In late October, the five members of PIMCO’s Global Advisory Board, a team of world-renowned macroeconomic thinkers and former policymakers, met to discuss critical and evolving factors influencing the global economy and markets. Their insights constitute a valuable input into PIMCO’s investment process. The discussion below is distilled from their far-ranging conversation.
Q: It’s a period of political uncertainty. How will political developments affect trade and globalization?
A: In the U.S., much depends on the new president and Congress. (Although the Global Advisory Board meeting occurred before the election, we analyzed implications of both a Clinton and a Trump victory. In light of the election outcome, here we focus on the Trump agenda, and incorporate select additional commentary from our members following the election.) Although both candidates expressed reservations about trade agreements, Trump went considerably further in vowing to renegotiate or rescind existing agreements, including NAFTA (the North American Free Trade Agreement, implemented in 1994). It is not clear that a president can unilaterally abrogate a congressional-executive agreement; moreover, the integration of the Mexican, U.S. and Canadian economies is far too advanced to be reversed. Still, the Trump administration could adopt protectionist policies in violation of NAFTA and other trade agreements and essentially challenge our trading partners to sue us, moves that risk disrupting supply chains and increasing economic uncertainty. Looking forward, the Trans-Pacific Partnership trade agreement is finished, certainly in its current form, which will strengthen Chinese economic influence in Southeast Asia. The populist backlash against globalization and trade is creating ongoing downside risks for growth, both in the U.S. and globally.
International economic and political relations are likely to be highly intertwined in the new administration. Trump has criticized the trade and exchange rate policies of China, but the Chinese prefer him to Clinton because they see him as a pragmatic dealmaker who will not push them on human rights issues. It is likely that we will see another North Korean provocation early in a Trump administration, which has the risk of escalating into a dangerous crisis if Trump pushes back hard on both North Korea and on China. President-elect Trump appears to be backing off his challenge to U.S. alliances with Japan, South Korea and NATO countries; his calls with Asian leaders have been conciliatory and he has expressed his support for NATO. His willingness to improve relations with Russia and cooperate on fighting ISIS/ISIL may improve the chances of reaching a settlement in Syria, but his emphasis on increasing fossil fuel production could hurt the Russian economy. Many U.S. allies will be wary of Trump; U.S. adversaries will wait and see. His election will have the greatest impact on European politics by strengthening the likelihood that populist parties on both the right and the left can win in France and Italy, possibly posing an existential threat to the continuation of the EU.
The board discussed the economic implications of alternative Brexit scenarios. At this point, a “hard” Brexit, in which the UK makes a clean break with the EU single market, seems the somewhat more likely outcome, since Britain will not accept the EU’s rules on free migration. In any case, the process will take years, with exit negotiations followed by bilateral trade negotiations between the UK and many countries, including non-EU countries whose trading relationships with the UK are currently governed by EU-negotiated treaties. Standards of living in the UK are likely to fall, as the decline in the pound raises the cost of imported goods and services. The weaker currency will boost exports to some degree but probably not enough to compensate for the more limited access to Europe’s markets. Capital investment in the UK is likely to decline following Brexit, particularly in key areas such as manufacturing, pharmaceuticals and financial services.
In summary, we are entering a period of greater uncertainty than we had envisaged, defined by new sets of political risks likely to slow already sluggish trade and hamper efforts at necessary economic reforms.
Q: What is the board’s outlook for the U.S. economy and monetary policy?
A: The U.S. economy continues its moderately paced recovery, now in its eighth year. The engine of the recovery is consumer spending, which is supported by good fundamentals, including stronger household balance sheets, increased employment and labor income, low gas prices and relatively high levels of confidence. Good prospects for consumer spending together with an improving housing sector suggest that moderate growth will continue. Expansionary fiscal policy could be an added boost to the economy in the coming years; indeed, a greater role for fiscal policy seems possible in a number of leading economies. We anticipate some rebound in productivity growth, reflecting in part the ebbing of the effects of the financial crisis and recession on capital investment, research and development, and startups.
Turning to monetary policy: Federal Reserve policymakers have accepted that the neutral policy interest rate is much lower than once thought – a view that PIMCO has held for some time, and which board members previously affirmed (see the Q&A published in June on the outlook for the global economy). A lower neutral rate implies that policy is not extraordinarily accommodative today, and that rate increases are consequently less urgent. That said, with the Fed near its employment and inflation targets and with reduced global risks, a rate increase is likely imminent, probably in December.
Looking forward, the debate at the Fed now surrounds the potential benefits and costs of overshooting, for a time, its targets for employment and inflation. Doves see meaningful advantages to allowing an overshoot, including possibly lasting increases in labor force participation as workers re-enter the job market as well as the cementing of inflation expectations, which have been soft, near the Fed’s 2% target. Doves also argue that the low level of neutral rates should make policymakers more cautious, since there is limited room to cut rates if a “hawkish mistake” or some other factor leads the economy to slow. On the other side, hawks at the Fed argue that going too slowly on rate increases raises the chance of falling behind the curve on inflation, which could result in the need for more rapid rate increases (and the attendant increase in the risk of recession or market volatility) later on. Hawks also note that financial imbalances could build under a more dovish policy. The likely compromise is that the upcoming rate increase will be balanced by communication emphasizing the gradual and cautious nature of any further policy tightening.
