Each quarter, PIMCO investment professionals from around the globe gather in Newport Beach to discuss the firm’s outlook for the global economy and financial markets. In the following interview, portfolio managers Ramin Toloui, Tomoya Masanao and Robert Mead discuss PIMCO’s outlook for the Asia-Pacific region over the next six to 12 months and the implications for investors.
Q. What matters in Asia for 2014?
Toloui: Asia’s trajectory will continue to be shaped critically by the growth path in the U.S. and Europe, as well as by policies of central banks, particularly the U.S. Federal Reserve. But we also see three homegrown issues to watch in the coming year.
First is the staying power of Abenomics in Japan, the impulse from which we expect to fade in the coming year amid headwinds like the increase in the value-added tax. Second is the progress that China makes in reducing its dependence on credit- and investment-led growth. We anticipate an incremental dialing-back of credit stimulus in China but not an abrupt pressing of the brakes. Third is the ability of emerging market countries in the region to navigate financial volatility without excessive economic disruption. We expect policymakers to face renewed bouts of market stress in places like India and Indonesia.
The upshot is an Asian outlook in which growth is stabilizing but not stellar. Prospects for an improved external environment offer the possibility of support on the upside, as countries in the region grapple with domestic challenges – be they long-run demographic headwinds in Japan and Korea, rebalancing to households in China or financial vulnerabilities. From a global perspective, we do not see an autonomous growth surprise emanating from Asia that would reconfigure the U.S. Federal Reserve’s calculations with respect to forward guidance on interest rates, which anchors PIMCO’s preference for investments in the front portion of the yield curve.
Q. Does the reform agenda announced at the recent Third Party Plenum change the cyclical economic outlook for China?
Toloui: We have argued for several years that Chinese economic growth is in the midst of a structural downshift as the export- and investment-led engines that powered 10% annualized GDP gains during the past decade have reached their limits. Growth in the next decade requires a rebalancing of the economy toward household demand. For this reason, there was great market anticipation surrounding the Third Party Plenum in November – an event that has periodically served as a watershed moment for reform since Deng Xiaoping’s opening in the late 1970s. So what did we learn from the Plenum?
There was not a great deal of new information on the content of the economic reform agenda and implementation timetable in the Plenum’s conclusions. The language on reform in areas like rural land reform, urbanization policy and financial liberalization was as expected, an echo of previous endorsed statements or lacking in detail.
Rather, the most striking outcome of the Plenum was the insight it provided into the emerging power dynamics within China – namely, the centralization of authority by President Xi Jinping. The Plenum established two powerful councils on economic reform and state security that will report directly to President Xi, signaling the potential for more decisive policymaking in these areas and a possible window for overcoming vested interests in the period ahead.
From a substantive perspective, the short-term impact of the Third Party Plenum is unlikely to be a cyclical game-changer. The implementation timeline – which runs through 2020 – extends far beyond the cyclical horizon. Moreover, the reform language endorsed in the Plenum is unlikely to be regarded as so ambitious as to warrant a dramatic confidence-induced investment wave in anticipation of the implementation. In the near term, China’s economic performance will be dominated by the dialing back and forth of the credit conditions by policymakers.
Q: What is PIMCO’s economic outlook for Japan in 2014, given consumption tax hikes as a fiscal headwind? How sustainable will the current growth momentum be?
Masanao: GDP growth in Japan will no doubt be slower in 2014, but PIMCO forecasts 1.2%, which is above both the market consensus and Japan’s potential growth rate. It is true that consumption was front-loaded ahead of the tax hike and fiscal stimulus was added, both of which were the key driver of Japan’s GDP growth over the last few quarters and will likely contribute much less in 2014. But we think that Japanese policymakers would still be “all-in” with demand-side policies if the economy weakens too much because of the need for growth, particularly since another consumption tax hike is planned in 2015. Fiscal policy would be adjusted, say, with a spending package, and the Bank of Japan (BOJ) would do more quantitative easing and monetize more debt. Growth strategy or a supply-side policy to raise potential growth rates will ultimately be a key for the success of Abenomics, yet it has not been promising. But at least for the next 12 months, monetary and fiscal reflation can still play a role.
Risks to our outlook remain, both external and internal. The rest of the world would not accommodate Japan’s reflation if growth of their economies fails to pick up. The domestic private sector may lose confidence if Prime Minister Abe starts to consume his political capital outside the economic policies.
Q: What do you suggest investors to do in Japanese markets?
Masanao: Japanese government bond (JGB) yields are artificially low and will likely be so in the near term, with their risk premium compressed by the BOJ’s aggressive quantitative easing, but investors should be cautious at the current level of JGB yields. Our view is that, around 0.6%, the 10-year JGB yield has more or less priced-in complete ineffectiveness of Abenomics and a continuation of deflation and risk-premium compression. While the BOJ’s target of 2% inflation is ambitious and is unlikely to be met, as the negative output gap narrows further with fiscal monetary reflation and the economy reaches full employment, deflation at least can be ended and turn into mild inflation, say 1%. Even in this “mild success” case of Abenomics, the current valuation of JGBs is unattractive.
Elsewhere in Japanese markets, we continue to think the Japanese yen is an attractive funding currency to own global assets. The direction of central bank policies in major economies will be diverging in 2014, which supports this view: Japan will remain the most aggressive in quantitative easing, while the U.S. will be reducing it and China will be tightening credit policy. Japanese stocks should also benefit from a continuation of Japan’s reflation policy and will outperform their global peers. Despite Japanese stocks’ significant rally over the last 12 months or so, their valuation is not overly stretched, with improved earnings prospective. Government policies to “induce” reallocation to riskier assets in domestic investors’ portfolios should also add technical supports to Japanese stocks.
Q. Is PIMCO’s moderately improving developed market growth outlook likely to flow through to Australian growth expectations?
Mead: The short answer is no, not over the cyclical horizon. The growth outlook for Australia continues to be weak, even from the starting point of only 2.3% annual GDP growth to September 2013. Despite sentiment improving immediately after the recent federal election, so far there is limited evidence of any non-mining investment actually taking place outside of the housing sector. And the most recent consumer sentiment survey indicates confidence may already be weakening. In fact, there have been recent announcements of further reductions in the manufacturing sector, which will negatively affect growth expectations over the next few years. In addition, PIMCO’s forecast for Chinese growth remains below consensus, so we do not expect any significant tailwinds from the external sector.
The clear investment implication of this is to maintain a positive curve position in Australia via an overweight of the front end of the yield curve. As rate cuts have been priced out of the Australian yield curve over recent months, the carry and roll-down of three- to five-year bonds have become much more compelling for investors globally, especially in an environment where the Reserve Bank of Australia will be required to keep rates lower for even longer, which PIMCO expects. Given our economic outlook, we believe the Australian dollar is likely to weaken further; however, the timing will be strongly influenced by the direction of global central bank policies.