Friday, March 16th, 2012
by Saumil H. Parikh, PIMCO
- We expect the eurozone economy to experience a recession in 2012 on the back of continuing pro-cyclical fiscal austerity measures.
- We expect 2012 to be the year in which the residential construction sector begins to gradually contribute to U.S. economic growth after a long and painful five-year hiatus.
- Major emerging market economies are struggling with domestic over-investment, rising income inequalities and inflation risks. Therefore, PIMCO expects major emerging market economies to be less of a global engine of growth in 2012-13.
The global economy finds itself sailing through calmer waters and clearer skies this quarter. Most financial asset prices have improved substantially in recent months. Liquidity conditions across markets have eased. Forced balance sheet deleveraging has slowed, and as a result, global economic growth has found a footing of sorts compared to last quarter.
The recent improvement in liquidity conditions and financial asset prices in Europe on the back of two Long-Term Repo Operations (LTROs) carried out by the European Central Bank (ECB) in early December and early March is of great importance to the evolving nature of PIMCO’s cyclical economic outlook. These operations have succeeded in providing highly at-risk European financial institutions with nearly a trillion euros in much needed financing to meet accelerating deposit flight, pay bond redemptions, secure longer-term funding and address asset-liability mismatches. Additionally, they have also driven positive spillover effects for certain sovereign bond markets (in particular Italy and Spain). In turn, this has slowed down the vicious European deleveraging feedback loop that was threatening the global economic outlook coming into 2012.
But the critical question for the year ahead is whether the ECB has done enough to halt and reverse deleveraging and change the course of the eurozone and global economic outlook on a sustainable basis? That is, is the global economy in the eye of the hurricane or has the hurricane passed over completely?
At PIMCO, we recognize the dynamics of economic and balance sheet healing but remain concerned that, in some key areas, they have not yet reached critical mass. This is particularly the case in Europe, where ECB liquidity provisions are necessary, but insufficient to deal with the twin underlying problems of too little growth and too much debt.
Eurozone’s Challenges Continue
In our view, it is still too early to give the all clear sign for the eurozone outlook. The fundamental problem facing the eurozone remains one of uneven competitiveness, currency rigidity and the lack of a coordinated vision shared between monetary and fiscal policy institutions.
We expect the eurozone economy to experience a recession in 2012 on the back of continuing pro-cyclical fiscal austerity measures, which will make eurozone sovereign risk indicators cyclically worse before they are given a chance to get secularly better.
This raises the specter of more downgrades, further destruction of demand for eurozone debt and the need to further deleverage balance sheets in the coming months and quarters. Spain has already raised its hand, demanding permission to run higher fiscal deficits than promised just a few months ago. The situation in Greece remains critical, and, along with Portugal, highlights the inadequacy of liquidity provisions to cure real solvency problems once debt dynamics move beyond the point of no return.
The future solvency of eurozone sovereigns can only be improved via the realization of much higher nominal growth and the reduction in sovereign borrowing costs which will require a lender of last resort. Rates need to drop to a level low enough to make debt burdens sustainable even at economic growth rates below the eurozone’s full potential. Neither of these solvency improving options are being offered to the troubled eurozone economies today.
As a result of our expectations for a eurozone recession, rising political risks across important countries and also the lack of critical solvency conditions, we believe the deleveraging feedback loop in Europe will remain in place and will continue to be the defining central feature of the global cyclical economic outlook. Like we said in December, as goes the eurozone deleveraging, so goes the global economy over the next six to 12 months.
U.S. Economic Growth Prospects
While the struggling eurozone economy will likely prevent the U.S. from achieving above-trend growth, some sectors of the U.S. economy have genuinely improved and are re-emerging from secular lows. This is clear in automobile output and more generally in manufacturing. One important inflection point in the story of U.S. deleveraging is the flattening out and reversal of the negative contribution of residential construction to overall economic growth. We expect 2012 to be the year in which the residential construction sector begins to gradually contribute to U.S. economic growth after a long and painful five-year hiatus. While we don’t expect the total contribution from this sector to be large (῀0.3%-0.4%), it does set the stage for a potential multi-year recovery in residential construction that we expect will eventually see a return to balance between household formation rates and new construction. This will add jobs and create income for many American workers that have endured a long depression in the sector. This is great news.
