A less benign view proposed by other participants states that Chinese investors, having been forced to invest mostly in domestic assets in the
past, are eager to internationally diversify their portfolios now that capital account liberalization has started. If so, capital outflows would
have only just begun and even the more than $3 trillion of Chinese foreign exchange reserves could be depleted relatively soon.
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[INSERT accordion from here down to the next accordion subhead, encompassing all text through paragraph that ends “…below $30 in the near
The worst for oil could be over
Rightly or wrongly, financial markets have viewed the drop in oil prices earlier this year as a clear negative, mainly because it raises the risk
of defaults in the U.S. and global energy complex, which in turn could lead to contagion to bank balance sheets. Conversely, the recent recovery in
prices has led to a big collective sigh of relief in equity and credit markets. Our commodity team presented a constructive baseline view where
higher demand sparked by lower prices and, more importantly, ongoing supply rebalancing will likely take oil higher in the course of this year to
around $50 (that said, we are cognizant of the risk of a renewed drop below $30 in the near term).
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[INSERT accordion from here encompassing all text through the paragraph that ends “…we are actively considering.””]
Testing the limits of policy potency
Our biggest debates at our forum raged around the question of whether central banks still have the ability to stimulate asset prices and
the economy or whether the toolkit is now exhausted. To be clear, hardly anybody doubts their resolve to do whatever it takes in the face
of persistent headwinds to growth and inflation. However, there is a growing skepticism among market participants and here at PIMCO about whether
additional quantitative easing (QE) is still effective given how low bond yields already are, and even more so about the negative side effects of
negative interest rates on bank profitability and thus the crucial bank lending channel. Overall, we believe that monetary easing, if done in the
right way, can still be supportive of asset prices, growth and inflation, even though the returns are clearly diminishing.
Somewhat encouragingly, judged by the ECB’s easing package announced shortly after our forum, central banks appear to have begun harboring the same
kind of doubts about the efficacy of negative interest rates and are now adjusting their toolkit yet again. The ECB added a larger credit easing
component to QE through additional purchases of non-financial corporate bonds and decided to provide more multi-year funding to banks at
potentially negative interest rates, which has the opposite effect on bank profitability of negative deposit rates. Also, the BOJ refrained from
cutting the interest rate on excess reserves further into negative territory at its 15 March policy meeting and left the door open for additional
purchases of private sector assets such as exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) at a later stage. And,
even though this was only a remote possibility for the Fed anyway, Fed Chair Janet Yellen emphasized in her 16 March press conference that a
negative interest rate policy was “not something that we are actively considering.”
So while China, commodities and central bank policies could potentially cause significant downside risks to economies and risk assets and will
likely continue to be sources of volatility this year, our base case for the cyclical outlook remains cautiously optimistic: China is more likely
than not to manage the challenges of capital outflows without a major disruptive devaluation, oil prices look more likely to rise than fall, and
central banks seem able and willing to find the right tools to support asset prices and keep the BBB economic expansion on track.
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[INSERT accordion with header “U.S. economy: Zeroing in on two percent
”, encompassing the next paragraph only, ending with “…the market is currently pricing in.”]
In a world of deficient aggregate demand and heightened uncertainty, the U.S. remains the “best of a bad bunch” in terms of economic growth. We
continue to see a two-speed economy with robust consumer spending and residential investment on the one hand, and weak export growth and capex on
the other. The net result is unexciting, slightly above-trend economic growth in a 1.75%–2.25% range for calendar year 2016. This is consistent
with a further erosion of labor market slack and a gradual acceleration in wages. Thus, we expect the “delicate handoff” from slowing job growth
(as the labor market reaches full employment) to higher wages as the main driver of income creation to succeed, supporting further decent gains in
consumer spending. Assuming a gradual lift in crude oil prices to $50 per barrel by year-end, headline inflation (as measured by the Consumer Price
Index or CPI) is likely to hover sideways in a 1.0% to 1.5% range for much of the year, before rising to 2% by the end of the year, thus converging
with core inflation which is expected to trend broadly sideways at slightly above 2% throughout the year. With PCE inflation (personal consumption
expenditures inflation, which is expected to run about 0.5% below CPI inflation) remaining below the Fed’s 2% target for the fifth year in a row,
and global developments still posing considerable risks to the outlook, we expect the Fed to move cautiously as mentioned, raising rates only once
or twice this year, slightly more than the market is currently pricing in.
