In the following interview, Andrew Balls, Deputy CIO and head of European portfolio management, highlights the conclusions from PIMCO’s quarterly Cyclical Forum in March 2014 and how they influence the firm’s European investment strategy. He also discusses the fiscal and growth challenges facing the eurozone over the coming year as fragile regional growth remains susceptible to external shocks and below-trend inflation.
Q: What is PIMCO’s outlook for eurozone growth and inflation over the coming six to 12 months?
A: Our baseline expectation for the eurozone is 1%–1.5% real growth, coming in at or a bit above the region’s potential economic output, with output growth balanced across countries and across domestic and external demand.
Business and consumer confidence has improved and we expect a moderate improvement in both business investment and household spending. Credit conditions remain tight overall in the eurozone and this will cap growth, but the contraction in bank loan books looks to be stabilising at least and we expect a gradual improvement in credit conditions. The eurozone may benefit from the unleashing of pent-up demand, as spending decisions delayed during the crisis are reactivated. But the eurozone’s recovery remains fragile. There are downside risks to our growth outlook, reflecting both eurozone credit markets and ongoing fiscal consolidation, but also in the event of an external growth shock that weakens demand for eurozone exports.
We forecast eurozone inflation in a 0.75%–1.25% range over the next 12 months. A high unemployment rate, which has been at about 12% over the past year, and ongoing structural reforms in some countries mean that there is very little inflation pressure, in spite of the region’s cyclical recovery.
We see risks as broadly balanced around this below-consensus projection, but it is worth noting that a prolonged period of very low inflation will lead to falling inflation expectations for the eurozone, further complicating the task of the European Central Bank (ECB).
Q: How does this outlook vary from the eurozone’s core to its periphery?
A: Rather than compare core versus periphery, our forecast makes a distinction between Germany and all other eurozone economies. Germany has the fastest growth rate; however, we expect all eurozone countries to deliver positive growth. For the coming year, we expect Germany to grow at about a 2% rate, compared with about 1% for France and Spain and 0.5% for Italy. For Spain, that is a significant improvement after the economy was essentially flat in 2013. Although Italy’s economy has stopped shrinking, it continues to lag the other large eurozone economies.
A number of peripheral countries have made improvements in their current account positions and wage competitiveness. Italy, however, stands out for having made very limited progress in boosting its overall competitiveness. But on inflation, it is worth noting that low inflation is not just a phenomenon in the eurozone’s peripheral countries that are going through adjustment; we see low inflation in the core countries too. Over the cyclical horizon, we expect inflation to remain very low.
Finally, we expect eurozone sovereign debt markets to remain stable and spreads overall fairly range-bound, supported by the improved regional growth environment and the market’s ongoing confidence in the ECB’s role as liquidity backstop and lender of last resort. Overall, we think the eurozone is out of the acute phase of the sovereign crisis, but the chronic challenges of achieving decent growth over the medium term remain, as do concerns over the fragility of eurozone institutions and governance.
Q: What are your expectations for ECB policy?
A: Our baseline expectation is that the ECB will likely take further liquidity-easing measures, but that it is not ready to move to asset purchases based on its own low inflation forecasts and to ward off deflation risks. The ECB, rather, appears comfortable with inflation undershooting its supposed target of close to, but below, 2% inflation. The central bank introduced a new three-year forecast at its Governing Council meeting on 6 March 2014 (previously, it forecast out only for two years) and projected inflation only rising very gradually to 1.5% in 2016. This underlines the asymmetry in the ECB’s attitude toward overshooting and undershooting the target and may reinforce the risk that inflation expectations ratchet down.
This may well reflect political/coordination issues on the ECB board, but it carries significant risks. The risk of external shocks, as mentioned in the context of the growth outlook, is very relevant again. In the event of a shock to the fragile eurozone economy, with inflation so low, there is little buffer against a slide into deflation.
