Economic Outlook
Tomoya Masanao, Robert Mead and Chia-Liang Lian Discuss PIMCO’s Asia-Pacific Cyclical Outlook
- After a remarkable rebound in 2009, the latest data, including industrial production and retail sales, suggest that China’s economic momentum in 2010 is moderating toward a pace that is more sustainable over the medium term.
- To the extent that Australian credit is priced at similar levels to emerging market opportunities, it may represent significant value for investors. Australia has presented more of a credit opportunity than an interest rate opportunity for most of 2010.
- The Bank of Japan’s policy decision at the October policy meeting reinforces our view that monetary policy in the developed economies will need to remain extraordinarily accommodative: The outlook for the global economy remains unusually uncertain, with deflationary tail risk over the cyclical horizon.
Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the outlook for the global economy and financial markets. In the following interview, members of the Asia-Pacific Portfolio Committee, Tomoya Masanao, Robert Mead and Chia-Liang Lian, discuss PIMCO’s cyclical economic outlook for the region over the next six to 12 months. Q: What are PIMCO’s key themes for the global cyclical outlook, and how does the Asia-Pacific region factor into the overall view?
Masanao: There are three key themes for our global outlook and the Asia-Pacific economy is an integral part of this outlook.
First, we live in a de-synchronized or multi-speed global economy. Different countries and regions across the globe entered the global financial crisis with markedly different initial conditions, and therefore are demonstrating vastly different post-crisis policy responses and economic performance. These differences will continue to be an integral factor in our cyclical outlook. China demonstrated its ability to jump-start its economy after the global financial crisis and has maneuvered adeptly to reduce the risk of its economy overheating. China, a frontrunner on the high side of this multi-speed global economy, is aiding the Asia-Pacific region as it becomes more and more China-centric through the intraregional trade linkages.
Second, we live in an unusually uncertain global economy with a flatter distribution of potential outcomes and fatter tails, raising the risk posed by events that are relatively rare but can have substantial impact on a portfolio. On one hand, a secular rise of the middle class in China and other emerging Asian nations, particularly if coupled with a large appreciation of their currencies, has the potential to become a right tail of global economic growth. On the other hand, while the Asia-Pacific economy is benefiting from having become increasingly China-centric, a double-dip slowdown or deflation in the U.S. economy over the cyclical horizon could pose a major downside risk to the region’s economy. However, a new round of quantitative easing in the developed world, whether it is the Fed alone or other central banks as well, could invite more capital inflows to relatively healthy economies – most notably emerging Asia – potentially exacerbating policy challenges on the inflation front.
Third, we continue to question the effectiveness of cyclical policy tools in the economy due to structural challenges. In the Asia-Pacific region, this theme applies specifically to Japan. In addition to the potential benefits from China’s growth, Japan also has implemented fiscal subsidy programs to bolster private sector demand in the wake of the financial crisis. But this type of cyclical policy response alone cannot lead to sustained economic growth unless the economy’s structural challenges are addressed with appropriate structural policy responses. We have seen this in Japan over and over again, and now we are seeing this in the U.S. and Europe. Australia, on the other hand, has not only been fortunate enough to benefit from China’s demand for commodities, but also is maneuvering itself into the New Normal with effective structural policy responses such as its immigration policy and mining tax.
Q: Given the importance of China to the global economy, what is PIMCO’s expectation for growth, and is it likely to be sufficient to serve as a global engine of growth? Are you concerned about a hard landing?
Lian: We view the likelihood of a hard-landing scenario in China as low. After a remarkable rebound in 2009, the latest high-frequency data, including industrial production and retail sales, suggest that economic momentum in 2010 is moderating toward a pace that is more sustainable over the medium term. Importantly, China has strong starting conditions, in the form of low debt-to-GDP levels, fiscal flexibility and generally unleveraged consumers. Indeed, sustained growth should help drive national incomes to new highs, potentially providing scope for higher wages and greater domestic demand for goods and services. China’s role in the global economy will continue to expand, underpinned by a strong national balance sheet and still-nascent economic development. Longer-term challenges include promoting financial market development and fostering a broader range of investible assets, as well as re-orientating the economy toward domestic sources of demand, notably consumption.
