Go for Growth

The global economy continues to face numerous challenges in the near term, including the U.S. fiscal cliff, Europe’s sovereign debt crisis and the emerging markets’ transition to a slower rate of economic growth. Over the medium to longer term, the demographics of aging populations are likely to collide with rising and unsustainable public sector debt levels in many areas of the world. In fact, persistent and chronic fiscal deficits in several developed economies could reach the point where austerity, spending cuts and tax hikes may become inevitable.

As a result of these significant, and increasingly structural, impediments to global growth, central banks around the world have implemented a comprehensive and aggressive program of unconventional monetary policy measures and stimulus, resulting in an unprecedented expansion of balance sheets. Despite these enormous efforts, monetary policy will likely not provide a long-term solution to what are ultimately fiscal, political and structural issues. While near-term cyclical challenges may justify increasing activism by global central banks, government debt levels for many developed markets need to be addressed to reduce growing structural barriers to longer-term economic growth.

As the world’s central banks go “all in” to help offset fiscal tightening, increasingly dysfunctional political processes in the U.S. and elsewhere have resulted in politicians kicking the can down the road in order to avoid addressing longer-term structural barriers to growth. At the same time, many nations have become more divided and, as is increasingly the case in the U.S., politicians appear more inflexible and entrenched. The heightened polarization of the U.S. political system has now reached a tipping point where many would argue the American system of government has lost effectiveness and its ability to function productively for its constituents.

Political leaders in America, as well as around the world, will need to work together more in order to effectively address the global economy’s lingering fiscal issues and structural barriers to growth. Simply put, political leadership is now a necessary condition for global policymakers to be effective in coordinating and implementing policies that can reduce public sector debt burdens, promote pro-growth tax reforms and stimulate near-term private sector growth. Around the world, we believe nations must put differences aside, work together and go for growth.

Investors should go for growth as well. We still see many opportunities for investors despite numerous headwinds and a subpar economic growth outlook. In this environment, investors should focus on bottom-up research in specific sectors and companies that can grow significantly faster than their economies. In the U.S., the energy and housing-related industries offer investors these opportunities. In emerging markets, investors looking for growth should consider Asia gas distribution and gaming, as well as Latin America banks.

U.S. energy industry
In our March 2012 Global Credit Perspectives, “Game Changer,” we described in detail the energy revolution taking place across America. PIMCO has focused on bottom-up analysis of the U.S. energy industry for years, and we continue to see numerous opportunities across the exploration and production (E&P), gathering and processing, oil field services and pipeline sectors. Why? Growth!

U.S. production of crude oil across America is at a 15-year high and is now growing at 15% or more annually, the fastest growth rate in over 40 years (Figure 1). Several unique characteristics have given America’s energy industry numerous advantages relative to the rest of the world, including technological progress, a breakthrough in horizontal drilling, the industry’s strong access to capital markets and well-established and sophisticated gathering and processing, pipeline and rail networks across the country. In addition, the U.S. energy sector’s relatively strong infrastructure and oil field services, “take away” capacity, refining base and technological and operating expertise provide logistical strengths.

In its growth outlook, the U.S. is in a rare position in the global energy sector. According to Bentek, non-U.S. and Canadian waterborne imports will decrease from approximately 50% of U.S. crude oil supply in 2010 to only 14% in 2017. This equates to a 16% decrease annually in imported crude oil. At current production rates and forecasts, we believe U.S. energy independence is achievable by 2025, with a dramatic ripple effect on U.S. manufacturing, foreign policy, defense spending and our nation’s looming budget deficit.

The U.S. produces some of the lowest cost energy in the world. Cheap natural gas and natural gas liquids, or NGLs, including ethane and propane, have spurred new investment in U.S. chemical and manufacturing plants. America’s recent ascent in domestic oil and gas production is truly a game changer for the U.S. energy industry and for the country.

Numerous companies across the energy sector are capitalizing on America’s energy revolution. Our investments have focused on the specific companies that stand to benefit most from growth in the emerging oil and gas shale regions across the U.S., particularly in the shale regions in the Bakken, Marcellus and Eagle Ford areas, as well as in the Permian Basin. We continue to find numerous opportunities in this sector and believe above-trend growth is likely, particularly for the many companies we have identified through our bottom-up research efforts.

U.S. housing-related industries
Our more bullish housing outlook, outlined in our May 2012 Global Credit Perspectives, “Back In,” has led us to favor specific companies in the housing, building products, title insurance and appliance industries. Why? Growth!

U.S. construction permits for single-family housing units are near 45-year lows (Figure 2). But U.S. housing inventories are coming down across the board, which should improve the outlook for housing prices and future construction. Existing home inventories are currently 2.3 million units, down 20% from a year ago and at a seven-year low. New home inventories are 146,000 units, near a 50-year low. At the same time, buyer psychology is turning more positive as consumer confidence and the outlook for employment gradually improve. Homebuilders are increasingly reporting that potential home buyers are no longer as worried that U.S. housing prices will go down and, in some markets, are concerned that prices will soon go higher. Home buyers have been sitting on the sidelines for years. However, we expect to see household formation and housing starts pick up from depressed levels today as the U.S. economy heals and pent-up demand is unleashed with improved buyer psychology (Figure 3).

