CYCLICAL OUTLOOK

September 2015

AUTHORS

Mike Amey
Managing Director
Portfolio Manager

Has Europe
Turned a Corner?
In the following interview, Managing Directors Mike
Amey, Andrew Bosomworth and Lorenzo Pagani
discuss the conclusions from PIMCOs quarterly Cyclical
Forum, in which the companys investment professionals
gathered in September 2015 to discuss global economies
and markets. They share our views on the medium-term
outlook for Europe and the critical implications for
investment strategy.
Q: Recent market volatility suggests investors are focused on developments in Asia, and
perhaps are more comfortable with conditions in Europe. What is PIMCOs outlook for
eurozone growth and inflation over the coming six to 12 months? Are things looking up?

Andrew Bosomworth
Managing Director
Portfolio Manager

Lorenzo Pagani
Managing Director
Portfolio Manager

Amey: Despite the market volatility in Asia and some turbulence in Europe around the difficult
situation in Greece, our expectations are for the eurozone to experience above-trend real
growth of 1.75%, a slight improvement over our Cyclical Outlook in March. We believe
domestic demand will be the primary source of this growth due to improving private sector
loan growth, which is responding to falling private sector interest rates, in turn driven down by
low official interest rates and the European Central Banks (ECB) quantitative easing (QE)
programme. Meanwhile, fiscal policy is moving more into balance, and as a result will no longer
be a drag on growth. Undoubtedly, there will be some challenges for the export sector, in
particular for the German economy, as exports to Asia come under pressure; however, our
assessment is that this recovery is becoming an increasingly domestic affair.
Looking at inflation in the eurozone, we expect it to edge higher to 1.25% in 12 months time as the
weakness in energy prices falls out of the headline Consumer Price Index (CPI) measure, and core
CPI ticks up from 1% as the effect of the weaker euro feeds through into prices. Relative to the
worries of persistent deflation that were prevalent earlier in the year, this is clearly good news;
however, we are still some way from the ECB target of close-to-but-below 2%.
In short, things are looking up, but there remains a long way to go before the ECB can be
confident of achieving its inflation target.

September 2015 Cyclical Outlook: Europe

Q: How would you assess the ECBs

efforts to stabilise inflation,
promote lending to the real
economy and stimulate growth?
Are we still seeing a two-speed
recovery in Europe?

improvement. Business and

consumer confidence has risen and
economic growth has stabilised.

Bosomworth: The ECBs policies are

gaining traction. In March this year,
the ECB began a QE programme that
will see it purchase 60 billion worth
of bonds per month until at least
September 2016. The cumulative
amount of money that will be
injected into the economy via QE is
equivalent to about 10% of eurozone
gross domestic product (GDP).
Although the ECBs QE is modest
relative to those conducted by the
U.S. Federal Reserve, the Bank of
England (BOE) or the Bank of Japan,
whose asset purchases amounted to
about 25%, 21% and 65% of their
countries respective GDP, it is
nevertheless a considerable amount
of stimulus. QE and negative interest
rates are a powerful combination,
and six months into the programme
there are already some tentative
signs of success.
In financial markets, for example,
borrowing costs have declined in all
eurozone countries, and banks have
eased their lending standards.
Companies and households are
taking out more loans and
mortgages, so we are seeing credit
beginning to grow again. Among
investors, eurozone inflation
expectations, as measured by the
five-year breakeven inflation rate
(starting five years forward), have
risen. And the euro is weaker and
equity valuations are higher. All of
these factors make for easier
financial conditions, which are
feeding through to the real economy,
where we are also seeing

If there is any lesson to learn from

comparing these four major QE
programmes, it is that QE works
better when fiscal policy is also
stimulative, and when labour and
product markets are both more
flexible and friction is low. In our
view, fiscal policy is no longer acting
as a drag on growth in the eurozone:
Ireland, Greece, Portugal, Spain and
to a lesser extent Italy have made
considerable progress on structural
reforms. While such reforms are
politically difficult to implement,
they do pay off. Spain, for example, is
now one of the eurozones fastestgrowing economies. Importantly, the
bifurcation in economic growth
among eurozone countries that we
saw in the aftermath of Europes
sovereign debt crisis is dissipating.
Q: What are the potential policy
risks over the cyclical horizon, and
how might policymakers react?
Bosomworth: Counterintuitively,
structural reforms might be making
the ECBs aim of moving inflation
towards its 2% target harder. The
Phillips curve, which shows a
historical inverse relationship
between unemployment and
inflation, is becoming steeper as a
result of the past recession. When
this happens, wages and CPI react
much more to changes in
unemployment: Eurozone
unemployment rose from just above
7% in 2008 to as high as 12% in 2014,
and remains stubbornly high at
10.9%. CPI will rarely rise when
unemployment is high and when
wages are more sensitive to the level
of unemployment. Even in Germany,

