Slower Growth in China and Japan Pressures the Region
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Our forecast for the global economy is below consensus mainly because of our views for regions outside of the U.S., including Asia, the emerging markets and Europe, although higher growth in the U.S. should offset some of the slowdown we see coming from China.
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Japan made a kick start under so-called Abenomics with massive monetary and fiscal reflation policies, but the recent data suggest to us that the effectiveness of those cyclical policies are already challenged by secular and structural headwinds.
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Australia’s economy is rebalancing away from mining assisted growth: Our base case is that monetary policy remains unchanged over the cyclical horizon, and consistent with our growth outlook, risks remain skewed to the downside.
In the following interview, Scott Mather, CIO U.S. Core Strategies and former head of global bonds and emerging markets; Tomoya Masanao, managing director and head of portfolio management Japan; and Adam Bowe, senior vice president and fixed income portfolio manager in the Sydney office, discuss the conclusions from PIMCO’s quarterly Cyclical Forum in September 2014 and how they influence our Asian outlook and investment strategy.
Q: While the U.S. economy has been growing, Europe has stalled. What is the broad outlook for Asia over the next six to 12 months?
Mather: With ongoing growth slowdowns in China and Japan, the region’s two biggest economies, our forecast is for lower growth for Asia as a whole.
The Chinese slowdown had the most influence on our forecast. The high frequency data has not been particularly good over the last few months, and after our discussion at the Cyclical Forum, we downgraded our forecast for growth in China over the next 12 months or so.We also think rising geopolitical and trade tensions throughout the world, including in Asia, are having a negative effect on the growth trajectory for the region as well as the global economy.Q: What is driving the slowdown in growth in China?Mather: From a global perspective, the U.S. is to a large extent a stand-out right now, and higher growth there should offset some of the slowdown we see coming from China. Nevertheless, our forecast for the global economy is below consensus mainly because of our views for regions outside of the U.S., including Asia, the emerging markets and Europe.
To put our outlook in perspective, China is in the midst of a multi-year transition away from a credit-intensive growth model toward a more balanced economy. Policymakers prefer slower but more sustained growth around 7%, while making structural reform a priority, and wish to only deploy stimulus in reaction to disruptive macro instability. The risk is that the government could lose control of the economy while unwinding the credit/investment excess, leading to a hard landing. But this is not our base case. We believe policymakers have the flexibility, tools and resources to manage the adjustment even while risks are rising.
From a cyclical standpoint, the recent selective mini-easing will not be powerful enough to offset the weakness in the property market. In the next 12 months, we project GDP growth slowing from 7.5% currently to about 6.5%. The reactive policy easing will only partly offset cyclical and structural adjustment pressures.
Q: What is PIMCO’s outlook for Japan, especially following the big second quarter drop in GDP of 7.1% on an annualized basis? Should we worry?
Masanao: Japan made a kick start under so-called Abenomics with massive monetary and fiscal reflation policies, but the recent data suggest to us that the effectiveness of those cyclical policies is already challenged by secular and structural headwinds.
Let me start with the good news. Policymakers have been well-coordinated under Abenomics and have focused on demand-side policy, rightly so, which has helped to reduce the output gap in the economy. The Bank of Japan’s (BOJ) commitment to achieving its inflation target and its massive quantitative easing appear to have changed inflation expectations upward. Employment has increased, which has pushed up total labor compensation. The economy is near full employment and even experiencing labor shortages in some industries. Corporate profits continue to rise, and profit margins are improving.
That said, secular and structural headwinds already weigh on cyclical policies, which concerns us. The recent tax hike and another one planned for 2015 are obviously not desirable as they are only squeezing household real purchasing power. Hiking tax rates at this early stage of reflation simply shows Japan’s structural limitations on fiscal policy. Japan aims to both end deflation and address fiscal consolidation at the same time. Neither is easy by itself, and achieving both is even more challenging. On the corporate side, manufacturers’ offshoring seems to be a firm secular trend and therefore hard to change, even with a weaker currency. And increased import penetration, particularly since the earthquake, is another structural phenomenon that weighs on net export growth.
The bottom line for investors is that the BOJ will remain a key driver of the markets. The BOJ only has an imperfect policy tool, but it is committed to doing heavy lifting.
Q: Australia’s economy has so far weathered the drop in mining investment reasonably well. What is PIMCO’s forecast for growth and monetary policy rates in the coming months?
Bowe: Australia continues to face significant challenges over the next few years as the economy rebalances away from mining-assisted growth. While it is true that headline real GDP growth has managed to remain close to trend, this masks a meaningful change in the composition of this growth; domestic demand is growing only modestly due to the decline in mining investment, which has been offset more recently by increasing bulk commodity exports as the resource investment projects come on line. This structural shift in the composition of growth away from mining investment has only just begun and will continue for a couple of years yet.
Over the next year, we expect growth to be a bit below trend in the range of 2.5%–3.0%, with risks to that outlook skewed to the downside. Australia’s economic fortunes have become increasingly tethered to Asia over the past decade, and we expect slower growth in China and lower bulk commodity prices to offset the improved outlook for the U.S.
Against this backdrop, the RBA (Reserve Bank of Australia) has a difficult task ahead with regard to the calibration of policy. On the one hand, it needs to continue to encourage growth from areas outside the mining industry by providing accommodative policy, while on the other hand, it needs to ensure that historically low interest rates do not result in rapid house price appreciation from already elevated levels. House prices rose nationally by 10.1% over the year to June, so this is a risk the RBA will be increasingly focused on. Our base case is that monetary policy remains unchanged over the cyclical horizon, and consistent with our growth outlook, risks remain skewed to the downside.
Q: What are the investment implications of PIMCO’s cyclical views on Asia?
Mather: One of the most significant implications of our cyclical outlook is on the currency side: We expect dollar strength after more than a decade of relative weakness, which has wide-ranging implications for financial assets in general. It also has important secular implications on how countries around the region, in particular in EM Asia, will confront the possibility of periods of volatile capital flows.
In the coming months, easy monetary conditions around the world should create a supportive backdrop for many financial assets, including equities and other risk assets.
For Asia, in particular, we expect continued easing in the major economies as they attempt to soften the blow of the economic slowdown. We are expecting interest rate cuts in China and continued quantitative easing in Japan. To the extent that yields fall in both countries against the backdrop of accommodative monetary policies, this exerts downward pressure on yields throughout the region – even as the U.S. is slowly moving toward normalizing policy.
Some investors are concerned about the potential impact of an interest rate increase by the Federal Reserve on the financial markets. But we think the Federal Reserve will move very slowly in raising rates, and easy monetary policy and slower growth in much of the rest of the world – China, Japan and the eurozone – should help offset the impact of any potential Fed tightening.
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