The U.K. housing market has been an ongoing topic of conversation at our quarterly Forums. What makes the British housing market interesting beyond its current impact on MPC policy is its recent history. In 2004, the MPC engineered a soft landing of the U.K. housing market after much higher growth rates than we have seen in the U.S., and all this without doing too much damage to the economy. We therefore started to look at the U.K. as a potential model for the slowdown in the U.S. housing market and the impact on the economy. This discussion continued at the September Forum.
Q: What were PIMCO’s main conclusions regarding the outlook for Europe following the Forum discussions?
Mather: We continue to expect real economic growth in the euro zone to slow to a range of 1.5% to 2% real GDP, which was our forecast following our last Cyclical Forum in March. However, we concluded that inflation is likely going to be a bit higher than we previously thought and we raised our headline inflation forecast to 1.75% to 2.25%, versus 1.5% to 2% in March. Our inflation forecast changed largely as a result of energy prices and an increase in the value added tax (VAT) in Germany, which is a sales tax that is included in prices of goods purchased.
This view on inflation is not heavily impacting our portfolio construction, though. The still remaining slack in the labor market of the euro zone and very low core inflation, which excludes food and energy prices, will dampen inflationary effects as they have over the past couple of years when energy prices spiked and the economy showed decent growth. To eliminate the slack it would take in our view another year or two of economic growth above potential but we don’t see this happening.
As with the euro zone we expect growth in the U.K. to slow significantly in 2007 to levels below what the market expects. There are not that many effects from fiscal and monetary tightening in the U.K. but it is – as I mentioned – an economy that is more exposed to external developments than the euro zone. In addition to external factors we expect the recent rate increase by the MPC to slow U.K. growth further since the monetary policy transmission works more quickly and with greater force in the U.K. than in the euro zone.
Q: How are global developments influencing PIMCO’s forecast for economic growth in Europe?
Mather: It is important to understand the market linkages that bind economies together. The connections exist not just through trade in goods and services but more important via financial markets. Psychological links are becoming increasingly evident in terms of investor, consumer and business confidence. These linkages are creating a real effect on economies and ultimately on rates in different countries. The result is a growing correlation between economies around the world.
Because of these growing linkages, a key theme to analyze was what European growth will look like in 2007 in context of our global outlook. In past cycles it has proven difficult for Europe to escape the impact of US growth dynamics and we should bear in mind that our forecast calls for the U.S. to lead the global slowdown. Contrary to the market consensus, we expect that the euro zone and the U.K. economy will not be able to de-link from global growth and escape the slowdown.
In our Forum discussions, we concluded that the main risk to our forecast for the U.S. is that we underestimate the extent of the slowdown. We think the U.S. economy could actually grow much slower than consensus, with a serious risk of recession. Keeping in mind the linkages between economies, we end up with a similar risk assumption for Europe. Thus, we see the potential for a dramatic slowdown in Europe in 2007 for a variety of external factors that are exacerbated by internally generated headwinds to growth from policy tightening, both fiscal and monetary. And with that we expect that bond yields will come down as well, but not as much as in the U.S.
Q: What actions do you expect from the ECB in this environment?
Mather: The ECB will be reluctant to reverse its tightening course. They may want to hike again in December to get to 3.5%, which is a rate that they would probably consider to be within the realm of “normal” monetary policy. And then they will likely want to pause to see how the economy reacts to this monetary tightening as well as the fiscal tightening planned for 2007. Germany is introducing a very large VAT increase in 2007, which is unprecedented. There is no other example of a large economy in Europe that hiked by 3 percentage points in one go, and we have to remember that historically much smaller tax increases have caused dramatic slowdowns. The rise in VAT will pull demand forward in the fourth quarter and make the economic indicators for Europe pretty difficult to analyze. Italy too has plans for fiscal tightening and so does France.
So the ECB will probably want to see how big of a drag to growth the fiscal maneuvers are going to create. It is very likely that the ECB will stop hiking soon. The market is currently priced for something more than 3.5%, which is unlikely because I think the ECB really will want to observe first what happens in 2007 to not overdo it, especially since core inflation has been low and falling. The ECB will also take comfort from signs of a cooling in housing markets, for example in Spain, Ireland and large portions of France that experienced housing bubbles similar to the U.S., and the rolling over of property lending. Concerns about property bubbles and lending growth in parts of the euro zone are other reasons why the ECB has been hiking.
Q: What does the situation for the Bank of England’s monetary policy look like?
Mather: The market expects the MPC to hike rates at least once more and has been flirting with the idea of even another hike in the U.K. While another hike to 5% looks increasingly likely, we don’t think the MPC will go beyond that. If our base case scenario of a slowing economy holds true, the MPC could even be cutting rates next year.
The stated mission of the MPC is to maintain their inflation target, which is around 2% with a margin of error around it. This means that all of the MPC’s actions are guided by headline inflation, not core inflation. This distinction in inflation targets is important when comparing central bank policies in Europe with the U.S. because it reveals a different psychological bent. Both ECB and MPC focus on headline inflation while the Fed flagged core inflation as the most important measure of prices. The Fed also takes the attitude that it is not their job to target bubbles per se – they don’t expect to know more than millions of market participants. On the other hand the MPC, for example, arguably emphasizes their role in preventing bubbles in asset markets.