Another positive for the U.S. economy in 2012 is the nascent revival of availability of consumer credit. In recent months, this has become most clearly evident in the areas of student loans and also automobile financing. The latter was a critical component in the recovery of automobile sales to a 15 million annualized sales rate in February 2012 (a level of activity not seen in the sector since March of 2008) according to the U.S. Department of Commerce.
An important question, however, is whether this recovery in consumer credit availability will filter deep enough and wide enough in the household sector to allow for a sustained and continued drop in the U.S. household savings rate, which will be needed to sustain cyclical U.S. economic growth in the face of a weakening outlook for fiscal stimulus and exports. The potential certainly exists and will be strengthened significantly if current improvements in employment and income can be sustained into 2013.
Emerging Market Slowdown
Europe and the emerging markets are very important destinations for U.S. exports. Brazil, Russia, India, China and Mexico, in total, are the largest market for U.S. exports, followed by Canada, followed closely by Europe. While we believe Europe is almost certainly going to encounter a recession in 2012, recent evidence from the major emerging market countries suggests that there is a significant cyclical slowdown underway there as well, especially in China, Brazil and India.
Our cyclical outlook for the major emerging markets is for growth to settle at the sector’s full potential, with risks of under-shooting due to policies designed to opportunistically contain inflation. Emerging market economies have played an outsized role in the global economic recovery since 2008.
Because of much better initial conditions, and also greater policy effectiveness, fiscal and monetary stimulation of major emerging market economies provided important external demand for both U.S. and European commodity and capital goods exports during fragile periods of post-crisis growth. But, we expect this external demand source to wane during 2012.
Major emerging market economies are struggling with domestic over-investment, rising income inequalities and inflation risks. Therefore, PIMCO expects major emerging market economies to be less of a global engine of growth in 2012-13.
Potential Grey Swans
Finally, there are three grey swans on the cyclical horizon.
The U.S. elections in November will be critical in determining the shape of U.S. fiscal policy going into 2013 and beyond. As is well known by now, the U.S. economy faces a “fiscal cliff” in January of next year, when tax stimulus and government spending worth approximately 3.5% of GDP are scheduled to be cut. Even if the new president and incoming congress are able to avoid the debilitating fiscal contraction in 2013, the risk remains that as we approach the “fiscal cliff,” political theatrics and uncertainty regarding the outcome will hinder confidence and animal spirits as they did before the debt ceiling debate of 2011.
There are also presidential elections in France, a country that is key to resolving the European debt crisis. We will be following developments there closely, with particular focus on their potential impact on the French policy stance, Franco-
German collaboration and the outlook for Europe.
It is the third swan that disturbs us most. The quietly rising tensions in the Middle East between Israel and Iran must be addressed by global leaders in a unified manner before long. The existence of known unknowns is exerting unwelcome pressure on oil prices at a time when the global economy is only beginning to stabilize and grow out of vicious secular deleveraging process. Any global complacency on this front will quickly embed itself in oil prices, which in turn will render our best cyclical forecasts useless during a time in which visibility is already poor on all points across the horizon.
While we are sailing through calmer seas and clearer skies this quarter, the horizon in most directions remains grey and visibility remains very poor. A sustainable resolution to the eurozone sovereign crisis, continued gains in U.S. employment and consumption and a peaceful resolution to Middle East tensions are all necessary before we can declare secular smooth sailing ahead.
