Developments in Europe continue to make global headlines. Taking a step back, Deputy Chief Investment Officer and head of European portfolio management Andrew Balls outlines PIMCO’s long-term outlook for the world’s largest economic zone, focusing on how low growth and inflation trends and policy responses may shape Europe over the coming three to five years.
Q: What is PIMCO’s secular outlook for Europe?
Balls: The central idea in our global secular outlook is for a New Neutral policy rate for central banks, with the U.S. Federal Reserve’s (Fed) rate likely to be close to zero percent in real terms, adjusted for inflation, over the next three to five years. Likewise, owing to very high leverage, demographics, fiscal tightening, more constrained credit conditions and – in the case of the eurozone – the aftermath of the sovereign debt crisis, policy rates are likely going to remain very low at the European Central Bank (ECB) and the Bank of England (BoE) over the secular horizon. This has broad implications for European markets.
We expect ongoing renormalisation of eurozone markets. Over the coming three to five years, we expect the eurozone to grow at a 1%–1.5% real rate, close to its trend growth rate of about 1.25%, but with some chance of a period of above-trend growth given the improvement in financial conditions. This equates to roughly 3% nominal growth that, while not very strong, should be enough to maintain overall stability and probably permit a very gradual reduction in government debt levels.
There are tail risks, for sure, around this secular baseline, but we see the eurozone as offering a wide range of opportunities for European and global investors alike, both from a top-down, macro-driven approach and from bottom-up security selection across the capital structure.
Q: Could you discuss country-level growth dynamics?
Balls: We see a multispeed eurozone ahead. Germany faces less structural headwinds than its eurozone partners and, benefitting from a low rate environment, is likely to have the strongest growth, continuing the current trend. In France, and particularly Italy, growth will lag behind Germany given the lack of real structural reform to raise potential growth rates. Spanish growth – in spite of ongoing deleveraging – should benefit from structural reforms.
Looking at the UK, we would expect growth close to potential, at about a 2%–2.5% real rate, and inflation close to the BoE target. However, high debt levels and fiscal tightening will constrain growth.
We see these developments as an evolution within the New Normal secular framework that we have used since 2009. While we witnessed significant recovery after the global financial crisis, the next stage of the New Normal is likely to be a return to modest-trend growth rates over the secular horizon.
Q: Are debt levels in the eurozone too high to be sustained?
Balls: Debt levels have risen significantly since 2008, with a very pronounced rise in sovereign debt across the eurozone. Given our outlook for The New Neutral of low nominal growth coupled with high debt levels, low real interest rates are crucial for regional economic and financial stability.
We expect a gradual reduction of fiscal deficits, though less than governments are currently targeting, stabilisation and very gradual declines in debt levels over the secular horizon. In the case of Europe’s larger economies, Italy is already running a primary surplus, though it needs growth in order to reduce its debt over time. Spain, however, will take longer to get to a primary surplus – but its initial conditions are better for deleveraging its public sector debt. In Portugal and Ireland, we have already seen debt restructurings in the form of official sector loans that have been extended to very long 30-year maturities and where interest rates have been lowered.
Greece stands out for having an unsustainable level of public debt, at close to 180% of GDP in spite of its debt restructuring, including both private and official sector creditors. We expect more restructuring of the official sector loans in the form of maturity extensions out to 50 years. Greece, in effect, has a 10-year interest holiday before payments are required on official loans. But the Greek political situation remains unstable and very difficult to forecast over the shorter term, let alone three to five years. This makes the investment outlook very hard to judge.
Overall, our baseline calls for a stable but not particularly healthy eurozone, with a low potential growth rate and high, but stable, levels of debt. The clear tail would be weaker growth than we expect, reflecting eurozone internal dynamics or an external slowdown. Either development would lead to increased tensions and growing concerns over the trajectory for public debt.
Q: What do you expect from the ECB over the secular outlook?
Balls: In the short term, the ECB is likely to cut its policy rate closer to zero percent and the deposit rate to negative territory. The ECB is also likely to provide banks with further long-term refinancing operations, which might be linked to banks making loans to small and midsize businesses. Likewise, we expect the BoE to maintain policy rates that are low and close to zero percent in real terms.
The big question is whether the ECB will engage in QE, following the Fed, the BoE and the Bank of Japan, given the macroeconomic headwinds and the very real deflation risk in the eurozone. Headline inflation in the eurozone has been below 1% for more than six months and the market’s, and indeed the ECB’s, forecasts for medium-term inflation are well below the target 2%. PIMCO’s baseline expectation is for inflation to average about 1.5% over the next three to five years, though we see downside risk.
With stability returning to eurozone financial markets, it appears that the question of QE – buying private and public sector assets – has become less controversial in Europe. Although Europe’s central bankers clearly hope that inflation will pick up and they can avoid QE, we believe, based on our forecasts, there is a better-than-50% chance that the ECB will be forced by the medium-term inflation outlook to act in line with the approach as recently set out by ECB President Mario Draghi at the 8 May press conference.
Q: What are the implications of The New Neutral outlook for European portfolios?
Balls: New Neutral policy rates that are close to zero percent, modest trend-like growth and subdued inflation pressures are substantially reflected in the level of yield curves, peripheral spreads and European credit spreads. Returns in fixed income and equity markets are likely to be relatively low, given initial valuations. We would use the baseline of 3% bond market returns and 5% for equities. But low policy rates, when fed into valuation models across asset markets, should help to provide stability to market pricing and reduce downside risks.
We expect a range of about 1%–3% for the 10-year German Bund over the next three to five years and 2.5%–4% for 10-year UK Gilts, with lower yields in much of the eurozone than in the U.S. given the lower nominal growth path. We continue to prefer the five- to 10-year part of the core eurozone curve to the 30-year sector as a structural trade, based upon the carry advantage and the very low level of eurozone long-dated bond yields reflecting liability-driven investment demand.
We see the baseline for Italy and Spain spreads to the Bund to be fairly stable over the secular horizon. Further tightening is possible but should be capped by ongoing concerns over credit risk and eurozone institutions. In a stable environment, the carry advantage will be attractive. Aggressive QE from the ECB could, of course, drive spreads tighter. We will continue to favour Italy and Spain over smaller eurozone markets, owing to their greater liquidity, although Slovenia stands out as a case with the potential to tighten significantly given its underlying fundamentals and the liquidity premium.
Given our New Neutral expectations, European credit valuations overall look fair. There is a lot of scope for bottom-up security selection, as in other markets, and especially so given the ongoing normalisation but also the potential for volatility in the periphery.
The euro has remained strong, reflecting capital flow back into the eurozone, as we have seen renormalisation of the eurozone investment landscape. Over time, we expect the sluggish growth of the eurozone, compared with other parts of the world, to be reflected in a weaker currency, particularly if the ECB delivers QE.