US in longest economic expansion since 1945: Joachim Fels, PIMCO

In a chat with Tanvir Gill of ET Now, Joachim Fels, Global Economic Advisor, PIMCO, says we are flying close to stall speed but there are no excesses that could lead to a recession any time soon. Edited excerpts

Tanvir Gill: My first question to you is regarding the market recovery that we are seeing over the course of the last month and a half. What do you make of this startling recovery for world markets from February lows? Does that indicate that investor sentiment has changed for good or is this as good as it gets for the rest of the year?

Joachim Fels: Well the market has recovered quite nicely from the early February lows. I think this is not only driven by the Fed but it is really on three-fronts that we have seen some improvement -- we call it the three Cs -- China, commodities and central banks. And the three Cs are related of course. I think what happened was that the market was very scared in January and February about the prospect of further Fed rate hikes, reaction from China in terms of larger currency depreciation and also the market was very scared about the plunge in oil prices that we had been seeing. When oil went all the way down to $30 and for some time even below that and the worries were that this was signalling a coming global recession that would see an increase of defaults in the energy sector. Then of course, central banks also contributed to the sell off because when Japan announced the introduction of negative interest rates, this really hit bank stocks. So that is the explanation. It is the combination of the three Cs; China, commodities, and central banks that help to explain the selloff. Now on all of these three fronts, we have seen improvement. So central banks have realised that pushing rates too negative is not a good thing. So the ECB has been focusing on domestic credit easing and helping the banks instead of cutting interest rates aggressively further. The Fed has become much more dovish. So Janet Yellen is now signalling only at most two rate hikes this year so we have come down on the central bank front and this has helped China to fix the currency relatively well against the dollar and it has also helped oil prices to recover. So we are in much calmer mood now and I think this is likely to continue.

Tanvir Gill: While you have highlighted the three Cs -- China, commodities and central banks have eased the whole story about policy divergence. But how healthy is this policy convergence among all the big central banks? It has not quite helped revive global growth in a meaningful manner?

Joachim Fels: The central banks have learned from the lessons of last year. The lesson was really that too much policy divergence is not a good thing. Too much dollar strength resulted from policy divergence when the Fed was hiking interest rates and the ECB and the Bank of Japan were cutting interest rates and doing more QE. So too much dollar strength is also not a good thing. There is now something in place that I call the Shanghai coop, it is a loose agreement that was struck by the four major central banks -- the Fed, the ECB, the Bank of Japan and the People’s Bank of China back in February when they met in Shanghai for the G20 meeting. I think there is an agreement in place to broadly stabilise the dollar. The dollar strength of last year was bad news for almost everyone because it hurt emerging market and those corporates and emerging markets that had taken up a lot of dollar debt; it hurt China because China’s currency appreciated alongside the dollar at a time when China was slowing and it also hurt the US because it led to a tightening of financial conditions which led to a slowdown in the US economy and kept inflation below target. So there is now an informal agreement in place and it seems to be working. It has stabilised markets so I would expect this to continue in the foreseeable future.

Tanvir Gill: Do you expect the dollar to remain stable at current levels 94-95 or could it go lower?

Joachim Fels: Yes, I think there is a certain limit to how weak the dollar can go and that limit is really defined by the ability of Europe on the one hand and that of Japan on the other to stomach further currency appreciation against the dollar. The euro has strengthened a lot. The yen has strengthened even more against the US dollar and I think this is now hurting the European and the Japanese economy. More importantly, it is making it very difficult for the ECB and the Bank of Japan to achieve their inflation objective. Inflation is too low in these countries. They want to see higher inflation. A stronger currency does not help. So I would expect to see more action in the foreseeable future from Japan, maybe as late as at the end of this month when the BOJ holds is policy meeting. I think we will also see more action from the ECB later this year in the form of more easing, more QE, potentially also a little bit more rate cuts and I think this will prevent an excessive weakening of the dollar. So while early this year, the dollar was too strong, you could now argue it has become a little bit too weak at least for the taste of the Europeans and the Japanese and I think the policy reactions we will see will keep it in broad range.

Tanvir Gill: My next natural question then is – what happens in the upcoming Fed meet? Most expect no rate hike this time but a clearer indication on when the second one could be timed. You are expecting at most two rate hikes this year; however, opinion is also building on a no-show for the rest of 2016 and there being a reasonable chance of a rate hike next only in Jan of 2017. How do you map the course of rate hikes from here?

