Global Economy Will Slow In Face of Severe Credit Crisis

The crisis in credit and financial markets will cause developed economies to operate well below potential for some time. Emerging economies are likely to fare better but will not enjoy a complete decoupling from the credit-induced slowdown in the U.S., Europe and the U.K. With the global economy mired in the most serious financial crisis since the Great Depression, policymakers are struggling to find responses that are both necessary and sufficient to cope with the problems. It remains to be seen what will constitute a sufficient response. Inherent in a crisis of this magnitude are heightened risks associated with the left tail of the probability distribution; that is, events which seem unlikely but which could have consequences that are highly negative and destabilizing.

• The Paradox of Deleveraging - The bursting of the residential real estate bubble has helped produce what PIMCO terms the “paradox of deleveraging.” As banks and other heavily indebted investors rationally attempt to unload mortgage-related assets, a spiral of debt deflation has ensued because there are not enough buyers with capacity on their balance sheets to accept the assets. Compounding the problem is the illiquidity and complexity of many of these securities, which make them difficult to value.
• A Floor for the Market? - Government policy has shifted during this crisis from targeting financial institutions to targeting both institutions and the financial markets. PIMCO believes that government support for the real estate and mortgage markets has been justified for some time. The best way to put a floor under the market, provide a mechanism for price discovery and set the stage for recovery is for the U.S. government to take at least some of these assets onto its balance sheet. However, even with implementation of the U.S. Treasury’s program for accomplishing these objectives, the Troubled Asset Relief Program (TARP), there is unlikely to be an economic revival anytime soon.
• Options for Policymakers - Global policymakers have other options besides TARP, and PIMCO believes that they should use them. With interbank lending rates at record levels and credit markets paralyzed, financial conditions are tight and the case for continued central bank easing is compelling. The European Central Bank and Bank of England are likely to ease even more than the Federal Reserve as their economies slow.
• More Options - In the U.S., the Treasury has the authority to buy mortgage-backed securities or the bonds of Fannie Mae and Freddie Mac outright, as well as expand Fannie and Freddie’s balance sheets. The Fed can and probably will continue to inject massive liquidity into the financial system. The Fed has already announced a program to assume credit risk by buying corporate commercial paper. The Treasury appears poised to inject equity capital directly into troubled banks. Lastly, PIMCO believes that the Fed should act as a clearing house for payments and settlements of financial transactions in order to bring normalcy back to this area of the system.
• EM to Cushion the Blow - Growth in emerging markets, led by China, may cushion the blow delivered by the credit crisis. Chinese growth will decelerate in the face of weaker external demand and the need to contain inflation, but the slowdown will come off of very rapid rates in the recent past. Domestic consumption and investment will continue to support the Chinese economy. Moreover, China and other emerging economies have the financial reserves needed to use fiscal stimulus to sustain domestic demand. Policymakers in emerging economies and elsewhere will have more flexibility to employ fiscal stimulus over the next year. Headline inflation pressures will likely abate as the weakening global economy keeps commodity prices soft compared to recently elevated levels.

Maintain High Quality, Defensive Posture Amid Turmoil PIMCO went into the present crisis with a defensive orientation, including a focus on the front ends of yield curves worldwide and holdings of high quality assets deemed to be under the Fed/Treasury policy umbrella. All of these elements will likely remain in place and should build in effective hedges to downside risks that will be a prominent feature of the investment landscape. In addition, our investment process will continue to concentrate on elements not readily visible to outside observers, such as cash, collateral and counterparty risk management.

• Interest Rate Exposures - PIMCO plans to be neutral to slightly overweight duration overall with tactical interest rate exposure to Europe and the U.K. where permitted. Interest rates in developed markets are unlikely to rise as these economies weaken. We plan to retain exposure to the front end of yield curves in the U.S., Europe and the U.K. in the belief that shorter maturities are likely to outperform as markets anticipate central bank easing and injections of liquidity.
• Concentrate on High Quality Assets - Agency mortgage pass-throughs will likely continue to be PIMCO’s largest sector overweight. PIMCO has about the level of exposure that we want to these high quality assets, which have performed relatively well amid the recent market turmoil. PIMCO will also focus on maintaining the liquidity that we need to gain exposure to other high quality assets as they become attractive. These securities could include municipals, where yields are near their highest in history relative to Treasuries, and select asset backed bonds with strong collateral protection and attractive yields.
• Hold Positions in Financials - In hindsight, PIMCO was premature in our purchases of banking and finance company bonds that offered highly attractive yield premiums but exposed us to the worsening situation in the financial sector. We are no longer adding to these positions but neither do we plan to sell them. We have focused our exposure primarily on large institutions that we believe fall under the protective “umbrella” of the Fed and therefore have potential for price recovery once financial and credit markets stabilize. Besides an expectation of government support, our holdings may also benefit going forward from bondholder-friendly economic trends that were already in place before the crisis. These trends include the consolidation and recapitalization of financial services companies, as well as deleveraging and greater balance sheet transparency.
• Currency Exposure Emphasizing Emerging Markets – PIMCO came into the financial market crisis with relatively neutral currency exposure overall – modest long positions in emerging market currencies roughly offset by short positions in developed currencies, especially the U.K. pound. We plan to retain this approach. Interest rate differentials among developed economies that now favor Europe and the U.K. over the U.S. are likely to narrow as all developed economies slow down. This trend should favor the U.S. dollar versus other developed currencies. By contrast, currencies of emerging economies should fare better against the U.S. dollar given their faster expected growth.