Europe's great growth unknown

The ECB's new role as a 'last-resort' lender has helped stabilise the eurozone, but the real question for the year ahead will be whether the region can begin to generate substantial growth.

Pimco

In the following interview, Andrew Balls, managing director and head of European portfolio management, highlights the conclusions from PIMCO’s quarterly Cyclical Forum in December 2012 and how they influence the firm’s European investment strategy and the unique challenges of forecasting the coming months given the European Central Bank’s policy actions and pessimistic outlook for the eurozone in 2013.

Question: What is PIMCO’s near-term economic outlook for Europe?

Andrew Balls: Looking ahead, we see ongoing recession in the eurozone and stagnation in the UK. We expect the eurozone economy to contract by 1 per cent to 1.5 per cent over the next four quarters – well below the consensus – driven by a deep recession and hampered by attempts at fiscal retrenchment in the periphery. The growth outlook has also weakened, though not as dramatically, in Germany and the other core countries. We expect a milder recession in Germany and France over the next four quarters. There is no significant driver of domestic demand growth in the eurozone and, at a time of slower global growth, little chance that overseas demand will help to pull the eurozone out of its malaise.

We have seen significant normalisation of eurozone financial markets owing to the ECB’s Outright Monetary Transactions programme, signalling that it will be a lender of last resort to eurozone governments. Yet, these actions and the ECB’s broader funding efforts, while they have helped to avoid a collapse, have been insufficient to promote decent growth.

In the UK, expect the economy to be flattish over the period, owing to the impact of fiscal tightening and the weakness of the UK’s biggest trade partners. As in the eurozone, monetary policy intervention has helped to prevent a deeper decline but has done little to promote better positive growth outcomes.

Q: Do you see European policymakers retreating on fiscal austerity over the cyclical horizon? How have key risks faced by the eurozone evolved?

AB: European austerity will continue. The good news is that eurozone governments, in terms of their own policies and the demands of the Troika (European Commission, ECB and International Monetary Fund) for adjustment in peripheral countries, are taking a more realistic approach, focusing on structural rather than cyclical deficits and setting more realistic timetables for fiscal adjustment in the face of significant growth challenges. Across a number of countries, we have seen an acceptance of higher cyclical deficits in 2012 budgets rather than demands to increase fiscal adjustment further to offset the shortfalls that are themselves the result of a lack of growth. This has been explicit in the case of the countries on Troika programmes. Across the board, fiscal adjustment targets for 2013 remain overly ambitious, but we expect that the more pragmatic approach will prevail again in the coming year. Fiscal austerity will continue to be a drag on growth, but with diminishing drag. 

Q: Have the ECB’s European Stability Mechanism and OMT programmes stabilised yields in the periphery?

AB: The ECB’s acceptance this year of its role as lender of last resort for eurozone sovereigns was a very important step forward, one that has helped to eliminate the tail risk of imminent eurozone collapse and led to a broad normalisation of financial conditions. Default risk is significantly reduced over the next 12 to 24 months. Still, there is a fundamental question of whether Italy and Spain have their own central bank and borrow in their own currencies – like the US, the UK, Japan and others – or whether they borrow in a foreign currency akin to an emerging market country borrowing in US dollars.

While we see significant questions over the effectiveness of further central bank balance sheet policy in the US and the UK, the question in Europe is more over the ECB’s willingness to intervene and coordinate political challenges. Like other central banks, the ECB does not want to be the only policymaker to take actions to promote stability and growth. Rather, the ECB is essentially offering to buy time for the fiscal authorities – eurozone governments individually and collectively – to get their acts together.

Although the ECB has clipped the tail risk of a downward-spiraling vicious circle, it is unclear how it will act. As with some creditor governments, the central bank wants to tread a fine line between promoting stabilisation and requiring market discipline to maintain pressure on Spain, Italy and others to adjust. Questions remain about the conditionality the ECB will insist upon and about how effective a lender of last resort it will choose to be. Spain has not yet applied for ECB support, in part reflecting improved market conditions, domestic political considerations and the lack of clarity over what the ECB intends to do. Having tightened over the summer, Spanish yields have been broadly stable since the start of September. It is likely, given Spain’s supply needs in 2013 that the country will have to request support during the first half of the year.

