Pimco’s predictions take a pessimistic turn

Pimco has warned that its outlook for the global economy has declined sharply in recent months, predicting the world will enter a two-to-five-year period of instability as governments seek to address economic imbalances.

Scott Mather (pictured), Pimco’s head of global wealth management, says the world’s sovereign debt problems will be a drag on the world economy and a risk to investors, even if they diversify their holdings away government bonds.

“You can’t escape a sovereign debt problem by investing in other asset classes; all you can do is have a bigger problem,” Mather says.

“Sovereign bonds are the foundation from which all of the other financial assets are valued and if that starts shaking and becomes unstable forget about real estate, equities and everything else, it all does worse.

“The sovereign debt problem is not going away. It is going to be with us for many years, so it should result in higher risk premiums in risky assets like equities as well.”

Mather says investors are entering a “policy-driven world” where governments will try a range of “experimental” options to try and rebalance their economies.

“The balance of risk, in our view, is tipped to the downside and these imbalances are really starting to weigh on prospects going forward,” Mather says.

Governments and central banks will reach for different economic policy tools to attempt to improve their economies, leading to sharply different outcomes, Mather says.

The political constraints policy makers face will also shape how different governments react to the challenges facing their economies, with Pimco expecting inflation and growth levels to vary between different countries.

Mather says Pimco predicts that developed world economies will “teeter on zero growth, with several economies slipping into recession”.

“What we are grappling with now is the developed world trying to grow without accumulating debt, and we have reached a tipping point where markets are no longer willing or able to finance that debt growth,” he says.

But Mather notes the low growth environment makes for “interesting times and lots of opportunities” for bond investors.

“Low growth and low inflation usually means higher bond prices, and that is something that holds true today,” he says.

“But what we anticipate we will have to deal with is that a lot of the traditional areas of the bond market are becoming riskier.

“And, that is true for the sovereign market as well. What you used to think of as something being risk-free has changed, and that presents some new risks to the whole economic system – but provides some opportunities as well.”

Mather rates his biggest concerns as being a further deterioration in the Eurozone, while on the upside he says the possibility of economic coordination between countries in a way not seen before could provide exciting opportunities for investors.

In managing the risk posed by sovereign debt concerns in Europe, Pimco has been under-invested in Portugal, Ireland and Greece.

It has also been underweight in Spain, but at times also has taken opportunities there if the price was deemed attractive.

Mather says Pimco is keeping a close watch on policy movements in Europe and the eventual effect this has on economic fundamentals of particular countries.

Mather says Europe is faced by two stark choices: either for Europe to disintegrate; or for a far closer fiscal union to emerge.

Pimco is also expecting a substantial deal to restructure Greece within the next three months, which, if handled correctly, could provide a confidence boost for the market.

But beyond policy and fundamentals, Mather says investors should not lose sight of the fact that even struggling European countries can provide tactical opportunities if the risk/reward premiums are attractive enough.

“The market can move and overshoot and move far in advance of the fundamentals, and we as investors can’t just have your fundamental and policy goggles on – market prices matter,” he says.

“Even risky bonds can become attractive if the price is low enough and there might be very great risk/reward opportunities to invest, even in the three problem countries [Portugal, Ireland and Greece].

In the US, Pimco is expecting further action from the Federal Reserve, including a higher degree of coordination from both fiscal authorities and regulators, to find innovative ways to ease mortgage stress in the housing sector.

Mather says that this push to re-ignite the country’s flagging growth will follow a change in the language used at the Fed.

“Maybe the first thing you will see is a change in the language,” he says.

“They [the Federal Reserve] are going to try and guide expectations and give people this notion that ‘you can rely on us’, because we have two settings: accommodative; and more accommodative.”