In the following interview, Adam Bowe, executive vice president and fixed income portfolio manager in the Sydney office, Tomoya Masanao, managing director and head of portfolio management Japan, and Robert Mead, managing director and head of portfolio management for Australia, discuss the conclusions from PIMCO’s quarterly Cyclical Forum in December 2014 and how they influence our Asian outlook and investment strategy.
Q: What matters for Asia in 2015?
Adam Bowe: We expect the environment across the region to remain challenging as individual countries continue to grapple with their own domestic economic issues. Japan continues to struggle to free itself from a liquidity trap, China is attempting to transition to a growth model (and growth rate) that is less reliant on credit expansion and investment, while in Australia, incomes and domestic demand remain heavily reliant on the mining sector. But in addition to these longer-term challenges that each individual country continues to face, we think there are three common issues that will influence the region as a whole next year.
First is the effectiveness of expected further policy support in the region as policymakers continue to support growth. Second is the fallout from the sharp decline in commodity prices over the second half of 2014. Third is the impact of the sharp rise in the value of the U.S. dollar. Each of these factors is creating winners and losers across the region. On one end of the spectrum, Japan looks likely to benefit the most from these dynamics over the cyclical horizon, with further aggressive fiscal and monetary expansion, cheaper oil imports and a sharply weaker yen. On the other end of the spectrum, Australia looks set to benefit the least with ongoing fiscal consolidation, a central bank that is reluctant to ease rates further and continued pressure on national income from the significant fall in the price of iron ore exports, which is only being partly offset by the decline in the exchange rate.
Q: And what about China? Should we expect more aggressive monetary policy support from the PBOC (People’s Bank of China) next year?
Bowe: The PBOC’s decision to lower policy rates in November was the first such move since 2012, and policymakers’ response to slowing growth and falling inflation continues to be measured and reactionary. Indeed, the important news out of China over the second half of 2014 was that policymakers have explicitly embraced three key policy themes: 1) tolerating slowing trend growth, 2) refraining from large-scale stimulus and 3) focusing on structural reform.
We also expect them to acknowledge this new reality by lowering the 2015 GDP growth target from 7.5% to 7.0%. This measured policy approach will aim to cushion the downside macro risks. The PBOC is expected to lower interest rates further next year to loosen monetary conditions, and there is room for additional fiscal expansion, but we are not expecting any large-scale reflation policy to reverse the moderating credit-investment cycle.
As the world’s largest consumer of commodities, China is clearly a net beneficiary from the sharp falls in the price of oil and iron ore, and this positive terms-of-trade shock will lower inflation and boost national income. Conversely, policymakers have fixed the yuan strongly versus the U.S. dollar and largely refrained from currency intervention. As a result, the yuan is appreciating strongly in real effective terms, and this is somewhat offsetting the positive terms-of-trade shock in addition to restricting the competitiveness of Chinese exports.
With policymakers increasingly comfortable with a gradual moderation of growth, we are forecasting below-consensus GDP growth of between 6%‒7% next year due to a prolonged adjustment in the property market and an over-leveraged corporate sector.
Q: After fairly mixed results to date, how do you view the prospects for Abenomics in 2015?
Tomoya Masanao: Over the cyclical horizon we expect Japan’s GDP growth to rebound back above potential, but still remain close to the consensus forecast at around 1.5%; we expect inflation to remain well below the BOJ’s (Bank of Japan) policy target of 2%, finishing the year at around 1%, excluding the impact of the recent increase in the consumption tax.
There have been four recent developments that have improved the outlook in Japan over the cyclical horizon. First, the BOJ acted boldly with additional easing in October and demonstrated its firm commitment to its inflation target. The Japanese yen has depreciated sharply since then; this should help raise inflation expectations, which might otherwise have fallen given the recent decline in oil prices and weak growth data after the tax hike. Second, Prime Minister Abe’s victory at the recently held snap election is also supportive for Japan’s growth. Political stability is key for policy and economic growth, and that’s what he has achieved.
Third, Abe has delayed the second scheduled hike of the consumption tax rate from October 2015 to April 2017. It’s important to remember the VAT increases were never part of Abenomics, but rather were a policy of the previous government. With Abe’s recent electoral win, he should be able to resist any further attempt by fiscal authorities to tighten policy until the economy becomes more resilient. Fiscal sustainability no doubt needs to be restored over the longer term, but it cannot be achieved without first ending deflation. So the good news in Japan is that the reflation policy is firmly in place, which should support economic growth next year. And fourth, the recent decline of commodity prices adds support to Japan’s growth via improvement in the terms of trade.
Q: So with this positive backdrop, why isn’t PIMCO forecasting above-consensus growth in Japan?
Masanao: While the cyclical reflation policy is clearly in full throttle, the private sector’s response is still challenged by structural and secular headwinds and difficult initial conditions. Wage growth remains sluggish despite the labor market tightening, reflecting low labor productivity growth. Wealth effects from the stock market rally are limited given very conservative asset allocation among households. And benefits of the currency depreciation to exporters are proving to be more limited than was the case historically as a substantial part of the manufacturing sector has been hollowed out with production facilities moved overseas.
Q: What is the outlook for Australia? What do you expect from the Reserve Bank of Australia (RBA) in the coming months?
Robert Mead: The Australian economy has been weakening quite sharply on the back of declining commodity prices, which impact nominal GDP growth via the terms of trade, and negligible economic rebalancing away from mining over recent years. In line with the commodity price declines, since the September highs, the Australian dollar has fallen around 13% versus the U.S. dollar, but only 8% versus Australia’s Trade Weighted Index (TWI), which limits the degree of improvement in Australia’s export competitiveness.
The one economic bright spot has been in residential construction, but significant capital-city property price increases have recently led to some macro-prudential policies designed specifically to temper speculative leveraged property investor activity ‒ as opposed to owner-occupancy. While our base case is that the RBA will remain on hold, the potential for further easing remains, especially if the Australian dollar’s decline does not continue and the macro-prudential policies get traction. Based on current pricing, the financial markets are currently entertaining the possibility of further policy easing.
Q: What are the investment implications of PIMCO’s cyclical outlook for Asia?
Mead: In an environment where tactical underweights of global interest rate exposure are recommended, the belly of the Australian yield curve represents a relatively defensive form of duration, given the headwinds the Australian economy faces over the cyclical horizon. Also, given the levels of Japanese yields and the expected nature of the Bank of Japan’s buying programs, a yield-curve-flattening bias is preferred in Japan.
In terms of currency positioning, underweight positions in the Japanese yen and Australian dollar versus the U.S. dollar will be supported both fundamentally and technically in 2015. In addition to Bank of Japan policies, Japanese portfolio rebalancing flows will continue to be a technical driver for a weaker yen. Also, a weaker Australian dollar on the back of declining terms-of-trade dynamics will be a prerequisite for needed economic rebalancing and improved export competitiveness.