In the following interview, Andrew Balls, managing director and head of European portfolio management, highlights the conclusions from PIMCO’s quarterly Cyclical Forum in December 2013 and how they influence the firm’s European investment strategy. He also discusses the continued fiscal and growth challenges facing the region over the coming year as regional momentum is stagnating at best and rising deflationary pressure is mounting.
Q: What is PIMCO’s outlook for European growth and inflation over the coming six to 12 months?
A: We expect the eurozone economy to grow by 0.25%–0.75% over the next year, after adjusting for inflation, emerging from recession but only managing weak, below trend growth.
Although the European Central Bank (ECB) has clipped the left tail risk of a eurozone collapse and fiscal policy is becoming less restrictive, credit conditions remain very tight in peripheral countries and banks continue to deleverage, with the bank deleveraging dynamic reinforced by the ECB’s planned asset quality review and stress tests in 2014.
There are both upside and downside risks to growth. The chief upside risk is that reduced macroeconomic and market uncertainty could release pent-up demand. In Germany in particular, companies could increase investment on the back of reduced macroeconomic uncertainty, while there is potential for stronger consumer spending. The chief downside risk that could drive growth below our expected range would stem from weaker-than-expected demand growth in Europe’s core countries and a worsening of the credit crunch in peripheral countries, driven in part by persistent interest rate and credit market fragmentation. Such low growth means that the eurozone remains vulnerable to external shocks that could tip it back into recession.
Over the coming year, we expect very low eurozone inflation in the range of 0.75%–1.25%, the result of underlying weakness in the economy and spare capacity, with eurozone unemployment stabilising at just above 12%. Core eurozone inflation, currently at 1%, has undershot consensus forecasts this year, with the fall in inflation broad-based across the Consumer Price Index (CPI) basket and across countries. The greatest disinflation can be seen in the peripheral economies that are undergoing a painful adjustment in costs and competiveness. Wages are stagnating in Spain, contracting in several smaller peripheral countries and slowing in France and Italy. This disinflation is not offset by developments in Germany, where inflation remains below the ECB’s target of close to 2% and wage growth remains weak in spite of a tight labour market.
Q: How does the outlook vary from the core to the periphery? Do you anticipate further fiscal tightening and structural reforms in the periphery?
A: In the core countries, growth is stronger but not all that strong, while peripheral countries are emerging from recession but only barely so. However, the gap between the core and the periphery has narrowed somewhat – momentum is slowing in Germany and France and economic conditions are improving in the periphery, with Italy poised to emerge from recession and Spain already having returned to growth.
Focusing on the big four eurozone economies, at the top of our forecast range we would expect Germany and France to grow at close to 1% and Italy and Spain at about 0.3%. At the bottom of our range, we would expect German and French growth at 0.5% or below and a return to recession in Italy and Spain.
Fiscal austerity is ongoing but should take less of a bite out of growth in 2014 compared with 2013. For the eurozone as a whole, fiscal drag will be about 0.75% of GDP, compared with 1.25% in 2013. We expect little change from current structural reforms, a positive for growth in the near term, but a factor that contributes to the outlook for very low eurozone growth over the secular horizon. Peripheral countries have improved their current account positions and, in a number of countries, also saw improvements in wage competitiveness, yet it remains far from clear how these countries can return to decent growth over the medium term. In spite of greater stabilisation of the eurozone crisis, real and nominal yields remain too high in Italy, Spain and other peripheral economies compared with their real/nominal growth rates. It is little surprise therefore that small- and medium-sized companies are struggling to find financing at affordable rates given the still-high risk premia on sovereign bonds. Amid this muddle-through outlook, political developments remain a key source of risk, as my colleague Andy Bosomworth has laid out in his December 2013 European Perspectives, “Muddling Through: The ‘Realpolitik’ of the Eurozone Crisis”.
Q: Has the ECB acted sufficiently to address price stability as well as stimulate lagging credit conditions? What is your expectation for further cuts?
A: The ECB finally reacted to a weak inflation outlook and the strength of the euro exchange rate in November this year, cutting its main policy rate to 0.25%, down from 0.5%. But the ECB’s forecasts, like ours, are for inflation to be stubbornly below its inflation target of close to 2%. Clearly, the ECB alone cannot solve the eurozone’s many challenges. That said, the ECB appears to be resigned to accepting low inflation for a long time. Its forecasts see inflation moving back to target in the medium to long term. The ECB appears more comfortable with the risks related to inaction than with those connected with action, which may in turn influence inflation expectations.
At the same time, national divisions at the ECB appear to be hampering its ability to act on the basis of the overall eurozone economic and inflation outlook, with Germany, the Netherlands and Finland reportedly having voted against the rate cut in November.
Our baseline expectation for 2014 is that the ECB will not do all that much, other than providing an additional Long-Term Refinancing Operation (LTRO) in some form, to smooth the cliff effect as the previous LTROs roll off. There may be more efforts at “forward guidance”, particularly when the U.S. Federal Reserve starts to taper its quantitative easing (QE). In terms of potential emergency responses, the ECB has raised the possibility of cutting the main refinancing rate to zero and the deposit rate to negative in the event that the central bank becomes more concerned about growth and inflation risks. The ECB could also pursue credit easing (buying private sector assets) or QE (buying government bonds).
However, we think that the bar is set high for further unconventional policy responses beyond those aimed at funding – again the result of national divisions at the ECB. Quantitative easing, as has been implemented in the U.S., the UK and Japan, is more straightforward in economies with one central bank and one finance ministry than in a currency union with myriad coordination problems.
Q: How will PIMCO’s cyclical outlook for growth, inflation and policy inform your investment strategies over the medium-term horizon?
A: We continue to emphasise the carry and roll-down in the five- to 10-year part of the German and European swap curves in our portfolios, underweighting the expensive long ends of those curves. We see the income we can earn from rolling down the yield curve as more attractive than overall duration, particularly long-end duration. We will supplement these positions with exposure to the U.S. and UK curves, which are steeper than the eurozone core curve offering superior carry and roll.
We are overweight Italy and Spain sovereign debt in our portfolios, balancing the cyclical outlook, where we expect the ECB to maintain stability, with secular concerns over growth in these countries. Again, we emphasise carry and roll-down over long-dated spread duration, preferring the three- to five-year part of the curve.
We continue to see Italy and Spain as constituting credit risk and will scale positions on that basis, but this is a relatively attractive source of credit risk compared with European corporate credit risk. The size, liquidity and systemic importance of the Italian and Spanish markets make them our preferred source of peripheral risk. European policymakers have demonstrated that they are prepared to countenance haircuts in the cast of smaller countries and have signalled their willingness to impose haircuts on bank creditors. This risk for haircuts remains a source of medium-term concern.
We continue to underweight eurozone corporate credit beta, but will look for good opportunities across sectors and across the capital structure.