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 December 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: What are your expectations for growth and inflation in Europe in 2016?
Our baseline for the eurozone is for a continuation of above-trend GDP growth this year, albeit at a tepid pace of about 1.5%, similar to 2015. The
European Central Bank’s (ECB) quantitative easing programme (QE) and negative interest rate policy are providing very easy financial conditions, which are
being reflected in a pickup of loan growth after a long period of contraction. Fiscal policy is also on track to remain marginally supportive of growth
this year as public expenditure in some member states expands a little to absorb the influx of refugees into the European Union. While net exports should
continue to benefit from the cumulative weakening of the euro to date, slower growth in the eurozone’s major trading partners may limit the contribution to
growth from this source in 2016.
We think headline inflation will increase from roughly zero last year to about 1% in 2016 as the euro’s past depreciation passes through to intermediate
goods and as last year’s low oil prices drop out of the consumer price index’s (CPI) year-over-year price comparison. With so much spare capacity in the
labour market, however, both headline and core inflation are unlikely to recover to the level consistent with the ECB’s inflation target anytime soon.
Q: How does PIMCO assess the outlook for the peripheral countries?
The recovery in growth across the eurozone is evenly spread across periphery and core countries in part due to the transmission mechanism for monetary
policy working much better than in the past and in part due to structural reforms in periphery countries that have spurred the return of investment capital
to these economies. We can observe this pass-through of expansionary monetary policy to the real economy in the periphery via the compression of bank
lending rates in those countries towards levels in core countries and also in the rebound in composite purchasing managers indices in countries like Spain
and Italy, which at about the 55 level are signaling an expansion of output in both the manufacturing and services industries.
Q: PIMCO has discussed the importance of diverging central bank policies for the global economic outlook: What are your expectations for the European
Central Bank this year?
We expect there will be ongoing pressure on the ECB during 2016 to recalibrate the size and pace of QE owing to the large gap between actual inflation and
its definition of price stability, which is inflation close to but below 2%. Since 2010 headline consumer price inflation has averaged only 1.4% and has
been in a disinflationary trend since 2011, even dipping below zero on several occasions last year. While the ECB stresses the medium-term nature of its
target, it also forecasts inflation returning to only 1.6% by 2017. If this forecast turns out to be accurate, inflation will have been below target for
five consecutive years. As in Japan, the risk that inflation expectations de-anchor from the target and become entrenched at a lower level is not
insignificant. Therefore we think policy will continue to remain expansionary this year and next.
Q: What are PIMCO’s expectations for the Bank of England, and for growth and inflation in the UK?
We expect above-trend growth and a further contraction in the output gap will leave the Bank of England (BOE) in a position to raise official interest
rates in 2016. However, a number of hurdles would need to be cleared before a rate hike could be implemented. In particular, headline CPI at 0.1% remains
well below the 2% target and even the 1% lower tolerance band. This has triggered quarterly open letters from BOE Governor Mark Carney to the Chancellor of
the Exchequer George Osborne explaining the undershoot as well as measures undertaken to raise the inflation rate. We believe CPI will rise back above 1%
around the middle of this year, when much of the fall in energy prices drops out of the CPI print. So while our base case is for a rate hike this year, one
minimum precondition will be to see headline CPI back above 1%.
The Bank would also want to see further evidence of rising underlying inflation, preferably via some increase in the core CPI (currently 1.2%) and nominal
wage growth (currently 2.4%). We believe above-trend GDP of 2%–2.5% and an unemployment rate already down to 5.2% should be enough to generate higher wages
and core inflation, but that the Bank would want to see the hard evidence via stronger data before moving. This all suggests any move higher in official
interest rates is unlikely until the second half of the year.
Q: In 2016 the UK is likely to hold a referendum on European Union membership? What are our expectations and what would be the implications of a
The so-called in/out referendum is likely to take place in Q3 2016, and while our central expectation would be the UK votes to remain part of the EU, we
are aware of the considerable uncertainty around the result. If the UK were to vote to leave, the uncertainty this would create would likely reduce GDP by
1%–1.5% in the 12 months thereafter and call into question the ability of the Bank of England to raise interest rates. So clearly the EU referendum skews
the risks to our forecasts to the downside.
Q: Could you discuss the role/impact of Europe in the global economy in 2016?
We can look at the impact of Europe in the global economy from three points of view: growth, inflation and politics.
While a 1.5% growth trend is not very exciting in absolute terms, it is an above-trend pace of growth for the eurozone. As a result, the region, at the
margin, is expected to provide a positive economic stimulus to the global economy. That said, the stimulus will not be strong, as the economies in the
eurozone that could spend (for example, Germany, where the current account surplus keeps rising and is now near 10% of GDP) are not doing enough
to boost domestic demand, and other economies cannot afford to spend much.
From the inflation point of view, the still large output gap and very high unemployment mean that eurozone inflation will see only a modest move upwards
relative to many economies around the globe. As Andrew already mentioned, the increase in inflation is expected to be only a modest one from 0% to 1%. This
will be sufficient to put a floor on deflation risks and modestly add to global inflationary pressure from here.
From the political front, the absence of growth for years, now coupled with the refugee crisis, mean that politics will remain bumpy and risky in Europe.
The Spanish government may take a while to be formed, there are Italian local elections in the spring, and political developments in Germany and France will need to be monitored closely in advance of general elections in 2017. Also, as Mike already mentioned, the UK referendum may
take a leading role in terms of defining the mood in markets.
Q: How should European investors be thinking about their portfolios given PIMCO’s outlook?
There are two main forces that we see driving European prices in 2016. On one hand, low inflation prints and ongoing ECB QE should keep providing support
for interest rates and asset prices. The duration and size of QE are such that it will remain a key factor for the whole of 2016. On the other hand, there
is no shortage of sources of uncertainty, both from the internal political front (UK referendum, regional elections) and from external factors (evolution
of the Fed rate cycle, China’s trajectory).
This tug-of-war will happen amid meaningfully reduced secondary market liquidity due to the increased balanced sheet costs of market intermediaries. We
expect the result will be alternating periods of stability and volatility. As investors we have to be prepared for the volatility in order to benefit from
it. We must take a disciplined approach to risk exposures, avoid chasing markets and maintain adequate liquidity, so that we have the ability to react to
market dislocations and profitably provide liquidity when markets require it.
Portfolios should be biased towards structural positions that provide positive carry over the course of the year, with the size of positions dependent on
prevailing market levels during the journey. In 2016 we expect European portfolios to average a duration close to neutral due to the low level of yield and
to have a focus on intermediate maturities. We prefer an underweight in shorter and longer maturities of the interest rate spectrum, as well as an
overweight in large peripheral countries, with position size that will be a function of market levels. We also expect currencies to continue to be a
contributor with performance even if less so compared with last year, with the US dollar supported by the Fed’s hiking cycle.