Asia’s Role in Global Economic and Portfolio Rebalancing
PIMCO
By Tomoya Masanao, Robert Mead, Ramin Toloui
June 12, 2012
- We expect that the reallocation of global investor portfolios toward more balanced allocations to emerging market bonds – the “Great Migration” – to support Asia in the coming years.
- To pivot to a growth model that emphasizes domestic demand, China must alter government policy on taxes, profits of state-owned enterprises as well as make other structural changes.
- Japan’s growth will continue to be challenged by secular dynamics, and by the country’s inability to respond to them. While its growth outlook is weak, its net external creditor status and ability to print its own currency are important advantages.
- With less Chinese policy support, the tailwinds that Australia has been experiencing since 2008-09 will turn into headwinds via declining terms of trade.
The
world is watching Europe, but the political and economic choices being
made in Asia are also critical for the future of the global economy.
Q: What is PIMCO's secular outlook for Asia? Will the region influence global developments in the years ahead, or react to them?
In
the following interview, portfolio managers Tomoya Masanao, Robert Mead
and Ramin Toloui survey how the major economies of Asia are adapting to
– and influencing – evolution in the global economy.
Q: What is PIMCO's secular outlook for Asia? Will the region influence global developments in the years ahead, or react to them?
Masanao: All regions have active roles to play in
the massive global transitions that are taking place, even as they are
affected by developments elsewhere. This interdependence is clear when
we look at how Asia relates to the ongoing deleveraging in the
industrialized world. Yes, household deleveraging in the U.S. is
reducing demand for exports from Asia. And, yes, the fiscal crisis in
Europe is causing financial institutions to pull back and transmit
volatility to Asian markets.
But unlike in the past, when Asia was economically smaller and
financially more fragile, the region is not a passive player in this
process. The choices made by governments, households and businesses in
Asia will determine whether we bring about a world where emerging market
domestic demand helps fill the vacuum left by retrenchment in the U.S.
and Europe.
Q: Is PIMCO concerned that China's economic growth will
slow down sharply? What effect will China's growth trajectory have on
the rest of Emerging Asia and the world?
Toloui: Nowhere is the transition just described
more difficult – or more important – than in China. The key drivers of
net exports and investment that powered the 10% to 11% growth rate that
China has achieved over the past decade have reached their limits.
The key question is whether China can pivot to a growth model
that emphasizes domestic demand – specifically consumption. This
requires significant changes in government policy, including reform of
tax policy, distribution of the profits of state-owned enterprises and
other structural changes affecting the markets for labor and energy.
These changes are not easy. PIMCO’s view is that a process of
incremental reform, supported by the financial wherewithal to protect
against a massive contraction, is likely to produce average growth over
the secular horizon in the 7% range – below what is predicted by
optimists, but not the severe hard landing predicted by pessimists.
Moreover, the changing composition of Chinese growth is likely
to produce winners and losers in the global economy. The big winners of
recent years – commodity exporters like Australia – are likely to enjoy
less of a boost in the next few years, as China de-emphasizes
commodity-intensive investment. In contrast, countries in the supply
chain feeding domestic Chinese demand are in a position to benefit.
Q: Is there substantial inflation risk in Asia, and, if yes, how should investors deal with that risk?
Mead: Many cross-currents are affecting the path
of inflation, including aggregate supply, aggregate demand, central bank
policy and expectations. In the near term, our view is that inflation
is unlikely to be a predominant concern globally, and is therefore
likely to retreat as a concern in Asia.
As we move further out in the secular horizon, the risks of
inflation become greater. One factor is central bank policy, which in
the core industrial economies is clearly geared toward generating
inflation over deflation. Second, the longer the economic crisis
continues, the more the productive base of the global economy erodes,
undermining aggregate supply. Workers experiencing long-term
unemployment lose their skills, and plant and equipment deteriorates. As
aggregate supply recedes, the risks of inflation begin to rise.
For this reason, we believe that inflation hedging remains a
key component of any well-balanced portfolio for the secular horizon.
This can be achieved through allocations to inflation-indexed bonds,
commodities, select equities or emerging market assets.
Q: What is PIMCO’s secular outlook for Japan? How does it inform your view on Japan’s sovereign risk?
