Asia sweats a real policy breakthrough

The 'new normal' is set to catch up with the Australian dollar in the year ahead, while Japan's effective reinflation is questionable and China will most likely see incremental – not radical – reform.

Pimco

In the following interview, members of PIMCO's Asia-Pacific Portfolio Committee – Tomoya Masanao, Robert Mead and Ramin Toloui – discuss PIMCO’s outlook for the region over the next six to 12 months.

Question: What are the key takeaways for Asia from Pimco’s fourth-quarter cyclical forum?

Ramin Toloui: In preparation for the forum, the Asia-Pacific Portfolio Committee analysed what we see as the critical bottom-up dynamics at work in China, Japan, Australia, Korea and India that shape the near-term trajectory. During the firmwide discussions in Newport Beach, we combined that view with what is happening in the US on the budget, in Europe on the ongoing peripheral crisis, and so on, as well as the spillover effects from Asia on the rest of the world. Integrating all these factors, we identify three key conclusions relevant for Asia in 2013.

First, the global economic backdrop will remain weak in 2013 due to continued deleveraging dynamics in the US and Europe. Despite stronger balance sheets and lower debt levels, Asian economies – and emerging markets elsewhere – are finding it increasingly difficult to escape this persistent weakness in the world’s industrialised core.

Second, cyclical policy around the world has less traction in shaping economic outcomes, because so many fiscal and monetary policy bullets have been fired in recent years in response to the global financial crisis. In Asia, this has been evident in Japan for some time. But now even in China, the government cannot respond to its current slowing economy with a 2008-2009 style mega-stimulus because of existing overcapacity and concerns about excess leverage in the financial system.

Third, for these reasons, the cyclical economic outlook for 2013 is unusually dependent upon whether we see a structural policy breakthrough somewhere in the world. In principle, this could take the form of fiscal agreements in the US or political breakthrough on integration in Europe. In Asia, such a breakthrough could be in the form of an announcement by China’s new leadership that it is embarking upon a concerted program of structural reforms to facilitate the transition to a growth model focused on boosting domestic demand. A breakthrough on structural policy could act as a catalyst for boosting investor animal spirits and prompting businesses to put their massive cash stockpiles to work in new investment.

Q: How does China’s leadership transition affect the economic outlook for 2013? Do you expect a major change in policy?

RT: Our base case for China is one of incremental – not radical – reform. The policy agenda to boost domestic demand and reduce dependence on exports is well known. It includes increasing household disposable incomes through tax cuts and other fiscal reforms; strengthening the social safety net in health, education and social security to reduce the incentives for excess household savings; increasing competition in the state-owned enterprise and service sectors to reduce monopoly profits and spur increased productivity; fighting corruption and improving rule of law; and so forth.

China does not need to do all of these things, but it will need to do some of them in order to sustain economic growth in the 7 per cent range in the years ahead. We think the most likely scenario is that the Chinese leadership proceeds in an incremental fashion, responding to the necessity of boosting economic growth but restrained by the need for consensus among political elites and vested interests that are resistant to moving too quickly.

Although our base case is for incremental reform, we think that the net result of the recently completed 18th Communist Party Congress is an increased chance of a potential positive surprise scenario on reform. This is different than the market consensus. Many analysts have concluded that because several of the more reform-oriented party members did not make the cut for the Politburo Standing Committee, the prospects for reform have diminished.

Our view is that this misses a key outcome of the Party Congress, namely the centralisation of power around new President Xi Jinping. President Xi has assumed immediate command of the armed forces, in contrast to previous transitions where the outgoing president retained command for two years; President Xi and Premier Wen are likely to be the only Standing Committee members who will serve for the entire next 10 years; and the Standing Committee itself has been reduced from nine members to seven. These changes signal a possibility that decision-making could be more decisive at the centre and thus overcome policymaking-by-committee paralysis.

Q: Politics is also at the top of the agenda in Japan. Do the elections there signal a change in policy that would help Japan emerge from deflation in 2013?

Tomoya Masanao: Post-election policy’s intention will clearly be reflating Japan’s structurally impaired economy, but its effectiveness will remain questionable.

The new government led by the Liberal Democratic Party will intend to shift economic policy from the income redistribution policy of the outgoing Democratic Party of Japan to growth promotion with Keynesian cyclical policy tools. Fiscal policy will probably be more expansionary with public investment reviving. Monetary policy will be more aggressive under the new leadership appointed to the Bank of Japan next spring.