The outlook for longer-term interest rates is that they will remain generally low, the result of slow growth and low inflation. But our view of the U.S. economy and the Fed does suggest some upside risks to longer-term yields, including more expansionary fiscal policy, a modest increase in inflation pressures and inflation breakevens, a rebound in productivity and an increase in risk premiums from historically low levels.
Q: Developments in China often reverberate globally. What is the board’s outlook for China’s economy, policy and currency?
A: China’s economic growth has remained solid, even if there is some doubt regarding the precision of the official data. Political jockeying continues in anticipation of the critical National Party Congress next fall, where many key leadership positions will be determined. In the meantime, we are seeing a mix of constructive developments and continued challenges and risks.
Among the positive trends, the transition away from a growth model based on mercantilism and heavy industry to a model emphasizing consumer spending and services is slowly but surely advancing, with the most recent GDP growth figures showing an increase in the contribution of consumer spending and a decline in the reliance on exports. We have also seen some progress in reducing excess capacity on the supply side, particularly in coal and steel production; however, this is only occurring in those provinces where there are other activities that can absorb excess workers. And while China’s levels of nonperforming loans have raised concerns, current estimates suggest that predicted losses would be manageable, with government support available if necessary.
Additionally, China has improved its management of its exchange rate, with an orderly depreciation of its currency this year versus both the U.S. dollar and a broader basket of currencies. The decline in China’s international reserves has moderated and capital outflows have slowed, especially compared with 2015, when a rush to pay off foreign liabilities put more downward pressure on the yuan. Going forward, confidence in China’s reforms and in its economic management should keep its currency on a stable trajectory. One possible near-term risk to this trend would be a hawkish Federal Reserve raising the U.S. policy rate more rapidly than anticipated, which could lead to exchange rate volatility.
Turning to the ongoing challenges and potential negative trends confronting China, we note the risk that the focused pursuit of near-term economic growth may come at the expense of needed structural reforms, exacerbating imbalances in the economy and damaging longer-term growth prospects. As we concluded in our May meeting, although it is not the Global Advisory Board’s base case, the risk of China having a “hard landing” still exists. The adverse scenario could occur if social unrest and political resistance from entrenched interests, such as the state-owned enterprises, result in a stalling of reform and a corresponding loss in confidence. Even if President Xi Jinping is able to consolidate support next year among members of the Standing Committee, reforms will still be politically challenging, and we will need to monitor their progress carefully.
China’s housing market is another area of concern. Home prices have increased rapidly in top-tier cities, and new mortgages make up an increasing share of bank lending. The buildup in mortgage debt is disconcerting, although high down payment requirements mitigate the risks. More broadly, the Chinese government has promoted credit-financed growth, with diminishing effectiveness. China’s leadership has the tools and the fiscal capacity to manage the credit boom, but doing so may involve allocating losses to stakeholders and thus add to the political difficulties of reform.
Q: What is the outlook for Europe’s economy and monetary policy?
A: Buffeted by sovereign debt crises as well as the global financial crisis, Europe’s recovery has been painfully slow despite some more upbeat growth numbers recently. The recovery also remains unbalanced, with large cross-country differences in performance and with a few countries, notably Germany and the Netherlands, maintaining undesirably large current account surpluses. High rates of youth unemployment in many countries, growing inequality and concerns about migration and terrorism are creating political and social stress. Future growth will depend on successful implementation of structural reforms in many countries. The restructuring of the banking sector, which plays a much larger role in credit creation in Europe than in the U.S., remains of the essence. Some countries have fiscal “space”; and, in principle, fiscal policies could supplement the efforts of monetary policymakers and help reduce trade imbalances. However, as Germany is unlikely to support significant expansionary fiscal policies – outside of programs to help resettle refugees and some tax reduction – we don’t see major fiscal initiatives as likely in Europe.
The European Central Bank (ECB) is expected to announce plans for its quantitative easing program at the December meeting. We don’t think it is very likely that the ECB will begin “tapering” its asset purchases when the current program ends in March unless the U.S. dollar is significantly stronger. The ECB could continue its current pace of purchases for at least an additional six months. It is likely to be reluctant to cut its deposit rate further because of concerns about the effects on bank profits, pension funds, life insurance companies and ordinary savers.
Q: Any other global economic developments of note?
A: The Bank of Japan recently made important changes to its framework, including adding a commitment to overshoot its inflation target while aiming to keep the yield on 10-year government bonds roughly at zero (“yield curve control”). The BOJ’s plan is intended to raise inflation expectations while reducing risks to financial stability; by committing to keep the cost of government borrowing near zero, it could also encourage further fiscal actions, beyond those already announced by Prime Minister Abe. The Japanese economy has made progress overall, with the labor market close to full employment and core inflation higher. It’s not yet clear, though, whether the monetary and fiscal policies currently in place in Japan will be sufficient to overcome Japan’s deflationary psychology. To the extent that a President Trump will end the U.S. “pivot to Asia,” both by letting the TPP die and by reducing U.S. attention to Southeast Asia, many Asian countries will look more to Japan as an economic and political counterweight to China in the region.
Investor confidence in emerging market economies has improved notably in the past year. Although specifics vary by country, three factors that have contributed to the broad-based improvement are the perceived stabilization of the Chinese economy and currency, some recovery in commodity prices and accommodative policies by the major central banks.