Likewise, Italy has had fairly stable yields over the past two months. However, the start of the Italian election campaign promises to test that stability. Our baseline expectation is for a centre-left coalition in Italy to maintain the broad approach taken by Italian Prime Minister Mario Monti’s government and which may indeed see Monti or other ministers remaining in office. The uncertainty over the election outcome may test the sustainability of the relative period of calm that the ECB’s pledge of intervention has provided. It may also increase the pressure on Spain to formally request ECB support.

Q: Are positive developments sustainable?

AB: Although the ECB has been unable or unwilling to provide much clarity on how it would intervene in the event that the OMT is enacted, it seems likely that the central bank will be able to promote stability over the next 12 to 24 months. To provide longer-term stability will require actions on the part of the fiscal authorities, including: a better balance between needed fiscal austerity and growth; progress toward a true banking union; and progress toward a closer fiscal union. Eurozone leaders have laid out a long-term roadmap toward those goals, but there is great execution risk in technical, political and cross-border coordination challenges.

Together with the significant challenges of achieving decent medium-term growth, the secular outlook for the eurozone remains very difficult. The ECB can buy time, but it cannot by itself achieve the outcomes of a more stable and prosperous eurozone. We see the survival of the eurozone as depending on the big four countries – Germany, France, Italy and Spain – sticking together and, with the support of the ECB, forging a more stable currency union.

Q: With eurozone inflation expected to decline and the European Central Bank issuing a bleak outlook for the eurozone, do you anticipate further rate cuts?

AB: It is likely that the ECB will deliver cuts to its main refinancing rate, currently at 0.75 per cent, although it is unclear whether it will cut the deposit rate, currently at zero, into negative territory. We don’t anticipate that such action on the main refinancing rate will have any significant impact on the eurozone economy although it may preface, over time, a shift by the ECB to implement quantitative easing (QE) as we see in other countries. As with the OMT, it is likely that the ECB has significant policy effectiveness if it does decide to implement QE. However, this is again fraught with political and coordination challenges.

Q: How will PIMCO’s cyclical outlook shape your European and global investment strategies over the near-to medium-term horizon?

AB: Our investment strategy for the eurozone remains very similar to the approach we set out following our last Cyclical Forum in September.

The level of core government yields – including Germany and the UK – leaves little room for further capital appreciation, except in the event of renewed systemic pressures in the eurozone. At a time when central banks are attempting to peg the front ends of yield curves, we see the potential for earning relatively stable income from rolling down the steep end of the curve, favouring the intermediate parts of the yield curve and underweighting the long ends.

We remain neutral to overweight on Italy and Spain, after a long period in which we were previously underweight European peripheral risk. This reflects the impact of the ECB in reducing the risk of significantly adverse outcomes over the cyclical period and the relative value that Italian and Spanish sovereign bonds, as well as select private sector credit opportunities, offer versus European and global credit alternatives.

While we have targeted our exposure on Italy and Spain under the ECB’s potential bond-buying umbrella of one- to three-year sovereign bonds, we have extended a bit beyond that in an effort to garner the carry on the yield curve. We continue to take a cautious approach, scaling our Italy and Spain positions as credit risk, and reflecting the extent of execution risk surrounding the plans of the ECB and eurozone governments in building a more stable union. We will continue to monitor the process very closely and adjust portfolios accordingly.

More broadly, global credit spreads have exhibited a compressed range to the risks and the weaker growth we forecast, including eurozone industrials and financials. We continue to take a very cautious approach and be underweight in European credit risk and European financials in general, looking for specific opportunities rather than broad exposure. For corporate exposures, we will continue to look for better global alternatives. In equities, while there is certainly a lot of scope for bottom-up stock selection in European markets, including companies domiciled in Europe that have good exposure to growth in emerging market countries, overall we are taking a cautious approach and see better value in emerging market equities compared with developed country stock markets.
 
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Andrew Balls is managing director and head of European portfolio management at PIMCO.