The PIMCO outlook sees growth coming in at close to 2% in the U.S., Eurozone and Japan over the next 12 months. The U.S. growth forecast is below the consensus 2½% expectation, while the Eurozone and Japan forecasts are close to consensus. The PIMCO outlook is one of continued below-trend growth in the U.S., a return to trend-like growth in the Eurozone following the recent strength and a return to trend-like growth in Japan following the country’s recent soft patch.

Overall, this adds up to a soft landing for the U.S. economy and for the global economy following a period of robust global growth. The Federal Reserve and a number of other central banks remain focused on late cycle inflation risks, but we expect those concerns to subside. We expect a combination of continued sub-par growth and an improving inflation outlook to lead to Fed rate cuts, starting after the first quarter.

This benign outlook is very similar to what is priced into global bond markets, and indeed equity markets. But it is at the turning points in the cycle that forecasting is the most difficult. No one needs reminding how swiftly the Federal Reserve’s main source of concern shifted from upside inflation risks to downside growth risks between late 2000 and early 2001. Optimism last time round that the rest of the world would decouple from the U.S. slowdown had a short shelf-life.

Overall, we see the risks to our U.S. soft landing call as slanted to the downside. The U.S. housing market, which helped to support U.S. consumer spending and in turn the global economy earlier in the decade is now a significant source of global risk. Eurozone and Japanese economic performance has improved markedly. But growth that is driven by investment spending rather than consumer spending remains vulnerable if U.S. consumer spending slows significantly. The U.S. remains the world’s bass drum.

Partial Rebalancing

Slower U.S. growth means that the world economy has become a bit more balanced. The Eurozone and Japan took much longer than the U.S. to recover from the growth slowdown of 2001/02. But Japan’s 2% average growth rate over the past three years reflects a marked improvement on the lost decade of the 1990s, and has not relied on fiscal stimulus. The Eurozone economy has grown at about its 2% trend rate on average over the past three years. But recent performance has represented a boom by continental European standards. In the past two quarters the Eurozone economy has grown at a 3.1% annualized rate, faster than the 2.4% growth rate in the U.S.

The convergence of global growth rates across the G3 economies is shown in more stable year over year comparisons. The U.S. economy grew by 3% year over year in the third quarter, owing to greater strength earlier in the period, compared with 2.7% in the Eurozone and just under 1.7% in Japan. That represents considerable convergence already, following a period since the end of the U.S. 2001 recession in which it has grown roughly twice as fast as the Eurozone and Japan, and PIMCO’s forecasts see continued convergence next year around a 2% growth rate.

Within the U.S., growth has become more balanced, shown in Figure 2, owing to the moderation in consumer spending and the housing correction. U.S. consumer spending has cooled, growing by 2.7% year over year in the third quarter, compared with an average of about 3.5% since the start of 2004 and 3.7% over the past decade. Over the past two years U.S. GDP and U.S. domestic demand have expanded at the same rate. In contrast, over the past 10 years, domestic demand growth outstripped GDP growth by about half a percentage point per year. The current account deficit, which increased from 1% of GDP in 1996 to more than 7% in the fourth quarter of 2005 has since stabilized below that level.

 
Consumer Imbalance

The clearest sign of decoupling in the U.S. lies in the fact that the ISM non-manufacturing survey indicates the service sector remains strong, to date. The clearest sign of global decoupling lies in the fact that business surveys in the Eurozone and Japan remain at elevated levels, even though the expectations components have weakened.

Strong business confidence is reflected in strong investment spending. Gross fixed capital formation in plant and equipment has grown at close to a 6% rate in Japan since the start of 2004. Eurozone overall gross fixed capital formation grew at close to a 3% rate over the same period.

But as Figures 3 and 4 show, consumer spending has lagged, growing at about a 1.5% rate in the Eurozone and a bit slower than that in Japan. In part this reflects weak wage growth, which has been held down by both cyclical and secular factors, even though employment growth has strengthened this year.

