Growth Momentum Is Encouraging, but Global Slowdown and Monetary Policy Limits Weigh on Long-Term Outlook
As the U.S. economy continues a slow healing process and Latin American economies increasingly look both within and externally for sources of growth, a brighter yet uncertain outlook is taking shape. In this issue of the Secular Outlook Series, portfolio managers Josh Thimons and Lupin Rahman discuss key trends and likely inflection points affecting these economies over the next three to five years, and offer insights for investors.
Q: What is your secular outlook for the U.S.?
Thimons: Overall, we find the U.S. economy is much further along the road to repair relative to its developed market peers. Important pockets of strength – energy and technological innovation, for example – contribute to the positive longer-term growth outlook. However, the U.S. is still dealing with an unsustainable fiscal situation, which means achieving economic escape velocity over the secular horizon is far from certain. Also, growing social inequalities have some potential to lead to friction, which could in turn affect the economy.
We expect U.S. GDP growth in the 1.5%–2.5% range over the next three to five years, which is probably not enough to return the economy to pre-crisis levels of full employment. Higher inflation is also a significant risk toward the back end of the secular timeframe as the economy absorbs the impact of hyperactive and experimental monetary policy.
Q: What is the secular outlook for Latin America?
Rahman: The outlook is broadly constructive: We expect overall Latin American growth to be in the 4%–5% range and inflation to be relatively contained over the next three to five years. However, differentiation across the region is very high and likely to persist. On the positive side of the spectrum, there are those countries that have undertaken notable structural improvements and are likely to see relatively strong growth, including Colombia, Mexico and Peru. Others, like Brazil, are in the middle, and are navigating supply-side bottlenecks or face headwinds from the decline in commodities and the global economic slowdown. Finally, at the negative end of the spectrum we have economies like Argentina, which is struggling with a deteriorating and unsustainable macroeconomic and policy framework.
Q: How do policy trends influence the outlook in these regions?
Thimons: Federal Reserve policy is definitely a key factor in the U.S. secular outlook. Within the secular timeframe we expect the Fed will at least be on the path toward policy normalization – both in terms of the policy rate and quantitative easing (QE) program. However, it is extremely unlikely that policy will be fully back to “normal.” The Fed’s balance sheet will still likely be elevated for years to come and the proactive sale of assets is unlikely even in our secular window.
Looking more broadly at U.S. policymaking, unfortunately we do not expect any meaningful fiscal reform. While what is needed is a bipartisan compromise on entitlements and tax policy, what is likely over the secular horizon is more of the same: continued congressional inefficiency and animosity. The sequestration is a prime example of likely reform falling far short of optimal reform.
Policy actions could very well bring the U.S. to a “T-junction” sometime in the next three to five years. (A T-junction is an intersection with two contrasting outcomes, but no path to continue in the same direction.) For example, a fiscal policy mistake could take us down a path of too much near-term austerity, which would likely serve to cripple overall growth. Or a fiscal policy turn in the right direction, such as a grand bargain, could be a tremendous and welcome secular boost. However, as I indicated, we see less likelihood of the brighter path given our established political challenges.
Rahman: Global policy actions, particularly the Federal Reserve’s and Bank of Japan’s policies, are important drivers for Latin America’s secular outlook. To the extent that the U.S. moves to a more stable growth and policy front and the monetary experiment in Japan is successful, we could see positive spillover effects for the region. In the event of a policy mistake in the developed world, Latin America is likely to suffer, although the negative impact is likely to be contained for the countries with strong balance sheets and policy flexibility to deal with external shocks.
Aside from global politics, structural policy reform, the so-called second generation reforms, will also be critical to Latin America’s secular growth potential. These include progress on infrastructure investments, implementing fiscal best practices, improving the business climate and deepening legal and regulatory frameworks. Finally, political developments in Latin America will also be a key factor in the secular outlook, with elections in Brazil, Mexico and Argentina expected over the next few years.
Q: How strongly is Latin America’s growth outlook tied to the broader global economy?
Rahman: The region is closely coupled to the rest of the world; what happens in the U.S., China and Europe is especially critical. A relatively positive outlook in the U.S. over the next three to five years would likely mean a knock-on effect in Latin America due to the strong trade linkages via the commodities and manufacturing channels. That said, over the secular horizon we also expect to see an increase in trade among Latin American countries and with other emerging economies.
Q: Currency trends are on many investors’ minds – could you discuss the outlook for the U.S. dollar, specifically?
Thimons: We can view the dollar’s outlook through two lenses: On one side, it is on a race to the bottom versus other developed market currencies. But it may lose this race, as the Fed is not the only major global central bank engaged in extraordinary policy measures. These policy measures are all aimed, at least in part, at domestic currency devaluation. Over the long term, and with the support of a gradually healing U.S. economy, the dollar may strengthen versus its developed market peers, most of which have relatively more tepid secular growth outlooks.
On the other side, the dollar will likely weaken versus key emerging market (EM) currencies due to a combination of factors – the relatively higher real yields in EM markets, the relatively lower levels of sovereign debt, and what PIMCO expects to be a secular outperformance in EM growth over developed economies. While we are observing a longer-term trend of foreign exchange reserve managers diversifying some holdings away from the dollar, over the secular horizon and likely beyond, we see no viable alternative to the dollar as the world’s reserve currency.
Q: What are the key secular investment themes in the U.S. and in Latin America?
Rahman: First, because Latin America is likely to be an increasingly differentiated story, investors should be consistently aware of the credit risk they are taking. Second, we see attractive opportunities in local markets due to the potential for rate compression, which we expect to be borne out by improvements in credit ratings for countries in the positive end of the spectrum. Finally, we expect an increase in external credit issuance across countries, which would offer interesting diversification benefits for hard currency investors.
Thimons: I will echo Lupin’s point on risk awareness, which applies more generally across the global economy. Our secular investment outlook calls for a more defensive posture toward risk. Current valuations are extremely stretched. Since the end of the financial crisis, while real economic activity has failed to rebound forcefully, nearly all asset markets have in fact rebounded with force. We fear that the divergent trends between the real economy and financial markets may be unsustainable, even with a continuation of hyperactive monetary policy. In U.S. fixed income specifically, this suggests positioning for alpha rather than capital appreciation. The outlook also suggests a defensive posture toward credit risk and a focus on healthier parts of the capital structure and healthier segments of the economy, such as energy and housing. Finally, investors should consider an overweight in real assets (assets with the potential to rise in value when inflation increases) and a gradual withdrawal from those assets that are being so artificially supported by central banks.