Paul A. McCulley
Managing Director, Portfolio Manager

Paul McCulley is a Managing Director, generalist portfolio manager, member of the investment committee and head of PIMCO’s Short-Term Desk. He also leads PIMCO’s Cyclical Economic Forum and is author of the monthly research publication Fed Focus. Mr. McCulley joined PIMCO in 1999, previously serving as Chief Economist for the Americas for UBS Warburg. During 1996-98, he was named to six seats on the Institutional Investor All-America Fixed Income Research team. He has twenty-two years of investment experience and holds a bachelor’s degree from Grinnell College and an MBA from Columbia University Graduate School of Business.

McCulley leads the firm’s quarterly Cyclical Economic Forums, in which our investment professionals from around the world gather to discuss the outlook for the global economy and financial markets over the next 12 months. In the following interview, Mr. McCulley discusses the results of the March Forum and its implications for PIMCO’s investment strategy.

See a related article: PIMCO's William Powers on Cyclical Outlook & Strategy.

Q: PIMCO held its latest Cyclical Economic Forum in early March. Before we discuss the conclusions from the March Forum, could you set the stage for us with some background on the global economic environment heading into the Forum?
McCulley: In recent years, we’ve seen de facto coordinated global monetary policy—and to a lesser extent fiscal policy—serve as the reflationary anchor and impetus for a revival in global nominal aggregate demand. The reflationary process hasn’t always been pretty, contributing as it has to imbalances in global savings and investment that would make an accountant blush and to a compression of global risk premiums that make price-sensitive investors want to find a new line of work.

On a secular basis, we’ve compared policymakers’ efforts to stimulate the global economy to trying to start a fire with wet logs. If you add enough fuel, in the form of reflationary policies, the logs will burn. But is the fire a mirage, or is it real? Will the logs that are burning brightly now reveal underlying structural wetness once global monetary reflation is unwound? Does the global expansion have sufficiently sturdy endogenous demand-generating power to withstand the withdrawal of exogenous monetary stimulus? These were the critical questions heading into the March Forum because the European Central Bank has now joined the Fed in removing stimulus, and the Bank of Japan will be ending quantitative easing in the months immediately ahead.

Q: What conclusions did PIMCO draw from the Forum? Is global growth strong enough to weather the withdrawal of policy stimulus?
McCulley: Our global base case is that yes, global aggregate demand is sufficiently under girded by endogenous growth dynamics to withstand more withdrawal of global monetary reflation, even with Japan joining the parade of central banks removing stimulus.

Over the next 12 months, we see U.S. real GDP growth in a range of 2.75% to 3.25%, with core inflation ranging from 1.75% to 2.25%, which is essentially where we were coming out of the September and December Forums. In Europe, we expect both real GDP growth and inflation to range from 1.5% to 2%, almost exactly the same as our forecast three months ago. For Japan, our forecast is a touch stronger versus three months ago at 2.5% to 3% for real GDP and 0.25% to 0.75% for core inflation.

As for risk, however, we see more downside than upside because the withdrawal of stimulus is likely to be more painful than anticipated, rather than a liberating tonic to animal spirits.

Q: Does PIMCO see higher global inflation as the primary risk in the base case scenario, or is slower global growth the bigger risk?
McCulley: Global inflation is well contained. The secular war against inflation has been won and the mission of central banks now is to maintain the peace of price stability. We think they will.

Winning the peace of price stability doesn’t mean inflation won’t fluctuate on a cyclical basis. Inflation is a cyclical variable and cyclical variables tend to move cyclically. But as a structural and secular matter, the big issue isn’t inflation; it’s growth. Will we have enough growth, given the imbalanced nature of it today? Cyclically, we think so. But on a secular basis, we worry about how dry the logs really are.

Q: Why does PIMCO expect stronger growth out of Japan?
McCulley: We spent a lot of time on Japan, even though we all know that China, not Japan, is the straw that stirs the Asian aggregate demand drink. We did this because the looming pullback of Japanese monetary reflation most likely will have a more profound effect in the next six to 12 months on global asset prices and risk premiums than changes in Chinese monetary policy.

And the key question regarding the Japanese economy is whether Japan is just a closet subsidiary of the Chinese economy, relying primarily on high-value exports to China, or is the Japanese consumer, who is also the Japanese worker, finally able and willing to provide internal support to aggregate Japanese demand growth?

