In the following interview, Managing Directors Mike Amey, Andrew Bosomworth and Lorenzo Pagani discuss the conclusions from PIMCO’s quarterly Cyclical Forum, in which the company’s investment professionals gathered in September 2015 to discuss global economies and markets. They share our views on the medium-term outlook for Europe and the critical implications for investment strategy.
Q: Recent market volatility suggests investors are focused on developments in Asia, and perhaps are more comfortable with conditions in Europe. What is PIMCO’s outlook for eurozone growth and inflation over the coming six to 12 months? Are things looking up?
Amey: Despite the market volatility in Asia and some turbulence in Europe around the difficult situation in Greece, our expectations are for the eurozone to experience above-trend real growth of 1.75%, a slight improvement over our Cyclical Outlook in March. We believe domestic demand will be the primary source of this growth due to improving private sector loan growth, which is responding to falling private sector interest rates, in turn driven down by low official interest rates and the European Central Bank’s (ECB) quantitative easing (QE) programme. Meanwhile, fiscal policy is moving more into balance, and as a result will no longer be a drag on growth. Undoubtedly, there will be some challenges for the export sector, in particular for the German economy, as exports to Asia come under pressure; however, our assessment is that this recovery is becoming an increasingly domestic affair.
Looking at inflation in the eurozone, we expect it to edge higher to 1.25% in 12 months’ time as the weakness in energy prices falls out of the headline Consumer Price Index (CPI) measure, and core CPI ticks up from 1% as the effect of the weaker euro feeds through into prices. Relative to the worries of persistent deflation that were prevalent earlier in the year, this is clearly good news; however, we are still some way from the ECB target of close-to-but-below 2%.
In short, things are looking up, but there remains a long way to go before the ECB can be confident of achieving its inflation target.
Q: How would you assess the ECB’s efforts to stabilise inflation, promote lending to the real economy and stimulate growth? Are we still seeing a two-speed recovery in Europe?
Bosomworth: The ECB’s policies are gaining traction. In March this year, the ECB began a QE programme that will see it purchase €60 billion worth of bonds per month until at least September 2016. The cumulative amount of money that will be injected into the economy via QE is equivalent to about 10% of eurozone gross domestic product (GDP). Although the ECB’s QE is modest relative to those conducted by the U.S. Federal Reserve, the Bank of England (BOE) or the Bank of Japan, whose asset purchases amounted to about 25%, 21% and 65% of their countries’ respective GDP, it is nevertheless a considerable amount of stimulus. QE and negative interest rates are a powerful combination, and six months into the programme there are already some tentative signs of success.
In financial markets, for example, borrowing costs have declined in all eurozone countries, and banks have eased their lending standards. Companies and households are taking out more loans and mortgages, so we are seeing credit beginning to grow again. Among investors, eurozone inflation expectations, as measured by the five-year breakeven inflation rate (starting five years forward), have risen. And the euro is weaker and equity valuations are higher. All of these factors make for easier financial conditions, which are feeding through to the real economy, where we are also seeing improvement. Business and consumer confidence has risen and economic growth has stabilised.
If there is any lesson to learn from comparing these four major QE programmes, it is that QE works better when fiscal policy is also stimulative, and when labour and product markets are both more flexible and friction is low. In our view, fiscal policy is no longer acting as a drag on growth in the eurozone: Ireland, Greece, Portugal, Spain and to a lesser extent Italy have made considerable progress on structural reforms. While such reforms are politically difficult to implement, they do pay off. Spain, for example, is now one of the eurozone’s fastest-growing economies. Importantly, the bifurcation in economic growth among eurozone countries that we saw in the aftermath of Europe’s sovereign debt crisis is dissipating.
Q: What are the potential policy risks over the cyclical horizon, and how might policymakers react?