On PIMCO’s baseline forecasts, a U.S. soft landing and growth at trend in the Eurozone and Japan next year will hopefully facilitate a handover to consumer spending outside the U.S., which is crucial to a rebalancing of the global economy over time. It would be easier to be confident that global rebalancing would continue during continued sub-par U.S. growth – or if there was a hard landing in the U.S. – if consumer spending rather than investment was already driving growth in the Eurozone and Japan. Business confidence and investment plans are likely to be highly sensitive to weaker than expected global growth.

 
Trying to assess the impact of flat or lower home prices on consumer spending is more of a walk in the dark. A large part of the problem is that there is no U.S. precedent for the current conjunction of a housing correction, a personal savings rate of zero and the uncertainty created by the boom in mortgage equity withdrawal (MEW) in recent years and its uncertain relationship with consumer spending. Therefore, it is necessary to be modest in making a forecast.

PIMCO’s  forecast of a U.S. soft landing includes the expectation of a moderate slowdown in consumer spending next year, with the negative ongoing impact from the housing market partially offset by wage growth and the boost to real incomes from lower energy prices. But there is a great degree of uncertainty in the outlook. Indeed, one reason the Federal Reserve has left rates on hold since June, in spite of near-term inflation concerns, must reflect concerns about the downside risks associated with the housing market.

The wealth effect from rising asset prices, and the greater ease of liquefying house price gains, has meant that, in aggregate, U.S. households have stopped saving out of income. Savings rates are hard to forecast, but the current stagnation of house prices and a reassessment of the rate of future house price appreciation will put upward pressure on the savings rate over time.

U.S. consumer spending has proved largely impervious to the forces of gravity in recent years. If MEW turns out to have been an important driver of consumer spending, then the leveling off of house prices and associated drop in equity withdrawal may have a more direct, mechanical and pronounced impact on consumer spending. Conventional economic models would put relatively little weight on MEW as a driver of consumer spending – as opposed to a financing device – but it is notable that Alan Greenspan has placed great emphasis on the importance of MEW.

The experience of the U.K. and Australia offer both comfort and warning. Consumer spending growth decelerated when the housing markets slowed in those countries in 2004-2005, but it did not grind to a halt. But it is not clear how useful those examples will prove as guides. The U.K. was helped by buoyant global growth and Australia by the commodities boom. Neither had the same huge rise in housing inventory that we have seen in the U.S.

Global Spillover Risk

Canada and Mexico are the economies most directly exposed to weaker U.S. growth. But in thinking about the impact of a weaker U.S. growth impulse on the global economy, direct trade links are only the starting point.

Figure 5 summarizes the ways in which weaker U.S. growth can impact the global economy, including trade, business confidence and a broad array of financial market linkages. Indeed, U.S. economic data and associated market movements at turning points in the U.S. cycle tend to have a greater impact on Eurozone and Japanese markets than the local data. To the extent that U.S. growth has contributed to lower crude oil prices, this has been a boost to real incomes in oil importing countries. Meanwhile, the Eurozone is experiencing another form of spillover, in the form of the euro’s appreciation against the dollar. 

There is little scope for fiscal offset in Japan. In the Eurozone, fiscal policy is set to tighten in Germany and some other countries. As for monetary policy, one question is how long the window of opportunity remains open for the Bank of Japan and possibly the European Central Bank to raise rates further. Fed rate cuts would send a signal of external risks. In the event of weaker than expected growth, the BoJ will be extremely reluctant to cut rates and past experience would suggest that the ECB would be in no hurry at all to react. Monetary policymakers in English speaking countries, which are further ahead in the rate cycle and, like the Fed, currently focused on near-term inflation risks, would be the first to follow the Fed’s lead.

China has provided an increasingly important source of demand growth in Asia owing to its rapid economic expansion and openness to trade. The U.S. has accounted for about 20% of overall global growth since 2002, measured at purchasing power parity (PPP) exchange rates, while China has contributed 30% of global growth. But while PPP adjustments make sense when gauging changes in global living standards, GDP calculated at current exchange rates sheds more light when it comes to judging global growth spillovers. (Particularly since the Chinese renminbi has been pegged to the dollar.) In spite of its rapid growth, in nominal U.S. dollar terms, China’s economy is not much larger than the U.K.