We tentatively concluded that yes, Japanese consumers have re-found their mojo! I say “tentatively” because many find it difficult to believe, after more than a decade of successfully betting against the Japanese consumer, that it is time to cover that bet. But incoming evidence is increasingly pointing to that  conclusion, which is consistent, I suggest, with a turn from deflation to reflationary expectations. As Tug McGraw of the ’73 Mets said, you just “gotta believe”. We are collectively working in that direction. But over our cyclical horizon, we concluded that it might not matter very much whether or not the Japanese consumer breaks out. More important on a cyclical horizon is that Japanese exports and business investment activity connected to the Chinese juggernaut are likely to remain strong, because the Chinese juggernaut isn’t likely—barring a shock—to run out of gas.

Q: Why does PIMCO expect China’s growth to remain strong? And how does this affect the outlook for growth in Asia as a whole?
McCulley: With regard to China, we see two salient facts that should support growth over the cyclical horizon. First, the Beijing Olympics aren’t until 2008, which China unambiguously wants to be successful on the back of massive infrastructure investment. And second, China still has a command and control government structure; notwithstanding the colossal steps it is taking towards a market-driven economy.

There are risks to China’s growth, to be sure. A slowdown in American consumer demand growth would have, at the margin, a negative impact on Chinese exports. America could also do something stupid regarding protectionism and China. And there is the unforecastable possibility of the bird flu. But, we are collectively of the tentative view that China is not just a mercantilist reliant on exports for growth, but also a mercantilist importing high-value capital goods from Japan and commodities from emerging market countries. Thus, our collective view is that the basic fundamentals of the Asian region, anchored by China, are sturdy and that growth will keep on keeping on.

Q: How does the outlook for Asia affect PIMCO’s view on emerging markets?
McCulley: There is huge overlap between Asia and the emerging markets, of course, but the EM universe is not just China, which our EM team detailed at the Forum. As Ben Bernanke preached over a year ago, there is indeed a glut of global savings relative to desired non-USA investment. And out of this milieu was borne the Bretton Woods II currency regime we’ve discussed many times.

What has changed over the last year is the composition of the savings glut, with an increasing share shifting to commodity producers, in particular oil producers and notably to Russia and Saudi Arabia. These commodity producers are every bit as inclined to save their terms-of-trade winnings as the mercantilist emerging market countries of Asia.

Secularly speaking, these countries present the next great opportunity for global aggregate demand growth, as capitalist progress and wealth beget a savings intermediation system capable of financing for their peoples what is known in the U.S. as the American dream. On the secular horizon in the emerging market world lies a boom in split-level homes with three bedrooms, one and one-half baths, and a carport with a car in it. But not on our cyclical horizon.

Q: Demand from China also seems to be helping the European corporate sector. Has PIMCO become more optimistic on European growth?
McCulley: On Europe, we concluded that growth is still being driven by external demand, with Germany leading the way, primarily via exports of capital goods to China. Domestic demand will continue to face the headwind of weak household real income growth, borne of capitalist reform internally and capitalist competition from the east. But it would be a mistake to say Euroland is fragile. Euroland is less than robust, certainly, but it’s not fragile anymore.

Business optimism is booming in Europe and investment is following. To be sure, one of the key reasons that businesses are happy is that they are picking the real income pockets of workers. But happy businesses, with a strong global demand for their high value-added capital goods, are not the stuff of growth anemia, at least not until the Euro takes a huge leap upward and/or European countries with booming property markets running on variable rate mortgages start feeling the effects of the ECB’s rate
hikes.

Q: If consumer demand and wage growth are weak in Europe, is inflation likely? And if not, why is the European Central Bank raising rates?
McCulley: Inflation is tame, period, despite the ECB’s angst. You just don’t get a self-feeding inflation dynamic when workers are getting the real income shaft. You may get a one-off increase in inflation, borne of external price shocks, notably in oil; or internal price shocks, borne of administered price hikes from fiscally challenged governments. But systemic inflation? No. Thus, we concluded that the ECB is tightening not because of a need to do so as a prophylactic against inflation, but rather because they can, as a prophylactic against boom and bust in asset prices, borne of robust credit growth and skinny risk premiums.

Q: The Fed is also tightening but PIMCO’s growth forecast for the U.S. has been pretty steady following the last several Forums. What conclusions did the firm draw about the U.S. outlook at the March Forum?
McCulley: The U.S. outlook is all about the property market, which has been the wind beneath consumers’ wings this decade. The property market is rolling over, but at this stage we’re only seeing a slowing in the market because property is a momentum-driven market with support from mortgage lenders making exotic loans and selling them to strangers in foreign lands.

