PIMCO Cyclical Outlook for Asia: How Leadership Changes Are Shaping Asia's Outlook

Our latest discussions pointed to “slow, but not slowing” global growth. In the U.S., the positive of a vigorous rebound in housing will be weighed down by the negatives of fiscal contraction at the federal level and persistent structural dislocations in the labor market. In Europe, the acute pressures from private capital flight have abated, but political noise and policy disputes on the terms of assistance to the periphery will weigh upon already fragile sentiment. In short, while we do not see growth deteriorating in 2013, neither are the ingredients for a robust recovery yet in place.

The upshot for Asia is that the external demand environment will be generally neutral in the near term – that is, Asia will neither ride the coattails of a robust global recovery nor be dragged down by a double-dip recession in the U.S. Homegrown factors, in particular on the policy front, will therefore have an important role in shaping the economic outlook in Asia, particularly developments in the largest economies of Japan and China.

In Japan – the topic of extensive discussion at this quarter’s Forum – we see a significant boost to aggregate demand coming from the concerted monetary and fiscal expansion of the new Abe government. The stimulative effect of a weaker yen and higher government spending is likely to generate a bounce in growth this year, with progress on the government’s “growth agenda” required to sustain the rebound in 2014. In China, we see policies moving in the opposite direction in 2013, with the government withdrawing the credit-intensive stimulus implemented last year. Concerns about potential inflationary pressure, excesses in the housing market, and long-term financial stability are prompting policy restraint that we expect to keep growth below 8% this year.

Q: Do you think the policies of Prime Minister Abe represent a decisive break?

Masanao: Yes, at least over the cyclical horizon, though sustainability of growth momentum over the longer term remains challenging. Three months ago, we were unimpressed by campaign pledges in the run-up to the lower-house election, as they sounded rather unrealistic and unfeasible. But since his party’s landslide victory at the election, “Abenomics” has become more sophisticated, and Prime Minister Abe himself has demonstrated his strong leadership in economic policy initiatives.

Critically, under the newly appointed leadership, the Bank of Japan (BOJ) is making an important ideological shift with decisive policy actions. Before, the BOJ long believed that hyperactive monetary policy would be ineffective in ending Japan’s deflation and more costly than beneficial. That is no longer the case under new Governor Kuroda. The BOJ delivered on April 4 its new policy package, which we consider a “regime shift,” consisting of an aggressive balance sheet expansion, both in scale and scope, a strong commitment to achieving its policy objective and effective communication of its policy.

The BOJ’s ideological shift and hyperactive monetary policy will likely lower Japan’s real rates and underpin continued weakness of its currency. As previous cycles of depreciation of the Japanese yen were associated with cyclical boosts to net exports, the recent currency depreciation suggests a net export boost to GDP growth in 2013.

Q: What is necessary for Japan to sustain growth momentum?

Masanao: Japan’s economy has been in a deflationary trap, which requires decisive policy actions on multiple fronts. The combination of zero growth expectations, zero inflation (or deflation), and zero lower bound for the policy rate made traditional monetary policy impotent in Japan. As a result, the private sector has continued to retain excess savings, which in turn helped finance the fiscal deficit domestically while leaving the current account in surplus. The Japanese yen appreciated, as the country’s current account remained in surplus and its net international creditor position attracted global money flows as a perceived “safe” currency in the post-crisis world – all of which helped fuel deflation expectations in the economy. The BOJ under Governor Kuroda will try to break this spiral by changing inflation expectations with its hyperactive monetary policy.

The BOJ’s decisive policy actions are welcome and necessary but not sufficient to end this spiral. The Abe administration will need to accelerate its growth strategy − described as “the third arrow” (with monetary policy and fiscal policy as the first and second arrows) − and take decisive action on this front. Before the lower-house election, the campaign’s growth strategy sounded rather contradictory with protectionism and reform agendas. It is encouraging to see that the growth strategy has come to emphasize structural reforms and competitiveness, and that some progress has been made on the domestically controversial but strategically important trade initiative of participating in the Trans-Pacific Partnership (TPP).

However, Japan’s list of necessary structural reforms is long, from labor markets and the social security system to taxation, and each area involves vested interests. Another victory by Prime Minister Abe’s party in the upper-house election in the summer may boost the prospects for this long-term growth strategy to be implemented.

Q: Are other regional governments likely to pursue reflationary policies?