Since trade accounts for such a large share of China’s economy, the gap with the U.S. in terms of imports is much narrower than the GDP gap. In October, U.S. imports were worth about $182bn while China’s came in at about $64bn. But a large share of that import bill represents intermediate goods shipped in from China’s neighbors to be re-exported in the form of finished goods to the U.S., meaning that independent of the Chinese authorities’ efforts to slow investment spending, slower U.S. growth should have an impact on Chinese import demand. The U.S. trade deficit stood at $59bn in the month of October. China’s trade surplus was $24bn. Over time, continued growth and a shift towards consumption will mean that China will indeed emerge as a second global bass drum. For now it is the high-hat cymbal.

To give an idea of the amount of ground that would have to be made up in the event of a more pronounced slowdown in U.S. consumer spending, it is worth noting that U.S. consumer spending accounts for about 21% of world GDP, compared with 14% for the Eurozone and a similar amount for the whole of Asia, including Japan and China. As for the oil exporting countries, the OECD² points out that in spite of the big rise in petrodollars over the past few years, merchandise exports from its member countries to OPEC have been decelerating since early 2005. Oil exporters have taken over from developing Asian nations as the largest component of the global savings glut, measured by their combined current account surpluses.

Over time, strong growth in China and other emerging market countries will reduce the role of the U.S. in setting the global tempo – a long-term decoupling. A matter of secular concern is the question of whether the likely rise in desired savings relative to desired investment in the U.S. will be accompanied by a decline in desired savings relative to investment in the rest of the world. Part of the reason for high household savings rates in the Eurozone and Japan is concern about social safety nets as those populations age, while in emerging market countries, gaps in social safety nets and in some cases the absence of social insurance contributes to the imbalance between savings and investment. Every country can’t run a current account surplus: the world is a closed economy.

Risk Management

PIMCO’s baseline outlook of a U.S. and global soft landing, with the risks skewed to the downside, translates into a risk management approach to global portfolio management: positioning for the most likely outcome and taking insurance against the biggest tail-risks. Duration and curve bets remain most attractive in the U.S., where the Fed is likely to cut rates, similar to the 1995/96 cycle, as inflation concerns ease in the baseline case, and more aggressively if the slowdown is sharper than expected. The prospect of lower U.S. interest rates provides cyclical support for PIMCO’s expectation of U.S. dollar depreciation over a secular horizon.³ The English-speaking countries provide sources of diversification from the U.S., given past correlation of central bank cycles. The Eurozone and Japan look better positioned to withstand weaker U.S. growth than five years ago, but are vulnerable if downside risks to U.S. growth materialize owing to the imbalance between investment and consumer spending. The difficult question in the Eurozone and Japan is how long the window of opportunity for further rate hikes will remain open. The European Central Bank is in data-dependent mode. BoJ policymakers would like to be in data independent mode, but recent weaker indications on growth and inflation, and U.S. spillover risks are hard to brush aside. The BoJ will normalize rates over time, but if the Fed is in rate cut mode, the BoJ is likely to adopt a more measured pace than it might ideally choose. 

Best wishes to all for 2007.

Andrew Balls

Senior Vice President

andrew.balls@pimco.com

December 16, 2006

¹ For Paul McCulley’s overview of the forum see: http://www.pimco.com/LeftNav/PIMCO+Spotlight/2006/Cyclical+Forum+McCulley+12-2006.htm
  
² OECD Economic Outlook, 80, November 2006.
³ See Rich Clarida and Sudi Mariappa’s November Global Market Perspectives, “Dollar Downdraft to Resume: The Case for Currency Diversification” http://www.pimco.com/LeftNav/Global+Markets/Global+Perspectives/2006/Global+Perspectives+November+2006.htm