December 26, 2009PIMCO Managing Director Paul McCulley leads the firm’s quarterly Cyclical Economic Forums, in which investment professionals from around the world gather to discuss the outlook for the global economy and financial markets over the next six to 12 months. In the following interview, Mr. McCulley discusses the results of the December Forum and its implications for PIMCO’s investment strategy in 2010. Q: PIMCO recently developed its outlook for 2010. What are the general conclusions? McCulley: The global economic recovery underway will likely be very much de-synchronized, borne of heterogeneous initial conditions on display prior to the recession, with a full range of possible outcomes. In the developed world, we had double bubbles in property and credit creation. Much of the developing world, in contrast, had already gone through its “baptism by fire” a decade ago and actually had incredibly sound balance sheets in the public and private sector as a starting point. In addition to these differing initial conditions, there is still uncertainty over three major issues, which in turn creates a range of possible outcomes in our forecast. Depending on how these issues progress, we’re looking at multiple potential resolutions of the inherent tension in the overall system. There will likely be some bipolar market outcomes. Q: Can you talk more about those three major issues? McCulley: The first issue is the peg between the Chinese yuan and the U.S. dollar, which essentially gives us a one-size-fits-all monetary policy in a very differentiated world. Progress, or lack of progress, on this issue could lead to several outcomes. If China were to let its currency appreciate, it could regain a degree of monetary policy autonomy and a better ability to manage the risk of overheating and asset price inflation. Another outcome, however, is that China refuses to let the yuan appreciate, essentially maintaining too easy of a monetary policy for itself and the developing countries that shadow Chinese policies. This would create bubble risk, particularly for assets such as emerging market (EM) equities and commodities. The second major uncertainty is what will happen when the Fed completes its mortgage-backed securities (MBS) buying programs. We know that it will have an unfriendly effect on the interest rate markets, but we don’t know the magnitude, because it’s too hard to isolate the supply and demand dynamics between fundamentals and the stimulus programs. The key variables are the “stock” effect, or the lingering price impact of the amount of duration taken out of the marketplace, and the “flow” effect, which is the price impact when the Fed stops buying. They’ll keep the stock, but they’re just not going to be part of the flow any more. The third uncertainty is any change in the Fed’s pre-commitment language, which is currently committed to keeping the fed funds rate exceptionally low for an “extended period.” We don’t think the Fed is going to tighten any time in 2010, but long before the FOMC (Federal Open Market Committee) actually does the deed, it will have to change its language. That could very well happen in 2010, and there is genuine uncertainty over how quickly and strongly the market will anticipate a tightening process. Our gut feeling is that the moment the Fed changes any one of its words, it’s going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination. The most important book at the Fed right now is a thesaurus, and it’s probably sitting on top of Paul Samuelson’s Foundations of Economic Analysis. Q: Will U.S. fiscal policy play a role in determining the economic and financial outcomes? McCulley: We don’t think the U.S. is going to get a new stimulus package, but there will be a hodgepodge of things that fit the description. In fact, that’s one of the reasons that the Treasury has been pushing so hard for the banks to pay back Troubled Asset Relief Program (TARP) money, because the president plans to ask to Congress to move TARP money into Cash for Caulkers and other job stimulus measures. So we will get fiscal stimulus, but it will not be as big or explicit as what we’ve had so far. The big unknown gets back to what we’ve already discussed: We’re probably going to have a $1.4 trillion deficit this year without the Fed on the buy side of the market for duration. There is major uncertainty about how the supply/demand equation for duration will resolve itself when the Fed is out of the picture. Q: With all these uncertainties, what is PIMCO’s global economic outlook for 2010? McCulley: Cyclical turning points in the context of secular turning points are devilishly difficult to handicap. It was actually easier to make economic forecasts nine to 12 months ago than it is now. Back then, when the global financial system and economy were caught in the throes of the moral equivalent of a life-threatening cardiac arrest, key questions were simple: Would policymakers go “all-in” with their balance sheets, and would those efforts restore private sector risk appetite? The answers have been yes and yes. But with the yes-yes answers now in, forecasting is much more difficult as markets navigate improved cyclical conditions within the framework of a New Normal secular outlook. Bottom line is that we have a very real possibility of a wide range of economic outcomes in the new year, and it’s a dangerous game to maintain a religious devotion to any one in particular. We need to weigh potential outcomes not only from a fundamental economic perspective, but from a behavioral economic perspective that evokes Keynes’s beauty contest. That said, we do have forecast numbers that generally capture the spirit of our discussions: sturdy growth in the emerging markets space, even if less than the Old Normal, and slower growth in the developed countries. Inflation, meanwhile, will probably be too low in the developed world because of still-huge output gaps. What the forecasts can’t tell, however, is that asset price inflation – including commodities – is becoming a more important dimension in our forecast because it’s becoming a more influential component of central banks’ reactions around the world.
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