Will politicians make common breath..? explains Neel Kashkari

Chaos Theory

• Debating a future of inflation vs. deflation is radically new territory for investors. The chaotic nature of the choice facing societies is whipsawing equity markets and dominating bottom-up factors.
• Equity investors seem to be pricing in a combination of outcomes, with the largest weighting going to a goldilocks, mild inflation scenario. But the market’s large daily swings reflect jumps back and forth as investors update the probabilities of very different destinations.

Once per quarter investment professionals from across PIMCO’s global offices gather in Newport Beach for our Economic Forum. These sessions have been the foundation of PIMCO’s investment process for years; we debate and update our short-term and long-term views for the global economy, and, from that, for individual asset classes, such as government bonds, corporate bonds, mortgages and stocks. Last month we gathered for our December Forum and the topic that dominated the discussion, as it has in recent quarters, was the fate of the euro. Will the eurozone break up? Will European governments impose extreme, deflationary austerity to control their deficits? Will the ECB monetize the region’s debts and risk inflation in order to preserve the common currency? 

This is a debate that has raged within PIMCO for quite a while. There is a wide range of opinions, each supported by relevant precedents and sound economic reasoning. Yet despite our intense focus, we don’t know the answer with certainty. 

Here in America we too face a similar question, though markets are not currently demanding an immediate answer. For the last few decades America has fueled its economic growth by borrowing and consuming, and, in doing so, has racked up large, unsustainable debt. Families that take on too much debt must eventually cut spending, either to pay back loans, or at least because banks stop lending them money. They are eventually forced into some combination of austerity and default. But countries with their own currencies have a choice: 1) austerity-induced deflation, or 2) print money and eventually trigger inflation, which makes their debts easier to pay off, while robbing creditors of the real return they were promised. Will we find the political will to cut spending? Or will we continue running large deficits? Will the Federal Reserve resume quantitative easing, in effect monetizing our debts? Will it unintentionally trigger inflation?

Listening to my colleagues make their arguments during the Forum, I was taken back to my days fifteen years ago when I was an engineering graduate student at the University of Illinois. You may wonder what a debate about the global economy has to do with engineering. It reminded me of one of my favorite classes: nonlinear systems – the study of natural and man-made systems that, at times, behave very oddly. Allow me to explain.

Most systems we interact with every day are linear: if you change an input to the system by a small amount, the output will also change by a small amount. Think about driving to work: if you leave your house 10 minutes early, you will usually arrive about 10 minutes early. If you turn up the flame on a stove a little, the pot of water will heat a little faster.

But some systems, under certain conditions, behave very differently. These systems are said to have “sensitive dependence on initial conditions” – very small changes of the inputs can lead to enormous variations of the output. Mathematicians have given these systems the label of being “chaotic” and experts in the field are called “chaoticians.” (The term “chaotician” always struck me as ridiculous. Could you imagine introducing yourself this way?) The weather is the best example of a real-life chaotic system. Predicting the weather beyond a few days is impossible because minor variations lead to large changes in the future. Go back to the driving example: if you leave 10 minutes late, rather than 10 minutes early, you might hit rush hour, and the extra 10 minutes ends up costing you an hour. Chaos theory describes the conditions under which a system changes from linear and smooth to highly nonlinear and violent, where minor changes to the inputs will lead to enormous variations of the output.

Western societies are facing a seemingly minor choice, but that choice will lead to vastly different endpoints for the global economy and for asset prices.

In a “normal” economic environment investors debate a narrow range of outcomes: will the U.S. grow by 2.8% or 3.2%? Will inflation remain at 2.0% or climb to 2.3%? Debating a future of inflation vs. deflation is radically new territory for investors. The chaotic nature of the choice facing societies is whipsawing equity markets and dominating bottom-up factors.

