PIMCO Managing Director Paul McCulley leads the firm’s quarterly Cyclical Economic Forums, in which our investment professionals from around the world gather to discuss the outlook for the global economy and financial markets over the next 12 months. In the following interview, Mr. McCulley discusses the results of the September Forum and its implications for PIMCO’s investment strategy.
 

Q: PIMCO held its latest Cyclical Economic Forum in early September. What were PIMCO’s expectations for the global economy heading into the Forum and what were the key issues to discuss in updating the firm’s cyclical outlook?

McCulley: At the March Cyclical Forum, we concluded that global aggregate demand was strong enough to withstand the removal of monetary stimulus by the Fed, European Central Bank and Bank of Japan, leading us to expect a soft landing for the global economy.

 

Over the last six months, however, we have become more concerned about downside risks to growth, particularly in the U.S., because of the slowdown underway in the U.S. housing market. Therefore, many of the key questions that defined our discussions at the just-completed Forum were related to the U.S. property market. How nasty will the slowdown in housing become, in terms of both volume and prices? How nasty will the spillover effects of a slowdown in housing be for non-housing economic activity and growth?

 

Since the U.S. has led the global growth parade, many of the key questions we had at the September Forum in terms of the global outlook also related back to the U.S.  How contagious would a slowdown in the U.S. be for non-U.S. growth, and what would be the effect on inflation? And finally, how would global central banks react in this environment given current monetary conditions and inflation?

 

Q: What was PIMCO’s overall conclusion from the September Forum? Does the firm still expect a soft landing for the global economy?

McCulley: We continue to expect a soft landing as our base case scenario, but with a stagflationary smell. Specifically, we see appreciably slower growth for the U.S., with very mild contagion on non-U.S. growth, and with inflation a touch higher than previously anticipated. I should note that my modern-day definition for stagflation is when inflation has a majority share of nominal GDP growth, which allows for a stagflationary smell even at low absolute levels of inflation, versus the stagflation of the 1970s.

 

Looking at the numbers, the biggest change in our forecast is in the U.S., where we see real GDP growth over the next 12 months in a range of 2% to 2.5%, which is down from our March forecast of 2.75% to 3.25%. We also raised our core inflation forecast for the U.S., with the range now 2.25% to 2.75% versus 1.75% to 2.25% in March. In Europe, we continue to expect real GDP growth to range from 1.5% to 2%, which is unchanged from six months ago, but raised our core inflation forecast to 1.75% to 2.25%, versus 1.5% to 2% in March. For Japan, our forecast is 1.75% to 2.25% for real GDP growth, down from 2.5% to 3% in March. We made no change in our core inflation forecast of 0.25% to 0.75% for Japan.

 

On the face of it, our base case scenario would imply that central bankers get to do what they really want to do over our cyclical horizon: the Fed sits on hold, neither hiking nor cutting rates, while the ECB [European Central Bank] hikes a couple more times and the Bank of Japan hikes one or two more times. This scenario would also imply that the dollar has a downward tilt.

 

Q: Since the global outlook seems to depend heavily on the U.S., let’s start there. Why did PIMCO lower its forecast for U.S. growth?

McCulley: The consensus at our September Forum was that the recession in the U.S. housing sector—and, yes, it is fair to call that sector in recession—will be nastier than expected, both directly in terms of residential investment and indirectly via the effect on consumption. I hasten to add that not everyone at PIMCO agrees with that forecast. A vocal minority at the firm believes we are focused too much on housing, particularly its indirect effect on consumption.

 

But it is a fact that sales volume in the housing market is crashing, just as PIMCO’s housing guru Scott Simon and his team always said would happen first, before deflation—if any—hit prices. Slower volume has created an inventory problem for builders, and clearing their inventories means a cut back in production, which directly reduces GDP. What we don’t know is just how quick or drawn out this process will be. If builders reduce production quickly, the more negative it will be for growth in the quarters immediately ahead, and the quicker the subsequent recovery will be. The slower this process is, the more this inventory correction will act as a longer-term head wind.

 

Gauging the economic impact of slower existing home sales, which represent about 85% of total home sales, is even trickier. Existing home sales do not add directly to GDP, except to the extent of closing costs. These are not inconsequential, of course, and there has been a lot of job growth in recent years in the “closing costs” industry – real estate brokers, mortgage brokers, etcetera. Those industries are not going to be creating jobs but rather destroying jobs. That we do know.   