Separately, concerns that the property market could overheat, and related concerns regarding the potential risk for a banking crisis, have dominated headlines. However, the recent withdrawal of policy stimulus is intended to cool the economy toward a more manageable pace over the medium term, and avoid a sharp boom-bust asset market cycle; we do not believe it is targeted toward asset prices. Overall, we believe the property market is manageable in the baseline scenario over a three-year horizon. Credit losses will likely be significantly higher under more extreme stress conditions. Even then, we estimate the potential recapitalization cost would be roughly similar to levels that prompted the restructuring of major Chinese state-owned banks from 1998 to 2005.
Q: What are the most attractive investment opportunities in emerging Asia?
Lian: As emerging Asia economies present stronger growth dynamics and become more prominent destinations for capital, the region’s currencies are likely to appreciate relative to the currencies of developed economies. The buying in the Chinese yuan, and other Asian currencies like the Korean won, Singapore dollar and Philippine peso reflect how important exchange rate appreciation in emerging Asia will likely be in rebalancing the global economy. Dollar-denominated bonds issued by emerging Asian sovereigns, banks and corporates are another opportunity to diversify credit exposure from corporate credit in the U.S. and other developed countries. Many corporations in emerging Asia are global market leaders and have demonstrated a strong track record of withstanding economic cycles. In addition, many offer attractive yields and risk-return profiles.
Q: How about Australia? Where do you see the most attractive investment opportunities there?
Mead: Australia continues to be the so-called economic battleground between the divergent influences of developed and emerging markets. Australia’s initial conditions of fiscal and monetary flexibility, accompanied by a relatively clean banking sector, bore almost no resemblance to the majority of developed countries. This comparative advantage has been enhanced over time, especially as the fiscal positions in the developed world are forecast to diverge further over time with Australia expected to be comparatively better off.
As a result, Australia has presented more of a credit opportunity than an interest rate opportunity for most of 2010, and only recently are we beginning to see some opportunity reappear in Australia’s interest rate structure. Having already raised rates by 150 basis points since the crisis lows, the Reserve Bank of Australia (RBA) retains its mildly hawkish tone. PIMCO continues to believe the RBA will raise rates toward 5%, implying a slight tightening bias vs. a New Normal neutral rate expectation, which would be approximately 4.75%. However, with the Australian dollar trading close to parity with the U.S. dollar, near-term pressure for RBA rate action is reduced slightly.
To the extent that Australian credit is priced at similar levels to emerging market opportunities, it may represent significant value for investors, especially in primary markets when new issues offer discounts to the prices of comparable bonds in the secondary market. Global credit markets remain somewhat inefficient, so many opportunities continue to exist across currency denominations.
As global credit markets have rallied strongly, carefully selected Australian residential mortgage-backed securities (RMBS) continue to stand out as offering potential attractive relative value, especially when considering the majority of Australian RMBS naturally deleverage over time and are self-liquidating, as mortgages are paid down. While some commentators claim that Australian housing has become a bubble, the protection via increased subordination requirements in current vintage RMBS securities, such as additional excess spread, which provides a cushion for investors, and declining loan-to-value ratios in older vintage RMBS securities, may provide significant downside risk mitigation against potential house price volatility.
Q: How should Australian investors be positioning their portfolios?
Mead: Generating real investment returns with manageable levels of risk should always be the goal of any investor. Given the RBA’s inflation management credibility, which has realized an average CPI rate of approximately 2.5% for the past 15 years, Australian investors have an excellent opportunity in the current markets to earn real returns of 3%–4% via Australian bonds or global bonds hedged to Australian dollars. The investment landscape is also expected to remain volatile, which provides active managers with significant opportunities to obtain alpha for investors through both top-down and bottom-up drivers. Investing passively in this environment or with too narrow a focus could result in lower return expectations.
