- The eurozone may be nearing a critical junction, owing to its weak growth, weak institutions, debt dynamics and domestic and cross-border political challenges.
- The German government may take a more active leadership role after its national election, but it is more likely it will continue with piecemeal measures.
- Considering the current low yield environment and ample central bank liquidity, it is important to focus on absolute yield levels and returns, and consider global alternatives such as emerging market securities and currency exposure.
Developments in Europe are making global headlines every day. Taking a step back, head of European portfolio management Andrew Balls assesses the long-term outlook for the world’s largest economic zone, focusing on how political, fiscal and monetary structures may change and shape secular developments in Europe.
Q: As the European Central Bank and European policymakers struggle with the widening contagion, what do we see as the key potential developments in the eurozone over the secular (three- to five-year) horizon?
Balls:In contrast to greater healing in the U.S. and stronger growth in emerging markets, we expect growth in the eurozone to be very weak over the secular horizon. Mired in recession, regional growth will not likely exceed 0.5% per year on average over the coming secular period, with somewhat better outcomes in the core and worse outcomes in the periphery. Our secular baseline is for an ongoing muddling through – or “zombification” of the eurozone’s economies and institutions – rather than collapse. However, weak growth means that political and social tensions will continue to build.
Globally, we have referred to a situation of “stable disequilibrium” and the prospect of “T-junctions” where economies and regions tip into right tail or left tail outcomes. (PIMCO’sSecular Outlook, by Mohamed A. El-Erian, discusses both these concepts in depth.) We believe that the eurozone is closest to a T-junction, owing to its weak growth, weak institutions, debt dynamics and domestic and cross-border political challenges.
Although the eurozone has achieved relative stability since the European Central Bank (ECB) pledged to be a lender of last resort, little progress has been made by national governments toward a real banking union (including a common resolution authority and cross-border deposit insurance) and a closer fiscal union. We expect that progress will continue to be slow and reactive to market pressure, not pre-emptive. While any plans for a full fiscal union and common Eurobonds may lie beyond our secular horizon, there is the potential for some greater mutualisation of risks between fiscal authorities.
At the same time, we expect the ECB to have to use its balance sheet to buy more assets as its focus turns more to macroeconomic management rather than crisis management, with growth weak in the core countries and the presence of significant disinflationary forces. The ECB, however, is likely to swing between periods of “whatever it takes” activism and periods of refusal to act.
Political events throughout Europe will play an important role in the eurozone’s secular outlook. One question in national elections, and also next year’s European parliament elections, is to what extent a rise in populist parties will shape the coming political landscape. Italy’s political system is a clear example of the danger of political fragmentation, while Spain’s extreme levels of unemployment underline the political and social challenges to European stability and the huge costs of ongoing muddling through.
Q: Faced with a choice between a full or partial breakup or a full political and fiscal union, what viable and sustainable options does PIMCO see for the eurozone?
Balls: We think it is most likely that the eurozone’s big four countries – Germany, France, Italy and Spain – maintain their monetary union and bind themselves into a more comprehensive banking union and closer fiscal union. However, it is not clear that all smaller countries will be either welcome or willing to take part: There remains a significant risk that some of these countries may exit the eurozone or, if they remain in, do so with second-tier status and not as part of a more integrated core group.
In addition to a banking union and closer fiscal union, eurozone countries, especially in the periphery, need a better balance between the demands of austerity and structural reforms to promote growth. Without growth, countries with relatively better debt dynamics will deteriorate while countries with relatively weaker debt dynamics will be unable to restore stability other than as semi-permanent wards of the court surviving with external support.
Given our outlook for very weak secular growth, we believe that stressed non-systemic countries and banks across the eurozone will likely face significant risk of possible future haircuts. More recently, Cyprus has demonstrated that almost all options are on the table, including domestic burden sharing in the form of haircuts for bank depositors, to make such an approach acceptable to core country taxpayers.
The further we move away from the most acute phase of the crisis and the longer the period of weak growth continues, the greater the potential for governments and external creditors to focus on eliminating the debt overhangs that are inhibiting growth.
Q: How do you expect Germany’s current role in the eurozone to evolve and how can it contribute to a more stable eurozone?
Balls: Part of the reason that there has been such limited progress in building stronger eurozone institutions has been Germany’s reluctance to countenance any big developments in an election year. While such reluctance may continue, it is also possible that, with the September 2013 elections out of the way and perhaps a grand coalition in place, Germany will take a more constructive approach. That said, we believe it is more likely that Germany will continue with piecemeal measures owing to the demands of its domestic politics.
Overall, we expect eurozone countries as a group will continue to struggle rather than meet system-wide challenges with coherent system-wide responses owing to overall reluctance to mutualise risks. At the same time, Germany, which is worried about its own medium-term demographics and related budget pressures, is unlikely to make significant efforts to promote stronger domestic-led growth.
Amid a weak eurozone outlook, it is, however, likely that the German government will be more supportive of the ECB using its balance sheet to promote growth and ease the burden of adjustment. While the ECB is likely to be significantly less tolerant of inflation than its U.S. or UK counterparts, we believe that somewhat higher inflation will be accepted in Germany as part of the process of adjusting eurozone imbalances.
Q: What are the key secular investment themes for European portfolios?
Balls: We will maintain a cautious approach to investing in the eurozone, reflecting the weak fundamentals, very real secular challenges and need to protect against the risk of haircuts over time.
Eurozone assets have rallied significantly, encouraged not only by ECB action but also owing to the wave of global central bank liquidity and the resultant reach for yield on the part of European and global investors. In such an environment, it is very important to focus on absolute yield levels and absolute returns, not just spreads and relative returns.
We will aim to hedge the risk of haircuts in the case of sovereigns and private sector assets as well as the potential expansion of assets subject to bail-ins in the event of continued weak secular growth. In turn, we will continue to avoid smaller, less systemic eurozone sovereigns that we believe offer poor risk/reward, and target Italy and Spain, which we expect will avoid sovereign haircuts. But the level of yields does not provide very attractive compensation for the risk and volatility in what we expect to be a bumpy journey.
With few exceptions, eurozone bank debt looks expensive and, more broadly, industrial credit offers only skimpy risk premia for the most part. While bottom-up analysis may uncover opportunities for security selection, we will continue to look to add strong global alternatives in European portfolios, including emerging market securities and currency exposure. Given the weak growth outlook and the prospect of greater ECB intervention over time, we anticipate the eurozone to depreciate, particularly versus stronger-growing emerging market countries.
In that context, we will continue to speak to clients about the benefits of forward-looking guidelines that permit such positions in eurozone portfolios, and forward-looking global benchmarks.
All investments contain risk and may lose value. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2013, PIMCO.
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