ach quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the firm’s outlook for the global economy and
financial markets. In the following interview, portfolio managers Michael Gomez and Lupin Rahman discuss PIMCO’s cyclical outlook for the emerging markets
Q: What is PIMCO’s outlook for growth and inflation in EM?
Differences across EM countries in initial conditions, commodity reliance and sensitivity to U.S. Federal Reserve and dollar moves suggest we are likely to
see further divergence in economic outcomes over the next few quarters. Our baseline for the BRIM (Brazil, Russia, India, Mexico) economies as a whole is
growth of 1.5%–2.5% year-over-year through the first quarter of 2016, with output gaps in the negative territory for most countries, particularly Brazil
and Russia. BRIM inflation is forecast to print around 6.0%–7.5% year-over-year with risks to the upside. Overall, we expect to see greater dispersion
across countries, with the commodity-exporting bloc likely to face stagflationary pressures as currency weakness keeps inflation high and sticky, even as
Asian and Eastern European importers experience disinflation due to lower energy prices.
Q: How will U.S. policy normalization and dollar strength affect EM?
Historically, Fed tightening cycles have been associated with volatility in EM, and in light of EM’s sharply negative reaction to the 2013 “taper tantrum,”
investors have naturally questioned how resilient the asset class will be in the face of an eventual Fed liftoff. Our baseline is that EM as a whole is
likely to be able to weather a gradual and predictable Fed exit, but that there may be volatility and accidents along the way.
Underpinning this view is the reality that most emerging markets are entering this cycle with higher foreign exchange (FX) reserve buffers, lower external
indebtedness and more flexible exchange rate regimes, all of which leave them better positioned to withstand higher “risk-free rates” and a potentially
extended period of U.S. dollar strength. Policy frameworks are also generally stronger, allowing several central banks to deploy countercyclical rate cuts
despite FX weakness and prospective Fed hikes. This is a marked departure from past experience.
That said, the recent period of plentiful global liquidity has produced pockets of froth. For example, since 2008 we have seen increased leverage in China
and, more generally, higher external leverage on EM corporate balance sheets. These are areas to keep an eye on and ones where we are focusing our
bottom-up analysis to help us better distinguish where vulnerabilities might exist. We also expect differences across regions, particularly as the European
Central Bank and Bank of Japan QE will likely be more supportive of emerging Europe and Asia, leaving Latin American commodity exporters more vulnerable.
Q: Mexico’s economy has historically been highly correlated with the U.S. How does PIMCO expect Mexico to navigate the Fed liftoff from zero?
Mexico has navigated the post-crisis period relatively well and is progressing steadily on its planned structural reforms. Recent economic data point to a
dovish central bank bias given weak activity indicators, decreasing inflation and the ongoing drag from steady fiscal consolidation. These domestic
factors, together with the weaker peso and financial stability considerations, are likely to be driving factors for the Bank of Mexico’s (Banxico) rate
decisions. Our baseline, in line with recent comments from the central bank, is for any policy shift from Banxico to be well-telegraphed and in lock-step
with the Fed. Nevertheless, in the event of an adverse market reaction, Mexico has strong policy buffers including the potential to increase FX
interventions, the availability of International Monetary Fund/Fed lines and the potential for local debt buybacks and other policy levers.
Q: Have emerging markets adjusted to lower commodity prices?
Our bottom-up analysis indicates that, in addition to allowing their currencies to weaken to absorb some of the initial shock, many exporters have already
started to consolidate their fiscal balances using more conservative commodity price assumptions for their 2015 budgets. However, some countries are
already behind the curve, both in terms of treating lower prices as a more permanent shock and being unwilling to adjust rigid policies on fiscal
expenditures and exchange rate regimes.
As for commodity importers, many appear to have adjusted rather rapidly to lower prices, with some proactively using the declines to alleviate the fiscal
drag of subsidized domestic energy consumption. These economies are already benefitting from lower current account deficits and improved fiscal balances
due to the savings from lower oil prices and, as a result, they are seeing greater underlying support for their currencies.
Over the next few quarters, we expect further adjustments from both importers and exporters. Some will take advantage of the opportunity to make difficult
structural adjustments, while others will take a more myopic view and look to smooth the shock as a short-term phenomenon.
Q: What is PIMCO’s general outlook for Russia? Are there any areas for optimism?
Russia is likely to face continued headwinds given the drop in oil prices as well as constraints due to geopolitical tensions, which are showing limited
signs of near-term resolution. We expect the country to undergo a deep recession and inflation running in the mid-teens. Nevertheless, the combination of a
current account surplus and drawdowns in the existing stock of FX assets should be more than sufficient for Russia to cover its upcoming external
obligations. This baseline is contingent upon a somewhat orderly financial environment in Russia and assumes a continuation of the status quo in eastern
Ukraine, albeit with occasional flare-ups of violence. We recognize there are tail risks to this, both good and bad, but the pricing of Russian assets
suggests the market is more skewed toward the left tail of the distribution of outcomes. Thus, we see opportunity, particularly among issuers with strong
Q: Brazil appears to be progressing on the reform front, albeit with many challenges ahead. Can the new financial team’s focus on reforms bring a return to growth in 2016?
We expect 2015 to be another difficult year for Brazil, with macroeconomic risks compounded by several negative shocks including potential energy
rationing, the Petrobras scandal and the adjustment to lower commodities prices. Our baseline is for a contraction of 0.5%–1%, with meaningful downside
risks given the potential for lower investment from the energy sector and lower external demand given the drop in commodities. Meanwhile, inflation will
remain high and above the 6.5% upper bound of the inflation target range as the upward adjustment in regulated prices continues and recent currency
weakness passes through to prices. This challenging macro backdrop together with a more difficult political landscape make the planned fiscal adjustment
even more critical to foster confidence in the government and improve the business environment in 2016 and beyond.
We expect to see Finance Minister Joaquim Levy deliver a fiscal adjustment close to his initial announcement using a combination of cyclical measures such
as discretionary spending cuts as well as some progress on expenditure and tax reforms. Fiscal consolidation, along with improved central bank credibility
and movement in the exchange rate toward a more flexible and fair level for the currency, should go a long way toward addressing the recent buildup of
imbalances and eventually underpin strong growth in the medium term.
Q: What are the investment implications of PIMCO’s cyclical outlook for EM?
Taken together, the backdrop suggests a high degree of differentiation is required ahead in the EM asset class, and PIMCO is focusing on select
opportunities across countries, credits and markets. While currencies remain the most vulnerable given their role as the macro release valve, we see value
in a scaled basket of EM long positions funded with non-U.S. dollar core currencies to remove the dollar risk, particularly in EM currencies that have
already adjusted significantly. We remain cautious on overall duration given valuations, and instead prefer to express EM longs versus shorts in core rates
markets that appear fully priced. Finally, we remain focused on strong-balance-sheet credits in the sovereign and corporate space, which we view as
relatively more anchored in the current global backdrop of lower commodities prices and desynchronized global central bank actions.