Q: The Bank of Japan (BOJ) seems to have taken one step further toward a more aggressive monetary policy at their policy meeting on October 4th and 5th. How does that affect PIMCO’s outlook on Japan?
Masanao: The BOJ’s policy decision at the October policy meeting only reinforces our view that monetary policy in the developed economies will need to remain extraordinarily accommodative: The outlook for the global economy remains unusually uncertain, with deflationary tail risk over the cyclical horizon. However, we still remain skeptical about the prospects for the effectiveness of the BOJ’s policy, and expect deflation to remain an issue in Japan for two main reasons.
First, the BOJ’s reaction function has not materially changed and will not change in the foreseeable future, in our view. While technically opening up a door for more asset purchases and easing, the BOJ made it very clear that the bank would continue to retain discretion regarding the timing of an exit from its near-zero interest rate policy, and indicated its decision would be based on its own inflation forecast and asset price developments. Therefore, we still see a risk that the BOJ would prematurely exit on a rise of asset prices while deflation would not be ended.
Second, the effectiveness of monetary easing alone is limited when the economy is faced with structural challenges that have mired it in a liquidity trap. The central bank’s quantitative easing could be more effective if coordinated with the fiscal authority, and even more so, if structural problems are addressed by the right structural policies. Japan needs to urge structural reforms to enhance productivity growth.
Q: Then, where do you see investment opportunities in Japan?
Masanao: We believe seven-year to 10-year Japanese Government Bonds (JGBs) offer relatively prudent carry for portfolios that are managed against local indexes. Admittedly, though, potential for capital gains is quite limited. Selling default protection on Japan sovereign debt, either outright or as a substitute to low-yielding short-term JGBs, is another way to earn prudent carry. As we argued in April (PIMCO Asia-Pacific Cyclical Outlook April 2010), we are quite comfortable that Japan is not going to default. For portfolios that have discretion to invest outside Japan, we would look to underweight Japan duration, as there are opportunities to earn even more attractive carry, such as the belly of the U.S. Treasury curve or some quasi-sovereign and corporate bonds in the emerging markets.
As for our currency strategy, we currently remain neutral on the Japanese yen. Fundamentally, Japan’s current account surplus and deflation (which results in high real interest rates) will likely remain supportive for the Japanese yen. Expectations that the Federal Reserve will be more aggressive than the BOJ when it comes to monetary easing should also be a yen positive vs. the U.S. dollar. But for fundamental attractiveness and long-term valuation, we see much better value in currencies in emerging Asia.
Thank you.
Masanao: There are three key themes for our global outlook and the Asia-Pacific economy is an integral part of this outlook.
First, we live in a de-synchronized or multi-speed global economy. Different countries and regions across the globe entered the global financial crisis with markedly different initial conditions, and therefore are demonstrating vastly different post-crisis policy responses and economic performance. These differences will continue to be an integral factor in our cyclical outlook. China demonstrated its ability to jump-start its economy after the global financial crisis and has maneuvered adeptly to reduce the risk of its economy overheating. China, a frontrunner on the high side of this multi-speed global economy, is aiding the Asia-Pacific region as it becomes more and more China-centric through the intraregional trade linkages.
Second, we live in an unusually uncertain global economy with a flatter distribution of potential outcomes and fatter tails, raising the risk posed by events that are relatively rare but can have substantial impact on a portfolio. On one hand, a secular rise of the middle class in China and other emerging Asian nations, particularly if coupled with a large appreciation of their currencies, has the potential to become a right tail of global economic growth. On the other hand, while the Asia-Pacific economy is benefiting from having become increasingly China-centric, a double-dip slowdown or deflation in the U.S. economy over the cyclical horizon could pose a major downside risk to the region’s economy. However, a new round of quantitative easing in the developed world, whether it is the Fed alone or other central banks as well, could invite more capital inflows to relatively healthy economies – most notably emerging Asia – potentially exacerbating policy challenges on the inflation front.