Masanao: Japan’s growth will continue to be
challenged by secular dynamics, both internal and external, and,
importantly, by the country’s inability to respond to them.
Internally, the deteriorating demography is the most powerful
secular driver in Japan. Potential growth is already low but will likely
further decline closer to zero. The labor force, and even capital
stock, are decreasing and should decrease further. Young people are
unlikely to become more enthusiastic about spending as taxes and social
security payments will likely be raised. Reform is needed to moderate a
widening of “inter-generational” wealth inequality, but the probability
of such reform seems very slim. Traditional monetary policy alone will
remain ineffective since the policy rate has been at a nominal zero
bound for so long.
Externally, slower growth and a bumpy macro-rebalancing of the
Chinese economy would likely have mixed effects on Japanese growth.
China moving toward a higher-income economy could be an opportunity for
Japan’s high-end consumer goods. However, China rebalancing with less
investment could adversely affect some of Japan’s main exports to China,
which are production goods.
Japan’s growth outlook is weak, but its net external creditor
status and ability to print its own currency are important advantages
compared to European peripheral countries. Also, to be clear, Japan’s
fiscal problem is not external solvency but rather inter-generational
solvency. Inter-generational transfers may reach a limit in the future,
but probably not, at least, in the next three to five years.
Q: You mentioned China's impact on Australia. How will Australia adapt to the changing global landscape?
Mead: PIMCO has previously dubbed the Australian
economy as experiencing “Dutch Disease-Lite” and recent experience
suggests the economic symptoms are intensifying.
China is Australia’s largest trading partner, and China’s
historical focus on infrastructure building has amplified the divergence
in Australia’s two-speed economy, in which the natural resources
sectors significantly outpace the consumer and manufacturing sectors.
Many non-mining sectors are no longer globally competitive –
manufacturing, for example, has seen a significant drop as a share of
the Australian workforce – but these non-mining sectors are much more
influential on employment prospects. Over the secular horizon, with less
Chinese policy support, the tailwinds that Australia has been
experiencing since 2008-09 will turn into headwinds via declining terms
of trade.
Despite the fact that Australia has been a significant
beneficiary of China's growth and demand for commodities since the
crisis began, Australia has run large fiscal deficits. One lesson
learned from the developed world is that running permanent fiscal
deficits is not sustainable, so migrating back to surplus is sensible
secular policy. The appropriate timetable for reaching budget balance is
debatable. Given the 3% fiscal drag embedded in the 2012-13 federal
budget and the expectation that ongoing fiscal austerity will be the
mantra, a weaker Australian dollar and lower interest rates will be the
only escape valves for the economy.
Q: What are the investment implications of PIMCO’s secular outlook for Asia?
Toloui: A defining feature of PIMCO’s outlook is
the unusually broad range of plausible outcomes over the secular
horizon. Preparing for this means thinking about portfolio
diversification in a non-traditional way. Analysis of narrow,
backward-looking correlations is likely to be less relevant than a
scenario-based approach to diversification. This may be achieved by
mapping the potential ways the global landscape could evolve and working
to ensure that the overall portfolio’s asset allocation is robust
against these contingencies.
To take one example: PIMCO’s base case is for a world of low
growth in industrialized countries and higher but still historically
modest growth in emerging market countries. This is an environment where
emerging market currencies may continue to appreciate and outperform
against industrial peers to facilitate global rebalancing.
Income-producing investments in emerging markets – such as
emerging market local currency bonds – are poised to be the sweet spot
in this scenario, offering some of the best potential risk-adjusted
returns globally. Unfortunately, the portfolios of most global investors
are disproportionately allocated to industrialized country securities.
We expect that the reallocation of global investor portfolios
toward more balanced allocations to emerging market bonds – the “Great
Migration” – will be a major theme in the coming years. This will mean
more investor flows into Asia. It will also mean more flows from Asian
investors into other global emerging markets. We believe investors who
participate in the leading edge of this process are in the best position
to potentially benefit from a “first-mover” advantage, since their
portfolios may own assets poised to gain from future investment flows.
On a related note, the increased focus on sovereign
creditworthiness is also likely to benefit Australian fixed income
markets. As Australia’s federal budget moves back into surplus and bond
issuance declines, we are likely to see continued interest from offshore
investors.
(c) PIMCO