where unemployment is quite low,

wages are not rising much partly
because of increased immigration
from other eurozone countries
with high unemployment rates.
To move inflation up towards the
ECBs target, the eurozone needs
to get unemployment down,
and for that it needs more
economic growth.
Together, inflations greater
sensitivity to unemployment, high
unemployment and potential
external risks, such as slower growth
in emerging markets, are likely
colluding to keep inflation low, and
we think this constellation will
persist over the cyclical horizon. The
ECB currently forecasts overall CPI
to rise to 1.7% by 2017. We share the
ECB Governing Councils view that
the risks to this forecast are to the
downside. As a consequence, we
think monetary policy may have to
become more stimulative. In our
view, this will likely take the form of
the ECB increasing the quantity of its
current 60 billion monthly bond
purchases by 10 billion to 70
billion per month. Alternatively,
come September 2016, if inflation is
still low and the ECBs inflation
forecast remains as is, which is what
we think will happen, QE might
likely extend into 2017.
Q: Is the increase in migration to
Europe likely to affect its
economies or markets in the
year ahead?
Pagani: The impact of the unfolding
refugee crisis on the European
economy over the cyclical horizon is
positive at the margin due to the
increase in fiscal spending in support
of the migrants. The effect on GDP
and CPI over the next 12 months,

September 2015 Cyclical Outlook: Europe

FORECAST

REAL GDP

HEADLINE INFLATION*

Current**

Q315Q316

Current**

Q315Q316

United States

2.7%

2.25% to 2.75%

1.8%

1.75% to 2.25%

Eurozone

1.5%

1.5% to 2.0%

0.2%

1.0% to 1.5%

United Kingdom

2.6%

2.25% to 2.75%

0.0%

1.25% to 1.75%

Japan

0.8%

1.25% to 1.75%

0.6%

1.0% to 1.5%

China

7.0%

5.5% to 6.5%

1.5%

1.5% to 2.5%

BRIM***

0.3%

2.0% to 3.0%

8.4%

5.0% to 6.0%

World****

2.7%

2.5% to 3.0%

2.1%

2.0% to 2.5%

*U.S. inflation forecast is for core CPI, and Japans forecast reflects CPI ex fresh food and adjusted for the VAT change
**Current data for real GDP and inflation represent four quarters ending Q2 2015
***BRIM is Brazil, Russia, India, Mexico
****World is the GDP-weighted average of countries listed in table above
Source: Bloomberg, PIMCO calculations

however, is likely to be small. The

longer-term impact could be more
significant to the extent that migrants
are allowed to work and integrate into
the labour force. Offsetting this
positive impact is potential political
turmoil stemming from the crisis.
Overall, we think that the market
impact over the cyclical horizon is
likely to be minimal.
Q: Turning to the UK, how do you
expect the economy to perform
over the cyclical horizon? And
what is your expectation for the
BOEs monetary policy?
Amey: The UK recovery is now
starting to look like a classic UK
recovery, where mortgage rates fall,
consumer confidence improves,
housing activity and broader
consumer spending come through
and businesses invest in both

In our view, fiscal

policy is no longer
acting as a drag on
growth in the eurozone.

physical capacity and new

employees. The worry for some time
has been the resilience of the
recovery in the face of poor
productivity growth, lower public
spending and a stronger sterling;
however, with mounting evidence of
rising productivity and real wage
growth, the UK recovery now looks
well supported. Our expectation is
for real growth to continue at an
above-trend pace of 2.5% over the
next 12 months.
Inflation remains well below the
BOEs 2% target, with headline CPI
hovering around zero, while the core
rate has stabilised around 1%. Our
expectation is that a tight labour
market and strong domestic demand
will drive the core rate higher, with
headline inflation converging to core
at around 1.5% in 12 months time.
That in turn should be sufficient for
the BOE to finally start the monetary
tightening cycle, which we believe to
most likely be in May 2016. By that
time, headline CPI will have spent
several months above the 1%
threshold, and we expect the BOE
should be sufficiently confident of
inflation returning to its 2% target
within their two-year horizon. We
expect two hikes of 25 basis points
over the cyclical horizon.

Q: How will PIMCOs outlook for

growth, inflation and monetary
policy in Europe guide the
companys investment strategies
over the medium term?
Pagani: Looking at interest rates, we
think that there is value left in
intermediate maturities, which do not
fully discount the possibility of a QE
extension beyond the ECBs
September 2016 deadline and provide
good carry opportunities. At the same
time, we remain underweight the
front end of the yield curve, which is
trading at negative yields, and
underweight the long end, which
does not seem to compensate
sufficiently for the increased volatility
and the possibility of ECB reflationary
success beyond the cyclical horizon.
The scenario of positive growth and
relatively low inflation, coupled with
continued QE, remains supportive for
spreads in Europes periphery, where
we retain an overweight bias in Italy
and Spain. Our overweight position
in these peripheral economies is held
as a stable positive contributor to
carry in the portfolios, rather than on
the expectation of continuous spread
tightening over the cyclical horizon.
In the corporate sector, we also
look outside of Europe, for example
to the U.S., where we believe the
recent spread widening relative to
Europe provides investors with
better risk rewards.
Finally, in currencies, we continue to
maintain an underweight bias to the
euro versus the U.S. dollar. However,
in the context of portfolio
construction, we focus our attention
on position sizing that has to
acknowledge the fact that the euro
has been developing a price behavior
that is positively correlated to other
risk assets.

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