Viewpoints

Practical Policy Prescriptions to Help Offset Geopolitical Uncertainties

Geopolitical uncertainty continues to test the global economy and markets.

Geopolitical uncertainty continues to test the global economy and markets. Events in Ukraine and developments in Iraq and Syria are front of mind, but geopolitical risks are rising globally. These events have hurt the global economy, particularly Europe, and they are coming at a particularly unhelpful time, as the European Central Bank is already trying to fend off disinflationary forces.

While solving these protracted problems is extremely complicated, we believe these events point to clear policy tools to address the economic vulnerabilities:

  • Coordinating efforts among European governments and central banks to offset the negative economic effects,

  • Developing European policies aimed at weaning off energy dependence on Russia, and

  • Revisiting the long-standing U.S. policy against oil exports, signaling the role the U.S. ultimately plans to play as an energy supplier.

While these policy responses do not minimize the human suffering, we believe they would broadly benefit the global economy and help rectify some power imbalances.

Recent developments are a headwind to the European economic recovery
At the start of 2014, optimism was growing that Europe – although still facing disinflationary forces – had passed the trough of the economic cycle. European peripheral economies were growing again, and our early cyclical forecasts had acceleration in European GDP of nearly 75 basis points (bps) from 2013’s rather anemic levels of only 50 bps of growth. Fast-forward six months, and European growth has slipped, consumer and business confidence have taken a significant hit and disinflationary forces remain extremely problematic. While geopolitics is by no means the sole reason for the economic disappointment, developments over the spring and summer are clear headwinds to an already fragile economic recovery in Europe.

In our baseline economic scenario, effectively a frozen conflict, we believe the negative impact of events in Ukraine on European growth going forward will be around 0.3% of GDP, mostly through direct trade linkages. However, if the military conflict escalates and sanction pressure increases with commensurate retaliatory actions, the impact on GDP could become much bigger as the negative effects spread through the energy price and supply effect, hitting market confidence and deepening trade drag. Although a near-infinite number of scenarios can be constructed with many economic outcomes, it is clear that both proactive fiscal and monetary policy should be considered to combat deflation and support the fragile economies.

We believe the best approach for Europe would be to relax fiscal budget constraints to allow for fiscal stimulus to offset any economic drag, while maintaining extremely accommodative monetary policy, most likely including quantitative easing to stimulate the flow of credit to the economy. Allowing Europe to fall back into recession and allowing disinflation to increase is in no one’s best interest.

Energy politics should be central to Europe’s policy response
Although Ukraine is not a material producer of oil or natural gas, the country plays a critical role as a transit state for Russian oil and gas to reach Europe and the world markets. Because of this, energy “politics” has played a central role in past conflicts and should be a central factor in the policy response. In fact, the signing of a natural gas supply deal between China and Russia this summer, after nearly a decade of discussions, reflects Russia’s reorientation eastward, partly in response to declining European demand for Russian natural gas and growing pressure from Azerbaijan and potentially Eastern Mediterranean producers, but also because of the new political contention.

Europe should respond by revisiting plans to phase-down nuclear power, continuing to develop renewables supplies and technologies to enhance energy efficiency, and supporting greater integration and connectivity so that energy can flow across regions to prevent any one member from being held captive to any one supplier. In addition, Europe should expand drilling and exploration and strongly reconsider the rather broad antipathy toward hydraulic fracturing (also known as “fracking”), which has helped dramatically change U.S. energy balances and could, at least on the margin, help Europe reduce import dependence, support economic growth and reduce the industry’s structural disadvantages. However, reports are suggesting Russia is in fact supporting anti-fracking environmental efforts in order to hinder European energy independence from Russia.

What the U.S. can do
The U.S. and its relatively newfound energy renaissance can also play an important role in supporting Europe and the global economy by signaling its intention to compete for energy market share. Developers are already progressing with liquefied natural gas (LNG) exports, with the first plant scheduled to begin exporting at the end of 2015. By the end of the decade, the U.S. will be one of the largest exporters of natural gas. Unfortunately for Europe this winter, there is little the U.S. can do to help replace any lost supplies. Speeding up the approval process and creating a blanket authorization for all plants to export anywhere (not just free-trade countries), plus eliminating time-consuming and expensive hurdles to development, would send a signal to the world that the U.S. plans to compete for natural gas market share.

In addition, the U.S. should revisit its now long-standing restrictions on crude oil exports. While exporting petroleum products, processed condensates (but not field condensates), petrochemicals, coal and nearly any other product derived from petroleum is permissible in the U.S., crude oil remains absent from the list, and this is increasingly tough to reconcile. Although the U.S. is still a net crude oil importer, it is rapidly moving toward balance and may reach market saturation in the next few years for light crude oil, suggesting some U.S.-produced oil would struggle to find a home without significant discounts or even reduced production. Allowing for crude oil exports would support continued investment in exploration and midstream development by ensuring market outlets for new production, a condition that, in our opinion, would be net negative for prices of global oil and U.S. gasoline, which are currently traded freely on the global markets and whose prices are not directly linked to those of U.S. crude oil.

 

Those opposing energy exports argue that keeping energy domestically will support industry at home – but while some of the discount will narrow, the U.S. energy advantage would not go away. We view increasing U.S. exports as net supportive of the U.S. economy, likely depressing global prices in time and providing allies with some certainty over the security of supply.

A policy trajectory that reflects the current reality
With the hope that deepening the integration of European and Russian economics would have ushered in an era of peaceful coexistence now thoroughly quashed, Europe and European allies should frame the policy trajectory to reflect the current reality. In the short term, Europe should proactively work to shore up the local economy through supportive fiscal and accommodative monetary policies. In addition, long-term planning should begin today to reduce Europe’s energy dependency on Russia, and the U.S. should revisit current export policy to send a powerful signal to the markets and allies over the security of future supplies.

The Author

Scott A. Mather

CIO U.S. Core Strategies

Greg E. Sharenow

Portfolio Manager, Real Assets

Disclosures

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd- Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1° andar, Rio de Janeiro – RJ Brasil 22210-906.

All investments contain risk and may lose value. This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.