[INSERT accordion with header “Eurozone and UK: OK growth, tricky politics
”, encompassing the next two paragraphs, ending with “…following the referendum..”]
For the eurozone, our baseline for calendar year 2016 is for trend-like GDP growth in a below-consensus 1% to 1.5% range and a continued
significant undershooting of the ECB’s “below-but-close-to-2%” inflation objective, with headline HICP (Harmonised Index of Consumer Prices)
inflation in a range of 0% to 0.5% and core inflation staying below 1%. We expect the headwinds for growth from weak global demand and the
tightening of financial conditions earlier this year to be roughly offset by the lagged effects of the weaker euro on exports, low oil prices and
rising employment supporting consumption, and fiscal policy turning slightly expansionary for the first time since 2009. The ECB’s March easing
package should also be mildly supportive, with higher purchases of public sector bonds and, for the first time, also non-financial corporate debt,
as well as lower marginal lending and deposit rates, and long-term, large-scale loans to banks at potentially negative interest rates. Yet, with
inflation likely to continue to undershoot the objective (on the ECB’s and our own projections for at least another couple of years), further ECB
easing later this year appears to be in the pipeline.
The UK outlook is complicated by the “Brexit” referendum on 23 June. We attach a 60% probability to a vote to stay in the European Union. In our
baseline “stay” scenario, we see growth in a below-consensus 1.5%–2.0% range for 2016 due to the drag from net exports and further fiscal
tightening amounting to about 1% of GDP. Bank of England Governor Mark Carney will likely have to continue to write letters to the Chancellor every
month this year (a statutory requirement if inflation deviates from the 2% target by more than 1%), explaining why inflation remains below 1%. In
this environment, rates will likely remain on hold. We view the risks to our growth forecast as skewed to the downside mainly because we attach a
40% probability to a pro-Brexit vote. This could lead to a major hit to business investment and confidence, and could reduce GDP growth by 1%–1.5%
over the one-year period following the referendum.
[INSERT accordion with header “Japan: Lackluster growth and inflation
”, encompassing the next paragraph only, ending with “…in the lending program for banks..”]
Japan is yet another case where we expect below-consensus economic growth and inflation to undershoot the central bank’s target. We see GDP growth
in a 0.25%–0.75% range for calendar year 2016 (which is not bad for a country with a shrinking population), about the same growth rate as 2015.
With China slowing and the benefits from past yen depreciation petering out, the external sector will continue to be a small drag for economic
activity. However, easier fiscal policy ahead of the upper house election this summer will provide some offset. Inflation looks set to continue to
fall short of the 2% target – our forecast is for headline inflation in a range of 0.25%–0.75% and (U.S.-style) core inflation staying below 1%
throughout this year. Against this backdrop, we anticipate further easing measures by the BOJ in the course of this year. Following markets’ and
the public’s negative reaction to the introduction of negative rates in January, we expect the BOJ to tread cautiously on this front (though a
further small reduction still seems likely) and rather concentrate on additional asset purchases skewed towards equity ETFs and J-REITs, as well as
additional improvements in the lending program for banks.
[INSERT accordion with header “China: Challenging transition, all eyes on capital outflows
”, encompassing the next paragraph only, ending with “…to control capital outflows better.”]
China’s transition from “old” (as in industrial, state-owned and export-oriented) to “new” (as in service sector, private and consumption-oriented)
growth drivers continues to sputter. We expect “official” GDP growth to fall short of the government’s 6.5%–7% target range this year, for three
reasons. First, the room for monetary policy easing is limited as large liquidity injections and rate cuts would intensify capital outflows and
therefore the downward pressure on the currency. Second, given the past buildup in public sector debt (mainly by local authorities and state-owned
enterprises), the government seems unwilling to expand fiscal policy beyond the announced 3% deficit target. And third, volatility in the equity
market and overcapacity in the property market have increased uncertainty and are weighing down on consumer confidence. This has also contributed
to the capital outflows and the related downward pressure on the CNY. As discussed earlier, our baseline view is for gradual depreciation rather
than a disruptive, large devaluation, aided by further currency intervention and measures to control capital outflows better.
[INSERT accordion with header “Brazil, Russia, India and Mexico: Give us a catalyst
”, encompassing the next paragraph only, ending with “…depreciation of the currency.”]