Tags: Asset Liability, Asset Prices, Austerity Measures, Bond Markets, Brazil, Canadian Market, Construction Sector, Critical Question, Emerging Market Economies, Feedback Loop, Financial Asset, Fiscal Austerity, Global Economic Growth, Global Economic Outlook, Global Economy, Income Inequalities, Inflation Risks, Liquidity Conditions, Outlo, Parikh, PIMCO, Russia, Spillover Effects
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Wednesday, March 23rd, 2011
As was first disclosed by Zero Hedge, PIMCO trimmed its Treasury holdings in February to zero. While many speculated that the reason is concern for global inflation, we now have the confirmation courtesy of a rhetorical Q&A with Saumil Parikh released by the Newport asset management giant. In a nutshell: “Setting aside immediate oil shocks, we believe global inflation has cyclically troughed and we see a secular upswing in inflation, which naturally will put upward pressure on interest rates. We see three key global factors as potentially adding to inflation over a long horizon: (i) The degradation of sovereign balance sheets and the structural inflexibility of fiscal deficits. (ii) Emerging markets used to export disinflation to the developed world, but over the secular horizon we see them as exporting inflation. (iii) As populations age, they tend to save less and consume more. Demographics may thus become an inflationary force globally, though possibly this risk will be balanced somewhat by demographics in emerging nations. In the near term, we anticipate most, though not all, global central banks are likely to err on the side of allowing inflation to rise above stated or implied targets during 2011. In the U.S., if the economic recovery sputters, the Fed could expand quantitative easing. But further deficit accommodation would pose inflation risks. Obviously nothing new here, and just a confirmation that in order to preserve the Wealth Effect, Bernanke will be forced to put the global Genocide [due to anti-revolution force in North Africa] (And Printing) Effect into overdrive.
Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the outlook for the global economy and financial markets. In an interview, senior portfolio manager Saumil Parikh discusses PIMCO’s cyclical economic outlook for the next six to 12 months. Parikh, who leads the forums, is a managing director, generalist portfolio manager and member of PIMCO’s Investment Committee.
Parikh also comments on investment strategies that PIMCO is applying to manage risk and deliver returns amid global uncertainty and shifting growth dynamics.
Q: Could you discuss the economic recovery in the U.S. and whether PIMCO believes it will be a lasting rebound?
Parikh: I would first note that, as a baseline, PIMCO continues to foresee a multi-speed global recovery over the next few years, with advanced economies facing muted growth and unusually high unemployment, while systemically important emerging economies continue gradually to close the global income and wealth gap. This forecast is governed by more favorable initial conditions of debts and deficits in emerging markets as well as by the loss of capacity for fiscal stimulus in certain developed nations.
Having said that, there are certain cases where the cyclical outlook deviates somewhat from the secular outlook. Nowhere is this juxtaposition between the secular (three to five years) and cyclical (a year or less) more evident than in the U.S. The country is experiencing a cyclical economic rebound, but its strong durability is uncertain. While endorsing the resilience and innovation of U.S. citizens and the economy, there are concerns about the country’s ability to achieve in the short-term “escape velocity” due to the legacy of the global financial crisis and other structural headwinds.
Currently, governmental revenues are not growing fast enough to close deficits in a pro-growth manner, and the private sector continues to deleverage. As a result, the national savings rate has continued to decline as opposed to rise as is customary during a self-sustained recovery. Meanwhile, on the margin, political winds are changing and the next fiscal policy surprise could be contractionary – as opposed to the expansionary tax-cut deal of late 2010. And, further, we are concerned about the potential economic drag if oil prices remain elevated.
Bottom line: On a cyclical timeline, and also taking into account the external environment, we continue to forecast a 3.0%–3.5% real U.S. GDP growth rate for 2011, with risks tilted toward slower growth in 2012.
Q: And will the Federal Reserve extend quantitative easing?
Parikh: We do not anticipate that the Fed will add to the total quantity of Treasury purchases this year. If it were to change course, it could taper off the purchases (e.g., so instead of ending abruptly in June, the Fed starts buying less in April or May and stretches out purchases a few months beyond June).
Q: What is PIMCO’s outlook for Europe?
Parikh: The cyclical outlook for the eurozone and U.K. economies contrasts starkly with that of the U.S. Notwithstanding the favorable developments in Germany, several countries there face headwinds to growth via national austerity measures and the resulting fiscal drag over our cyclical horizon.
In our detailed forum discussion about the internal dynamics of Europe, the core economies are expected to achieve at- or above-potential economic growth due to strong initial conditions of competitiveness and a significant tailwind from emerging market external demand. Also, PIMCO sees a non-trivial probability of fat tails on both ends (positive or negative) for the European economy in 2011, depending on whether the sovereign crisis affecting Greece, Portugal and Ireland can be successfully quarantined before spreading to Spain and Italy.
Q: Turning to Japan, many of us have watched the incredible images of the events and the tragedy inflicted there. Certainly others are commenting on the humanitarian needs; perhaps you could discuss the impact on Japan’s economy and if there is hope on that front?