Keynesian policy will probably be either unfeasible or ineffective in ending deflation in a sustainable manner unless accompanied by a major breakthrough of structural policies. The new government’s idea of large-scale public investment will be difficult to implement given Japan’s fiscal constraints. Meanwhile, effectiveness of monetary policy remains challenged by secularly low growth expectations in the private sector. Also, public resistance to inflation seems structural and secular given prolonged wage deflation and an aging population, and therefore remains a drag on aggressive monetary policy.

Structural measures – for instance, to ease increasing inter-generational wealth inequality and improve service sector productivity – are essential, but, unfortunately, we believe they are unlikely to be delivered.

Q: Australia has been a favourite of global investors in recent years. How does Australia fit into Pimco’s cyclical outlook?

Robert Mead: Having benefited from a tremendous boom over several years from strong global demand for commodities, the New Normal is finally catching up with the Australian economy. In fact, even the Reserve Bank of Australia recently referenced a potential "new normal” in relation to the level of interest rates going forward.

Australia is essentially being burdened by the unintended consequences of the policy responses of others, accompanied by the impending rebalancing of the Chinese economy. The combined impact to date has been a strong Australian dollar as a result of both global quantitative easing and global reserve managers seeking to diversify into Australia’s relatively clean government balance sheet. At the same time, the recent decline in commodity prices has put downward pressure on the terms of trade and reduced nominal income.

When we overlay these headwinds with a tightening fiscal stance in Australia, we end up with all the natural economic stabilisers being simultaneously absent, leaving all the heavy lifting to monetary policy and creating the expectation for interest rates to remain lower for longer.

Q: With global interest rates so low, investors are scouring the globe seeking assets with yield. Are there opportunities in Asian credit that offer good potential returns in the cyclical horizon?

RM: Definitely, there is a growing opportunity set in Asian credit, and that opportunity set offers the potential for attractive yield pick-up relative to traditional bond alternatives. We have been seeing increasing investor interest in Asian corporate bonds against the backdrop of low yields in core developed markets, dynamism among companies in Asia, and the fact that existing investor portfolios have small exposures in Asia versus their large exposures in the US and Europe. We believe it is likely we are in the early stages of investor reallocations into Asian credit.

The key to being successful in the Asian market, however, is being able to differentiate sound versus unsound credits. Not all companies in the region will be reliable guardians of bondholders’ investments, a fact that some investors in marginal companies have learned in recent months. Corporate governance and quality of accounting disclosures vary widely. A large and on-the-ground credit research analyst team is essential, which is why Pimco has more than doubled its credit resources in the region in the last two years.

We continue to favour high-quality state-owned enterprises in countries like Korea, Indonesia and China. And the recent spread widening of some Japanese companies on investors’ concerns about their competitiveness seems overdone and therefore offers attractive entry points to purchase select Japanese corporate bonds. On the higher-yield side of the spectrum, we have increased our holdings of credits in Mongolia poised to benefit from the development of the mining sector.

Q: What are the other investment implications?

TM: Pimco’s outlook for tepid global economic growth in 2013 suggests that yields are likely to remain low, and therefore that exposure to bonds with a reliable stream of income continues to be an integral part of any well-balanced asset allocation. Within Asia, Australian bonds give investors higher nominal yields than other alternatives in the region or than the core markets like the US or Germany. In Japan, we believe expected policy changes under the new government will lead to investors demanding a higher yield premium on government bonds. Outside of Asia, we believe that allocations to higher-yielding local currency bonds in countries like Brazil, Mexico and South Africa should increasingly be considered as part of a core global bond portfolio.

Regarding currencies, we favour a diversified basket of emerging Asia currencies as a superior alternative to developed currencies both outside the region (US dollar and the euro) and within the region (Japanese yen and Australian dollar). The Australian dollar will struggle to maintain its value against the headwinds of declining commodity prices and a weakening economy, while the Japanese yen faces risks from a more experimental Bank of Japan that could be expanding its balance sheet following the elections.

Finally, equities globally will face headwinds, as companies struggle to maintain profits amid low nominal growth. We see attractive entry points in Chinese equities, which have lagged other markets. As we have said, the Chinese leadership may take advantage of a strengthened governing core to implement more aggressive structural reform than expected, especially if the economic recovery loses steam in the first half of 2013 as we project.

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Tomoya Masanao is a managing director in Pimco's Tokyo office and head of portfolio management Japan.

Robert Mead is a managing director in Pimco's Sydney office and is also head of portfolio management in Australia and head of Asia-Pacific credit portfolio management.

Ramin Toloui is an executive vice president in Pimco's Singapore office and global co-head of emerging markets portfolio management.

© Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.

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