As growth recovers to modest levels in the U.S. and Europe, it is slowing in China, with broad implications for the global economy. Scott Mather, Deputy Chief Investment Officer for global bonds and emerging markets, expands on PIMCO’s secular outlook of The New Neutral – in which the world’s major economies are converging to modest trend growth rates – and discusses potential opportunities for investors in developed and emerging markets over the long term.
Q: Over a secular horizon PIMCO sees China as less of a contributor to global growth. Could you discuss the reasoning for that view, and how “shadow banking” fits in?
Mather: To put the story in context, China was the standout after the financial crisis in 2008–2009. While the rest of the world was entrenched in the New Normal, including sluggish growth, China grew far above potential with the aid of massive fiscal and monetary stimulus. And while much of the world was deleveraging, China was re-leveraging both in the official banking system and outside of it, in the so-called shadow banking system. China has continued on the same path over the past few years by relying on growth that includes a massive buildup of debt.
Recently, that has begun to change. Policymakers in China are aware of the problems that come with relying on rapid debt growth; such reliance has already created some imbalances in the economy. Last year, the government started to re-intermediate, shifting some debt away from the shadow banks and toward the official banking system, where credit growth can be better regulated and controlled. As China tries to transform the economy into one that depends less on credit expansion, economic growth will slow − just as we saw in the developed world after the financial crisis.
Q: How much does PIMCO expect China’s economy to slow?
Mather: China’s economy is expanding at a little more than a 7% annual real rate today, and we expect that to average about 6% over the next three to five years, perhaps slowing to 5% by the end of that horizon.
It is important to emphasize, however, that China’s economy is still much larger than it was five years ago when the financial crisis began, and we do not expect growth to slow in China to the point that it becomes a big drag on the global economy. Instead, we see a more balanced global economy in the years ahead: The baton is being passed in part from China to the developed world, and in particular to the U.S. and Europe, where some of the drags on growth are dissipating.
Slower growth means that monetary policy in China should be accommodative. So our New Neutral outlook holds for China too, where we expect close to a 0% real policy rate in the years ahead, down from current levels of 2%–3%.
Q: What are the implications of PIMCO’s secular outlook for the rest of Asia?
Mather: One of the most important places to watch is Japan. By pulling all the levers at once – monetary and fiscal policy along with a structural re-engineering of the economy – amid demographic changes and a massive debt overhang, Japan is embarking on a big experiment.
Over the secular horizon, we think Japan’s economy is likely to have periods of instability, and our global forecast has the widest range of possible growth and inflation outcomes for Japan. We could see an overshoot from deflation into inflation, or growth could diminish if structural reform fails. Yet the experiment is a good thing; although there are likely to be some hiccups along the way, if Japan is successful, it could become a model for other advanced economies that are trying to grow their way out of debt, such as those in Europe and perhaps even the U.S.
Australia is another economy to watch in the region, given its dependence on China as a buyer of its commodities. Like much of the world, Australia is attempting to re-engineer its economy toward domestic demand-driven growth.
Q: Looking beyond China, what is PIMCO’s view on emerging economies in the coming years?
Mather: We think emerging market growth will pick up, although it will be a slow trip back to potential growth levels. In addition to political challenges, many emerging economies are facing lower demand for commodities exports, and like much of the developed world, they are trying to find the “magic formula” for boosting internal demand without expanding credit too much. Elections this year in several big economies have also delayed policy measures there.
Still, sovereign debt metrics look very good in several countries, including Brazil and Mexico. Brazil is starting to gain traction in its fight against inflation, and after elections in the autumn, the government should be able to move faster with some reforms. So we expect to see growth closer to potential in the years ahead. Mexico is probably in the best position among emerging economies: It is politically stable, the economy is balanced and the government is deregulating and privatizing state-owned enterprises. It is also becoming a favored destination for U.S. companies looking to outsource with inexpensive labor, and Mexico has close ties with the U.S., where growth is improving, albeit modestly.
Q: What are the investment implications of the secular outlook for global bond investors?
Mather: The biggest implication for investment portfolios is our call on interest rates. Our forecast is for interest rates to go up over the secular horizon but not by as much as people fear. All around the developed world, we are describing an environment in which a 0% real rate would be a gravitational force, The New Neutral for policymakers. As a result, the equilibrium level of interest rates all along the yield curve has also dropped versus pre-crisis levels.
Investors who can draw on the global opportunity set can diversify away from countries where broad estimates are wrong about the path of central bank rate setting and focus on countries where markets have overshot relative to what policymakers are likely to deliver.
Q: Where do you see opportunities for global investors?
Mather: Although we do not know today which countries will make inflationary mistakes or even bigger policy mistakes and end up with deflation, we do know that countries will approach the journey to The New Neutral differently. Before the financial crisis, the developed world seemed to be growing seamlessly in terms of the economic cycle, and when the crisis hit, these economies responded in similar ways, with low interest rates and quantitative easing. Now, we are forecasting that countries will start to evolve differently. In our view, the best way for investors to minimize the risks and maximize alpha in this environment is by diversifying across borders.
While much of the past five years has been about portfolio offense – seeking the largest capital gains – going forward, investors should not forget their defense, realizing that we are at the lower end of the secular yield range for many countries and policymakers will be attempting to gradually normalize rates in many countries over the next few years.
Finally, while real policy rates in many countries will undergo normalization to a New Neutral rate near zero, we should anticipate that currency and interest rate volatility will settle into a new lower range as well. There will be secular trends that represent opportunity in the context of lower volatility (for instance, generalized U.S. dollar strength and weakness in the Japanese yen over our secular horizon). And emerging markets may see reduced volatility relative to history, but attractive overshoots will occur throughout the normalization process. It is important to remember the secular journey that many EM countries are on; one with better balance, improving fundamentals and maturing institutions that will make them more comparable with advanced economies.