Economic Outlook

December 2012
Saumil Parikh
Your Global Investment Authority

PIMCO Cyclical Outlook:

At Policy Crossroads
The global economy is in the midst of a cyclical slowdown. The
slowdown visible in real growth and inflation across all major
economies is driven in part by economics and in part by politics.

On the economics front, the cyclical tailwinds from global inventory

replenishment and post-crisis productivity gains are behind us. This is most
evident in slowing corporate profit growth, flatlining commodity prices, and
declining capital expenditures and industrial production in recent months. Global
trade volumes, one of the best indicators of where we are in the business cycle,
have also stagnated recently.

Saumil Parikh
Managing Director
Portfolio Manager

On the policy front, we are at important crossroads in every major economy.

Broadly speaking, developed countries (the U.S., Europe and Japan) are
struggling to find the right fiscal and monetary policy mix between cyclical
stimulus and secular normality. The persistence of imbalances, defined by too
little investment and too much consumption, combined with growing
maldistribution of income, is making this task infinitely more complicated for
political institutions that have not needed to make structural policy decisions
before.
Still in terms of policy, developing economies are not faring much better. Exportled growth models are increasingly under pressure from domestic
overinvestment, rising idle capacity, diminishing productivity and cost increases
that are inevitably caused by importing overstimulative monetary policies via rigid
capital accounts.
The maturation of the global cyclical growth phase suggests we look to a
handoff to more secular drivers of growth. But, with the exception of residential
investment in the U.S., labor productivity improvements in select European
countries, consumption growth in some developing economies and fringe
improvements in global energy production, strong secular drivers remain elusive
due to the continuation of New Normal headwinds from overindebtedness,
imbalances, reregulation, and deglobalization.
Global indebtedness continues to rise amid higher global imbalances. Developed
countries, in general, continue to rely on consumption growth driven by ultraloose fiscal and monetary policies, which transfer debt from private balance
sheets to public balance sheets, endangering future economic growth to deliver
outcomes today. Meanwhile, developing countries continue to rely on
investment growth driven by mercantilist capital account policies that promote
market share gains above productivity increases, which are increasingly being
financed by credit rather than cash flow.

Global regulations are also on the rise. Financial

regulations act as a headwind against renormalizing credit
channels, but are necessary for preventing future systemic
shocks. Capital account regulations remain very high, with
developing countries increasingly resorting to new forms
of controls to combat ultra-loose monetary policies from
developed country central banks. Environmental
regulations, while not a headwind to cyclical growth thus
far, are likely to become a reality in the not-so-distant
future.
Deglobalization is starting to enter the equation as well.
Domestic maldistribution is leading politics away from
global coordination and toward domestic agendas.
Combined with increased transportation costs, the trend
of public and private policies to slow globalization is
hurting global trade growth, one of the key contributors
to economic growth over the past cyclical and secular
periods.
At our recently concluded December Cyclical Economic
Forum, PIMCOs regional portfolio committees led by Josh
Thimons (Americas), Ramin Toloui (Asia-Pacific) and
Lorenzo Pagani (EMEA) presented on cyclical topics that
included the outlook for U.S. housing, the likely resolution
of the U.S. fiscal cliff, Chinas leadership transition and
policy implications, Japans turn to nationalism and the
next steps toward European financial and political
integration, all of which are discussed below in the context
of our cyclical economic forecast for 2013: a year of policy
crossroads.
In the United States, 2013 will bring a policy mix of
untimely fiscal tightening and increasingly ineffective
monetary easing, amid a mixed but relatively stable
economic outlook. We expect residential investment will
be the dominant driver of domestic demand in the U.S.
economy, growing by 20%30% on the year and
contributing a respectable 0.5%0.75% to U.S. growth
improvement. Home prices are expected to keep up with
inflation. Against this, the U.S. economy will be buffeted
by a weak external environment for exports and an
uncertain environment for capital spending as secular fiscal
policy uncertainty is unlikely to be resolved in a meaningful
manner over the cyclical horizon. While we expect the
fiscal cliff issue to be behind us (resulting in a 1.25% to
1.75% drag on GDP) by the time we reconvene for the
March Cyclical Economic Forum, we continue to believe
that most of the difficult decisions regarding long-run
fiscal uncertainties will remain unresolved during 2013.
We expect the U.S. economy to grow between 1.25%
and 1.75% in 2013, below the 2% growth rate achieved
in 2012.
In Europe, the European Central Bank (ECB) will continue
to be the only active policy institution. In 2012, the ECB