Joachim Fels: Well I think the markets are clearly pricing in very low chance of a rate hike anytime soon. Even for December, the probability of a rate hike priced into the market is now at below 50 per cent, it is closed to 50 but below 50 per cent whereas the Fed, the DoT plot of the Fed still tells us that they think the base case is something like two hikes this year. I think the truth is probably somewhere in between but it really depends on how we will see progress on two fronts. The first one on the domestic front, it is very important to see what inflation will be doing. The Fed is focussed on core inflation. For core inflation, on the measure that they look at most closely is the PCE deflator which is running significantly below 2 per cent and in the next few months it is likely to come down a bit. So inflation will not move towards the target but it will move away from target. So I think this constitutes a case for waiting particularly as Janet Yellen is very focussed on inflation expectations which have also been slipping recently.

The second factor is the external factor, the global factor, and there I think it very much matters what the dollar does, what global financial markets do because the Fed is not only data dependent, it is also financial conditions dependent because today’s financial conditions tell us something about growth tomorrow and the day after tomorrow. So I think the outlook is for near term I would not expect the Fed to move, not at this meeting in April, most likely also not at the June meeting because inflation is moving in the wrong direction, also do not forget that the important Brexit referendum in the UK is only eight days after the Fed meeting in June so I do not think they will want to rock the boat ahead of that referendum which if the British people vote for exit from the European union could cause a lot of market volatility. So I do not think the Fed wants to move before that. But given that we think the US will return to a growth trend of about 2% later this year after the soft patch in the first quarter, given that we think later this year headline inflation will move higher and will move towards 2%. I still think one rate hike and maybe if things go well, even two rate hikes this year is the most likely outcome.

Tanvir Gill: In one of your recent notes, you talked about how US recession in 2016 is unlikely. But your 2016 growth forecast for the region stands at 2 per cent which is below par given past trends. Given your outlook on growth being brittle and bumpy, how much confidence do you have in growth sustaining in the region through 2017 and 2018. The risk of recession is off the table for now, but could it come back to haunt the US economy into the coming few years. Is US growth at a tipping point?

Joachim Fels: This is what we call the new normal, the new neutral world here at PIMCO. This is a world where growth is much lower than it has been in previous cycles. This is a world where inflation is much lower. It is actually below target and it is a world where interest rates and the neutral interest rates is much lower. So in a way you can say we are flying close to stall speed. It does not take much do derail an expansion that is already bumpy below par and brittle this triple B expansion that I have been talking about for a while. Having said that, here is one reason for confidence and it is that typically recessions happen if there is a combination of either excessive consumption, excessive investment overheating and monetary overkill by the central bank that is how recessions happen. You have imbalances in the domestic economy that build up and then the central bank reacts to it and hikes interest rates aggressively. But today’s world is very different. We have no over consumption in the US. If anything, the US consumer has been cautious and has been building up a savings cushion which could be used. Second, there is no over-investment. Yes there was over-investment in the energy sector but that is a relatively small sector. Other companies and other sectors have been extremely cautious in building up capacity. There is no overheating. Wage growth is very low and stagnant. Inflation as we discussed is very low and finally, there is certainly no monetary overkill from the Fed. The Fed is very cautious. So that is why I am quite confident that the recession probability is very low even though we are seeing low growth.

Tanvir Gill: Sure. But in your recent notes, you have also pointed out a recession possibility down the line in the year 2020. So does that mean that each year the risk of a possible US recession still looms on investors’ mind?

Joachim Fels: Yes. The one thing we know is that eventually at some time, at some stage down the road, there will be another recession, that is almost inherent in our capitalist system. You get expansions. You get booms. Towards the end of the expansion, you get excesses either on the debt front or on the inflation front or both on in financial markets more broadly well and then you have usually a short recession, sometimes a very deep recession.

Tanvir Gill: My only follow-up question then is – will we see more growth expansion in the US economy before we hit the next recession or given the question and sustainability of this kind of relatively below par growth, that it is only a matter of time and the clock is ticking on that that the US economy faces headwinds and is pushed into a recession?

Joachim Fels: No I think this expansion has legs in the US. Yes it is already fairly old and mature. It is almost seven years old now. It started in the middle of 2009 but it has been a very unusual expansion. It has been a slow expansion. There are no excesses that could lead to a recession any time soon so that is why I think this could actually become the longest economic expansion in the US since 1945. So far the longest one was the one in the 1990s. It lasted 10 years. This one is seven years old and well it could last even longer than 10 years.