balancing risks and opportunities in the multi-speed world - pimco
TRANSCRIPT
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CYCLICAL OUTLOOK
Te past several months have
investors and policymakers
reassessing global economic
prospects amid elevated
concerns over emergingmarket growth models
and policy effectiveness.
In the midst of these global
uncertainties, PIMCO
investment professionals
gathered recently for our
September Cyclical Forum.
Balancing Risks andOpportunities in theMulti-Speed World
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2 September 2015 Cyclical Outlook
Although the turbulence in global markets that ollowed the bursting o the Chinese equity
bubble in June and the allout rom the devaluation o the Chinese yuan in August was the
major financial event that has occurred since our March orum, our goal at the September
orum as at every orum was to look ahead rom initial conditions so as to ormulate a
baseline view or the global economy as well as to identiy and assess the balance o risks to
that baseline view. Our orum discussions benefited enormously rom the active participation
o and valuable contributions rom PIMCO senior advisors Ben Bernanke, Mike Spence and
Gene Sperling. Drawing on superb presentations rom our Americas, European, and Asia-Pacific portolio committees, as well as rom our emerging market (EM) team, and ollowing
a very robust and wide-ranging internal discussion, we coalesced on a baseline view that
global economic prospects over the next months remain broadly unchanged from where we
saw them in March and are consistent with global GDP growth in the range of .% to % and
global inflation of % to .%.
While this is our baseline cyclical view, the averages it represents mask significant and in
some cases widening divergences among the worlds major economies. As we shall discuss
urther below, our baseline view or GDP growth in the U.S., eurozone, U.K. and Japan over
the next year is actually consistent with a modest increasein the pace o growth or this group
AUTHORS
Richard Clarida
Global Strategic Advisor
Andrew Balls
Chief Investment Officer,Global Fixed Income
At our previous Cyclical Forum in March , weconcluded (as detailed in our post-forum essay)
that the global economy was Riding a Wave of
Accommodation Carefully. Since then, while
the wave of global monetary accommodation
has if anything expanded in scale and in scope
and may well deepen further over our cyclicalhorizon to date it has been insufficient to stave
off a decline in commodity and equity prices or
to discourage renewed fears of disinflation amid
concerns that China will not be able to navigate
the New Normal trajectory for growth and global
financial integration they have set for themselves.
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3September 2015 Cyclical Outlook
PIMCOs investment process is
anchored by our Secular and
Cyclical Economic Forums. Four
times a year, our investment
professionals from around the
world gather in Newport Beach to
discuss and debate the state of the
global markets and economy and
identify the trends that we believe
will have important investment
implications going forward. We
believe a disciplined focus onlong-term fundamentals provides
an important macroeconomic
backdrop against which we can
identify opportunities and risks and
implement long-term investment
strategies. At the Secular Forum,
held annually, we focus on the
outlook for the next three to five
years, allowing us to position
portfolios to benefit from structural
changes and trends in the global
economy. At the Cyclical Forum,
held three times a year, we focus
on the outlook for the next six to
12 months, analyzing business cycle
dynamics across major developed
and emerging market economies
with an eye toward identifying
potential changes in monetary and
fiscal policies, market risk premiums
and relative valuations that drive
portfolio positioning.
United States
2.25% to 2.75%
BRIM2.0% to 3.0%
BRIM is Brazil, Russia,India, Mexico
United Kindgom
2.25% to 2.75%
Eurozone1.5% to 2.0%
China
5.5% to 6.5%
Japan1.25% to 1.75%
ABOUT OUR FORUMSGROWTH OUTLOOK FOR THE NEXT 12 MONTHS (GDP RANGE)
FORECAST REAL GDP HEADLINE INFLATION
Current* Q315Q316 Current* Q315Q316
United States 2.7% 2.25% to 2.75% 1.8% 1.75% to 2.25%
Eurozone 1.5% 1.5% to 2.0% 0.2% 1.0% to 1.5%
United Kingdom 2.6% 2.25% to 2.75% 0.0% 1.25% to 1.75%
Japan 0.8% 1.25% to 1.75% 0.6% 1.0% to 1.5%
China 7.0% 5.5% to 6.5% 1.5% 1.5% to 2.5%
BRIM** 0.3% 2.0% to 3.0% 8.4% 5.0% to 6.0%
World*** 2.7% 2.5% to 3.0% 2.1% 2.0% to 2.5%
*Current data for real GDP and inflation represent four quarters ending Q2 2015
**BRIM is Brazil, Russia, India, Mexico
***World is the GDP-weighted average of countries listed in table above
Source: Bloomberg, PIMCO calculations.