While we don’t know with certainty which path societies will choose, we can identify a few potential outcomes and make reasoned assessments of what they mean for the economy and for equities:

1. Austerity and deflation

Borrowing money to consume allows families and societies to live beyond their means – for a time. Once the debt accumulation has run its course, reality has to set back in. For a family that may mean getting rid of a second car, dining out less often or cuts which are far more painful. It necessarily means consuming less, and to the extent that consumption equates to standard of living, it likely also means a reduced living standard. Societies face a similar challenge. The U.S. and parts of Europe have enjoyed exaggerated living standards enabled by borrowing from our future. Now that creditors are warning us they won’t let this continue forever, governments may reach consensus to cut spending and/or increase taxes to bring budgets into balance. Whatever the mix, by definition this likely means lower economic growth and perhaps a lower level of overall economic activity until debts are worked off and real growth restored. Deflation runs the risk of creating a vicious cycle, where prices fall, causing wages to fall, causing spending to fall, causing prices to fall further. This is a lower risk for a growing population such as in the United States, whereas Japan continues to suffer from such stagnation today. Europe’s demographics are much worse than America’s. The outlook for equities in this environment is negative in the short run and potentially very negative in the long run if a deflationary cycle kicks off. Corporate earnings at some point must be linked to economic growth, and stock prices represent the present value of a future stream of earnings. In a deflationary environment cash will be king – because your purchasing power will increase by just sitting on the sidelines.

2. Explicit default
The scenario of governments not paying back their creditors is extremely unlikely for countries that have their own currencies. Why default on your debt, which would trigger a crisis of confidence in your economy, when you can simply print more money? Of course, unpredictable politics can make the unthinkable possible, as we came dangerously close to seeing this summer with Washington’s debt ceiling debacle. In Europe it is likely some smaller countries, such as Greece, will default on their debt. They simply have taken on more debt than their economies can reasonably hope to pay back. And they don’t have their own currency, so printing drachma is not an option. It is hard to imagine a scenario where an explicit default would be good for equities. Just how bad depends on the size of the country defaulting and the extent of the preparations put in place to minimize the damage. For example, if countries have capitalized their banks to withstand the losses from a Greek default and the ECB funds Italy and Spain so they are not at risk of contagion, the impact to equities should be more muted. An uncontrolled default, or a default of a larger country would be very bad for risk assets and could trigger a deflationary spiral described above.

3. Mild inflation
Mild inflation is the goldilocks scenario: central banks print money to help fund governments while they employ structural reforms to make their economies more competitive and generate long-term growth. Such structural reforms take time to produce results, often many years. Printing money provides governments with that time while, in theory, reducing the sacrifices citizens must make, and the inflation that usually follows makes the fixed debt stock easier to service, because prices (and hence taxes) increase. It often results in a falling currency, which makes exports more competitive. It is easy to see why countries with their own currencies usually choose inflation as the preferred response to overwhelming debt. Although creditors suffer because the purchasing power they were expecting has been reduced, society has to make fewer hard choices and can continue to enjoy its exaggerated standard of living until the pro-growth economic reforms come to the rescue. In a scenario of mild inflation, equities should do well. Prices are contained, the economy functions and corporate profits should continue increasing. Of course, if policymakers do not use this time to implement real economic reforms, which can still be painful for certain constituencies, mild inflation doesn’t solve anything. It just delays the necessary day of reckoning.

4. Runaway inflation
The danger of mild inflation is that it may not remain mild. Inflation is driven by expectations, the collective beliefs of what the future holds that reside in the minds of millions of people. If people expect prices to go up, they will demand higher wages so they can maintain their standard of living. This will increase the cost of labor, pushing the cost of goods higher. A vicious cycle of inflation can take hold as prices climb higher and higher. The U.S. suffered from double-digit inflation in the 1970s, and in an extreme case, Germany suffered from hyper-inflation following World War I. Runaway inflation is devastating because an economy loses its anchor. People are afraid to hold cash because their purchasing power drops rapidly and so they must hoard real assets. Interest rates soar causing investments to plummet. Central bankers are generally afraid of attempting to induce mild inflation for fear they may nudge expectations more than they hoped. Nudging the collective beliefs of millions of people is an inexact science. The Federal Reserve is cautiously experimenting with its expectations-nudging-arsenal with its recent communication innovations. Runaway inflation would be very bad for most risk assets and equities in particular because of the devastating affects on real economic growth and the increases in costs of production and of capital. A loss of faith in paper currencies would mean gold and real assets would likely be king.

