PIMCO Cyclical Outlook: At Policy Crossroads
By Saumil Parikh
December 11, 2012
- The maturation of the global cyclical growth phase suggests we look to a handoff to more secular drivers of growth. But strong secular drivers remain elusive due to the continuation of New Normal headwinds.
- Policies are at important crossroads in every major economy. Developed countries are struggling to find the right fiscal and monetary policy mix between cyclical stimulus and secular normality, while developing economies’ export-led models face a multitude of pressures.
- 2013 will be the year of policy change, with policymakers in major economies challenged to enact structural changes that spur private sector growth before government-balance-sheet-led growth is exhausted.
The global economy is in the midst of a cyclical slowdown. The slowdown – visible in real growth and inflation across all major economies – is driven in part by economics and in part by politics.
On the economics front, the cyclical tailwinds from global inventory replenishment and post-crisis productivity gains are behind us. This is most evident in slowing corporate profit growth, flatlining commodity prices, and declining capital expenditures and industrial production in recent months. Global trade volumes, one of the best indicators of where we are in the business cycle, have also stagnated recently.
On the policy front, we are at important crossroads in every major economy. Broadly speaking, developed countries (the U.S., Europe and Japan) are struggling to find the right fiscal and monetary policy mix between cyclical stimulus and secular normality. The persistence of imbalances, defined by too little investment and too much consumption, combined with growing maldistribution of income, is making this task infinitely more complicated for political institutions that have not needed to make structural policy decisions before.
Still in terms of policy, developing economies are not faring much better. Export-led growth models are increasingly under pressure from domestic overinvestment, rising idle capacity, diminishing productivity and cost increases that are inevitably caused by importing overstimulative monetary policies via rigid capital accounts.
The maturation of the global cyclical growth phase suggests we look to a handoff to more secular drivers of growth. But, with the exception of residential investment in the U.S., labor productivity improvements in select European countries, consumption growth in some developing economies and fringe improvements in global energy production, strong secular drivers remain elusive due to the continuation of New Normal headwinds from overindebtedness, imbalances, reregulation, and deglobalization.
Global indebtedness continues to rise amid higher global imbalances. Developed countries, in general, continue to rely on consumption growth driven by ultra-loose fiscal and monetary policies, which transfer debt from private balance sheets to public balance sheets, endangering future economic growth to deliver outcomes today. Meanwhile, developing countries continue to rely on investment growth driven by mercantilist capital account policies that promote market share gains above productivity increases, which are increasingly being financed by credit rather than cash flow.
Global regulations are also on the rise. Financial regulations act as a headwind against renormalizing credit channels, but are necessary for preventing future systemic shocks. Capital account regulations remain very high, with developing countries increasingly resorting to new forms of controls to combat ultra-loose monetary policies from developed country central banks. Environmental regulations, while not a headwind to cyclical growth thus far, are likely to become a reality in the not-so-distant future.
Deglobalization is starting to enter the equation as well. Domestic maldistribution is leading politics away from global coordination and toward domestic agendas. Combined with increased transportation costs, the trend of public and private policies to slow globalization is hurting global trade growth, one of the key contributors to economic growth over the past cyclical and secular periods.
At our recently concluded December Cyclical Economic Forum, PIMCO’s regional portfolio committees led by Josh Thimons (Americas), Ramin Toloui (Asia-Pacific) and Lorenzo Pagani (EMEA) presented on cyclical topics that included the outlook for U.S. housing, the likely resolution of the U.S. “fiscal cliff,” China’s leadership transition and policy implications, Japan’s turn to nationalism and the next steps toward European financial and political integration, all of which are discussed below in the context of our cyclical economic forecast for 2013: a year of policy crossroads.
In the United States, 2013 will bring a policy mix of untimely fiscal tightening and increasingly ineffective monetary easing, amid a mixed but relatively stable economic outlook. We expect residential investment will be the dominant driver of domestic demand in the U.S. economy, growing by 20%–30% on the year and contributing a respectable 0.5%–0.75% to U.S. growth improvement. Home prices are expected to keep up with inflation. Against this, the U.S. economy will be buffeted by a weak external environment for exports and an uncertain environment for capital spending as secular fiscal policy uncertainty is unlikely to be resolved in a meaningful manner over the cyclical horizon. While we expect the “fiscal cliff” issue to be behind us (resulting in a 1.25% to 1.75% drag on GDP) by the time we reconvene for the March Cyclical Economic Forum, we continue to believe that most of the difficult decisions regarding long-run fiscal uncertainties will remain unresolved during 2013. We expect the U.S. economy to grow between 1.25% and 1.75% in 2013, below the 2% growth rate achieved in 2012.
In Europe, the European Central Bank (ECB) will continue to be the only active policy institution. In 2012, the ECB made an important policy decision of conditional, but unlimited, balance sheet expansion to clip the left tail risk of disorderly deleveraging, but it has yet to address the declining outlook for European growth during 2013. Europe does not have an active growth policy for 2013. Fiscal austerity, while likely to be less severe in 2013, will continue to be a drag on growth. Private credit rationing and bank deleveraging will remain a reality, and labor productivity increases are not yet large or disperse enough to generate private investment growth to counter public spending cuts. We expect the eurozone economy to shrink between 1% and 1.5% in 2013.
In China, 2013 will challenge the new political leadership with a weak external demand environment, diminishing returns on domestic investment and the urgent need for a more balanced growth model. While 6.5% to 7.5% growth is likely to be achieved over the year in China, the prospect of realizing the 7.5% secular growth target beyond 2013 will hinge importantly on structural changes being executed in a timely fashion from this year onward. We will be looking for policies that strengthen the household sector balance sheet, giving security to an aging population planning for retirement. We will also look for the development of a domestic service sector, including financial and credit services that allow for the smooth disintermediation of high domestic savings across the private sector to facilitate more consumption and more productive investment to boost domestic demand. It is clear, from our discussions, that China cannot sustain its current growth model for more than a few years. Domestic leverage is on the rise, and productivity is on the decline.
Japan’s economy in 2013 will perhaps see more interesting developments than it has for several years. The rise of political nationalism in the aftermath of a devastating economic shock from 2011’s Tohoku earthquake and tsunami promises to alter the policy landscape in a meaningful way. First, we expect a more dovish and active Bank of Japan in 2013, driven by a prospective leadership change in that direction. Struggling to combat currency appreciation with deflation expectations firmly entrenched, the Bank is likely to adopt more aggressive balance sheet policies to try to raise inflation expectations in Japan, not unlike what the Federal Reserve, the Bank of England and the ECB are attempting to do. Second, we expect a new government that is more focused on domestic growth and stability issues, in particular accelerating the rebuilding efforts, shoring up domestic energy security and potentially remilitarizing the country gradually against a rising regional power in China. Japan’s monetary and fiscal policy outlook suggests a year of positive growth in 2013, with a PIMCO forecast of 0.5% to 1.0% growth.
2013 will be the year of policy change. Global policymakers will face both domestic and international pressures to enact structural changes across all the major economies we cover. At stake is the continuation of current growth trends, and the successful handoff of public-policy-driven growth to private sector growth prior to the exhaustion of balance sheets that have supported the global economy through this New Normal recovery from crisis.
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