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It’s a low-rate, low-growth world. But even as China slows and dynamics are set to shift for equity markets over the next three to five years, PIMCO sees opportunities for investors. Virginie Maisonneuve, Deputy Chief Investment Officer and global head of equities at PIMCO, discusses her long-term outlook for markets, sharing key conclusions from our annual Secular Forum in which investment professionals gather from our global offices for a detailed examination of markets and economies. Following this May’s Forum, PIMCO defined the global economy as approaching The New Neutral.
Q: What are the implications for equities if the Fed’s neutral policy rate is close to zero in real terms and 2% nominally in the years ahead as described in PIMCO’s New Neutral worldview?Maisonneuve: There are several implications for equity investors of the low rate, low growth environment that we expect over the secular horizon. The combination of high leverage in the global economy (mostly due to elevated government debt, which is in turn due to actions undertaken during the crisis to ease systemic risk) and slack in the global economy (as shown by relatively elevated output gaps) is constraining the ability of central banks to normalize monetary policy quickly – therefore it is likely to come at a very measured pace. In other words, the patient is healing, but that doesn’t mean he can be taken off life support overnight! In addition, the combination of this environment together with key long-term trends that affect global supply and demand – namely the need to adjust to competitiveness in a lower-carbon economy, important demographic shifts globally and continued shifts in emerging markets – supports the case for lower long-term economic growth globally.
Overall, however, the low rate environment will be supportive for stocks provided inflation remains subdued, as companies can take advantage of historically cheap financing. While bank lending remains constrained, particularly in Europe, good companies – such as Apple recently – are good examples of how companies are using low rates to tap the market for liquidity. This access to financing is particularly helpful to companies in sectors or activities with attractive demand profiles relative to overall demand in an otherwise slow growth world. This outlook means that investors should look for alpha and stock-picking skills as opposed to equity beta in the years to come. Strong teams with strong processes and proven ability to exploit market inefficiencies are key.
Also, current valuations are fair. Globally, they are not cheap, but neither are they expensive. And, in a world headed toward low real policy rates, equity risk premiums are exhibiting unusual characteristics relative to historical levels. I believe that in a relatively stable environment, equity markets exhibit attractive expected-returns-to-valuations ratios, especially when considered versus other sources of investment returns, such as cash. In emerging markets (EM), valuations are in fact inexpensive, but there are other issues in EM, including the difficulties in Russia and the steep slowdown in growth in China. Those pressures are mostly priced in, however, and underweight investors should consider adding to their positions. While emerging markets have been hurt by the prospects of tapering and policy normalization in the U.S., The New Neutral outlook may help reverse some of those fears. The extent to which EM countries can use interest rates to manage their economies and limit upward pressure on their currencies will likely be the key differentiator in secular EM performance.
Volatility is another important consideration, and here, one must understand the relationship between a stable economic environment (low growth, low inflation, low rates) and equity markets volatility. While volatility as measured by the VIX index has come down sharply recently, we should expect bouts of volatility surges that coincide with unexpected pressures, political or otherwise, that might appear in a world with a delicate economic and geopolitical balance.
Q: PIMCO sees China’s growth slowing from more than 7% to an average of 6% over the next three to five years. What does that mean for global equities broadly? Maisonneuve: Undoubtedly China is slowing down, which will have a dampening effect on the global economy, but it’s important to remember that China is still a growing economy and it is still gaining market share of global growth. It is the second largest economy in the world, behind the U.S., and it might be on its way to becoming the largest.
China is undergoing demographic, economic, political and governmental transitions. Their new leader, President and Communist Party General Secretary Xi Jinping, aims to bring China forward to a new age of growth and standards. He is trying to change how things are done in China. His anti-corruption, anti-pollution campaigns combined with political refocusing converge toward structural adjustments and away from heavy investment cycles and inefficient capital allocation. Although very positive for the country over the medium term, the anti-corruption policies are dampening short-term growth as they hit consumer spending and, to a certain level, delay business decisions and initiatives. The “roll-over” of the property market in China recently is a signal of this happening. There is also another potential ripple: China is the largest emitter of CO2 pollution in the world, and there are signs of backlash emerging from the general population. People are upset by the impact pollution is having on their lives.
Dealing with these issues – and curtailing the explosion in “shadow banking” of recent years – is a long-term positive for China, but it will slow domestic growth, and have an impact on global growth. We could see China GDP running at 5% by 2018.
Q: Which (types of) companies or industries are the likely winners and losers in the environment ahead? Where does PIMCO see opportunities for investors?Maisonneuve: While we believe it is likely to be a positive environment for equities, in order to get alpha, investors need to focus on the growth areas – regions, sectors and companies – that will benefit from solid fundamentals. Investors also should focus on super-secular trends that will be drivers of growth or change over the long-term horizon. Shifting demographics, climate change and a growing middle class in emerging economies will have profound effects on supply and demand dynamics, for example.
Certain industrials in the U.S. and globally stand poised to benefit from shifting global dynamics, particularly with regard to new energy, capital expenditure, productivity enhancements, energy efficiency and electricity generation, all of which show positive long-term trends. We are also bullish on consumption. Given changing demographics and an emerging EM middle class, we expect to see gradual increases in demand. Product innovation and brand recognition are essential there.
Also, exposure to companies that offer dividends likely to grow over time can be useful for investors in a lower growth environment, and can help extract alpha. Investment strategies focused on dividend growth can also serve an ageing population in search of income in a low interest rate world. And in an environment where slow growth creates potential bouts of volatility in an otherwise lower volatility world, investors may also benefit from very patient, contrarian stock-picking strategies that also offer capital preservation potential. In addition, we believe strategies that can leverage information on stocks from both long- and short-term perspectives will usually have a competitive advantage. Finally, strategies that can target alpha in emerging markets or globally by selecting good companies with solid growth potential and attractive competitive advantages should do well.
Q: This was your first Secular Forum at PIMCO. How do equity investors benefit from the Forum process?Maisonneuve: I believe that to be a successful stock picker, one requires a focus on fundamental analysis. In order to evaluate valuations, growth potential for businesses and sectors, competitive pressures, etc., investors need to have a robust macroeconomic and secular framework. What I find particularly beneficial about the Forum is the robust and candid debate from some of the smartest investors I have ever met. The debate, the discussion is key for me: That is exactly how I run my team.
Many equity investors do not embrace the top-down macroeconomic analysis that we believe is essential. PIMCO’s investment culture combines top-down and bottom-up analysis and that is one of the reasons I came to PIMCO.
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