5. Miraculous growth
A list of potential solutions to our unsustainable debt load would be incomplete without including a high growth scenario. It is true there could be a major breakthrough in, for example, energy technology that spurs extraordinary economic growth, which would drive tax revenues higher and enable governments to pay down their debt without asking their citizens to give up their exaggerated living standards. In such a scenario, equity returns would likely be very strong, especially for the sector enjoying the innovation. The technology sector in the 1990s was an example. However, such a scenario today is low-probability. We invest based on what we think is likely to happen, rather than what we would like to happen. Policymakers can’t count on a growth miracle and neither can investors. And don’t forget the bumper tax revenues of the 1990s actually led to increased government spending in some cases when politicians wrongly assumed the increased tax revenues would last forever.

While the expected value of two equally possible outcomes, 0 and 1, is 0.5, there is zero chance the outcome will actually be 0.5. It will either be 0 or 1. Based on the level of the stock market today, with a price to earnings ratio of about 13x in the developed world and 11x in the emerging economies, equity investors seem to be pricing in a combination of these outcomes, with the largest weighting going to the goldilocks, mild inflation scenario. But the market’s large daily swings reflect jumps back and forth as investors update the probabilities of these very different destinations.

I believe societies will in the end choose inflation because it is the less painful option for the largest number of its citizens. I am hopeful central banks will be effective in preventing runaway inflation. But it is going to be a long, bumpy journey until the destination becomes clear. This equity market is best for long-term investors who can withstand extended volatility. Day traders beware: chaos is here to stay for the foreseeable future.

PIMCO sees as MINSKY for 2012

 
PIMCO Cyclical Outlook: Deleveraging, Austerity and Europe’s Potential Minsky Moment

• ​As things stand today, it is more likely that the ECB will leap to a rescue only when it is too late. Absent any increase in private or external sources of aggregate demand, the eurozone economy will likely experience a recession in 2012.
• Chinese deleveraging and rebalancing could mean much slower Chinese growth and a smaller impact of Chinese aggregate demand on the global economy.
• We expect the global economy to grow by 1% to 1.5% in 2012. This is significantly slower than the 2.5% growth rate achieved in 2011 and the 4.1% rate achieved in 2010. 

The year ahead will likely be very challenging for the global economy. Growth faces several hurdles that we believe collectively will impose a sense of greater uncertainty and increased volatility on financial markets. These hurdles include the need for accelerated balance sheet deleveraging, slowly creeping but surely rising risks of financial and economic de-globalization, and the constant drum beat of re-regulation, particularly in developed country banking systems.

Global balance sheet deleveraging will play the dominant role in PIMCO's current cyclical economic outlook. Front and center in this regard is the rapidly progressing sovereign debt crisis in the eurozone, the debt deflationary feedback loop associated with it, and the quality and quantity of policy responses applied to contain it. As goes the eurozone deleveraging, so goes the global economy over the next six to 12 months.

 

The eurozone is facing an accelerated reversal of imbalances accumulated over several years after the creation of the euro. These imbalances are the product of differing real trends in productivity, labor flexibility, and national savings and investment rates across the member nations of the eurozone. Prior to the implementation of the single European currency, current members had individual currencies and individual control of their respective money supply, making it relatively easy to absorb real economic differences via relative currency value changes and inflation differentials. Today, however, those countries that adopted the euro do not possess the same degree of flexibility needed to smoothly diffuse frictions along these fault-lines. With one common currency and one common central bank, but individual fiscal agents and differentiated trends in economic performance and governance, the full burden of reversing sovereign deficit and debt imbalances falls onto the shoulders of only the fiscal agents. And as we see it, fiscal agents have one option and one option alone: deleverage the government balance sheet by practicing secular austerity.

 

To judge the impact of eurozone deleveraging on the global economy, we must answer three questions. First, how much austerity will the eurozone impose upon itself to restore the balance between debtors and creditors? Second, will eurozone sovereign haircuts or defaults remain a part of the deleveraging process? And third, what role will the European Central Bank (ECB) play in controlling the depth, breadth and velocity of sovereign debt deleveraging?

 

Stress Testing the Plan
Eurozone governments are about to legislate a plan of significant fiscal austerity over the coming years. By PIMCO estimates, austerity programs across both healthy and unhealthy balance sheet countries in the eurozone will pose a drag on growth to the tune of 1.5 to 2 percentage points over the next 12 to 24 months. This means that, absent any increase in private or external sources of aggregate demand, the eurozone economy will likely experience a recession in 2012. Indeed, PIMCO expects the eurozone economy to shrink by 1% to 1.5% in 2012.

