From the periphery to the core, it's a slow-grow eurozone

Pimco

Although the eurozone is emerging from recession, the region faces a very weak growth outlook. We forecast slightly positive real (inflation-adjusted) growth in a range of 0 per cent to 0.5 per cent over the coming year. We expect inflation of about 1 per cent. That policymakers and investors would regard such an outlook as cause for celebration is quite telling of how low expectations have been set.

At the country level, France and Germany will have positive but below trend growth, while Italy, Netherlands and Spain will have flat or barely positive growth. Greece and Portugal will continue to contract. The high level of nominal interest rates in Italy and Spain, when compared with those in the core or with those countries’ nominal growth outlooks, are not conducive to healthy growth. Progress has been limited on structural reform to promote better medium-term growth outcomes.

There are both upside and downside risks to Europe’s weak cyclical outlook. A key source of upside risk is linked to the very low level of overall economic activity (real GDP is still around 3 per cent below the pre-Lehman peak). Reduced macro uncertainty could therefore trigger a stronger than expected release in pent-up and catch-up growth. The biggest source of downside risk is a worsening of the credit crunch in the periphery as policymakers fail to successfully respond to the tight credit environment and persistent market fragmentation.

Risks to inflation also appear balanced around our forecast. The large negative output gap and the efforts at internal devaluation in the periphery could lead prices to decelerate more quickly. Commodity prices and a potential depreciation of the euro are key sources of upside risk.

The impact of fiscal and monetary policy on growth

 Less austerity means that fiscal policy will be less of a drag on growth, with overall eurozone fiscal tightening coming down from a drag of about 1.25 per cent in 2013 to about 0.75 per cent in 2014. The European Central Bank’s continued pledge to be a lender of last resort has led to greater stability in eurozone financial markets and a partial reversal of the capital flight of recent years. This has been evident in the reduction in ECB TARGET2 balances (cross-border inter-bank payments within the central bank system). Italy and Spain lost around 15 per cent and 35 per cent of GDP worth of private capital respectively from mid-2011 to the autumn of 2012. Following the ECB’s Outright Monetary Transactions announcement, both countries have regained about a third of the prior loss.

Yet the ongoing negative fiscal impulse and the relative tightness of monetary policy at the eurozone level means that the region is still struggling to get back to potential growth rates. Household income growth is weak across much of the region as companies and countries struggle to restore competiveness.

There is little scope for eurozone governments — and seemingly the ECB — to respond to large unforeseen market shocks. Monetary policy could be a source of upside risk were the ECB to use its balance sheet more aggressively to try to drive down the cost of borrowing in Italy and Spain. For now, such an approach does not look to be on the table. The ECB’s role looks likely to be limited to introducing another longer-term refinancing operation in the event that liquidity conditions tighten excessively.

Tail risks for the eurozone

On a cyclical basis, we expect the ECB pledge to be a lender of last resort to countries with market access that need support to continue to clip the tail risk of a downward spiral. Indeed, it is notable that Italy and Spain sovereign bond spreads behaved well during the period of US Federal Reserve-induced volatility over the summer, a significant stress test and a period in which emerging markets suffered far greater liquidity withdrawal and volatility.

More recently, the German election results — while leaving uncertainty over the precise nature of the final coalition arrangement — suggest continuity in an Angela Merkel-led government.

We do not expect any great changes in Germany’s strategy for dealing with eurozone governance issues. With the German election now out of the way, there is a list of matters that eurozone policymakers need to address, which are potential sources of volatility. This includes the Economic Adjustment Programme reviews for Greece and Portugal, negotiating the end of the Irish programme and, in spring next year, the scheduled end of Portugal’s current programme and the likelihood that Portugal will need to negotiate a second round of funding. In addition, the ECB is embarking on its Asset Quality Review of eurozone banks with a target date for completion towards the middle of 2014 — another source of event risk. Finally, Italian politics continues to be a source of vulnerability.