Third, we continue to question the effectiveness of cyclical policy tools in the economy due to structural challenges. In the Asia-Pacific region, this theme applies specifically to Japan. In addition to the potential benefits from China’s growth, Japan also has implemented fiscal subsidy programs to bolster private sector demand in the wake of the financial crisis. But this type of cyclical policy response alone cannot lead to sustained economic growth unless the economy’s structural challenges are addressed with appropriate structural policy responses. We have seen this in Japan over and over again, and now we are seeing this in the U.S. and Europe. Australia, on the other hand, has not only been fortunate enough to benefit from China’s demand for commodities, but also is maneuvering itself into the New Normal with effective structural policy responses such as its immigration policy and mining tax.
Lian: We view the likelihood of a hard-landing scenario in China as low. After a remarkable rebound in 2009, the latest high-frequency data, including industrial production and retail sales, suggest that economic momentum in 2010 is moderating toward a pace that is more sustainable over the medium term. Importantly, China has strong starting conditions, in the form of low debt-to-GDP levels, fiscal flexibility and generally unleveraged consumers. Indeed, sustained growth should help drive national incomes to new highs, potentially providing scope for higher wages and greater domestic demand for goods and services. China’s role in the global economy will continue to expand, underpinned by a strong national balance sheet and still-nascent economic development. Longer-term challenges include promoting financial market development and fostering a broader range of investible assets, as well as re-orientating the economy toward domestic sources of demand, notably consumption.
Separately, concerns that the property market could overheat, and related concerns regarding the potential risk for a banking crisis, have dominated headlines. However, the recent withdrawal of policy stimulus is intended to cool the economy toward a more manageable pace over the medium term, and avoid a sharp boom-bust asset market cycle; we do not believe it is targeted toward asset prices. Overall, we believe the property market is manageable in the baseline scenario over a three-year horizon. Credit losses will likely be significantly higher under more extreme stress conditions. Even then, we estimate the potential recapitalization cost would be roughly similar to levels that prompted the restructuring of major Chinese state-owned banks from 1998 to 2005.
Q: What are the most attractive investment opportunities in emerging Asia?
Lian: As emerging Asia economies present stronger growth dynamics and become more prominent destinations for capital, the region’s currencies are likely to appreciate relative to the currencies of developed economies. The buying in the Chinese yuan, and other Asian currencies like the Korean won, Singapore dollar and Philippine peso reflect how important exchange rate appreciation in emerging Asia will likely be in rebalancing the global economy. Dollar-denominated bonds issued by emerging Asian sovereigns, banks and corporates are another opportunity to diversify credit exposure from corporate credit in the U.S. and other developed countries. Many corporations in emerging Asia are global market leaders and have demonstrated a strong track record of withstanding economic cycles. In addition, many offer attractive yields and risk-return profiles.
Q: How about Australia? Where do you see the most attractive investment opportunities there?
Mead: Australia continues to be the so-called economic battleground between the divergent influences of developed and emerging markets. Australia’s initial conditions of fiscal and monetary flexibility, accompanied by a relatively clean banking sector, bore almost no resemblance to the majority of developed countries. This comparative advantage has been enhanced over time, especially as the fiscal positions in the developed world are forecast to diverge further over time with Australia expected to be comparatively better off.
As a result, Australia has presented more of a credit opportunity than an interest rate opportunity for most of 2010, and only recently are we beginning to see some opportunity reappear in Australia’s interest rate structure. Having already raised rates by 150 basis points since the crisis lows, the Reserve Bank of Australia (RBA) retains its mildly hawkish tone. PIMCO continues to believe the RBA will raise rates toward 5%, implying a slight tightening bias vs. a New Normal neutral rate expectation, which would be approximately 4.75%. However, with the Australian dollar trading close to parity with the U.S. dollar, near-term pressure for RBA rate action is reduced slightly.