Therefore, as PIMCO’s mortgage guru Scott Simon and his team have so presciently forecast over the last year, property market euphoria will not go quickly and quietly into the good night, but rather on the installment plan, with much screaming of denial.

Collectively, we believe the end of denial is rapidly approaching. But none of us can say with confidence whether the end will come in the next three weeks, three months, or three quarters. But the end of the housing boom will come soon, we think, and when it does, sales volume in the property market will reverse wickedly. Housing prices don’t crash, but volume of transactions does, as sellers refuse to face reality on pricing and buyers wait them out.

Q: How will a slowdown in the property market affect mortgage equity withdrawals, which have been a big part of consumer disposable income, and thus consumer demand, in the U.S.?
McCulley: The truth is we don’t know how significant the effect on mortgage equity withdrawals will be because no one has experienced this scenario before. But our collective sense is that the effects are going to be large. For good or for bad, Alan Greenspan shared that view, though much of the Fed staff doesn’t.

Q: If mortgage equity withdrawals are unlikely to provide much support for the consumer sector, can the corporate sector step up as an engine of U.S. growth?
McCulley: In the corporate sector, capital spending is growing at a very sturdy pace. Not a boom, certainly, but sturdy. We concluded that sturdy capital spending could possibly morph into robust capital spending, considering robust corporate profits and pristine corporate balance sheets, but the more likely case is that corporate leaders will spend their capital in fast-growing emerging countries.

We also anticipate that many corporate leaders will continue to look at strategic balance sheet re-levering as the quickest path to rising earnings-per-share. Growth for the sake of growth is no longer a religion and giving back cash via share buybacks and dividend increases is now considered honorable corporate behavior.

So we collectively see a soft landing for the U.S. economy, with perhaps a whiff of stagflation, depending on whose nose is asked. U.S. inflation is well-contained at the core level, and likely to stay that way, for all the reasons we’ve discussed many times, notably global competition holding down U.S. wage inflation. But statistically speaking, it’s hard to see core inflation going down much and easier to see it going up, on the back of that dreaded imputed rent series. Both the consumer price index (CPI) and the personal consumption expenditure (PCE) index include a rent component that is imputed from the cost of houses.

Basically, homeowners are assumed to have rented their home to themselves, so rent costs in the CPI and PCE are tied to property prices, which have been inflating. There is a significant lag in incorporating changes in imputed rents into the indexes, so the rise in home values hasn’t shown up in inflation yet. But rents account for a significant portion of both core CPI and core PCE, so the rise in housing prices should show up in both series eventually.

Q: How are the conclusions from the March Forum shaping PIMCO’s investment
strategy?
McCulley: Our key theme is as it was a quarter ago: exploit the fact that region-specific business cycles are not synchronous, even though we have synchronous global growth. The Anglo Saxon economies are slowing, on the back of prolonged monetary policy tightening, while Europe and Japan are accelerating, with monetary tightening only in nascent stages. Thus, in the context of our current neutral-to-slightly long overall duration stance, we want to be meaningfully overweight duration in the United States, concentrated in the front end of the yield curve, versus the rest of the world.

We will want to go meaningfully long of duration, again concentrated in the United States in the front end of the curve, once it is clear that U.S. housing is rolling over significantly and that the Fed is finished its tightening cycle, with an easing cycle on the horizon in 2007. This could unfold in the months immediately ahead or perhaps not until summer or fall, so we will want to be nimble, with special vigilance on incoming
data.

With respect to sectors, we will remain very meaningfully underweight of corporate bonds; spreads are incredibly thin, the economy is set to slow and corporations are strategically re-levering their balance sheets. That's a nasty brew of risk relative to potential rewards. We still favor an overweight in mortgage-backed securities, which have performed exceedingly well this year so far. But the overweight is likely to be a bit more modest than in recent months, as we anticipate that volatility is likely to pick up somewhat from very low levels, the result of monetary tightening 'round the globe.

We will continue with allocations to emerging markets, but at reduced levels versus recent quarters, reflecting the fact that spreads have narrowed very sharply and global liquidity is set to become less favorable with the Bank of Japan exiting quantitative easing. We still like municipal bonds, particularly long-dated munis, and will add to our modest positions when opportunities afford themselves. With respect to TIPS, we are broadly neutral, in contrast to large overweight positions in recent years—real yields have fallen and commodity prices are topping out. Remember, TIPs are not indexed to core inflation, but to headline inflation, which has been boosted by appreciating commodity prices, in particular oil.

Finally, we will be modestly long of Yen and Emerging Market currencies, reflecting both the cyclical recovery in Japan and the positive secular story for EM.