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PIMCO’s 2004 Secular Outlook Summary

Each year PIMCO’s investment professionals and invited guests gather in Newport Beach, California for the firm’s Secular Forum. At this three-day meeting, PIMCO studies the long-term-or secular-economic, social and political trends that they believe will exert the most powerful and sustained influences on the fixed-income markets. Based on this study, the firm formulates its Secular Outlook-a forecast of how PIMCO believes the economy and financial markets will perform over the next three to five years. This Outlook guides the way PIMCO structures portfolios in terms of duration, yield curve positioning, sector exposure, credit quality and other risk measures.

The following is a summary of PIMCO’s 2004 Secular Outlook:

Global Economy: Walking A Tightrope
The global economy, propped up for the last several years by cheap money and a government and consumer borrowing binge in the U.S., is perched on a tightrope. Deflation and inflation are on either side of the wire. In this leveraged world, conditions for instability that could tip the walker in one direction or the other will accelerate over the next three to five years. Momentum swings will supplant the more durable economic trends witnessed during recent periods of disinflation (1980-2000) or inflation (1965-1979).

U.S. real growth will stabilize at about 2% over this period, with Europe and Japan near that level. The benchmark 10-year Treasury yield looks fairly valued for now but could climb to around 6.0%-6.5% should the economy tip toward inflation, which is more likely than a move toward deflation. More inflation and higher rates could, however, produce a reversal in growth and rates later in the secular time frame.

The following are risks that could tilt the economy in one direction or another:

More Government, More Inflation-Emphasis on the private sector from 1980 to 2000 promoted disinflation, but history suggests that as government spending climbs as a share of GDP, inflation and interest rates tend to rise. Early indicators of a coming bull market in government are: large fiscal deficits; litigation across the securities industry; implementation of Sarbanes-Oxley over the entire corporate sector; imposition of steel and lumber tariffs; and higher military spending to combat terrorism and support Homeland Security measures.

Policy Mistakes-A leveraged U.S. economy is vulnerable to policy mistakes by a Federal Reserve that is no longer proactive in battling inflation but reactive to economic data. Leaving rates too low for too long may have fueled inflation and created bubbles in housing, stocks and bonds, but raising them too quickly would eventually force a painful retrenchment by the overextended U.S. consumer.

Imbalances in Trade and Finance-Asian central banks provide much of the financing for the U.S. fiscal and trade deficits. To date, playing banker to the U.S. has suited China and Japan’s political agenda, which is to keep their currencies cheap to support internal growth. A change in China’s agenda sparked, for example, by a geopolitical shock over North Korea or Taiwan would mean a pullback in their purchases of Treasuries, higher interest rates and a plunge in the dollar.

Geopolitical Risks-America is stretched geopolitically as well as financially. A seemingly endless struggle against terrorism worldwide, accompanied by constraints on travel and trade, will be a persistent threat to consumer confidence and spending.

Investment Implications: Bet on Inflation, Guard Against Deflation

Mildly Bearish On U.S. Bonds-PIMCO expects upward pressure on interest rates, especially early in the secular time frame, with the greatest risk focused on longer maturities that are more vulnerable to inflation. Yields on shorter maturities will be more predictable, as the Fed will be forced to raise short-term rates only gradually in a finance-based economy. Real short rates of about 1%, which translate into a nominal fed funds rate of 2.5%-3%, are about all the global economy will be able to take. These forecasts argue for reduced durations and emphasis on short/intermediate maturities.

TIPS For Insurance-Treasury Inflation Protected Securities (TIPS) are at fair value after their strong rally over the past year. Even so, they remain an effective hedge against a potential surge in inflation.

Diversify With Eurozone Bonds-The Euroland will move in the opposite direction from the U.S. Smaller fiscal deficits and modest efforts at deregulation point to less government involvement in these economies, though admittedly from a higher base. It makes sense to purchase bonds of governments where the inflationary bias and upward pressure on rates will be more muted.

