In the following interview, Managing Directors Mike Amey, Andrew Bosomworth and Lorenzo Pagani discuss the conclusions from PIMCO’s quarterly Cyclical Forum in March 2015 and how they influence our European investment strategy. They also delve into the impact of the European Central Bank’s (ECB) balance sheet expansion on growth and inflation and reflect on Europe’s improving economic health.
Q: What is PIMCO’s outlook for eurozone growth and inflation over the coming six to 12 months?
Amey: Since our last Cyclical Forum in December, we have upgraded our expectations for European growth and inflation, such that we expect real growth to come in around 1.5% and the consumer price index (CPI) to increase 1.0% over the next 12 months. We see the eurozone benefitting from a number of cyclical tailwinds, including weak oil prices, a falling euro and the effect of a larger-than-expected quantitative easing (QE) programme from the ECB.
While there are clearly winners and losers as a result of a decline in oil prices, the eurozone will be one of the prime beneficiaries, given that prior to the fall in energy prices the eurozone was running an annual oil import bill equivalent to 3% of GDP (source: Statistical Office of the European Communities, as of 31 December 2014). When combined with a longer-term boost to exports from the falling euro and easier financial conditions, we expect to see above-trend growth in the region as we move through 2015.
We believe the improvement in growth, alongside a weakness in the euro, should also be sufficient to prevent a further decline in core CPI, with the potential for a small increase as the euro effect works through into the real economy. Once the decline in food and energy prices falls out of the headline CPI rate towards the end of 2015, we would expect to see headline CPI move towards the core rate; although at 1%, this is still below the ECB’s longer-term inflation target of just under 2%.
Q: With the start of full-blown quantitative easing in March 2015, how would you assess the ECB’s efforts to stabilise the recovery and promote growth?
Bosomworth: Although it took the ECB a long time to conclude that QE was a necessary step to revive eurozone growth and inflation, the central bank eventually did. And it is quite a powerful policy!
In the lead-up to its QE announcement on 22 January 2015, the ECB implemented many innovative policies to ease financial conditions, including a negative policy interest rate of 0.20% on its deposit facility; however, neither inflation nor growth responded favourably to this stimulus. The time it took the ECB to arrive at QE might have entailed some costs, such as delaying the recovery or entrenching low inflation expectations, but we have to view this delay in light of the political and fiscal differences between a monetary union, in this case with 19 member states, and a unitary state with a federal fiscal policy. Moral hazard concerns about insufficient implementation of structural reforms on behalf of the fiscal agents played a role in delaying the ECB’s QE implementation. What potentially makes this QE different from those implemented in other countries, such as the U.S. and the UK, is that the excess reserves that will be created by QE will be remunerated at the ECB’s -0.20% deposit rate. This will potentially raise the velocity of money as savers seek to reallocate their portfolios away from negative yields, including into other currencies. We believe such a development could have important implications for global capital markets.
Q: How does PIMCO’s outlook vary from Europe’s core to its periphery, and what are the broader implications of ongoing negotiations between Greece and its creditors, including the ECB?
Bosomworth: A number of countries in Europe’s periphery are now reaping the growth benefits of restructuring their economies and receiving additional support provided by monetary policy. The rate of growth in output in countries like Ireland and Spain, and even Greece prior to the change in the country’s government in January this year, was stronger than in many core countries. We also observed positive, albeit tentative, improvements in Italy’s labour market in response to changes made to its labour law late in 2014. Given a favourable fundamental backdrop and the ongoing search for yield induced by negative yields, we continue to expect spreads to compress between Europe’s periphery and core country bonds.
Looking at Greece, there are two features to Greece’s negotiations with its creditors that suggest that while it is proving difficult to find a solution, one will eventually be found. Under its mandate, the ECB is forbidden by law to extend loans to a sovereign. So long as Greece does not have access to private capital markets, the prohibition on monetary financing makes it unlikely that Greece will be able to increase its government bond or Treasury bill issuance. With no capital market access and no increase in government bonds, Greece will ultimately have to turn to its European partners to unlock funds that are currently earmarked for disbursement. Europe has a strategic geopolitical incentive to keep Greece, which is a NATO member, in the European Union (EU). Keeping Greece in the EU and the political commitment to maintain the unity of the eurozone suggest an encouraging outcome to Greece’s ongoing negotiations.
Q: How might the outlook for Europe affect the global economy and markets?
Pagani: We expect rates to remain low in Europe for the next couple of years, and the ECB’s QE to keep a cap on yields and spread. This will trigger portfolio rebalancing as investors seek out a better relative value alternative to invest their savings and will likely accelerate flows away from Europe into other regions of the world. In our view, a direct impact will be on currencies, and we will continue to see a weaker euro and a stronger U.S. dollar. At the margin, investors’ rebalancing of their allocations will also provide some support to medium and long maturities in other developed market interest rates curves, such as the U.S. and the UK.
Q: Turning to the UK, how do you expect the economy to evolve, and how much will the May UK general election influence the outlook?
Amey: We continue to expect UK growth to be at 2.5% to 3%, while we expect CPI to be at or below the official target of 2%, in a range of 1% to 2%, over the next 12 months. While the UK is also a net importer of oil, with the trade deficit in oil at just 0.5% of GDP, this is much less of a cyclical tailwind for the UK than it is the eurozone. That said, the labour market is much stronger in the UK, and with less labour market slack we expect to see stronger wages support UK growth through 2015. Compared to the disinflationary effect of the strengthening currency, core CPI will be caught between the two counterbalancing effects of strong domestic demand and a narrowing economic output gap. As such, we expect core CPI to be little changed over the next 12 months, and for headline inflation to move towards the core rate once the effect of lower commodity prices has worked its way through the annual rate.
We believe the UK will likely experience at least one general election over the cyclical horizon, and, as it stands, it is very uncertain who will form the next government. Weak support for the two major parties (Tories and Labour) and a splintering vote across a range of other parties makes this one of the most uncertain UK elections in decades. Thus, it is highly likely that the UK elects a weak government, probably a minority administration dependent on other parties for ad hoc support. Such a weak government will no doubt create a lot of headlines; however, we do not expect it to seriously derail what looks to be a relatively well-entrenched UK recovery.
Q: How will PIMCO’s cyclical outlook for growth, inflation and monetary policy guide the firm’s investment strategies over the medium term?
Pagani: Over the cyclical horizon, we believe investors will have to be able to distinguish between fundamental value and technical flows.
The ECB has embarked on full-blown QE and is committed to purchase €60 billion of assets, mostly government securities, per month, which corresponds to more than the net supply of government bonds across the eurozone. Due to the size of the ECB’s programme, the technical flows will likely continue to dominate investment strategies over the next few months.
While we see little value in a 30-year Bund trading at about 0.65% (source: Bloomberg, as of 24 March 2015), from a fundamental point of view, QE-related purchases are large and will continue to provide support to interest rates, which should continue to remain low. In search of value, we believe investors will continue to be driven to look sequentially for higher yields: first in longer maturities that will likely result in a flattening of the interest rate curve, then peripheral issuers offering potentially higher yields and finally in corporate assets and in opportunities outside of Europe. This speaks to investment strategies that try to front-run current market behavior, with positions on the curve that benefit from duration extensions, an overweight to peripheral spreads and select corporate issuers, as well as an underweight to the euro.