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4 September 2015 Cyclical Outlook
o countries versus the past year.On the other side o the ledger, we
concluded that prospects or
growth in China are clearly
deteriorating, though we note the
market consensus view is
converging toward PIMCOs more
bearish orecast published in
March, which in act remains
roughly unchanged. Finally, other
major emerging economies such as
Russia and Brazil find themselves
at present in recession with at best
uncertain prospects or recovery
over our cyclical horizon.
In terms o policy, although more
than central banks have eased
monetary policy thus ar in ,
the odds or additional monetary
easing by the European Central
Bank (ECB) and the Peoples Bank
o China (PBOC) are material, and
urther easing by the Bank o Japan(BOJ) is certainly possible. As or
the Federal Reserve, while our
baseline view remains that it will
commence a rate hike cycle
sometime over our one-year
cyclical horizon, the pace o lifoff
is likely to be even more gradual
than we expected in March.
Moreover, as our new and already
valued colleague Joachim Fels
reminded us, there is a chance that
the Fed, like a number o central
banks in recent years, may find it
impossible to escape the effective
lower bound to which policy rates
were cut during the dark days o
the crisis some seven years ago.
As or global inflation, we see
prospects or a modest pickup in
inflation in many countries as the
pass-through o lower oil prices and in the case o the U.S., the
stronger dollar on price indexes
ades. By contrast, in Brazil and
Russia, where inflation well
exceeds target, recession and (in
Brazil) tight monetary policy are
expected to bring inflation lower
over our cyclical horizon.
In short, we find ourselves today
and or some time are likely to
remain in a multi-speed world orgrowth, inflation and economic
policy; a multi-speed world that is
indeed one o the key elements o
PIMCOs secular New Neutral
thesis. Below is our more detailed
economic outlook or this multi-
speed world over the next
months, and then a discussion o
some o the key investment
implications that flow rom it.
U.S. Outlook
For the U.S., our baseline view sees
economic growth in the range o
.% to .% over the next our
quarters and CPI inflation o .%
to .%. Tis baseline represents a
modest pickup in growth and
inflation relative to the pace
recorded in the first hal o ,
and it is slightly below the pace o
GDP growth over the most recent
our quarters. Projected
employment and labor income
gains should support consumption,
while historically low mortgage
rates and a pent-up demand or
housing driven by household
ormation and demography should
boost residential construction. In
contrast to robust consumption
and housing, business investmentconronts the headwinds rom low
oil prices and cutbacks in drilling
and exploration, while exports will
be challenged by the delayed effects
o a stronger dollar and slower
growth in emerging economies. As
or the Fed, one consequence o the
summer sell-off triggered by
surprise devaluation o the
Chinese yuan (CNY) on August
has been to lower the odds that we
get a hawkish mistake rom the
Fed. While the Yellen put
analogy is imprecise i there is a
put, then where is the strike, and
is this Fed really prepared to
deploy its balance sheet to deend
it? it is clear rom their
statements that this Fed is alert to
the state o financial conditions
and is inclined to go slow once it
starts to hike so as to avoid
tightening too much.
Eurozone and U.K. Outlook
For the eurozone, our baseline sees
economic growth o .% to .%
over the next our quarters with
inflation in a range o % to .%.
Tis baseline also represents a
modest pickup in growth and
inflation relative to the paces
recorded in recent quarters. Unlike
the U.S., the eurozone hasbenefited rom a weaker currency
and rom low oil prices, and the
tailwinds rom low oil prices and
the weaker euro currency should
support aggregate demand in the
year ahead. And or the first time
in several years, fiscal policy is no
longer projected to be a drag on
eurozone aggregate demand.
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5September 2015 Cyclical Outlook
Moreover, the ECB is gainingtraction in transmitting the thrust
o accommodative monetary
policy to easier credit conditions.
