PIMCO Managing Director Paul McCulley leads the firm’s quarterly Cyclical Economic Forums, in which investment professionals from around the world gather to discuss the outlook for the global economy and the financial markets over the next six to 12 months. In the following interview, Mr. McCulley discusses PIMCO’s cyclical economic outlook and its impact on the firm’s investment strategy.
Q: What is PIMCO’s cyclical outlook for the global economy?
McCulley: Our cyclical outlook revolves around two core themes, or tensions, in the global economy.
First, we have the huge disparity between the developed and the developing economies that stems from the starkly different initial conditions going into the financial crisis. The emerging economies had healthy reserves and balance sheets, which have moderated but remain strong. However, the developed world had overleveraged, bubble economies that are still in the process of deleveraging. As a result, we continue to expect a “desynchronised” recovery, with less leveraged emerging economies likely to grow more robustly than the developed economies.
The second tension is within the developed world. Here the cyclical recovery we have started to see faces resistance from structural headwinds.
Q: What structural headwinds stand in the way of recovery in the US?
McCulley: We believe the US is in the second stage of a three-stage recovery. The economy was first propped up by policy response – low interest rates and fiscal stimulus. Currently, we are moving from the dark to the sunny side of the inventory cycle. The final stage – job creation, private income creation and self-sustaining demand growth – has yet to materialise, due to headwinds of deleveraging and de-risking.
We like to use the analogy of the three-stage-rocket; we are waiting for the thrust from that third rocket. There’s a great deal of uncertainty surrounding the hand-off from stimulus and inventories to job creation, and that is reflected in the Federal Reserve’s continued exceptionally low interest rate policy.
Q: Are you expecting any change to the Federal Reserve’s interest rate policy in the next six to 12 months?
McCulley: The end of quantitative easing is basically a form of monetary tightening. It means the Fed won’t be creating money to buy hundreds of billions of government-related securities, month after month after month. Before contemplating a nudge up in short rates from near zero, the Fed will want to assess the overall effect of quantitative easing – including the absence of more of it.
Indeed, the Fed resolutely remains committed, in its own words, to maintaining “exceptionally low” short rates for an “extended period.” At some point in the next three to six months, the Fed is likely to moderate this language, but we do not expect the Fed to begin tightening until 2011, which will be well before the ECB (European Central Bank), as Europe faces headwinds of a much greater magnitude than the US.
Q: What is holding back recovery in Europe?
McCulley: Europe’s recovery is delayed by deflationary headwinds: Our forecast for eurozone inflation is only about one-half of a percentage point. We believe the severe austerity measures brought on by the fiscal problems in the periphery countries, such as Greece and Spain, will lead to a chronic shortfall of Euroland-wide aggregate demand, leaving open and even expanding a large output gap. The inability or unwillingness to increase consumer spending in any significant way in the core countries, especially Germany, points in the same direction.
Q: China’s exchange rate continues to be a concern, particularly for the US. What is PIMCO’s outlook for exchange rates in China?
McCulley: We expect China will allow the yuan to appreciate over the next year, in part to dampen inflationary pressures as well as part of a process to rebalance toward more household consumption and less investment and exports. But the timing of any currency appreciation is difficult to predict because of the politics.
China is pushing back hard against US pressure to revalue. We view the stand-off as similar to the weigh-in before a championship boxing match: The two competitors have to look very strong, but the match has not even begun yet.
Politics are increasingly a major factor in our cyclical outlook considerations, not only in China but throughout the world. In our discussions, we at PIMCO have reiterated that the world economy is becoming ever more a world political economy.
Q: PIMCO is forecasting very strong growth for China of 9%–10%. Do you expect China’s economy to overheat or develop asset bubbles?
McCulley: The real estate market is frothy, but in general, we believe the risks of overheating and asset bubbles in China are manageable. China has stronger underlying fundamentals than other countries that have experienced bubbles. China also has a range of administrative policy tools available to fine-tune the economy, tools which are not usually employed in developed economies.
Q: How is PIMCO’s economic outlook being affected by the expected end of the Federal Reserve’s purchases of Agency mortgage-backed securities?