 

Eurozone sovereign haircuts and defaults will likely remain a part of the deleveraging outlook. The acceleration of the European Stability Mechanism (ESM) and the introduction of collective action clauses on newly issued sovereign debt under the ESM mean that future haircuts, write-downs and private-sector subordination are still possible -- and probable. This, in turn, means that eurozone banks -- which have been the chief private-sector financiers of eurozone sovereigns -- will need a substantial amount of new capital to maintain their own balance sheets and provide ongoing credit to the real economy for growth. This new capital will be needed primarily to fill the ex ante equity hole generated by now “risky" sovereign credit exposures. It will also be a necessary condition for maintaining an effective monetary policy transmission mechanism to the eurozone real economy. If eurozone banks remain under-capitalized for much longer, their borrowing costs could climb too high for credit growth, and they would be forced to deleverage private credit commitments at a time when eurozone sovereigns are attempting to do the same with fiscal policy.

 

To be clear: The eurozone economy cannot bear a concomitant deleveraging in sovereign and banking system balance sheets, given an already weak growth outlook.

 

The ECB, therefore, must play the critical role of deleveraging police in the year ahead. Only the ECB has a balance sheet large enough, credible enough, and flexible enough to prevent the eurozone sovereign and banking system deleveraging from turning into an uncontrolled Minsky Moment (referencing economist Hyman Minsky and referring to the inflection point when investors must sell assets to pay off debts, pushing down asset prices across the board). An acceleration of the debt deflationary feedback loop will be the odds-on outcome if the ECB continues to play coy with its own balance sheet. The ECB must, at some juncture in the not so distant future, become a lender of last resort to eurozone sovereigns. And, equally important, it must do so with a transparent and credible plan such that private sector demand for eurozone sovereign debt is crowded back in before it is permanently destroyed. 

 

But what will it take for the ECB to make this leap from a bankers' banker to a sovereigns’ banker? To begin to answer this question, we have to consider the mandate of the ECB and the "game of chicken" being played between European fiscal agent and the ECB.

 

The ECB’s Evolving Mission
First, the ECB has a clear mandate of maintaining price stability and nothing else. In the best traditions of the German Bundesbank, the ECB maintains fierce independence from fiscal policy and financing sovereign deficits and does not believe it is responsible for shaping cyclical real growth outcomes (unlike the U.S. Federal Reserve). A key question, however, is whether the ECB's mandate is symmetrical around low and stable inflation? Will the ECB act aggressively to combat deflation, as it does to combat above-target inflation when the time comes? And if it will, what tools will it be willing to use, especially if policy rates are already at the zero-bound and the transmission mechanism of policy is broken? At this point, the rate of inflation in the eurozone is too high for the ECB's liking and is thus likely to prevent the ECB from taking any dramatic steps to pre-emptively combat the forward deflation risks arising from a deteriorating economic outlook across the eurozone.

 

Second, the ECB is engaged in a dangerous but necessary game of chicken with eurozone fiscal agents, which prevents it from becoming a transparent and credible lender of last resort to eurozone sovereigns. On the one hand, with the credit transmission mechanism broken and bank balance sheets stressed, the ECB recognizes that it must prevent sovereign bond prices from falling too far. On the other hand, the ECB remains fearful of introducing secular moral hazard into the process of enhancing fiscal unity and stability across the eurozone by pre-emptively financing fiscal deficits. This game cannot continue for too much longer. If it does, we believe either the deteriorating economic prospects for the eurozone will accelerate the feedback loop to its Minsky Moment, at which point sovereigns and banks will enter a race to try to out-deleverage the other; or the ECB will take pre-emptive action to become a transparent and credible lender of last resort to sovereigns thereby stabilizing the eurozone banking system and the eurozone economy. As things stand today, it is more likely that the ECB will leap to a rescue only when it is too late. As a result, the odds of a European Minsky Moment are uncomfortably high now.

 

Chinese Growth Levels Off as U.S. Deleveraging Continues
Moving from Europe to Asia, China has joined the U.S., the eurozone, Japan, and the UK in some form of balance sheet deleveraging. However, we expect Chinese deleveraging to be rather benign as long as policymakers use their substantial financial resources to manage the process over time. China for the last two years has engaged in an accelerated program of domestic investment via rapid credit creation in its domestic banking system. This has provided the global economy with a substantial and much-needed boost to aggregate demand at a time when developed economies were all undergoing private sector deleveraging. But this source of global aggregate demand is slowing significantly now. 