 

But the economy doesn’t “need” to create as many jobs as it did in earlier years because the U.S. is near full employment. Indeed, the Fed won’t let the economy create as many jobs as it did earlier in the recovery, particularly given recent evidence that labor market tightness is exerting some degree of upward pressure on compensation. So, in and of itself, a housing recession is not the stuff of an economy-wide recession, unless and until it tips consumer animal spirits into a recessionary funk.

 

Q: What did PIMCO conclude regarding the effect that a housing market slowdown might have on consumer spending?

McCulley: Collectively, we believe housing is a significant downside risk to our base case growth scenario. But we have to be humble about how much we just don’t know about the indirect effects of the housing market. Some of us believe the wealth effect from housing and mortgage equity withdrawals have been the wind beneath consumers’ wings, sustaining consumption in the face of tepid growth in real disposable income. Others at the firm are not so sure, particularly following recent and massive revisions upward in personal income growth. And then there is Scott Simon’s view, which is that mortgage equity withdrawals are simply a statistical reflection of the fact that housing turnover creates demand, over and above closing costs, for housing-related stuff. So again, we have to be humble about just how much we don’t know about how housing will perform and how it will affect the economy over our cyclical horizon. 

 

Q: Are there risks that PIMCO’s U.S. growth forecast could be too low?

McCulley: Perhaps. Some Forum participants noted that energy prices might not go up and just might come down a bit; after all, prices have come off quite sharply in recent weeks. Could it be the case that consumers have been in a funk not just because of the softening property markets, but also because of gasoline prices at the pump? It’s hard to know, but this is an upside risk to growth that can’t be ignored.

 

Q: Given PIMCO’s forecast for slower growth, as well as the risks to that forecast, what does the firm expect from the Federal Reserve over the next year?

McCulley: The Fed’s decision to stop tightening was one thing, but a decision to start easing will be quite another thing. The Fed ended tightening because it had tightened a lot, inverting the yield curve in the face of incoming evidence of a housing market slowdown. So stopping the tightening campaign was not a hard call, even with inflation above the Fed’s putative comfort zone of 1% to 2%. Inflation is, after all, a lagging variable and inflation expectations have been well contained. Given the Fed’s dual mandate to promote full employment as well as maintain price stability, continued tightening would have been the greater surprise than stopping.  

 

However, the hurdle to starting an easing process is high, because the Fed actually does want to see softer employment growth, stabilizing the unemployment rate, if not letting it drift up to or above the 5% level that is presumed to balance growth and inflation. The recent acceleration in unit labor costs no doubt reinforces this presumption regarding the need to get the unemployment rate up toward the 5% level.    Thus, a deceleration in growth is not necessarily sufficient on its own for the Fed to start easing, particularly when the Fed wants inflation to actually come down rather than just stop going up.

 

The Fed has communicated that it has a fair bit of patience about waiting for inflation to fall back into its 1%-2% comfort zone, and we still think the decision to pause in August wasn’t a pause, but an end to the tightening process. Nonetheless, for the Fed to start easing in the face of inflation above the comfort zone, the risks of an economy-wide recession must become much more visible. Those risks aren’t there at the moment, and on our base case forecast, they won’t get there over the cyclical horizon. But the risks are moving in that direction.

 

Q: Turning to the rest of the world, what did PIMCO conclude regarding how contagious a U.S. slowdown would be for Asia?

McCulley: The China juggernaut has got some very serious legs. Yes, China does depend too much on growth in exports to America for its aggregate growth. But let there be no mistake: China is in the midst of a powerful domestic investment boom.    And only part of that—a small part—is related to the 2008 Olympics in Beijing.    

 

Some of the investment going on in China is undoubtedly excessive, mal-distributed and perhaps even plain stupid. But the sins of excess investment are not revealed in real time, only in the fullness of time. And we concluded that time is highly unlikely to become full over our cyclical forecasting horizon.   

 

We also concluded that China’s continued growth has profound implications for the rest of the region, in particular Japan. Yes, Japan is still “dependent” in a meaningful way on durable goods exports to the U.S., notably in the motor vehicle sector. And if car and truck sales in the U.S. slow sharply, on the back of elevated gas prices and/or indirect multiplier effects from housing, Japan would certainly feel a growth pinch.  

