Tea leaves augur an ECB stirring

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 March 2013 and how they influence the firm’s European investment strategy. He also discusses the unique challenges facing the region in the short term given possible shifts in the European Central Bank’s policy, fiscal tightening and rising political risks. 

Q: In view of the recent political developments in Europe’s periphery and a continued ‘muddling through’ scenario, what is Pimco’s outlook for Europe over the next six to 12 months?

A: Our economic outlook for the eurozone is one of recession, with growth in a range of negative 0.75 per cent to negative 1.25 per cent over the next year. Set against Pimco’s wider global forecast, the eurozone stands out as the weakest region and one where we are furthest below the consensus forecast. While we expect the pace of contraction to diminish over the course of the year, the duration of the recession is likely to be longer than consensus forecasts. The ECB’s pledge to be the lender of last resort for eurozone sovereigns prevented a return to the crisis levels and volatility experienced in recent years. But a very weak eurozone economy, political risks and a lack of progress by governments in strengthening European institutions mean that it will continue to be a very bumpy journey. 

Q: Has your outlook for the eurozone changed significantly from earlier forecasts?

A: While our short-term economic forecasts are similar to earlier projections, we are now seeing confirmation in the data on the weakening of the core countries, notably France. 

France provides further evidence that evolving developments in the periphery are starting to drag down the core countries. French forward-looking indicators have been on a steep downward trend. Trade – the traditional channel of cross-border influence – does not provide a clear explanation of what is happening in France. Rather, it looks like French growth is suffering from the effect of the developments in the eurozone on leveraging and credit channels. We think it is likely that ongoing weakness in France will force a shift by the ECB to promote growth and ease overall credit conditions for the eurozone as a whole. We also expect that, more broadly, the weakness in France will reinforce the need for a more balanced approach between growth and austerity across the eurozone. 

While weakness elsewhere means Germany may experience two quarters of negative growth in 2013, stagnation rather than recession is a better description of our economic outlook here. This contrasts with France and the Netherlands, where tighter credit conditions and fiscal policy mean that the recession is likely to be on a similar scale to the eurozone average. 

Looking at Spain and Italy, we expect both countries to continue to experience a deeper recession than the rest of the eurozone. However, the pace of contraction should ease over the course of 2013 as credit conditions improve and the pace of fiscal tightening slows. We continue to see evidence that private capital is returning to Italy and Spain following the ECB’s pledge to be the lender of last resort for eurozone sovereigns. The behaviour of private capital flows (and foreign official capital flows) is one key metric for assessing the overall success or failure of the eurozone’s muddled policy responses to the crisis. Of course, this positive development could be further tested by difficult political challenges in the eurozone. 

Q: With the Italian election behind us, what are the implications from the rise in political uncertainty there?

A: The uncertain outcome of the recent Italian election has reinforced the importance of political risk in assessing the eurozone outlook. The hung parliament and the rise of Beppe Grillo's Five Star Movement mean that it is very unclear how Italy will form a government and how stable any government will be over the longer term. While Italy has a low fiscal deficit and has implemented fiscal reforms, the prospects for any significant structural reforms to increase the economy’s potential growth rate look very limited indeed. 

In our assessment, since it is not in the interests of Italy’s centre-left and centre-right parties to have immediate re-elections, these parties will eventually form a coalition government. Since little agreement on policy exists between the parties, it is likely that such a government would focus almost exclusively on political and institutional reforms. 

Separately, German federal elections scheduled for September 22 reinforce the view that we will see little or no progress in 2013 to develop banking and fiscal unions in the eurozone, controversial areas that German Chancellor Angela Merkel is unlikely to address during an election year. 

Q: Do you anticipate European policymakers to shift away from current fiscal policy?

A: Hampered by economic stagnation, eurozone policymakers have shifted their focus from austerity at all costs to a more balanced approach between the need to reduce fiscal deficits and the impact on economic growth. This can be seen in the willingness of eurozone governments to focus on structural deficits rather than nominal deficits in the case of Portugal and other program countries, which is consistent with the International Monetary Fund’s long-held views and in contrast to the approach taken with Greece. 

Q: What are the implications of the Cyprus bailout and the tax on bank deposits? 

A: In the aftermath of the Greek default, European policymakers stressed that their private sector involvement was a one-off action. That pledge has been broken in Cyprus. Although there will not be haircuts on government and senior bank debt, depositors will suffer a de facto haircut in the form of a tax on bank deposits. The levy, as announced, will apply to all savers and not just those with large savings. 