Continued dollar weakness arising from the U.S. trade deficit will add to the appeal of non-U.S. bonds because of the inflationary implications of a weak dollar in the U.S. Eventual revaluation of China’s currency and a slackening in China’s Treasury purchases, though not likely until after 2004, is another reason to diversify away from U.S. bonds.

Munis Are Cheap-Expectations for higher taxes as government expands argue for outperformance by municipal bonds. Since non-U.S. investors do not generally own munis, these securities would hold up well in the event that investors outside the U.S. eventually display less appetite for U.S. bonds.

What the Experts Say
PIMCO taps the best minds in economics, finance, politics and history to help formulate its Secular Outlook. At this year’s Secular Forum PIMCO invited several outside speakers to supplement its internal analysis, discussion and debate. Here is a summary of what they had to say:

Steven Roach and Andy Xie
Managing Directors and economists at Morgan Stanley

Roach and Xie characterized the global economic theater as two-dimensional: American consumers and Chinese producers. They made the case for a slowdown in the Chinese economy and discussed the related effects on global economics. Chinese authorities, determined to foster sustainable growth, should be able to slow down fixed investment, attenuate the soaring property bubble and ward off inflation. Roach believes that a soft landing is most probable, with the rest of Asia (ex-India) feeling the impact of reduced trade with China. China should lumber towards a market economy, with infant industries protected from price and interest rate volatility through rules and quotas. Xie demonstrated that Chinese foreign exchange surpluses were dominated by speculative expatriate capital flows, rather than trade imbalances. Roach and Xie think that a revaluation of the Chinese currency is a remote possibility.

Niall Ferguson
Professor of Financial History, New York University and author of The Cash Nexus: Money and Power in the Modern World, 1700-2000

Professor Ferguson made the case that the U.S. behaves as a classic imperialist power. Because of the negative connotation of this, however, official policy statements, media and public opinion are conditioned to state a contrary case. Ferguson believes that the U.S. exhibits more power (military and commercial) than any empire in history. The process of bringing reform and democracy to conquered nations is inherently long-term and expectations of "quick fixes" (widely observed ahead of the U.S.-led invasion of Iraq) are fundamentally misplaced. Ferguson contrasted America’s creditor status with that of Britain, which at the peak of its colonial power (1875-1913) played banker to the developing world. He suggested that both the U.S. federal government and the U.S. consumer are unhedged against sharp rises in interest rates. He also raised the possibility that the U.S. dollar could lose its reserve currency status. Ferguson described a scenario of heightened global risk in which the U.S., bloodied from events in Iraq, withdrew from its role as global policeman, leaving the world without a dominant power.

Martin Wolf
Associate Editor and Chief Economics Commentator at the Financial Times

Wolf’s central thesis was that the current state of the world economy is unsustainable in the long run but that we will "muddle through" in the short run. We are starting this cyclical recovery in the same state as the last without addressing existing imbalances. He was optimistic regarding long run growth prospects due to higher productivity, upward convergence of income levels in developing countries to developed country levels and increasing economic integration. However, the current U.S. recovery, driven by massive monetary and fiscal stimulus, is exacerbating existing global imbalances, which must be unwound for growth to be sustained. Wolf pointed out that the hyper-Keynesian U.S. recovery has many elements of fragility: an overvalued equity market and U.S. dollar, a household debt bubble, structural fiscal deficits as well as a lack of aggregate demand in the rest of the world.

Amy Chua
Professor of law at Yale University and author of World on Fire: When Capitalism, Democracy and Ethnicity Collide

Ms. Chua noted that globalization and laissez-faire economics, coupled with universal suffrage democracy, could be a volatile concoction given market dominant ethnic minorities. The consequence can be ethnic hatred and genocidal violence throughout the developing world. She believes that the U.S. is a market dominant minority on a global scale. This fact, combined with the U.S. foreign policy of pushing free markets and democracy, is a cause for much of the current anti-U.S. attitudes. Ms. Chua discussed the negative sentiment arising from U.S. involvement in Iraq and the difficulties of trying to implement a true democracy there.