Parikh: The images are devastating and point to the massive calamities that have hit that country. Japan’s immediate focus is rightly on the enormous human suffering and on rescue operations, as well as containing nuclear-reactor risks.
Japan’s leaders have moved swiftly to stem fallout from the earthquake and tsunami on all fronts, including economic. Within days of the disaster, the Bank of Japan injected a record 15 trillion yen ($183 billion) into the world’s third-largest economy.
Japan’s economic growth rate will likely fall in the immediate aftermath of the natural disasters, but reconstruction activities should have a stimulative impact on growth over time. The loss of inventories and supply-chain disruptions could cause inflation to rise temporarily from very low levels.
Much will depend on the extent of the damage to Japan’s infrastructure. We are hoping for the best.
Q: Dramatic events are also sweeping the Middle East – is the region a threat to the global economic recovery?
Parikh: Certainly we are concerned that the sharp rise in global oil prices, and the threat that supply uncertainties could spur further increases, could lead to negative global growth consequences. A truly severe oil shock could shift our global GDP outlook from a soft landing to a more significant downturn with sharply stagflationary effects.
We continue, as with much of the world, to monitor and evaluate the situation closely. The risks are very asymmetric given the starting point of oil prices in 2011.
Q: Let’s shift to emerging markets. Does PIMCO still see them as drivers of global growth?
Parikh: We expect real economic growth in the major emerging economies of China, Brazil, Russia, India and Mexico to remain at a solid rate during 2011, but lower than 2010 due to fading monetary and fiscal policy tailwinds and some pockets of overheating.
In terms of composition, we see growth across the major emerging markets becoming more balanced, with less reliance on the inventory cycle as well as net trade and capital investments, and marginally more reliance on domestic final consumption as an engine for growth.
The main challenge for the major emerging economies in 2011 is managing the risk of greater overheating in the domestic economies. We judge idle capacity to be negligible and cyclical inflation and cost-push pressures on the rise to a degree that could threaten corporate profits, leading to a larger-than-expected slowdown. Once again, and similar to the U.S. outlook, the level and volatility of oil prices are a major cyclical risk to the emerging market growth outlook.
Q: What is PIMCO’s outlook on inflation and interest rates if the situation in the Middle East does not lead to a severe oil shock?
Parikh: Setting aside immediate oil shocks, we believe global inflation has cyclically troughed and we see a secular upswing in inflation, which naturally will put upward pressure on interest rates.
We see three key global factors as potentially adding to inflation over a long horizon:
- The degradation of sovereign balance sheets and the structural inflexibility of fiscal deficits.
- Emerging markets used to export disinflation to the developed world, but over the secular horizon we see them as exporting inflation.
- As populations age, they tend to save less and consume more. Demographics may thus become an inflationary force globally, though possibly this risk will be balanced somewhat by demographics in emerging nations.
In the near term, we anticipate most, though not all, global central banks are likely to err on the side of allowing inflation to rise above stated or implied targets during 2011. In the U.S., if the economic recovery sputters, the Fed could expand quantitative easing. But further deficit accommodation would pose inflation risks.
Q: Finally, could you discuss how PIMCO is applying its global outlook to its investment strategies?
Parikh: Let’s begin with inflation, which is a topic clients often ask us about, and how that applies to our investing decisions. Since we see a secular bias to global inflation, we expect fixed income yields to gradually rise; we believe the 20-plus-year secular duration tailwind that previously anchored portfolios is over.
So we have taken down duration in our strategies, moving to shorter maturity securities. For example, while we still have faith in the credit quality of U.S. Treasuries, we feel yields on longer-dated notes and bonds are likely to rise as the Federal Reserve ends its quantitative easing and investors price in growing inflation risks.
We continue to focus on attractive opportunities in other areas in the U.S. and across the globe, including foreign currencies and credits. There are lots of opportunities in this global marketplace. Finally, we are tempering our near-term enthusiasm for U.S. corporate bonds with a long-term outlook that the U.S. economy must eventually address fiscal deficits, rising rates and the potential for higher oil prices and those could all be negative factors for U.S. companies and the bonds they issue.
Thank you, Saumil.
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