To the extent that Australian credit is priced at similar levels to emerging market opportunities, it may represent significant value for investors, especially in primary markets when new issues offer discounts to the prices of comparable bonds in the secondary market. Global credit markets remain somewhat inefficient, so many opportunities continue to exist across currency denominations.
As global credit markets have rallied strongly, carefully selected Australian residential mortgage-backed securities (RMBS) continue to stand out as offering potential attractive relative value, especially when considering the majority of Australian RMBS naturally deleverage over time and are self-liquidating, as mortgages are paid down. While some commentators claim that Australian housing has become a bubble, the protection via increased subordination requirements in current vintage RMBS securities, such as additional excess spread, which provides a cushion for investors, and declining loan-to-value ratios in older vintage RMBS securities, may provide significant downside risk mitigation against potential house price volatility.
Q: How should Australian investors be positioning their portfolios?
Mead: Generating real investment returns with manageable levels of risk should always be the goal of any investor. Given the RBA’s inflation management credibility, which has realized an average CPI rate of approximately 2.5% for the past 15 years, Australian investors have an excellent opportunity in the current markets to earn real returns of 3%–4% via Australian bonds or global bonds hedged to Australian dollars. The investment landscape is also expected to remain volatile, which provides active managers with significant opportunities to obtain alpha for investors through both top-down and bottom-up drivers. Investing passively in this environment or with too narrow a focus could result in lower return expectations.
Q: The Bank of Japan (BOJ) seems to have taken one step further toward a more aggressive monetary policy at their policy meeting on October 4th and 5th. How does that affect PIMCO’s outlook on Japan?
Masanao: The BOJ’s policy decision at the October policy meeting only reinforces our view that monetary policy in the developed economies will need to remain extraordinarily accommodative: The outlook for the global economy remains unusually uncertain, with deflationary tail risk over the cyclical horizon. However, we still remain skeptical about the prospects for the effectiveness of the BOJ’s policy, and expect deflation to remain an issue in Japan for two main reasons.
First, the BOJ’s reaction function has not materially changed and will not change in the foreseeable future, in our view. While technically opening up a door for more asset purchases and easing, the BOJ made it very clear that the bank would continue to retain discretion regarding the timing of an exit from its near-zero interest rate policy, and indicated its decision would be based on its own inflation forecast and asset price developments. Therefore, we still see a risk that the BOJ would prematurely exit on a rise of asset prices while deflation would not be ended.
Second, the effectiveness of monetary easing alone is limited when the economy is faced with structural challenges that have mired it in a liquidity trap. The central bank’s quantitative easing could be more effective if coordinated with the fiscal authority, and even more so, if structural problems are addressed by the right structural policies. Japan needs to urge structural reforms to enhance productivity growth.
Q: Then, where do you see investment opportunities in Japan?
Masanao: We believe seven-year to 10-year Japanese Government Bonds (JGBs) offer relatively prudent carry for portfolios that are managed against local indexes. Admittedly, though, potential for capital gains is quite limited. Selling default protection on Japan sovereign debt, either outright or as a substitute to low-yielding short-term JGBs, is another way to earn prudent carry. As we argued in April (PIMCO Asia-Pacific Cyclical Outlook April 2010), we are quite comfortable that Japan is not going to default. For portfolios that have discretion to invest outside Japan, we would look to underweight Japan duration, as there are opportunities to earn even more attractive carry, such as the belly of the U.S. Treasury curve or some quasi-sovereign and corporate bonds in the emerging markets.
As for our currency strategy, we currently remain neutral on the Japanese yen. Fundamentally, Japan’s current account surplus and deflation (which results in high real interest rates) will likely remain supportive for the Japanese yen. Expectations that the Federal Reserve will be more aggressive than the BOJ when it comes to monetary easing should also be a yen positive vs. the U.S. dollar. But for fundamental attractiveness and long-term valuation, we see much better value in currencies in emerging Asia.
Thank you.
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