In Cyprus itself, this raises questions over the ability of the government to pass the measures and over social unrest given that this levy on bank deposits was clearly imposed on the country. But haircutting deposit-holders will make banking systems more vulnerable to runs in other countries, particularly in periods of acute crisis, regardless of whether the Cyprus action is presented as a one-off. More broadly, another instance of private sector involvement raises the risk of further similar actions in other eurozone countries. Although European leaders have stated that Greece was a one-off and similar haircuts will not be repeated in Portugal and other countries, that message has now effectively been undermined. 

Germany’s insistence on private sector involvement in the case of Cyprus also demonstrates the difficulty that the eurozone has in coming up with approaches aimed at promoting eurozone stability given the demands of domestic politics. Bailout fatigue is an important factor in countries trying to make adjustments – here we have a clear demonstration of creditor fatigue. The policymakers may see Cyprus as a small and containable case where they can make a point. But an important precedent has been set nonetheless. 

Q: Given these developments, how do you see ECB monetary policy evolving over the cyclical horizon?

A: We expect the ECB to cut its policy rate (its main refinancing operations rate, currently at 0.75 per cent) by 25 to 50 basis points. The ECB may also consider cutting its deposit rate (currently at zero) into negative territory, although policymakers appear quite reluctant to consider such a move at present, owing to the potential foreseen and unforeseen consequences. 

Rather, we think it is likely that the ECB will be pushed to follow the example of the US Federal Reserve and the Bank of England, shifting its policy from one of funding to one of buying assets outright. This is most likely to take the form of buying private sector assets (such as credit, covered bonds, asset-backed securities and potentially bank loans) rather than government bonds – at least in the first instance – owing to political controversies within the eurozone and in Germany over the latter practice. If the ECB does move towards credit easing/quantitative easing, it is likely to be a slow-moving process, owing to the need to create a policy consensus, including a demonstration of ongoing weakness in core countries. The ECB cannot promote better growth outcomes and needed medium-term stability for the eurozone all by itself. But it does have the potential to ease credit conditions in the eurozone and to attempt to overcome the broken transmission of monetary policy that has led to very wide divergences in private credit conditions across countries. 

However, such a policy shift by the ECB could be complicated if a country in the eurozone applies for support under its emergency Outright Monetary Transactions program, as such a request could ignite political tensions over the ECB role as a lender of last resort – again notably in a German election year. 

Q: Looking ahead, how will Pimco’s cyclical outlook influence your investment strategies over the near- to medium-term horizon?

A: We expect core government yields – including Germany and the UK – to remain range-bound over the cyclical outlook. 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. The prospect of banks repaying ECB borrowing means that there is little scope for front-end rates to fall very much, even with ECB rate cuts. We do not expect yields on the front end and belly of the curve to rise significantly. 

We remain neutral to overweight on Italian and Spanish credit spreads. This reflects the impact of the ECB in reducing the risk of significantly adverse outcomes over the cyclical period and the better relative value of Italian and Spanish sovereign bonds versus other sources of credit risk. We continue to target our exposure on Italy and Spain in the front end, under and extending a bit beyond the potential ECB bond-buying umbrella of one- to three-year sovereign bonds, and to take a cautious approach, scaling our Italy and Spain positions as credit risk, reflecting the extent of execution risk and political uncertainty in building a more stable eurozone. This caution is reinforced by the imposition of private sector involvement in Cyprus. As before, we continue to avoid the smaller eurozone peripheral countries where we see the level of risk as high compared with the level of spreads. 

In our foreign exchange strategy, we are underweight the ‘printers’ – currencies where central banks are aggressively using their balance sheets to buy assets versus high-quality currencies where central banks are less activist. The Japanese yen has therefore joined the British pound as a preferred currency underweight. We continue to like currencies of high-quality emerging market countries, including the Mexican peso, the Brazilian real and the Russian ruble, which offer attractive yields and are backed by clean balance sheets. 

We are broadly neutral on the euro. The ECB has thus far been the most conservative, least expansive major central bank when it comes to asset purchases. The euro has therefore been a shock absorber in the context of the global ‘currency war’. The eurozone economy, however, is very poorly positioned to be a global shock absorber and, over time, we expect markets to anticipate a more activist ECB.

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Andrew Balls leads Pimco's European investment team .  © Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved.