Each 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 Mike Cudzil, Ed Devlin and Lupin Rahman discuss PIMCO’s cyclical outlook for the U.S., Canada and Latin America.
Q: What is PIMCO’s outlook for the U.S. in 2015, including for Federal Reserve policy?
Cudzil: PIMCO believes the U.S., with GDP growth of 2.75% to 3.25%, will be a main driver of global growth in 2015.
Robust domestic growth will be driven by a continued increase in consumption and the government component of GDP. Government spending will no longer be a drag, instead adding 0.3% to GDP due to state and local hiring as well as increased defense spending on the federal level. Moreover, consumers are in a better place than they have been at any point since before the recession:
- More workers are employed today than at any time in our history, with new jobs over the past year being predominantly full-time. The employment gap continues to close, with the unemployment rate down to 5.8% and the U6 rate – total unemployed plus marginally attached workers and those working part-time for economic reasons – down to 11.4% and declining at an even faster pace.
- Consumer income should continue to increase on two fronts. First, as the employment gap closes, wages should normalize. Second, the recent oil price drop acts as a tax cut for consumers with the highest propensity to spend.
- Consumer net worth reached an all-time high in both the first and second quarters of the year. Meanwhile, equities are also near all-time highs and housing continues to appreciate.
- Yields continue to decline, and the commensurate drop in consumer borrowing costs – especially mortgage rates – has driven consumer financial obligation ratios to their lowest levels in 40 years.
According to our New Neutral thesis, the Fed will begin to slowly raise overnight lending rates from 0% sometime in mid-2015, eventually ending its hiking cycle at a lower level than they have historically. We see the neutral fed funds rate at roughly 2% nominal, or 0% real. However, the Fed will most likely overshoot this level to cool an economy that will have been running above potential growth for quite some time.
Q: What do you expect will be the effects of lower oil prices on growth and inflation in the U.S.?
Cudzil: Lower oil prices should be a positive contributor to U.S. growth. Although the U.S. is more energy efficient than it has ever been, while producing and extracting more barrels of oil per day than ever, it remains a net importer of oil. From a growth perspective, we believe the approximate 40% drop in oil prices will add 0.5% to 0.7% to U.S. GDP, while other factors – including a decline in capital expenditures (capex) and a decrease in net exports – will offset some of the boost. Cheaper energy will have substantial base effects on headline inflation, with the Consumer Price Index (CPI) declining to almost 0% at some point in the first half of 2015 and then rebounding. For core Personal Consumption Expenditures (PCE), the inflation measure closely watched by the Fed, we expect oil prices to have only a 0.1% to 0.2% drag next year.
Q: What are the risks to your growth forecast?
Cudzil: Although we are optimistic on U.S. growth, we are monitoring several risks.
Central bank activity remains easy and has driven valuations for several years now. While we expect growth of roughly 3% and unemployment of 5.5% in 2015, raising the fed funds off the zero bound after 6.5 years could have unknown effects on the economy and markets. Our base case is for a slow handoff from Fed-driven valuations to a market driven by fundamentals and sustained growth.
While lower oil prices are good for consumers, we are monitoring the collateral damage due to a drop in capex and potential disruptions in capital markets. However, our base case remains that the consumption uptick will outweigh the capex drag, with capital markets remaining open and liquid.
The stronger dollar could weigh on growth, both from a corporate profit and net export standpoint. However, our base case is for exports to be a mild drag on growth, with corporate profits being affected only modestly as an increase in domestic demand will offset the drop in competitiveness.
Finally, policy uncertainty has been much lower over the past year. While Republican control of Congress has the potential to lead to even worse deadlock or downright disruption, our base case remains more of the same, with little out of Washington to get excited about, either way.
Q: Heading north, what does PIMCO expect for Canada’s economy next year?
Devlin: We expect the Canadian recovery to continue, though the country is facing some divergent forces that could have significant implications for the economy. On one hand, the U.S. recovery is gaining momentum and will continue to power export growth in Canada. But on the other, recent dramatic declines in oil prices could be a drag on the Canadian economy, since Canada is a producer and exporter of energy. Taking both these factors into account, we expect the Canadian recovery to be a little slower than the U.S. recovery next year, with GDP growth at 2.25% to 2.75%.
