In the following interview, Andrew Balls, Deputy CIO and head of European portfolio management, highlights the conclusions from PIMCO’s quarterly Cyclical Forum in September 2014 and how they influence our European investment strategy. He also discusses European Central Bank policy actions and the growth challenges facing the eurozone’s recovery over the coming 12 months.
Q: What is PIMCO’s outlook for the eurozone?
Balls: Over the cyclical horizon, our baseline expectation for the region is 0.75% to 1.25% real GDP growth and inflation in the same 0.75% to 1.25% range. These are below-consensus forecasts, suggesting only very modest improvement from the 0.5% growth rate in the first half of 2014 and ongoing “lowflation” risk.
In addition to structural barriers to growth, current expectations reflect very weak demand growth in the eurozone. Although the European Central Bank’s (ECB) efforts to date have succeeded in preventing a collapse, the eurozone economy is stuck in a liquidity trap. Worse, due to the fragmented nature of the eurozone, the monetary policy transmission mechanism is particularly hampered in the peripheral economies. Fiscal policy at least will not be the big drag on eurozone activity that it has been in recent years; however, countries are either unable or unwilling to use fiscal policy to bolster growth, meaning it will not be a significant positive either. On the upside, credit flows in the region are at least stabilising after almost three years of credit contraction – but it is hard to find many reasons for optimism about a recovery in overall eurozone demand growth.
Given the eurozone’s already fragile recovery, the ongoing geopolitical conflict in Ukraine will have a significant impact on eurozone growth, and may threaten an even larger impact should tensions with Russia escalate. Our baseline expectation is that the Ukraine conflict is likely to have spillover effects in the eurozone that will shave about 0.3% off the growth rate, primarily via the trade channel with Russia. Although it does not appear to be a huge drag on growth, it is comparatively quite large given expectations for below-trend growth of about 1.25% for the eurozone (as my colleague Nicola Mai detailed in his September 2014 European Perspectives, “Will Russia Derail the Eurozone Recovery?”).
Eurozone inflation has been running very close to 0% year-to-date (0.4% as of August according to recent ECB data, September 2014) and core inflation – excluding food and energy – was only 0.9%. The impact of base effects in the absence of a further decline in food and energy costs would lead to the headline rate converging towards the core rate over the next 12 months. But given how low the inflation rate is now, the weakness of eurozone activity and the run of downside surprises we have seen in inflation in recent months, there is a significant risk that core inflation converges down towards headline inflation, raising the prospect of a slide into deflation. At a minimum, with inflation so far below the ECB’s close-to-but-below-2% target, there is a clear and present danger of an ongoing decline in inflation expectations.
Q: How does this outlook vary from Europe’s core to its periphery?
Balls: The clear divergence between the eurozone’s core and its periphery that we have seen in recent years no longer applies cleanly. This is in part because Germany’s activity has been disappointing on both the growth and inflation fronts in recent quarters and – more positively – owing to the growth recovery in Spain. Among the eurozone’s big four economies, we expect Spain to have the strongest growth at a rate of around 1.75% over the next 12 months, followed by Germany with 1.5% and growth in France and Italy of only 0.5% and 0.25%, respectively.
We expect inflation to come in at about 1.5% in Germany, 1% in France, 0.5% in Italy and 0.25% in Spain. A number of eurozone countries are adjusting to restore competitiveness, but this remains a painful process given that it is occurring at such a low rate of eurozone inflation. Although Spain has worryingly low inflation, its economy is making progress at least on the growth front. Conversely, the inability of the Italian economy to grow remains a matter of both cyclical and secular concern.
Q: In light of the ECB’s recent policy actions, what is your expectation for its next move?
Balls: Our baseline expectation is best explained by taking a look at the three-pronged framework that ECB President Mario Draghi has laid out:
- More conventional measures to address undue tightening of the policy stance, including the rates cuts, liquidity measures and the first longer-term refinancing operations (LTRO);
- Targeted LTROs (TLTRO) aimed at further impairments of the transmission mechanism; and
- Broad-based asset purchases aimed at the medium-term outlook for inflation.
In recent months, the ECB’s focus has shifted to the downside risks to inflation, given the downside surprises on inflation and the decline in inflation expectations. With the credibility of the ECB’s inflation target in doubt, Mr. Draghi has signaled that the ECB will act, if needed. This is hardly a pre-emptive move; however, Mr. Draghi has to tread a fine line between recognising the facts and keeping the German representatives at the ECB, and importantly the German government/public opinion, on board. Given Germany’s weak growth and inflation outlook, it is likely that the Bundesbank’s position on quantitative easing (QE) has softened. However, more evidence of downside inflation risks is required for the Bundesbank to support – or at least gracefully acquiesce to – broad-based asset purchases.