 

Due to a combination of issues ranging from excess capacity, rising income inequality and bank capital stresses that will require a slowdown in the rate of credit creation, China is likely to slow future domestic investment in favor of a more balanced and stability focused growth model. China is likely to use its substantial public financial resources to address imbalances between domestic investment and consumption, between capital and labor shares of national income, and to slowly re-capitalize its banking system as non-performing loans crystallize to losses. The major implication for the global economy is that the process of Chinese deleveraging and rebalancing could mean much slower Chinese growth and a smaller impact of Chinese aggregate demand on the global economy. PIMCO expects the Chinese economy to grow by just 7% in 2012, significantly below consensus expectations of 8% to 8.5% real growth.

 

And what of the States? The U.S. economy continues to make steady progress in private sector deleveraging, but little to no progress when public sector balance sheets are included. U.S. households and banks have generally reduced debt either via defaults or orderly recapitalizations, and many companies have benefitted tremendously from a weaker dollar and strong growth in global trade via the emerging market economies. Despite the progress made to date, the process of U.S. deleveraging is not nearly complete. This is especially the case given that the U.S. government continues to run large structural deficits to support private sector aggregate demand, and that demographically driven unfunded liabilities are starting to crystallize onto public balance sheets at a faster rate.

 

Were it not for the brewing crisis in the eurozone, and the expected slowdown in aggregate demand in China (and other emerging economies), the outlook for the U.S. economy might have been relatively sanguine for the year ahead. In 2011, U.S. GDP grew by a modest but decent 1.5% to 1.75%. But with global headwinds gathering -- and U.S. expansionary fiscal policy becoming much more difficult to maintain -- we think the U.S. economy will only manage 0% to 1% growth in 2012. This is substantially below the industry consensus expectation of 2% to 2.5% growth.

 

Turning from deleveraging to de-globalization, we believe the most important component of this creeping process is occurring in global finance. Global imbalances between savings and investment have long been sustained via cross-border intermediation across an integrated global banking system. European banks have played the major role in this process, with American and Asian banks being perhaps a degree less important. We have discussed the potential impact of European bank deleveraging on the eurozone economy, but have not spent much time on how they might impact the global economy in a direct way. The eurozone banking system is 2.5 times as large as the U.S. banking system, in part because it plays an important role in intermediating global savings. At $41 trillion in total balance sheet assets, the impact of a eurozone banking system deleveraging would dwarf the effect of any successful re-leveraging of the U.S. banking system, which is only about $16 trillion in size. The race to higher capital ratios combined with sovereign stresses means that the global banking system will likely turn inward and the process of cross-border savings intermediation could slow substantially in the year ahead. This is yet another hurdle for global growth.

 

A second component of de-globalization is the glacial but observable increase in trade skirmishes between the U.S. and China. There have been a series of tit-for-tat tariff increases lately, and the U.S. political machine has begun to increase calls for a more transparent and open Chinese economy only to be summarily rebuffed by Chinese officials. This glacial trend is an important one to watch, as trade between U.S. and China has been a very important source of strength for large portions of the global economy.

 

Finally, the cyclical outlook would not be complete without a mention of MF Global and the implications thereof on financial re-regulation.  We have long suggested that the developed world financial system has begun a gradual  process of returning to "utility banking,” a boring destination where the financial system largely separates deposit taking and loan making from the riskier endeavors of leveraged finance and asset price speculation. MF Global is likely to spark an acceleration in this process, only because it has shown that the regulatory changes planned (and yet to be fully implemented) after the collapse of Lehman Brothers in 2008 have done little to protect investors from concentrated financial system risks. We expect to see changes in the regulatory architecture of capital markets that may reduce system-wide liquidity, increase financial transaction costs and de-risk balance sheets even further. Think of this as an incremental source of friction to global growth in the year ahead.

 

In sum, we expect the global economy to grow by 1% to 1.5% in 2012. This is significantly slower than the 2.5% growth rate achieved in 2011 and the 4.1% rate achieved in 2010.  The risks to this forecast lay to the downside, which speaks to the question of inflation expectations.  We expect global inflation to slow to 2% in 2012 from 3.1% in 2011.