The ECB should be able to maintain stability over the cyclical horizon. Questions over the long-term stability of the eurozone remain as governments face the challenge of building a less vulnerable monetary union, including the need for a real and closer banking union. Given the lack of common analysis among eurozone governments (and within the ECB) on the eurozone’s underlying problems, it is little surprise that there is little agreement as yet on common plans to build greater and lasting stability.

Fundamentally, the outlook for regional growth on a secular basis remains very weak. Growth engines in a number of European peripheral countries look broken and there is little prospect of Germany shifting decisively from its reliance on export-led growth to becoming a source of domestic demand-led growth.

The hope appears to be that the eurozone as a whole will benefit from stronger global growth. Yet the eurozone as a whole, like the US, is largely quite a closed economy. Without healthy growth, eurozone debt dynamics will continue to be a source of significant financial risk. Unemployment is stabilising, but at such high levels in a number of countries that there are important secular risks to political stability. Given debt overhang problems, and a greater focus on burden sharing as evidenced by Cyprus and plans on banking sector bail-ins, the prospect of haircuts remains a source of secular risk.

Outlook for the UK

We expect the UK economy to grow by 1.5 per cent to 2 per cent over the coming year, stronger than the eurozone but continuing to lag the US recovery, where we expect growth in a 2 per cent to 2.5 per cent range. Likewise, we expect inflation in the range of 2 per cent to 2.5 per cent over the cyclical horizon, with overall nominal growth at about 4 per cent.

While that would be an improvement on the weak performance of the past few years, the UK economy continues to languish at a level of about 3 per cent below its peak in 2008 (adjusting for inflation). Real income growth is set to remain subdued, preventing a stronger cyclical bounce in economic growth. Fiscal policy continues to be a constraint on better growth outcomes.

On the upside, the stabilisation of the eurozone has led to a boost in business confidence that may in turn feed into somewhat better investment spending. Yet, rather than stronger growth and investment, the bright spot in the UK outlook has been higher house prices and the potential for this to feed into stronger consumer spending in spite of weak income growth.

Over the cyclical outlook, we do not expect very much from the Bank of England. The BoE has stopped quantitative guidance and, under its new governor Mark Carney, has placed emphasis instead on forward guidance. This has not proven very successful, with short-term rates higher now than they were in July this year when the BoE said in an unusual statement that rising market rates were “not warranted” by the state of the domestic economy.

Part of the issue is the design and robustness of forward guidance and part of it may reflect different views on the committee itself on the logic and efficacy of forward guidance. Rather than push aggressively against market expectations, the BoE has now settled for emphasising that it expects policy rates to remain on hold at current historical lows until mid-2016 given the subdued growth outlook and spare capacity in the economy. In the event of significantly worse macro outcomes in the UK, it is possible that the BoE’s Monetary Policy Committee would re-engage with quantitative easing. However, that seems unlikely for now.

Investment strategies over the medium-term

Given our below consensus growth forecasts for the eurozone and expectations that the ECB and the BoE will keep policy rates on hold for the next few years, we continue to emphasise the front end of the core eurozone and UK curves to maximise carry and roll-down on the curve. We see this as a more attractive and better-anchored source of return than the long end of the curve, in particular the structurally expensive core eurozone long-end. There are also good opportunities for selling volatility in segments of the European rates markets. We plan to emphasise the income we can generate from curve steepeners and volatility sales over duration extension.

We are broadly neutral on our positioning in Italy and Spain, balancing the cyclical outlook, in which we expect the ECB to maintain stability, with longer-term secular concerns on the eurozone outlook and valuations. We continue to emphasize carry from owning the front end of these curves, rather than taking greater spread risk in long-dated securities.

Core eurozone credit looks expensive versus the US credit market; peripheral corporate credit looks expensive versus those countries’ respective sovereign curves, adjusting for liquidity. At current valuations, we favour being underweight eurozone credit in our generalist portfolios, emphasising the US and other global credit alternatives.

That said, while remaining underweight the eurozone corporate credit beta, we will emphasise security selection, looking for pockets of value across the eurozone capital structure.

Andrew Balls is a managing director at Pimco. © Pacific Investment Management Company LLC. Republished with permission. All rights reserved.