On 4 September, the ECB announced that it will buy asset-backed securities (ABS) and covered bonds, which is essentially QE in the same way that the U.S. Federal Reserve (Fed) bought mortgage-backed securities (MBS). While ECB action appears to address the transmission mechanism, it makes more sense to understand this as the first step in the ECB’s broad-based asset purchases programme. Indeed, Mr. Draghi has made it clear that his concern over the shrinking of the ECB balance sheet (as LTRO loans have been repaid) is rooted in the ECB’s concerns over the medium-term inflation outlook. The TLTROs are certainly supportive for European banks, but we expect the macroeconomic impact to be limited. It is likely that the ECB will not be able to buy very large quantities of ABS unless the technical challenges to banks securitising loans on their balance sheets can be sorted out, and/or the technical and political challenges to government guarantees for ABS for small and medium-sized enterprise (SME) loans can be addressed. Hence the likelihood of a full-blown QE programme, which, political challenges aside, would be the most practical approach for the ECB, just as it was for the Fed, the Bank of England (BOE) and the Bank of Japan (BOJ).
There are a number of channels by which QE would work: anchoring real rates and suppressing volatility; signaling reflationary intentions to prevent a destabilising fall in inflation expectations; and the portfolio rebalancing channel, whereby financial market participants move out to riskier assets as risk premia on safer assets are compressed, further driving down risk premia. This, in turn, may generate the potential benefits of also weakening the euro currency. In addition, Mr. Draghi has stressed the need for fiscal expansion, where this is possible, and structural reforms, where they are needed to support any QE in promoting medium-term growth. While policy frameworks, including monetary/fiscal coordination, in the U.S. and the UK have been far from perfect, it is clear that they have worked better than in the eurozone when judged by growth and inflation outcomes. The eurozone already has a mild form of Japanese-style stagnation. If political constraints continue to prevent the ECB from acting accordingly, then the risks of a full-blown and destabilising deflation will increase.
Q: What is your outlook on the UK economy? What do you expect from the Bank of England?
Balls: Over the next four quarters, we expect UK growth to be in the range of 2.5% to 3%, and inflation at 1.75% to 2.25%, close to the BOE’s 2% forecast and in line with consensus.
The Scottish referendum “No” vote has removed one important source of uncertainty, given that a potential “Yes” vote would have disrupted both the Scottish and English economies, as well as the BOE’s policy plans. As it stands, the BOE faces a favourable economic outlook combined with very limited wage growth, meaning that while the central bank will want to start normalising policy, it is in no rush to do so. We expect the BOE to start tightening policy early in the first quarter of 2015 – well before the May 2015 UK general election – and to proceed at a quarter-per-quarter pace. We estimate that The New Neutral policy rate for the UK is in the range of 0.25% to 0.75%, and – assuming 2% inflation – a 2.25% to 2.75% nominal policy rate. This is close to what the market is pricing in as a terminal rate over the next two years.
Q: How will PIMCO’s cyclical outlook for growth, inflation and central bank policy inform your investment strategies over the medium-term horizon?
Balls: Over the next 12 months, we favour to be underweight eurozone duration. Taking into account our New Neutral framework and the eurozone’s ongoing challenge to escape from a liquidity trap, we see little value in core eurozone duration, other than in the event of a collapse into Japanese-style deflation that would move the yield curve down towards Japanese levels. There is some scope for core duration to rally in the face of ongoing weak economic data and the prospect of ECB QE, but not very much. We prefer to earn carry by selling volatility in eurozone rates markets, based on fundamentals and relative value comparisons. We expect the ECB’s actions to continue to repress volatility and a mild form of Japanification of the eurozone’s macro outcomes. Although eurozone core yields are close to Japanese levels, the implied volatility is significantly higher.
In eurozone core countries, long-dated forwards trade close to – or below – Japanese levels, and we expect to continue to be underweight the long end of the core curves. The rich level of the eurozone long end reflects regulatory-driven demand on the part of pension funds and insurers; but on top of past changes, there is the potential for further liberalisation that could trigger shifts out of the expensive long forwards.
We expect to remain overweight peripheral sovereign risk by focusing on Spain and Italy, reflecting their credit spread and liquidity and attractive carry versus Bunds and, indeed, versus investment grade credit. Supportive ECB policy has essentially cut off the left tail risk of a renewed eurozone debt crisis over the cyclical horizon, with weaker data making QE more likely. We think that Spain in particular has the potential to converge further towards the core, given its improving fundamentals. We expect to continue to look for opportunities in financials, notably senior debt in peripheral banks and bank capital more generally, and – given the ECB’s supportive stance – in ABS and covered bonds. We expect these positions to perform well in the absence of a full-blown ECB QE, and even better if the ECB finally delivers. This also applies to being underweight the euro. Growth differentials and the anticipated start of the Fed hiking cycle over the cyclical horizon provide the potential for ongoing euro depreciation. While the ECB – in word and deed – has attempted to weaken the euro, QE has the potential to push the common currency down further.
Looking at the UK, we favour to be underweight duration. Front-end prices are in a terminal rate close to our New Neutral estimate for the UK. The BOE may well be comfortable with that outlook given its inflation forecasts, but this leaves no additional risk premium, and the BOE has provided a number of surprises in recent months and may do so again. Further out the curve, the UK 10-year rate at close to 2.5% is right on top of the 10-year U.S. Treasury rate, whereas historically gilts have traded roughly 0.5% above U.S. Treasuries. We see the potential for the market to price in a more normal risk premium across the curve. With the uncertainty over the Scottish referendum behind us, we remain broadly neutral on the British pound.