On ECB policy, we see a significant
probability that the current
quantitative easing (QE) program
gets expanded beore its scheduled
conclusion in September . As
or the U.K, we are projecting GDP
growth o .% to .% with
inflation running in a range o
.% to .%. Te U.K. economy
is supported by a strong labor
market and the wealth effect rom
robust house prices benefiting
rom low interest rates. With
prospects or the eurozone
improving, U.K. exports should
also contribute to growth. As Mike
Amey (sterling portolio manager
on our European portolio
committee) reminded us, this is a
typical U.K. business cycle, and
one that is not threatened by
above-target inflation. I the Bank
o England does hike during our
horizon, it will almost certainly be
afer the first Fed hike, and not
until sometime in .
China Outlook
In previous orums, weve
concluded that China possesses the
will and the wallet to deal with thepolicy challenges it aces as it
transitions rom a development
model based on running huge
current account surpluses with
a closed capital account to a
model based more on domestic-
demand-supported growth and a
more internationally open capital
market. While this continues to be
true, recent events require us to aski will and wallet continue to be
sufficient. Tis assessment is a task
that will take us (and the markets)
some time to complete, and at the
September orum we only just
began the process. Clearly, the
challenges acing China today are
substantial. Te economy conronts
a property bust, a collapse in equity
prices, alling exports and an over-
levered shadow banking system.
Hot money capital is fleeing
China, and the central bank
(PBOC) is losing reserves in an
effort to prevent a urther
uncontrolled depreciation o the
CNY exchange rate. Under these
circumstances, our baseline sees
GDP growth in China in a range o
.% to .% over the next our
quarters, which is little changed
rom our March orecast but
remains well below consensus. We
see inflation in the range o .% to
.%. In the ace o such challenging
economic circumstances, we expect
to see a significant monetary policy
response rom the PBOC, with
basis points in deposit rate cuts, a
basis point cut in the required
reserve ratio and devaluation o the
CNY to a level o . to the dollar.
Japan OutlookTe Japanese economy has suffered
rom the slowdown in China and
the continuing drag rom the
hike in the VA. Corporate profits
are healthy due to the weaker yen
and the labor market is robust, but
Japan aces significant structural
headwinds to trend growth that
have not yet been offset by the
third arrow o Abenomics (thefirst two arrows were fiscal
stimulus and monetary easing;
structural reorm is the third). Te
Bank o Japan remains extremely
accommodative with its massive
Quantitative and Qualitative
Monetary Easing (QQE) program
in place, yet inflation is projected
to rise only modestly. Our baseline
view is that GDP growth in Japan
should rise rom an outright
decline in the second quarter, but
only up to a range o .% to .%
over the next our quarters. Under
this scenario, we see a possibility
that over our cyclical horizon the
BOJ expands yet again the QQE
program, as there is a limited
prospect that inflation reaches the
% target desired by BOJ Governor
Haruhiko Kuroda.
Brazil and Russia Outlook
In Brazil, the macro outlook will
largely be a derivative o domestic
politics as the gridlock in Congress
continues. We are orecasting the
recession to deepen throughout
this year with meaningul
downside risks as business
confidence and investment remain
weak. At the same time, we expect
inflation will remain high but start
to noticeably decline in the firstquarter o . Potential upside
risks to inflation could arise rom
the outcome o wage negotiations
in the all, a weaker currency and
urther fiscal slippage; downside
risks could arise rom a deep
disinflation rom the recession and
lower energy prices. Given this
backdrop, we expect only a modest
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6 September 2015 Cyclical Outlook
Te current account surplus hasbeen improving, and the
deleveraging by the corporate
sector has been impressive, i only
out o necessity.
Risks to the Baseline View
All probability distributions have
right as well as lef tails. oday, the
most significant lef tail risk to the
global economic outlook is or a
hard landing in China, which inthe extreme could trigger a
currency war and could increase
the odds o outright global
deflation. Tis is not our base case,
in no small part because we project
significant policy easing by the
PBOC over the next year as they
seek to clip this lef tail risk.
On the optimistic side, thus ar the
positive stimulus to global
aggregate demand rom low oilprices has been less than projected
by the Organisation or Economic
Co-operation and Development,
the International Monetary Fund
and other experts. I in act the
stimulus rom low oil prices
has only been delayed, not
overestimated, global growth
in the year ahead could surprise on
the upside.
Overall, we see the balance o risksto the global economy tilted
somewhat to the downside, in part
because o diminishing returns o
unconventional monetary policy
and also the market volatility
stemming rom developments
in China.
rate-cutting cycle in as long asthe political backdrop is stable and
currency pressures are contained.
