PIMCO's Asia-Pac Economic Outlook
Q: What are the economic themes and risk factors in Asia-Pacific currently driving your investment strategies? In particular, what is PIMCO’s view on China?
Masanao: Three key themes underpin our economic outlook for the Asia-Pacific region.
First, we think emerging Asia is among the frontrunners in our multi-speed global economy over both the cyclical horizon and the three- to five-year secular horizon. Focusing on China, PIMCO’s view on the economic outlook has been rather sanguine, as opposed to a more pessimistic hard-landing scenario that some hold in the market. True, there may be some turbulence in China’s growth trajectory and indeed we expect some growth moderation, but overall we believe China can absorb some turbulence: Its starting economic conditions are quite strong, with both private and public sector balance sheets relatively unlevered. Elsewhere in Asia-Pacific, Australia continues to be a direct beneficiary of China’s growth via commodity exports. Japan, a rapidly aging economy, is still struggling to reach sustainable growth due to a completely stretched public sector balance sheet.
Second, policy focus in emerging Asia is unambiguously shifting from downside growth risk to upside inflation risk. US monetary and fiscal policy actions have turned quite reflationary for the short term. The Federal Reserve’s expansion of quantitative easing not only helps to reduce risk of an external demand decline for emerging Asia, but also adds an inflationary pressure, as the output gap has now largely closed there. And in Australia, a policy tightening cycle is already underway as the economy has been faced with a capacity constraint under the resource boom. Japan will likely see improvement in terms of deflation, but only at a gradual pace, as its output gap still remains. Commodity inflation is likely a deflationary factor for Japan, as it deteriorates the terms of trade.
Third, the risk is that policy adjustment in emerging Asia will tilt toward too little tightening, rather than too much. Asia has been resistant to a devaluation of the US dollar in order to stay competitive. But given the increasing risk of inflation, the so-called “policy trilemma” is a reality for Asia, meaning each country can choose only two of these three things: free capital flows, managed foreign exchange rates or independent monetary policy. Each country’s policy choice should take into account both global and domestic economic considerations, yet is likely driven by domestic political considerations. Downside risks to growth in Asia-Pacific also include trade protectionism and geopolitical risks.
Q: What factors will drive policymaking in emerging Asian countries over the cyclical horizon?
Lian: Emerging Asia’s policy focus in 2011 will undoubtedly be centred on inflation management, as weather-related, cost-push factors reinforced demand-pull impetus for higher prices across the region. How each country will respond depends on its initial conditions.
Small and open city-states, such as Hong Kong and Singapore, opt to give up monetary policy independence. Given global easing in the past two years, this creates the “bubble-thy-neighbour” effect, which is felt especially in the housing market. Singapore views currency strength as the most effective tool for controlling imported sources of inflation. Hong Kong adopts a fixed exchange rate system, which acts as a nominal anchor for economic and financial stability.
Elsewhere in the region, there is less cross-border mobility of capital. The authorities exercise greater autonomy on domestic interest rates, and the efforts to rein in prices have been through multiple fronts: hikes in the policy rate and reserve requirement ratio, quantitative tightening on bank credit, as well as administrative controls on prices and exports of essential items. Broadly speaking, Asian policymakers remain wary of the impact of currency appreciation on jobs and growth, although more recently, some have expressed gradual willingness to loosen the grip on the exchange rate, a move we view as the single most effective inflation-fighting tool.
Q: Should investors think beyond the near term and consider the secular challenges emerging Asian economies will face?
Lian: Absolutely. The current attractiveness of emerging Asian assets reflects a rare confluence of regional factors: rapid GDP expansion, broad political stability, an underdeveloped infrastructure and a move toward privatisation. Because of the limited range of financial instruments available to express a constructive view on the region, foreign inflows have tended to be concentrated in the asset markets. While administrative measures can help discourage speculative elements in the short term, a longer-term approach would be to open, widen and deepen the domestic financial markets – and such efforts would require a progressive pace of exchange rate liberalisation. We are encouraged by recent policy steps in this direction in a few countries, notably China.
Against a backdrop of economic uncertainties in the developed world, we think it is important to assess the time frame for emerging Asia’s structural shift toward domestic sources of demand, particularly consumption. While we think household consumption will grow in tandem with gains in GDP per capita, putting in place social safety nets, such as education, healthcare and retirement, is essential in unlocking the true potential of the Asian consumer.
On a separate note, one long-term concern frequently cited by policymakers is the adverse socioeconomic impact of a rapidly aging population. In this regard, emerging Asia can draw lessons from neighbouring Japan.
Q: Where do you currently see value in emerging Asian assets?
Lian: In local markets, we continue to view Asian currencies as offering attractive value, given their fundamental undervaluation. The currencies we favour include the Singapore dollar, the Indian rupee, the Korean won and the Chinese yuan. In external credits, Asian high grade bank debt offers a good avenue to diversify and bolster exposure to emerging markets. We also favour quasi-sovereign issuers that are deepening the underdeveloped utilities sector. In the high yield credit space, we continue to see value in sectors such as infrastructure, commodities and telecommunications, but thorough individual credit analysis is crucial.
