should investors think about global investment opportunities?
Mather: Although our outlook calls for muted global growth of 1%-1.5% over the next year, it is important to remember that a low growth and low inflation environment is generally good for bondholders. However, investors must be discerning when making investment decisions given the rapidly shifting nature of risk; countries that have traditionally exposed investors mostly to interest rate risk now exhibit credit risk, while countries that historically embodied primarily credit risk now increasingly represent interest rate risk. This complicates matters for those investing abroad and highlights the importance of diligent macroeconomic analysis.
Within the developed world, we believe Australia, Canada, the U.K. and selected Scandinavian countries with strong balance sheets and solid economic prospects offer some of the best opportunities for global investors. And though they may experience volatility, we think emerging markets, especially in Asia, are also attractive since their economies stand to benefit from the secular shifts we anticipate over the coming years.
Q: Finally, the economic conditions in many other developed countries are strikingly similar to those in the eurozone. Will other countries be able to avoid the fate of the eurozone?
Mather: Ultimately, the eurozone countries and many other developed economies have very similar problems: unsustainably rising debt loads coupled with structurally weak and imbalanced growth. Too many developed world economies have been built on a perverse economic model of issuing more and more debt to create the illusion of economic growth with less and less success. It’s clear that borrowing from the future to consume today has severe consequences and eventual limitations. Until an entirely new economic model is developed, much of the developed world will likely continue to build imbalances that ultimately lead to severe economic crises.
Unlike many eurozone countries, the U.S. and other developed sovereigns have the ability to monetize their debt by printing money. But these machinations are not long-term solutions because they do not address the underlying problems of the economy. Frankly, they are a band-aid solution that simply buys the U.S. and others more time to develop lasting solutions, though politicians seem to be doing their best to avoid making hard choices. Europe does not enjoy the luxury of time and is being forced by the markets to make choices among a poor set of options. The lesson for the U.S. and potentially others is that waiting until the eleventh hour may not be the optimal strategy.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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