PIMCO’s investment professionals from around the world met recently in Newport Beach for the quarterly Cyclical Forum, where they discussed the global economic outlook for the next 6–12 months. In the interview below, Andrew Balls, managing director and head of European portfolio management, highlights PIMCO’s conclusions from the Forum and explains how these views influence the firm’s European outlook and investment strategy.
Q: With all the fast-moving developments in the global economic and financial situation, how has PIMCO’s overall view changed since the previous Forum?
Balls: The broad contours of the outlook are the same as we described in December but the European and global outlook has worsened significantly. This has increased the pressure on policy responses around the world, particularly in the U.S. owing to the difficult combination of finance, economics and politics and the size and complexity of the required interventions. There have been some significant changes in global policy responses: quantitative easing in the U.K., and also some of the signals from the European Central Bank (ECB) indicate greater efforts toward easing credit conditions and public debate among ECB policymakers on the need for stronger interventions.
What has not changed is the difficulty in designing policy responses at national levels that provide comfort and encouragement to the markets. And what else has not changed is the difficulty with creating a coordinated global policy response, or even within the European Union (EU) a coordinated European response, particularly to the problems within the banking sector.
Q: Could you please describe PIMCO’s economic outlook for the next 12 months, and explain any major revisions in the outlook and forecast compared to the previous Forum?
Balls: We see global recession and, in the short-term at least, global disinflation and deflation risk. We have revised down the growth forecasts and we have revised down the inflation forecasts. In the Eurozone and the U.K. we expect very weak growth – worse in fact than in the U.S., though clearly there is an even greater amount of uncertainty than usual in the current outlook. The one important exception is China, where we see a less dismal outlook but still a very significant slowdown.
Economic data going back to last September clearly show how the collapse of Lehman Brothers was an enormous shock to the global economic system. As a consequence, we have seen a collapse in economic statistics around the world, across the U.S., Europe and Japan.
Near-term weakness is not a surprise. As portfolio managers we devote a lot of attention to the outlook for 2010 and the potential extent of stabilization – and maybe some improvement – versus ongoing weakness next year. The traditional market and policy circuit breakers are not going to work. In judging the government policy responses around the world aimed at stabilizing the system, it’s important to take into account that this is not a normal economic cycle; rather we have seen a shock at the center of the world economy and in the global financial system. And that’s why we see such large-scale interventions and unconventional policy responses around the world and why the success or failure of these initiatives is so important to the outlook. The importance of these “non-market” forces is what makes it so challenging to forecast the 2010 outlook.
Q: You expect the U.K. and Eurozone to be hit even harder than the U.S. What are the main forces holding down these economies?
Balls: The pattern in Europe is similar to the rest of the world in that we had a shock in September 2008, and subsequently lending activity all but disappeared. Economic activity came to a screeching halt, with investment plans and consumption decisions put on hold. The feedback loop of consumers trying to increase savings and financial firms trying to delever simultaneously – what my colleague Paul McCulley has dubbed the paradox of deleveraging – in addition to the more common paradox of thrift is what makes this such a difficult and recessionary environment.
However, there are slightly different patterns when you compare the Eurozone to the U.K. In the Eurozone, the clear detractors are the weakness of the global economy and the decline in exports and industrial production. In the U.K., we have seen more evidence of the direct impact of the credit crunch and the drying up of lending activity. The Bank of England is working very hard to get credit markets flowing more normally. While the ECB has taken some aggressive action, there is more of a sense of waiting and seeing how well the economy can pull itself out of the slowdown.
We expect the extent of the policy response in the U.S. to promote some stabilization. But common to the Eurozone, the U.K. and the rest of the world in this cycle is the fact that the U.S. consumer cannot be relied upon to drive the global recovery yet again. The national policy response is stronger in the U.K. but with worse initial conditions. In the Eurozone the policy response has been weaker and our forecasts suggest some complacency or perhaps the greater willingness of policymakers in Frankfurt, Berlin and elsewhere to endure a more pronounced downturn.
Q: Confronted with the magnitude of the crisis, governments around the globe have initiated responses of unprecedented size. Central banks have cut interest rates close to zero and some have even embarked on active quantitative easing. Do you expect these policy measures to deliver positive effects in overall economic activity in 2010?
Balls: The 2010 outlook is very uncertain, given the shock to the system, the ineffectiveness of the regular internal circuit breakers and the failure to achieve coordinated intervention. There is the risk of spillover effects and collateral damage as governments try to address domestic and international problems.