McCulley: We have never seen the end of a programme like this before, so there is no way to predict the impact with a high degree of conviction. That said, we have made a “gut” estimation that when the Fed stops buying Agency MBS at the end of March, MBS spreads may rise 10 basis points to 20 basis points. Exactly how much widening will result depends on whether the bigger impact on the market comes from the “stock” effect – the Fed will continue to hold the MBS it has purchased and has therefore taken that supply out of the market – or the “flow” effect – the Fed will no longer be a source of MBS demand.
What we do know is the MBS purchase programme has taken a great deal of negative convexity and duration out of the marketplace for good. And the Fed is unlikely to sell these assets for a long time, despite the desire of a vocal Fed minority to do so. So we are cautious and remain underweight Agency MBS because they are historically rich and there is large uncertainty about where the market will clear with the Fed out of the picture.
Outside of the Agency MBS sector, we see some attractive buying opportunities in private label residential and commercial mortgage-backed securities. The ratings agencies typically downgrade these securities to as low as triple-C when investors stand to lose just one penny of principal. This inefficiency can create potential attractive loss-adjusted returns when the securities can be bought at significant discounts to par, for those investors with guideline flexibility to hold lower-rated securities.
Q: More broadly, how does PIMCO’s cyclical outlook translate into portfolio strategy?
McCulley: Because of the nature of the desynchronised global recovery – with the tensions in the global economy – PIMCO has made an active decision to have less than normal tracking error in our portfolios. We are taking an active decision to hug benchmarks more closely than before and avoid outliers.
Our strategy reflects two risks. One, the recovery could be stronger than we anticipate. If we are underestimating the strength of the sunny side of the inventory cycle, the Fed could tighten sooner than we expect, generating a bear flattening of the yield curve. The other risk would be stronger-than-expected deflation, which would lead to a bull flattening of the yield curve.
Our baseline forecast, though, is for subpar growth and subdued inflation, and we are expecting interest rates in the US to remain range-bound. We expect the yield on the 10-year Treasury to trade in a range of 3.50%–4.25% over our cyclical horizon.
Q: What is PIMCO’s current view on duration?
McCulley: We believe slightly longer duration vs. benchmarks makes sense in the current environment. Core countries of Europe, mainly Germany, are attractive places to take that duration, in longer tenors. In contrast, we are less favourable toward long-end duration in the US, the UK and Japan. As far as curve duration goes, we think a slight overweight is appropriate and the US and UK, where policy interest rates are likely to be on hold until sometime in 2011, are compelling places to express this view.
Because of the complicating factor of the periphery countries in Euroland, we have spent some time contemplating the risk to overweight duration in core Europe. But, if the northern European countries, such as Germany, have to step up to the plate for others, we think the fiscal risk premium will manifest itself more in downward pressure on the euro than in interest rates. A negative position on the euro is, in our view, the most meaningful way of reflecting this view.
Q: How is PIMCO positioned in the credit markets?
McCulley: We are sticking with a small market overweight in credit. We favour US financials because they benefit from a steep yield curve, strengthening balance sheets and a “too-big-to-fail” status. We also like Build America Bonds. On the other hand, credits from the periphery countries in Europe are not attractive in our view, given the sovereign credit problems there.
However, we are comfortable taking credit default swap positions in certain sovereigns, including the UK, Japan, Australia and Canada, although at higher spreads than we have seen recently. All of these countries can print their own currencies, essentially ruling out default, though not higher inflation.
And, given our expectation for ongoing growth and wealth handoffs from developed to developing economies, we think there are very attractive opportunities in carefully selected quasi-sovereign and corporate issuers in emerging market countries with healthy balance sheets.
Q: How is PIMCO positioned in other currencies to reflect the cyclical outlook?
McCulley: Along with the euro, we would underweight the British pound and the Japanese yen. We favour several Asian currencies, the Brazilian real, and the Canadian and Australian dollars. We are also comfortable being long Chinese yuan exposure through non-deliverable forwards.
Thank you, Paul.