The economic outlook for BRIM remains disappointing overall: We forecast a slight pickup in GDP growth from 0.4% in 2015 to a range of 0.75%–1.25%
for calendar year 2016, about in line with consensus. Yet, the small improvement is mainly due to Brazil’s and Russia’s economies contracting by
less than last year while still being mired in recession. India is forecast to grow at a 7.3% pace this year, about the same as last year, while
Mexico should see a small acceleration to 2.8% growth this year, slightly above consensus. In Brazil, the political situation remains fluid with
many market participants suggesting that an impeachment followed by a change in government could provide a catalyst for reforms. In Russia, we
think the sharp adjustment in unit labor costs presents an opportunity to rebalance the economy longer-term, and a further recovery in oil prices
would help to end the recession. However, a V-shaped recovery looks unlikely to us. Finally, in Mexico, we are encouraged by the joint
fiscal/monetary tightening announced in February, aimed at regaining investor confidence and stopping the depreciation of the currency.
While we do not expect a recession in the U.S. or the global economy over the cyclical horizon, and think that financial markets have been
over-anticipating recession risk, there are a number of key uncertainties and challenges that call for conservative portfolio positioning. Market
valuations in general look fair to full, in our New Normal/New Neutral framework, but there are still pockets of value following the recent bout of
market volatility. Valuations should be underpinned by central banks, but at the same time there are valid questions about the declining
effectiveness of their interventions.
At a minimum, central banks have shifted from being purely suppressors of volatility to being contributors to volatility. In recent days they have
contributed to a more positive tone in markets, but this was in response to their own friendly fire in Japan, Europe and beyond.
We continue to expect bouts of volatility, reflecting reduced market liquidity, some crowded positions and in turn a tendency for markets to
overreact to relatively minor changes in fundamentals. Growing political risks across jurisdictions reinforce an outlook in which historical
correlations and relations will be challenged.
We continue to see global policy divergence, with the Fed continuing its slow tightening cycle, while the ECB, BOJ and numerous other central banks
continue to ease. But part of the uncertainty over the Fed outlook relates to the influence of global macro/financial conditions on its tightening
path. The extent of policy divergence will be limited by the feedback to the U.S. economy via the U.S. dollar.
We see the currency war receding somewhat, with the recent G-20 statement, central bank rhetoric and actions suggesting that China will refrain
from further sharp moves in its currency, a retreat from competitive currency devaluation efforts via negative deposit rates on the part of the BOJ
and the ECB and instead a preference for QE and credit easing.
We see credit markets as offering value, and following recent dislocations we have a strong preference for higher-quality positions in the U.S.,
notably investment grade credit and senior financials. We continue to like non-agency mortgages based on a generally constructive view on the U.S.
housing market outlook and think that favorable fundamentals help insulate the sector from near-term macro risks. Overall, in credit, we want to
have perceived “safe” spread exposures that can weather storms, to be patient and long-term orientated in these investments, and to leave enough
room to add to positions depending on our assessments of further credit market weakness.
We are broadly neutral on U.S. and global duration, expecting global rates to be broadly range-bound over the coming months. We are also broadly
neutral on yield curve positioning; though we think that the level of rate hikes priced into the front end of the curve over the coming years is
too low, there is also a lot of uncertainty around the path. We continue to have a positive view on U.S. Treasury Inflation-Protected Securities
(TIPS) based on our forecasts of modest reflation in the U.S. and attractive valuations.
In the eurozone, we see investment grade credit and European peripheral sovereign risk as broadly fair, but not cheap. Eurozone bank senior
financial debt looks rich. There are select opportunities in subordinated debt but, at current valuations, we expect to focus on other countries
with more predictable regulatory and legal frameworks including the U.S., Switzerland and the UK – Brexit risk notwithstanding.
Emerging markets face considerable challenges in a difficult macroeconomic environment and also given the spillovers from China, but we anticipate
being able to find good opportunities – particularly so in an improving commodity market environment. After the recent recovery in commodity
prices, we are broadly neutral on commodities in our asset allocation portfolios, with a preference for oil. We see credit markets as still
offering better risk/reward potential than equities at current valuations. Within developed market equities, we think the cycle is more advanced in
the U.S. and prefer Japan or Europe. We expect to see greater stability in emerging market equities in the event that commodities and the U.S.
dollar behave in line with our base case expectations.
We expect to have less currency risk in our portfolios, reflecting the repricing of the U.S. dollar over the past two years, and the limits to
global policy divergence, discussed above. We expect a gradual depreciation of the Chinese currency and the broader Asia currency basket and also
see some attractive opportunities in commodity currencies.