In the U.K. we have seen aggressive fiscal and monetary action, but there are questions (in the U.K. and globally) about the amount of government spending and supply that will be needed. There is worry over the need to pay for these actions.
In the Eurozone, while the central banks seem to want to ride this out and see how the European economy develops, there is a potentially severe problem: with other governments in the world being so aggressive in their policy responses, there could be spillover impacts.
One clear example is the currency. Other countries in quantitative easing mode could pressure the euro to accelerate. A second problem that impacts the EU and the Eurozone in particular is the pressure on some peripheral countries. The severe decline in Spain’s economy or the recent downgrade of Irish sovereign bonds are examples of the problems arising within the Eurozone as individual members of the monetary union are constrained in their policy responses to this global financial crisis.
Q: When does PIMCO expect the economy to recover, and what will the recovery look like? Will there be a return to previous levels in growth rates?
Balls: We certainly won’t see a V-shaped recovery. At best we will see a kind of elongated U if not an L – the scale of the shock to the system is so great. Looking beyond the cyclical outlook to the secular horizon, it is very likely that OECD (Organization for Economic Co-operation and Development) countries will experience weaker growth than what we’ve seen in the past several years. The paradoxes of thrift and deleveraging will have implications that play out over several years, not just the coming months.
In the U.K., growth has been boosted to some degree by leverage and financial innovation. The reversal of this coupled with the need for the savings rate to rise and be sustained at a higher level means that growth would be weaker over the coming year and beyond. This is a pattern that will also play out in the U.S., given the role of the financial sector in boosting growth beyond sustainable levels in recent years. In the Eurozone there has been less of an impact from financial innovation and the housing sector. One question concerns the extent to which growth relied on an increase in corporate borrowing, and a related question involves the extent to which growth has been powered by very strong demand elsewhere in the world.
Many of the issues already mentioned, including the broad impact of deleveraging and the government involvement in markets, are likely to be secular as well as cyclical issues. These are not just cyclical questions of recession and fast recovery.
Q: One of the current debates is about the long-term consequences of the public response. Is deflation, disinflation, reflation or inflation the most likely consequence of government spending?
Balls: With the collapse in economic activity, in many cases there have been very sharp adjustments in inflation, e.g. in Germany and Spain. The U.K. experienced a pretty rapid decline in inflation, although there is some evidence of lingering inflationary pressures owing to the currency’s depreciation. In the medium term, we feel that the hit to growth and the decline in energy prices should translate into lower inflation readings in the coming months. The tricky issues will involve dealing with the impact of weaker potential growth over time, the potential stickiness of wages and businesses’ attempts to rebuild margins in this weaker growth environment. So, the concerns over the near term are about disinflation. Over the medium term, the question is whether we will see more of a stagflation than just a weak growth and weak inflation environment, owing to marked reductions in potential growth rates around the world combined with some ability for companies to raise prices even in a sluggish environment.
Q: What is PIMCO’s outlook for central bank rates? How does it affect your views on duration?
Balls: We don’t expect rate hikes in the U.K. or Eurozone in the next one to two years; central banks are signaling an extended holding period. In the Eurozone in particular, we think that the market is being too aggressive in its expectations for rate hikes in 2010. Therefore, the rolldown in the front end of the Eurozone and U.K. curves looks attractive. Overall, we’re not going to use as much of our risk budgets in duration and curve positions as we did one or two years ago, when we saw much greater potential for gains. But we do see a slight overweight duration position as sensible in what we expect to be a fairly range-bound environment.
Q: What is PIMCO’s outlook for long-term government bond yields?
Balls: Yields have come down significantly. There is some limited room for gains in the U.K. and the Eurozone, while yields in the U.S. are likely to be range-bound for some time. Overall we expect 10-year government bond yields to be in a range of 2% to 3% in the U.S. and perhaps 2.5% to 3.5% for Germany and the U.K. The bottom of the range is defined by the concerns over government supply and somewhat higher policy rates in the Eurozone. The top of the range is defined by the kind of “risk-free” rates that the economies can withstand in this environment.
In the Eurozone we don’t expect a hard form of quantitative easing (which means buying government bonds in the market) anytime soon. But the combination of weak growth elsewhere and range-bound government bond markets in the U.S. and probably the U.K. means that government bond rates in the Eurozone probably will likely remain in the range of 2.5% to 3.5%, and were the ECB to start targeting government yields directly, then we could see core Eurozone rates undershoot the bottom of that range. Overall our bias is to stick closer to the front end of the curve rather than the long end of curves owing to the greater ability of central banks to anchor the front ends.