In addition, we expect to see
pressures on Brazils sovereign
external ratings ollowing S&Ps
downgrade to high yield (with
negative outlook) as the political
dysunction continues and near-
term prospects o fiscal
consolidation and circuit breakers
remain slim. In Russia, the
recession continues unabated and
is set to peak in the third quarter o
(in year-over-year terms) on
the back o a negative terms-o-
trade shock and amid the weight o
Western sanctions. PIMCO
expects Russias GDP to contract
between .% and % this year,
and around .% in .
Domestic demand remains the
main drag to growth, with
household spending in particular
being hit under a sharp contraction
in real wages. Capital expenditures
are set to become the main
detractor to growth going orward
once the pressure on real wages
subsides. Meanwhile, the
disinflation trend is set to continue
as the impact rom the rubles
weakness has been relatively
contained, i.e., not validated by
wage growth. We expect Russiascentral bank to continue to cut
interest rates but to moderate the
pace o easing going orward. Te
mirror image (and the silver
lining) o the recession in domestic
demand has been the improvement
in Russias external balance sheet.
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7September 2015 Cyclical Outlook
INVESTMENT IMPLICATIONS
While our baseline views on the
global macro outlook have not
changed significantly, we see
somewhat higher macro and in
particular market risk. o the extent
that there is an impact on macro
variables rom the market volatility,
we expect that central banks will
respond over the cyclical path,
including a slower pace o hikes by
the Fed and increased QE rom the
BOJ and the ECB. As the Federal
Reserve noted in its statement
ollowing its September meeting
just afer our Cyclical Forum
while most o the FOMC
members expect to raise interest
rates beore the end o this year,
global developments have raised the
risks to the U.S. outlook or growth
and inflation in the near term.
At the same time, we see central
banks migrating rom being a
source o endogenous stability in
markets to being a source o some
exogenous instability. Te
willingness to attempt to suppress
volatility is there, but the ability to
do so is diminished. Over-reliance
on central banks (versus fiscal/
structural policy) has led to a wedge
between market valuations and
undamentals that requires a careul
approach to portolio constructionand close attention to correlated
risk positions and stress tests.
In broad terms, we see global fixed
income markets as anchored by our
New Neutral secular ramework or
interest rates. Lower central bank
policy rates over the next three to
five years mean that fixed income
markets look air to somewhat rich
but not grossly mispriced.
In terms o portolio positioning,
this translates into modest duration
underweights or the most part. We
expect markets to price more risk
premiums into developed country
curves, starting with the U.S. and
the Fed rate hike cycle.
We think that markets are probably
pricing insufficient tightening by
the Fed, based upon our baseline
orecast o above-potential growthand inflation getting back to the
Feds % target over the next our
quarters. Globally, we see the same
pattern o orward rates that look
air to slightly rich in nominal
duration. In U.S. reasury
Inflation-Protected Securities
(IPS), we see valuation as
attractive, given our expectation
or gradually rising inflation.
We continue to expect to maintainbroad credit spread overweights in
our portolios, with some
increased uncertainty in the
outlook compensated or by more
attractive valuations ollowing
recent market weakness. We
continue to see investment grade
and high yield credit industrials
and financials as attractive. We will
be vigilant on liquidity and ensure
appropriate new issue premiumsare on offer beore adding in
primary markets.
We continue to see value in
non-agency mortgages given
housing market strength, broadly
range-bound rate markets, and the
airly deensive nature o the
securities due to seniority in the
capital structure.
On currencies, we will maintain anoverweight to the U.S. dollar,
reflecting macro and policy
divergence at a time when the U.S.
economy is outperorming and the
Fed is set to tighten policy, while
we expect ongoing policy
loosening outside the U.S. We will
avor a diversified basket o
unding currencies, G-
currencies and Asian emerging
market currencies.
We will be cautious on emerging
markets holdings, reflecting macro
and market risks, but will continue
to look or select opportunities to
add risk at attractive valuations.
On global equities, we are broadly
neutral overall. At a time o
peaking U.S. profits and a
stronger U.S. dollar, we will
continue to avor European and
Japanese equities based onearnings growth momentum and
supportive central banks.
On commodities, we expect to see
supply and demand as broadly
balanced over the next months
and have a neutral outlook at
current prices.
We see central banksmigrating from being asource of endogenousstability in markets tobeing a source of someexogenous instability.
7September 2015 Cyclical Outlook
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