made an important policy decision of conditional, but

unlimited, balance sheet expansion to clip the left tail risk
of disorderly deleveraging, but it has yet to address the
declining outlook for European growth during 2013.
Europe does not have an active growth policy for 2013.
Fiscal austerity, while likely to be less severe in 2013, will
continue to be a drag on growth. Private credit rationing
and bank deleveraging will remain a reality, and labor
productivity increases are not yet large or disperse enough
to generate private investment growth to counter public
spending cuts. We expect the eurozone economy to
shrink between 1% and 1.5% in 2013.
In China, 2013 will challenge the new political leadership
with a weak external demand environment, diminishing
returns on domestic investment and the urgent need for a
more balanced growth model. While 6.5% to 7.5%
growth is likely to be achieved over the year in
China, the prospect of realizing the 7.5% secular growth
target beyond 2013 will hinge importantly on structural
changes being executed in a timely fashion from this year
onward. We will be looking for policies that strengthen
the household sector balance sheet, giving security to an
aging population planning for retirement. We will also
look for the development of a domestic service sector,
including financial and credit services that allow for the
smooth disintermediation of high domestic savings across
the private sector to facilitate more consumption and more
productive investment to boost domestic demand. It is
clear, from our discussions, that China cannot sustain its
current growth model for more than a few years.
Domestic leverage is on the rise, and productivity is on the
decline.
Japans economy in 2013 will perhaps see more interesting
developments than it has for several years. The rise of
political nationalism in the aftermath of a devastating
economic shock from 2011s Tohoku earthquake and
tsunami promises to alter the policy landscape in a
meaningful way. First, we expect a more dovish and active
Bank of Japan in 2013, driven by a prospective leadership
change in that direction. Struggling to combat currency
appreciation with deflation expectations firmly entrenched,
the Bank is likely to adopt more aggressive balance sheet
policies to try to raise inflation expectations in Japan, not
unlike what the Federal Reserve, the Bank of England and
the ECB are attempting to do. Second, we expect a new
government that is more focused on domestic growth and
stability issues, in particular accelerating the rebuilding
efforts, shoring up domestic energy security and
potentially remilitarizing the country gradually against a
rising regional power in China. Japans monetary and
fiscal policy outlook suggests a year of positive
growth in 2013, with a PIMCO forecast of 0.5% to
1.0% growth.

DECEMBER 2012 | ECONOMIC OUTLOOK

2013 will be the year of policy change. Global

policymakers will face both domestic and international
pressures to enact structural changes across all the major
economies we cover. At stake is the continuation of
current growth trends, and the successful handoff of

public-policy-driven growth to private sector growth prior

to the exhaustion of balance sheets that have supported
the global economy through this New Normal recovery
from crisis.

Table 1: PIMCO Cyclical Outlook

Forecast

Real GDP

Headline Inflation

Current*

Q4 12 Q4 13

Current

Q4 12 Q4 13

2.2%

1.25% to 1.75%

2.2%

1.8% to 2.3%

0.6%

1.5% to 1.0%

2.2%

1.0% to 1.5%

United Kingdom

0.0%

0.0% to 0.5%

2.6%

2.0% to 2.5%

Japan

0.0%

0.5% to 1.0%

0.4%

0.5% to 0.0%

China

7.4%

6.5% to 7.5%

1.8%

2.5% to 3.0%

BRIM**

2.7%

3.5% to 4.0%

6.8%

6.0% to 6.5%

World***

2.0%

1.5% to 2.0%

2.5%

2.0% to 2.5%

United States
Eurozone

*Current data for real GDP and inflation represent four quarters ending Q3 2012
**BRIM is Brazil, Russia, India, Mexico
***World is weighted average sum of PIMCO forecast countries
Source: Bloomberg, PIMCO

DECEMBER 2012 | ECONOMIC OUTLOOK

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