Should inflation or growth data surprise on the downside, we would expect ECB President Mario Draghi to take more decisive action in the form of asset purchases, triggering a more clear and present deflation threat. Such a move by the ECB would likely take the form of credit easing – private sector assets – but could also take the form of buying government bonds. Quantitative easing (QE) may be more politically controversial but would be far more straightforward to implement, technically, than attempting to buy loans from banks.
Q: What is your outlook on the UK economy? Given its recent about turn, what do you expect from the Bank of England?
A: The UK data have surprised on the upside compared with our previous forecasts and indeed with the Bank of England’s (BoE) own above-consensus forecasts. For the next four quarters, we expect UK growth to be in the range of 2.5%–3% and inflation at 1.75%–2.25%, in line with the BoE’s target.
Not only has the UK data improved, but the composition of the data has improved, including fledgling signs that business investment is starting to recover in addition to consumer spending growth.
More recently, the BoE has shifted its strategy in response to this stronger data and, from our perspective, has essentially abandoned its focus on forward guidance, as my colleague Mike Amey laid out in his 13 February 2014 European Market Update, “An About Turn at the Bank of England”, and endorsed UK forward rates, which price in BoE tightening in the spring of 2015. The BoE seems to be willing to embark on its tightening ahead of the U.S. Federal Reserve, but officials have also stressed that the New Normal terminal rate for policy rates is likely to be 2%–3%, rather than the historical normal rate of close to 5% in the decade leading up to 2008.
Q: How will PIMCO’s cyclical outlook for European growth, inflation and central bank policy inform your investment strategies?
A: Our baseline expectation is for fairly range-bound markets, and hence we will look to run positive carry in our portfolios, based upon both positioning in interest rate curves and spread position. In developing our investment strategy, we consider both the baseline case of the ECB on hold, but also the possibility that the ECB will be forced to purchase assets, in the form of credit easing or QE, to head off deflation risk.
For core eurozone duration, we favour an overweight in the 5–10 year part of the curve. The carry is attractive in this part of the curve and, in the event that the ECB moves toward asset purchases - or if the market merely starts to anticipate that ECB asset purchases are more likely - we would expect the belly of the curve to outperform the long end of the curve.
We regard long-dated forward rates in the eurozone core curves as structurally rich, reflecting demand for long-dated bonds from liability-driven investors. Rather than running an overweight duration position overall, we will run curve steepener positions by underweighting the long end of the curve. This reflects two considerations. First, our view on the eurozone and the positive carry of curve steepener positions. And second, the possibility that U.S. interest rates will rise, dragging eurozone rates higher with them - as it occurred in 2013.
Looking at the UK, we are underweight UK duration given the relatively low level of yields and the prospect of the BoE’s tightening cycle.
We remain overweight eurozone peripheral risk, favouring Italy, Spain and Slovenia and positioning at the front end out to the five-year part of the curve, where the curve is steepest and where we can generate the most attractive income. Our baseline case is that spreads should be range-bound. We continue to have concerns over the medium-term growth outlook in the eurozone, and we continue to see these positions as a source of credit risk and scale them appropriately. In the event of ECB asset purchases, we would expect peripheral government debt to be a primary beneficiary - even in the event that the ECB focuses its purchases on credit and loan markets - and we would look to increase our holdings if the probability of QE by the ECB were to rise.
We are broadly neutral on corporate credit and will continue to look to generate alpha across European credit and asset-backed markets. European credit default swap (CDS) indexes look reasonable value compared to U.S. CDS indexes. But strong demand from European insurers means that euro-denominated cash bonds remain expensive compared to U.S. dollar and pound sterling bonds, after hedging the exchange rate and duration risk. Within Europe, we continue to find good bottom-up opportunities in companies that are still implementing restructuring plans.
We do not expect the ECB’s Asset Quality Review to result in a significant capital hole for the eurozone banking system. However, there is already evidence that banks are responding with more conservative non-performing loan provisioning and capital raising. Subordinated and hybrid bank capital should benefit most from this, particularly against the senior part of the European bank capital structure which continues to trade rich compared to U.S. and UK peers.