In addition to an increasingly positive fundamental outlook, we have become more positive on U.S. housing because central banks around the world are increasingly going “all in” for growth (Figure 4). In the U.S., one could argue the Federal Reserve’s dual mandate of stable inflation and employment growth has been temporarily replaced with a near-term, more aggressive monetary policy focused on job creation, even if it results in a modest pickup in inflation and inflationary expectations. The highly expansionary and aggressive policies of the Fed and other central banks around the globe are really unprecedented and suggest reflation may be around the corner, which should support hard and real assets like U.S. housing.

A boost to housing would likely benefit housing-related companies. In the case of Weyerhaeuser, a large integrated forest products company and land owner in North America, lumber prices and volumes in the wood products division were up 19% and 8% year-over-year, respectively, at the end of the third quarter 2012 (Figure 5). Given declining housing inventories, significant pent-up demand and the depressed level of housing construction, investors may be well-served to favor U.S. housing-related industries and companies like Weyerhaeuser that appear to be well positioned to deliver above-trend growth and should benefit from a recovery in U.S. housing construction.

Asia gas distribution
In our recent travels throughout Asia, we came away increasingly positive on the outlook for gas distribution, specifically in China. Why? Growth!

In 2010, 69% of China’s total energy needs were supplied by coal and only 4% by natural gas (Figure 6). The government, however, is dedicating significant resources to moving the country toward clean fuel sources in order to reduce pollution and improve air quality. As a result, natural gas is expected to grow to 8% of total Chinese energy consumption by 2015. Thus, demand for natural gas should grow more than 20% annually over the next several years (Figure 7).

Increasing investments in the construction of liquefied natural gas terminals and natural gas pipelines, as well as planned pricing reforms, are testaments to China’s intent on fulfilling its energy policy. Moreover, natural gas is and will continue to be more price competitive when compared with electricity in the medium term, making it an attractive energy source for businesses and consumers.

Through our bottom-up research efforts, we have uncovered numerous opportunities to invest in companies throughout China that have solid growth prospects due to the government’s policies to promote the use of clean energy and more natural gas. Specifically, we have focused on gas distribution companies.

Asia gaming
Asia gaming, featured in our Global Credit Perspectives “Diamonds in the Rough” in August 2012, is an area we still see value in. Why? Growth!

Over the past 6½ years, the Macau gaming market has grown from roughly $6 billion in annual revenues to approximately $36 billion today (Figure 8). Despite the already substantial growth, the Chinese government is making significant infrastructure investments, including new bridges, ports, high-speed rail, highway expansions and visitation facilities, to improve access to Macau from major cities throughout China. New casino properties are being developed in the emerging Cotai area of Macau, referred to as the Las Vegas Strip of China, to serve the anticipated growth in demand.

We believe a rising middle-class Chinese consumer will lead to significant and sustainable double-digit growth in the mass market in Macau. We similarly believe that growing wealth throughout Asia, combined with improving infrastructure, will lead to increasing demand from Asian consumers for both Macau and Singapore gaming.

PIMCO is invested in several gaming companies with a significant presence in Asia and we remain constructive on the industry. We believe that the above-trend growth will continue for many companies in the sector.

Latin America banks
In our numerous travels throughout Latin America, our bottom-up research efforts have uncovered plentiful opportunities to invest in Latin American banks. Why? Growth!

Emerging market banks should experience robust loan growth relative to those in developed markets on the back of an emerging middle class eager to consume. In countries such as Brazil, the middle class has risen from 39% of the population in 2004 to 57% today, according to data compiled by Banco Bradesco, while a gauge of poverty has roughly halved over the past decade. Social mobility represents a strong secular tailwind.

Emerging market banks also benefit from low financial penetration. Mexico, Peru and Brazil have significantly lower loan-to-GDP ratios than the rest of the world (Figure 9). In these markets, we believe double-digit loan growth is achievable over the secular horizon, in contrast to the over-reaching for loan growth witnessed in developed markets leading up to the financial crisis. That said, this should prove a bumpy journey as elevated loan growth can (and has) driven asset quality weakness in select markets. Still, we believe initial conditions with respect to profitability and capital, coupled with careful security selection, offer attractive opportunities for credit investors.

We have been investing in a select group of emerging market banks with dominant market shares in countries including Mexico, Peru and Brazil. The specific banks we favor tend to boast growing deposit bases, high capital ratios, solid net interest margins and well-grounded risk management.

Go for growth
The global economy needs growth now more than ever. Global central banks have gone all in to help offset fiscal tightening in numerous regions in developed markets. Nevertheless, political and structural factors appear set to negatively impact “animal spirits” as both consumers and business sit on the sidelines to await election results and clarity from political leaders on the future direction for economic, fiscal, budgetary, regulatory and tax policies.

Whether or not political leaders will go for growth remains unclear; should our political leadership implement medium- and long-term policies to reduce public sector debt burdens and target pro-growth tax reforms, the outlook for private sector growth would likely improve.

Regardless, in the near term, we believe investors should focus on areas of the world and on specific industries and companies that can deliver healthy growth – higher than the growth rates of their broader economies. Today, we find these opportunities in U.S. energy, U.S. housing-related industries, Asia gas distribution, Asia gaming and Latin America banks.

Mark Kiesel
Managing Director


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