In the past, the MPC has had a bit more success with their headline inflation objectives than the ECB, but more recently they became concerned because of rising energy prices and other administered price hikes that were seeping into inflation. At the same time the U.K. housing market appeared to perk back up and the MPC grew concerned that inflation would break above 3%. If that happens, it is not only uncomfortable for the MPC but they also have to write a letter to the Chancellor explaining the causes for exceeding the 3% hurdle and what they are going to do about it. I think that’s what lead them to the hawkish stance. But just as in the euro zone, core inflation remains tame in the U.K. with headline inflation expected to converge towards core inflation.
It is also worth noting that the recent increase in U.K. real estate prices did not boost consumer confidence and consumer spending to the same degree this time around. A possible explanation for this development can be found in the levels of debt and the debt servicing costs after recent rate hikes. This would lead us to believe that we are near the top of the housing market’s influence on consumption.
Q: With all the inflation concerns from the central banks, why does PIMCO consider inflation only to have a limited impact on portfolio construction?
Mather: I don’t see the inflation demon rearing its head here in Europe as much as it does in the U.S. No matter which measure of inflation you look at in the U.S., headline or core, it is above what the Fed is comfortable with. This is not the case in Europe, neither in the euro zone nor the U.K., where labor appears to have very little pricing power. This lack in pricing power is likely to continue for secular reasons. Obviously you have the same effects from higher energy prices reflected in headline inflation, which has kept the measure above 2% in the euro zone and close to 2.5% in the U.K.
Headline inflation will probably drop dramatically because energy prices won’t continue to rise at the same pace of 30% to 40% year on year that they have been over the last couple of years. The global slowdown should probably take some of the wind out of other commodity prices as well, and we have already seen signs of that in the last few weeks. Even if energy prices are stable, we still expect headline inflation to drop towards core inflation. This is one of the things that make us confident that the ECB will stop their rate hikes in the next few months and very possibly consider cutting rates some time next year. Because central bankers understand that core inflation is low, all it takes is headline to start to fall a little bit and the central banks will want to be on hold. The focus will then shift to the slack in the economy and the slowing global environment.
Q: What role do exchange rates play in the central bankers’ considerations?
Mather: European central banks haven’t been too focused on exchange rates lately but the weakening dollar has strengthened their trade-weighted currency to the upper end of recent ranges. The trade-weighted currency shows the exchange rate against a basket of currencies of a country’s trading partners. While the market tends to focus a lot on the cross rates with the dollar, it is important to realize that it is the trade-weighted currency that matters most for an economy in terms of economic growth.
We are quite a way from where the ECB gets worried; we are a bit closer to where the Bank of England gets worried. But if our forecast of a continued dollar weakening holds true, it is very likely that European currencies will strengthen further against the basket of their trade partners and exchange rates could become an issue for monetary policy.
Q: Was the divergence between business and consumer confidence in European economies still a topic at the Forum?
Mather: Yes, that was another interesting thing that we discussed. This divergence is apparent throughout Europe. Business sentiment surveys are telling you great things about the economy but consumer sentiment and consumption haven’t recovered as much as they have in previous cycles. Based on business sentiment, growth should be running much higher than it is and investment spending should have increased much faster. But that is not happening. The profit recovery was lead by a lot of restructuring and cost containment exercises.
Because profit growth hasn’t resulted in investment spending, robust hiring or wage growth it hasn’t kicked in with the consumer. Real wage growth in the euro zone was very low between 0% and 1% for several years running. So it is important to see that you cannot just look at business sentiment surveys, which by the way started to turn down in August. If you did, you would come to the conclusion that the euro zone was going to grow 50% faster than it is now. This is clearly not going to happen.
One risk to our slower-growth scenario is the potential for pent up consumer demand in Europe. It is a risk that we discussed at the Forum and that bears watching. However, as long as we don’t see higher real wage growth change the consumer’s mood anytime soon, I think it is unlikely that the consumer is going to kick in and guide Europe to a normal recovery.
Q: Are there other risks to PIMCO’s outlook for the European economy?
Mather: Energy is a key risk because energy prices drive headline inflation and both European central banks focus on that measure. If energy prices spike or continue to rise at the same pace they have in the past few years, it could take headline inflation uncomfortably high. There is a high chance that the ECB and MPC would then continue hiking rates into 2007. Ultimately, this could lead to an even bigger drop in economic activity later in the year.
The other big risk is the U.S. economy. Our base case scenario is that the U.S. economy grows below potential and the Fed will need to cut rates. But there is a chance that the U.S. economy dips into recession. In this case, the U.K. and the euro zone would undershoot our growth and inflation forecasts. I think it is unlikely that a recession would occur in Europe but it would be something closer to a hard landing; we are talking about growth of about 1% or less in this scenario.
Q: As a European portfolio manager, how do you position the portfolios based on PIMCO’s outlook?
Mather: We think the front end of the U.K. yield curve offers value based on our expectation that the MPC could be cutting rates next year. The market, in turn, assumes that the MPC will hike at least once more and it has been flirting with the idea of even another hike in the U.K. We think that is unlikely.