Given that in all cases we see the front ends as well-anchored by central banks (including the ECB) and the rolldown on offer, we think that the duration is attractive in the front end, out to five years in Europe and the U.K.
Q: How does PIMCO generally structure its portfolios in this environment?
Balls: The first thing is to keep it simple in a difficult and deleveraging environment. We’ve made a great effort to streamline portfolios and to stick with the positions where we have the strongest convictions. We want to have a very high-quality bias in our portfolios, owning assets that have a greater potential to offer secure and predictable forms of income. In addition to the rolldown in core government and swap curves, we also look to invest in government-guaranteed bank paper, agencies, covered bonds and senior European financial paper.
Q: Most spread products seem cheap in the current market. What is PIMCO’s opinion on these products?
Balls: In this very uncertain environment, investors need to exercise great discipline in evaluating assets, including bargain-priced assets. When many different sorts of assets look historically cheap, we need to be very careful in determining whether to include them in our investment strategies.
This is not a normal market environment, a mean reversion cycle where we can buy assets just because they are cheap. We need to look beyond that for attractively priced assets not only based on fundamentals, but also where we think the policy response will provide support (or at least not do too much damage) and where we believe we can identify catalysts for outperformance in the next 6–12 months or significant and predictable sources of government support.
Q: Are there significant differences between European and U.S. strategy?
Balls: We have more European emphasis in our European portfolios, given the availability of high-quality assets and the prudent yields that we can buy in European markets. We will go outside of European markets when we see good opportunities, but the bar is higher than in recent years given the opportunity set here and the effort to have more simple and straightforward portfolios.
Q: Over the past several months, PIMCO’s stated strategy has been to “shake hands with the government.” With the U.S. heading down the path of burden sharing, will European and U.K. governments follow? How does this affect your strategy?
Balls: We do feel that European and U.K. governments have taken a more consistent and predictable approach. This is not to say that we believe the policy response has been perfect. But we have seen somewhat greater consistency compared to the U.S., looking in particular at how countries have been helping sustain financial systems, and greater support for financial institutions and the legal framework.
One result from our recent Cyclical Forum’s strategy session is that we favor adding to European senior bank positions, but we are refraining from adding to U.S. senior bank positions because we need greater clarity on the policy interventions in the U.S. A second result of our recent strategy session is that we will not be adding to bank capital positions in the immediate future, again waiting for greater certainty in the policy response in Europe as well as in the U.S.
Q: Will the government umbrella help protect the banking sector in Europe and the U.K.?
Balls: While in general the U.K. and Europe’s policy responses have been stronger and more consistent, we would need to assess Europe’s banking sector market by market. The indications we have on the French and the U.K. banking system look very encouraging; however, given the scale of the problems, the depth of the crisis and the spillover from other countries, we do remain cautious. The government is now a player in the financial markets, not just the referee, and we want to better understand the potential positive and negative impacts of the government interventions. Important questions include where the government will hold, and whether there could be collateral damage on other sectors or asset classes.
Q: Looking ahead, what could be the major topics for discussion at the PIMCO Secular Forum in May?
Balls: As we have discussed, many of the big questions in the current outlook have both cyclical and secular dimensions and implications, including the deleveraging of the global economy, the great changes we see in the global financial system and the implications for market growth. Second, the implications of having the government as a market player as well as the referee will be a focus of discussion for a number of years, and the related de-risking of the global financial system that we are going to see as a result of both market forces and government intervention. Third, and related, I expect we will look closely at property rights and capital structures given the scale of government interventions. Fourth, we’re likely to discuss the difficulties global policymakers are having with formulating coordinated responses. This can involve pressure on weaker countries owing to the extent of policy support in stronger countries, and it can involve protectionist pressures as well.
Fifth, an important discussion for the secular outlook will be the extent of government bond supplies and the ability of global financial markets to absorb such a degree of government spending. Sixth, and related, is the extent to which countries outside the U.S. and Europe will take over as providers of demand for the global system and the ability of the world to rebalance away from the U.S., and particularly the role of the systemically important emerging markets in this process.
Finally, related to all of the above, there is the issue of inflation beyond the current recessionary and disinflationary environment. This could be the result of the extensive policy actions gaining traction and resulting in stabilization combined with the lagged impact of stimulus. And in an ongoing weaker secular growth environment, we could face higher inflation over the secular horizon resulting from the shift toward decreased efficiency in the global supply side and weaker productivity growth in OECD countries.
Thank you, Andrew.