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Anne Gudefin, Maria (Masha) Gordon
Certain developed nations appear to be facing the potential for flat, or even tepid, economic growth, while some emerging nations are beginning to face inflationary pressures and other challenges resulting from their faster growth rates. Investors may find asset allocation challenging in this multispeed world.In the fifth of a series of Q&A articles accompanying the recent release of PIMCO's Secular Outlook, portfolio managers Maria (Masha) Gordon and Anne Gudefin discuss global growth and inflationary dynamics and what they may specifically mean for equity markets in the years ahead.Q. PIMCO has said low real interest rates have pushed investors out the risk spectrum. Could you discuss what that means for equity valuations?Gudefin: There definitely seems to have been a rebound in risk tolerance since the financial crisis, which in turn has supported higher equity valuations. We believe this higher appetite for risk has been encouraged by central bank activities that tend to ultimately suppress real interest rates.But we do view some pockets of opportunities in the equity market. This can work in investors’ favor as it allows them to remain contrarian and look for good investment opportunities. And considering that PIMCO sees gradually rising inflation in the years ahead, I believe some equities may outperform fixed-rate securities over the next three to five years since certain companies appear to have the potential to translate nominal growth into higher nominal earnings.Q. Some economic indicators suggest growth may be slowing in parts of the world. What is PIMCO’s outlook, and how are companies positioned for that outlook?Gordon: After two years of strong growth, emerging market (EM) economies appear to be undergoing a mid-cycle rebalancing. We view this as a welcomed cyclical adjustment rather than the end of their growth cycle. Fiscal consolidation, macro prudential measures and monetary tightening are likely to have the desired effects of slowing domestic demand and curtailing asset bubbles. In some places, such as China, this process appears to be well advanced.These countercyclical measures are likely to put modest pressure on earnings of select EM corporates, particularly EM banks in countries where growth in credit has been buoyant. However, we still see the EM corporate profit pool growing at a healthy clip of 10% to 12% in 2011.Gudefin: As part of PIMCO’s New Normal worldview, advanced economies should see headwinds to growth including deleveraging and greater regulation, and these could persist for the next few years. This potentially means investors may be generally willing to pay lower multiples to earnings, especially if high unemployment persists and growth remains moderate in advanced economies, as we expect. Still, many developed market companies have greatly improved their cash positions, though they seem to favor investing in developing economies and distributing their earnings through dividends or share buyback programs. Perhaps they feel it is better to distribute their earnings than increase production capacity in the developed world, given the limited growth outlook for that part of the world.Q: Does PIMCO still view emerging markets as a compelling growth story over the long term? What about inflation risks?Gordon: Yes. We believe that the long-term fundamentals remain intact, and they include demographics favorable to growth, unleveraged consumers and a thirst for investment that is poised to underpin further productivity gains. Over a secular horizon, we expect to see a move to a more balanced growth model across the larger EM economies, such as China, with diminishing reliance on exports and greater contribution of domestic consumption. Along with these trends we anticipate appreciation in EM currencies.As to inflationary pressures, while they appear to have started homogeneously across emerging economies emanating from higher food prices and robust gross domestic product (GDP) growth, they are likely to become less synchronous over time. For example, Mexico seems to be experiencing little if any price pressures due to a weak labor market and less robust domestic demand. Differentiation is key as reality appears to be far more nuanced. This underscores the importance of incorporating a global macro framework to one’s bottom-up stock selection process. Over the secular horizon, we are likely to see a rise in wages in EM countries that may lead to a somewhat higher level of trend inflation. On average, emerging market companies should be able to adjust to this environment since they tend to have pricing power due to the health of EM consumers and because corporate leverage is only about 20%. Clearly, there will be exceptions to this rule such as companies that depend on wholesale funding to finance working capital or firms that are involved in low-end manufacturing.Q. Considering PIMCO’s outlook, what are the key metrics you look at when evaluating companies? Gudefin: We are attracted to good business models. We have observed over the years that quality companies tend to perform well, and we look for companies with high barriers to entry and strong cash flow generation and the ability to pay down debt. And we evaluate businesses based on what kind of pricing power they might have in the face of rising inflation. We also look at management’s ability to successfully steer the ship and catalysts for value to be unlocked. This is usually in the form of a new CEO, a restructuring program or maybe plans to spin off or divest non-core assets. We look to buy these high quality companies at times when short-term issues bring valuation to what we feel are attractive levels. Our strategy, as it relates to the global economy and its many influences, remains opportunistic. For example, companies in developed economies with significant exposure to developing ones could be a place to search for attractive opportunities. Also, part of our worldview is for the potential for heightened market volatility – as our CEO Mohamed El-Erian likes to say we are on a bumpy journey – and that can create attractive opportunities as well. In addition to discerning security selection, we aim to mitigate downside risk through the use of appropriate risk hedging strategies. I believe the ability to hedge our portfolios is a key differentiator for us.Gordon: We spend a lot of time thinking about the return profile of businesses, favoring those that have high cash flow return on invested capital. Another important consideration for us is an ability to self-finance growth. A number of emerging market franchises may look great from the revenue growth perspective but they often rely on continued financing from new equity issuance that may not be return accretive or sustainable.The maturity profile of a company’s debt is also an important consideration as business cycles in emerging economies tend to be shorter and companies that rely on short-term financing may find themselves locked out of the market.Q: Finally, are there any secular equity market considerations that haven’t received much attention but deserve to?Gordon: We believe China should continue its move up the value chain in select industries. Over the medium term, this could result in significant margin pressure for the European and U.S. industrials that have enjoyed unchallenged dominance of the Chinese domestic market.Separately, a potential retreat of the United States from dominating global geopolitics is likely to lead to a power vacuum giving rise to regional powers. In light of this, we think defense spending will likely grow considerably in larger EM economies. Gudefin: In the energy sector, many have written down nuclear energy after the Fukushima tragedy. Although some reactors will be closed, we believe it is not the end of nuclear. Safety norms will tighten, but a number of developing economies will likely continue their aggressive construction plans, starting with China, India and South Korea. Saudi Arabia reaffirmed in June its commitment to build 16 reactors by 2030.
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. ©2013, PIMCO.
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