Q: Turning to Australia, what is the near-term outlook for the economy and investment opportunities?
Mead: Australia continues to be the so-called economic battleground between the divergent influences of developed and emerging markets. Australia’s initial conditions of fiscal and monetary flexibility, accompanied by a relatively clean banking sector, bore almost no resemblance to those of the majority of developed countries. This comparative advantage has been enhanced over time, especially as the fiscal positions in the developed world are forecast to deteriorate further, while Australia is expected to be better off. As a result, Australia presents more of a credit and currency opportunity than an interest rate opportunity going into 2011. As Tomoya mentioned, at our quarterly Forum we analysed potential policy responses of different countries to the currency trilemma, and we concluded that the only major country in Asia-Pacific to maintain a truly open market approach with no currency intervention nor capital controls was Australia.
The Reserve Bank of Australia (RBA) understands the secular impact of Chinese demand will drive long-term structural change in the Australian economy. The increasingly infrastructure-oriented nature of the Chinese economy and the associated increase in bulk commodity prices has directly benefited Australia via the terms of trade. While the RBA has raised the policy rate seven times since October 2009, they have specifically taken into account the Australian dollar’s strength when setting the policy rate.
PIMCO continues to believe the RBA will raise rates toward 5%, implying a slight tightening bias vs. our New Normal neutral rate expectation, which would be approximately 4.75%. The Australian yield curve is very flat, so nominal bonds remain relatively unattractive for generating carry in portfolios (i.e., there is little to gain currently from rolling down the yield curve).
Q: How should Australian investors be positioning their portfolios?
Mead: Investors should always look to generate real investment returns with manageable levels of risk. Thanks to the RBA’s inflation management credibility that kept the average CPI rate at approximately 2.5% for the past 15 years, Australian investors have the opportunity to earn attractive real returns by investing in Australian credits or global bonds hedged to Australian dollars. Given the market noise surrounding policy responses and macroeconomic divergence, the investment landscape is expected to remain volatile and provide active managers with significant opportunities to target alpha through both top-down and bottom-up approaches. Investing passively in this environment or with too narrow a focus could result in lower return expectations.
To the extent Australian credit is priced at similar levels to some emerging market opportunities, it may represent significant value for investors, especially in primary markets when new issues offer discounts to the prices of comparable bonds in the secondary market. We have already seen significant corporate bond issuance in the initial weeks of 2011, including bonds denominated in Australian dollars, and we expect this trend to continue. Global credit markets remain somewhat inefficient, so many opportunities are available across currency denominations.
As global credit markets have rallied, carefully selected Australian residential mortgage-backed securities (RMBS) continue to stand out as offering potential attractive relative value, especially when considering the majority of Australian RMBS naturally deleverage over time and are self-liquidating as mortgages are paid down. While some claim that Australian housing has become a bubble, investors can expect significant downside risk mitigation against potential house price volatility, as current vintage RMBS securities have increased subordination requirements such as additional excess spread providing a cushion for investors, and older vintage RMBS securities have declining loan-to-value ratios. Recent selling activity from the European investor base has provided an excellent source of secondary market supply.
Q: Let’s shift the focus to Japan. In 2010, Japanese investors purchased record amounts of foreign bonds. How should they be positioning their portfolios this year?
Masanao: Japanese institutional investors bought a tremendous amount of US Treasury bonds, even at 10-year yield levels below 3%, with some investors expressing a view that the US going down a Japan-style deflationary path. At PIMCO, we don’t necessarily agree with that view, so we’re more cautious about duration risk in the US and in developed markets in general. In our view, the US needs balance sheet adjustments in both household and public sectors and therefore is likely to continue to see sub-par growth on average over the secular horizon. However, US economic policy tends to focus on the short term, creating volatility in the US rate markets. Also, structurally, the labour market flexibility in the US allows the corporate sector to adjust labour costs efficiently: reducing employment in a timely manner, and at the same time preventing wages from slipping toward deflation. This helps to maintain expectations for future inflation in the US. Another factor we should note is that emerging Asia’s tightening policy stance should also nudge global real rates upward.
Japanese investors should consider buying foreign bonds as a source of prudent carry, and in the current market they should look for that from spread products rather than from interest rate duration. Foreign spread products may also be attractive as similar opportunities are limited in the Japanese domestic markets.
As for the Japanese government bond (JGB) market, we remain cautious about interest rate risks on the long end of the curve. Though we do not expect significant rises in JGB yields in 2011 (say above 2% on the 10-year maturity), given Japan’s long-term fiscal sustainability risks we see little value in the longer tenor when 30-year JGBs are traded only slightly above 2%. Selling default protection on Japan sovereign debt, on the other hand, remains an attractive return enhancement strategy, either as a substitute to low-yielding short-term JGBs or even outright, given the current premiums on credit default swaps for JGBs and our expectation that a default by the Japanese government is extremely unlikely.