 

At the same time, our Asia Team reminded us that Japan is a huge and growing exporter of capital goods to China, which plays beautifully to Japan’s comparative advantage. And as long as the China investment booms continues, Japan is less coupled to U.S. growth than has historically been the case. This is particularly true given that the Bank of Japan is likely to be very kind and gentle in normalizing monetary policy from a very accommodative stance, which has the effect of both encouraging and de facto subsidizing risk-seeking behavior in the domestic Japanese economy.   

 

To be sure, the Bank of Japan really does want to continue the normalization of monetary policy, after the very adroitly-handled exit from quantitative easing and the zero interest rate policy. There are those at the Bank of Japan who are concerned about inflation, though their concerns are linked more to asset price inflation than to goods and services inflation. But with the recent re-benchmarking of Japanese inflation data, which pushed inflation lower, our Japan team assures us that concerns about inflation at the Bank of Japan will be well contained.

 

Q: For Europe, PIMCO made no change to its forecasted growth range but did raise the forecast for European inflation. Why no change in the European growth forecast?

McCulley: We actually are looking for a deceleration in European growth. But Europe really is a low-volatility region when it comes to growth: robust at the top of a 1.5% to 2.5% range, and gnashing of teeth at the bottom of that range. European growth is at the top of that zone right now for two reasons. One is sturdy business confidence, due in part to robust capital goods exports in Germany. The second reason is sturdy consumer confidence elsewhere in Europe, on the back of strong property markets, which are fueling robust consumer borrowing and pulling down the personal saving rate.

 

The anticipated deceleration in European growth reflects our expectation that these two sources of exuberance—business and consumer confidence—will moderate, in part because policy makers want that to happen, with fiscal tightening in the cards in Germany and elsewhere, and the ECB determined to rein in credit and monetary growth.

 

Indeed, the ECB remains wrapped around the axle of inflation risks, even though core inflation has actually been slowing and is currently running 1.5%. If the Fed were running the ECB, the next move would be to ease, not tighten! But make no mistake, the ECB has a single mandate of headline price stability and inflation has almost always been above target since the ECB’s creation—much to their embarrassment. Thus, the risk for Europe is a policy mistake, with the ECB tightening because they can, not because they should, piling monetary tightening upon fiscal tightening.

 

Q: What is the risk to emerging market countries if the U.S. economy slows as PIMCO expects?

McCulley: The story in emerging markets is much as it has been for a long time: improving domestic fundamentals and institutions, large stocks of self insurance in the form of reserves, and the joy of riding a positive terms-of-trade shock borne of soaring commodity prices.

 

The story isn’t uniformly positive; there are differences. But in general terms, the contagion risk of decelerating growth in the U.S. is much less than has historically been the case. That doesn’t mean the emerging market countries won’t feel a slowdown in the U.S. They certainly will, particularly if commodity prices retreat. But the secular improvement in emerging market fundamentals will cushion the impact in a very material way. Emerging market countries never want to have another experience like they had in 1997-1998 and have taken appropriate steps to prevent that outcome.

 

At the same time, over our cyclical horizon, emerging market countries are unlikely to be an independent source of global aggregate demand growth. Over the long term, the emerging economies will mature and morph from mass producers to mass producers who are also massive consumers, but not during the cyclical timeframe.

 

Q: How is the updated cyclical outlook influencing PIMCO’s portfolio strategy?

McCulley: As base cases go, we think this is a pretty sensible scenario and essentially a “Goldilocks” outcome—not too hot, and not too cold—for the global economy. What is more interesting and more actionable from a portfolio strategy perspective is the distribution of risks around the base case. It’s a risk management world. You take your best shot at figuring out the baseline scenario, then you figure the distribution of risks around that central tendency and then you take action accordingly by setting or changing risk exposures.

 

Currently, a great deal of our focus is on the downside risk to our base case forecast, primarily due to the property market in the U.S. We have not seen a property market bubble burst in a long time, and previous examples have been in the context of nasty Fed policy, or a shock, or a recession. So popping a housing market bubble in the context of a non-recessionary outcome is a forecast that I’ve never made in 25 years. That doesn’t mean it’s not the right forecast, but you can’t draw upon history to have a huge amount of confidence that it will unfold that way.

 

We also recognize that there are upside risks to our forecast, notably in the U.S. given the sturdy growth in personal income and the decline in petroleum prices. If we consider $3 gas in the U.S. to be a tax hike on the consumer, we also have to consider a decline to $2 gas, in relative terms, to be a tax cut. But in general, we think the risks to our forecast are skewed to the downside.

Q: Thank you, Paul.