Bosomworth: Counterintuitively, structural reforms might be making the ECB’s aim of moving inflation towards its 2% target harder. The Phillips curve, which shows a historical inverse relationship between unemployment and inflation, is becoming steeper as a result of the past recession. When this happens, wages and CPI react much more to changes in unemployment: Eurozone unemployment rose from just above 7% in 2008 to as high as 12% in 2014, and remains stubbornly high at 10.9%. CPI will rarely rise when unemployment is high and when wages are more sensitive to the level of unemployment. Even in Germany, where unemployment is quite low, wages are not rising much partly because of increased immigration from other eurozone countries with high unemployment rates. To move inflation up towards the ECB’s target, the eurozone needs to get unemployment down, and for that it needs more economic growth.
Together, inflation’s greater sensitivity to unemployment, high unemployment and potential external risks, such as slower growth in emerging markets, are likely colluding to keep inflation low, and we think this constellation will persist over the cyclical horizon. The ECB currently forecasts overall CPI to rise to 1.7% by 2017. We share the ECB Governing Council’s view that the risks to this forecast are to the downside. As a consequence, we think monetary policy may have to become more stimulative. In our view, this will likely take the form of the ECB increasing the quantity of its current €60 billion monthly bond purchases by €10 billion to €70 billion per month. Alternatively, come September 2016, if inflation is still low and the ECB’s inflation forecast remains as is, which is what we think will happen, QE might likely extend into 2017.
Q: Is the increase in migration to Europe likely to affect its economies or markets in the year ahead?
Pagani: The impact of the unfolding refugee crisis on the European economy over the cyclical horizon is positive at the margin due to the increase in fiscal spending in support of the migrants. The effect on GDP and CPI over the next 12 months, however, is likely to be small. The longer-term impact could be more significant to the extent that migrants are allowed to work and integrate into the labour force. Offsetting this positive impact is potential political turmoil stemming from the crisis. Overall, we think that the market impact over the cyclical horizon is likely to be minimal.
Q: Turning to the UK, how do you expect the economy to perform over the cyclical horizon? And what is your expectation for the BOE’s monetary policy?
Amey: The UK recovery is now starting to look like a classic UK recovery, where mortgage rates fall, consumer confidence improves, housing activity and broader consumer spending come through and businesses invest in both physical capacity and new employees. The worry for some time has been the resilience of the recovery in the face of poor productivity growth, lower public spending and a stronger sterling; however, with mounting evidence of rising productivity and real wage growth, the UK recovery now looks well supported. Our expectation is for real growth to continue at an above-trend pace of 2.5% over the next 12 months.
Inflation remains well below the BOE’s 2% target, with headline CPI hovering around zero, while the core rate has stabilised around 1%. Our expectation is that a tight labour market and strong domestic demand will drive the core rate higher, with headline inflation converging to core at around 1.5% in 12 months’ time. That in turn should be sufficient for the BOE to finally start the monetary tightening cycle, which we believe to most likely be in May 2016. By that time, headline CPI will have spent several months above the 1% threshold, and we expect the BOE should be sufficiently confident of inflation returning to its 2% target within their two-year horizon. We expect two hikes of 25 basis points over the cyclical horizon.
Q: How will PIMCO’s outlook for growth, inflation and monetary policy in Europe guide the company’s investment strategies over the medium term?
Pagani: Looking at interest rates, we think that there is value left in intermediate maturities, which do not fully discount the possibility of a QE extension beyond the ECB’s September 2016 deadline and provide good carry opportunities. At the same time, we remain underweight the front end of the yield curve, which is trading at negative yields, and underweight the long end, which does not seem to compensate sufficiently for the increased volatility and the possibility of ECB reflationary success beyond the cyclical horizon.
The scenario of positive growth and relatively low inflation, coupled with continued QE, remains supportive for spreads in Europe’s periphery, where we retain an overweight bias in Italy and Spain. Our overweight position in these peripheral economies is held as a stable positive contributor to carry in the portfolios, rather than on the expectation of continuous spread tightening over the cyclical horizon.
In the corporate sector, we also look outside of Europe, for example to the U.S., where we believe the recent spread widening relative to Europe provides investors with better risk rewards.
Finally, in currencies, we continue to maintain an underweight bias to the euro versus the U.S. dollar. However, in the context of portfolio construction, we focus our attention on position sizing that has to acknowledge the fact that the euro has been developing a price behavior that is positively correlated to other risk assets.