Mead: The short answer is no. Many Asian countries will suffer the unintended consequences of reflationary policies in developed countries, with some being on the receiving end via currency appreciation and others directly importing these reflationary policies via currency pegs. We have seen economies like Hong Kong and Singapore turn to macro-prudential policies aimed at restraining domestic property markets that have been buoyed by global liquidity conditions. And some of Japan’s industrial competitors will be closely watching the evolution of the Japanese yen and the impact on their domestic industries.

Australia is also demonstrating a more ambivalent attitude toward reflationary policies than developed-market counterparts like the U.S. and Europe. In fact, fiscal policy has been oriented toward achieving a balanced budget. Though this could change at the margin with the upcoming parliamentary elections in September, the overall thrust of policy will tend to be more disciplined than elsewhere in the industrialized world. On the monetary front, we expect that the Reserve Bank of Australia (RBA) will likely have to implement more interest rate cuts than the market expects in response to weak domestic economic conditions and a weaker-than-consensus global outlook. However, the RBA will not be pursuing the kind of aggressive monetary expansion initiated by others.

Q: How do you see China's economy evolving under the new leadership?

Toloui: It is useful to frame China’s near-term outlook within the long-term context. China’s new leadership faces a challenge that is widely recognized as difficult and enormously consequential: transitioning China’s growth model from one dependent upon exports and investment to one driven by domestic demand, particularly consumption. China must move from an emphasis on aggressively mobilizing the factors of production to an emphasis on removing the impediments to boosting household incomes and the propensity to consume.

This is relevant to cyclical economic performance in China because it signals a limit to cyclical policies that threaten to amplify these long-term imbalances. Policy in 2012 was essentially a downscaled version of that in 2009, when China’s policymakers relied upon a massive credit expansion aimed at public investment to counter the global financial crisis. The difference in 2012 was that the credit flowed not through the formal banking system, but rather through off-balance-sheet vehicles, colloquially known as the shadow banking sector. Most of that credit flowed into infrastructure investment undertaken by provincial governments.

In 2013, we are likely to see a reining in of these expansionary credit policies and a consequent fading in the strength of the economic recovery. China’s economic leadership is cognizant of the risks of continuing policies dependent upon investment – which is already almost half of GDP – and perpetual debt creation that could undermine financial stability. In addition, the excess liquidity that has resulted threatens to push up politically sensitive food prices and push property prices further out of reach of the Chinese middle class. So whereas slowing growth was the primary risk in 2012, the focus is shifting to systemic stability in 2013. Policymakers will seek to tighten enough to wring out excesses, without tightening so much that it produces liquidity problems and financial distress among banks and companies.

Q: What are the key investment implications?

Mead: We can break down the investment implications into four categories: interest rate duration, currencies, credit and multi-asset.

On interest rate duration, PIMCO’s slow-growth outlook for the global economy points toward a greater willingness to accept interest rate duration risk in portfolios, since yields are likely to stay contained amid relatively weak growth and permissive monetary conditions. Global bond portfolios should express this interest rate positioning in high-quality developed markets (like the U.S.), as well as high-quality emerging markets (like Brazil) where positive real rates provide attractive compensation.

Our favorite local interest rate market in the Asia-Pacific region is Australia, where policy rates are lower than pre-crisis norms and are likely to stay low for longer, amid wider borrowing spreads and the need to offset the impact of a strong currency. In Japan, we think government bond yields are likely to stay very low, compressed by the BOJ’s aggressive bond purchases, but because the starting yields are so low, Japan is less attractive than other global duration markets.

In currencies, the main theme will continue to be the impact of central bank policies. In the context of expansionary central bank policies by the developed countries, we like long positions in higher-yielding emerging market currencies like Brazil and Mexico versus underweights in the euro and the British pound. Our current favorite currency position in the region is to be underweight the Japanese yen, which we think will continue to be kept weak by BOJ policy.

In credit, the key is to stay defensive in an environment where the compensation for credit risk in terms of spreads has compressed dramatically. The anchor for our credit investments globally is our team of research analysts around the world responsible for scrutinizing individual companies. Our Asian credit research team is distributed across all of our regional offices – Hong Kong, Singapore, Tokyo and Sydney – and provides the bottom-up insights that guide our investments in Asian credits in our dedicated regional and global bond portfolios.

In asset allocation, the compression in risk premiums globally suggests that investors should target lower portfolio volatility. Also, as investors search for alpha in this environment, country selection in both equities and fixed income will be increasingly important because returns are likely to be divergent, depending on conditions in each country. And we believe investors should start tilting their portfolios to have a higher responsiveness to potential inflation surprises.