Low interest rates should continue to drive consumption and residential investment, which will be positive in the short term. But in the long run, it causes financial stability concerns, so we are watching this area carefully for any signs that the overstretched Canadian consumer is becoming a problem.
We also will be watching closely the Bank of Canada’s (BOC) reaction to falling energy prices and their effect on inflation. Normally the BOC sets monetary policy based on core inflation – which, broadly speaking, strips out energy prices. One thing to note is the correlation between energy prices and the Canadian dollar. When energy prices go down, the currency usually declines too. But while falling energy prices bring inflation down, a declining currency actually boosts core inflation. So overall, we expect inflation to fall within the range of 1.75% to 2.25% over the next year, which is higher than the BOC’s forecast and one of the reasons why we think rates will go higher in Canada as the Fed moves its rate higher next year.
Finally, energy prices are also a downside risk to our forecast. We see energy as being a slight negative to growth in our base case, but if prices get more disruptive or disorderly, it could pull GDP growth down more than we expect. PIMCO’s current belief is that energy prices are close to bottom, and though they may recover slightly, they are likely to stay low. But if prices decline further or create more geopolitical shocks, we could see a further reduction in Canadian growth, since the energy markets affect consumer and business confidence.
Q: The Bank of Canada (BOC) recently said the Canadian housing market could be overvalued by as much as 30%. Does PIMCO share the BOC’s view that housing is still headed for a soft landing?
Devlin: The BOC actually just validated our forecast from a year ago, which stated that the housing market was 20% to 30% overvalued. In the short term, we don’t expect a sharp correction in housing because the quality of underwriting is high, rates are quite low and employment is relatively strong. But I think that over the secular horizon we will see house prices flat to down 10%. That’s our baseline in nominal terms, so if we have inflation of 2% over the next five years, that means in real terms that five years from now prices will have corrected 10% to 20% or so. So while we do expect a soft landing for the housing market, ultra-low interest rates combined with a reacceleration of the housing market could cause real financial stability issues down the line.
Q: What does PIMCO expect for the Latin American region in 2015? How critical are falling commodity prices?
Rahman: We expect 2015 to be marked by key transitions in the larger economies in Latin America. In Brazil, the new economic team will take over the reins with expectations of a return to more orthodox macroeconomic policies in President Dilma Rousseff’s second term, while in Mexico, reforms related to the energy sector will start to be implemented. On the political side, Argentina’s upcoming presidential elections will be keenly watched for any change in the policies toward its holdout creditors. And in Venezuela, upcoming legislative elections will be a strong indicator of the popularity of President Nicolás Maduro’s regime.
All of these dynamics will take place against the backdrop of Fed policy normalization and lower commodity prices than previously expected. The latter poses overall headwinds for the region, which is highly dependent on exports of oil (e.g., Venezuela and Colombia), metals and mining products (e.g., Brazil and Chile) and soft commodities (e.g., Argentina). Having said that, it is important to bear in mind that initial conditions are strong in most of the region (with some exceptions), with low levels of external leverage, high levels of currency reserves, flexible exchange rates and modest fiscal and current account balances, which should help cushion the near-term impact.
Q: With inflation on the rise in areas of Latin America, what is PIMCO’s assessment of the policies to contain it?
Rahman: We forecast the growth and inflation outlook to be more in sync this year than in previous quarters. Our expectation is that growth will be muted across the region, averaging around 2% year-over-year with some economies benefitting from the improvement in U.S. growth, and others dragged down by the slowdown in the eurozone and China. Meanwhile, inflation for the region (excluding the high-inflation economies of Argentina and Venezuela) should be contained in the 4% area, with some economies facing disinflationary pressures from negative output gaps and lower commodity prices. Our expectation is that as the Fed begins to normalize monetary policy in the U.S., Latin America’s central banks will also start hiking rates, lending some backstop to weakening pressures on currencies and helping to contain any pass-through to inflation.
Q: What are the investment implications of PIMCO’s outlook for investors in the Americas?
Cudzil: Given our outlook and current market valuations, we see limited upside in risk-free rates from these levels. While the market is priced for future rate hikes offering limited further upside from this scenario as the market coalesces around PIMCO’s views, the cyclical strength in the U.S. should bode well for an allocation to credit, in particular banks and financials, building materials and airlines, to name a few. Finally, our expectation of a continued recovery in the housing market should bode well for the non-agency mortgage market.