AllianzGI Insights - April 2015

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Volume 7, Issue 4
Allianz Global Investors
Insights
April 2015
Global View
Imagining the Unimaginable
On 10 March, near the beginning of
the European Central Bank’s (ECB) bondbuying programme, Executive Board
member Benoit Coeure made a noteworthy
comment: More than half of Germany’s
outstanding debt had a negative yield
to maturity.
To some market-watchers, this statement
would have been unimaginable a mere six
months ago, and surely marked an epochal
event that would be long-remembered.
But to unwind the facts at hand from our
reactions, let us take ourselves back to a time
before 2007 – both in expectation and
mindset – to test the limits of the markets’
collective imagination:
◾◾ The idea that the global financial system
might collapse – an event that very nearly
occurred in the days after the collapse of
Lehman Brothers, were it not for the swift
decision by US authorities to allow the
02 Heard at AllianzGI
Taking the Market’s Pulse on EM Debt
remaining broker-dealers access to
US Federal Reserve (Fed) liquidity –
was simply inconceivable.
◾◾ The quantitative easing policies espoused
by the Fed in the immediate aftermath of
the great financial crisis were the stuff of
textbook legend – but, again, were
unthinkable in the real world.
◾◾ The thought that the whole of the
Organisation for Economic Co-operation
and Development might lapse into a
protracted period of disinflation and falling
inflation expectations, despite monetary
policy approaching the zero bound, was
outside the imagination of all observers.
With these milestones in mind, let us
revisit Mr. Coeure’s speech: Anyone who
predicted two years ago that European
Monetary Union (EMU) peripheral spreads
would tighten beyond pre-EMU crisis
03 Viewpoint
Productivity: An Understated Wellspring
of Growth
04 Soundbites from Research
Low Oil Prices Spur Energy Industry
to Action
Andreas Utermann
Global Chief Investment Officer
levels and that European yield curves would
trade within Japanese government bonds
would have been dismissed as a fantasist –
or worse.
Yet not only have these events occurred;
they have happened more frequently than
one could have previously imagined.
(Cont. on page 2)
04 Perspective on Europe
How Low Can Interest Rates Go in the
Euro Zone?
Allianz Global Investors Insights
Global View
Do we then conclude from the current state
that the world has become so unpredictable
that we should give up on forecasting future
events, and instead seek to pre-position
ourselves for whatever comes?
Quite to the contrary. We continue to face a
range of previously unthinkable events that
demand creative solutions, including the
persistently high levels of overall debt that
burdens most economies; the massive, 300-
plus per cent level of gross domestic product
(GDP) to debt in Japan; and the enormous
imbalances within the global financial
system, to name but a few.
Moreover, the answers to these challenges
will most likely lie outside the scope of
conventional policy measures. History will be
but a poor guide, and obvious “black swans”
will likely not be as risky as they seem.
Succeeding in this very challenging
environment, where the most unimaginable
events may unfold at unthinkable speeds,
will require extraordinary and sustained
agility – a skill Allianz Global Investors is
particularly focused at developing among
its professionals.
We believe that in the midst of these
obstacles, opportunities abound, and we
strive to have the courage, initiative and skill
to help our clients take advantage of them
during exceptional times in capital markets.
Heard at AllianzGI
Taking the Market’s Pulse on EM Debt
Every year, dealers and independent think
tanks host emerging-market (EM)
conferences covering sovereign debt,
corporate credit and local currencies.
Arguably, the most important conference –
judging by the EM corporate issuers and
investors in attendance – is held every
February.
With 300 global investors attending the most
recent event in February 2015, our team was
able to take the pulse of the market on a
number of issues, both fundamental and
technical. In general, we found that many
people we spoke to agreed on a range of
important issues:
◾◾ EM corporate debt has the potential
to provide mid-single-digit US dollar (USD)
returns in 2015.
◾◾ Flows have recently turned positive for the
EM asset class, as the primary market has
ground to a halt, while substantial coupon
and principal repayments are being made
by issuers.
◾◾ Unconstrained global managers generally
prefer EM corporate debt at this stage.
◾◾ The primary market should slow in 2015.
Latin America issuance is expected to
decline due to lower capital expenditure
needs resulting from lower commodity
prices, and to idiosyncratic risks in Brazil.
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Issuance in Central and Eastern Europe is
declining on the back of the Russia/Ukraine
standoff, while Asia is likely to maintain
its 2014 pace.
◾◾ Valuations in Russia and Brazil are
extremely attractive but come with
significant near-term idiosyncratic risks –
primarily geopolitical risks for Russia and
political risks for Brazil.
◾◾ Argentina and Venezuela appear to be
the two biggest sovereign risks in Latin
America. Argentina’s main risk is political,
which may be mitigated after the October
2015 elections. Venezuela, hit by the oil
price correction, is seen as vulnerable, but
the Venezuelan government will muddle
through 2015 to buy time.
◾◾ Russia’s spreads are not expected to
improve this year; investors expect credit
default swaps to widen from February
levels by the end of the year.
◾◾ Investors generally believe Ukraine may
default on its debt before the end of 2015.
◾◾ Views on Brazil were mixed; many people
we spoke to believe Brazil will be
downgraded to junk before 2017.
◾◾ While China’s growth is trending down,
its economy is still not perceived as
vulnerable to a hard-landing scenario,
Greg Saichin
CIO Global Emerging Markets Fixed Income
despite pockets of instability.
Our takeaways from this event ratify our
sanguine views on the market, despite the
ongoing volatility. From a general investment
perspective, we believe not much has truly
changed over the last three years. We live
in an era of financial repression, now also
supported by the new quantitative easing
policy by the ECB. As a result, there are few
compelling stories out there, and EM debt is
one of them. It is an asset class that is valued
attractively at a time when EM governments
are enacting policies to reinforce solvency.
Allianz Global Investors Insights
Viewpoint
Productivity: An Understated
Wellspring of Growth
Throughout the post-Great Recession period,
many developed-market economies
experienced real economic growth at rates
well below their long-term trend line.
Persistently disappointing cyclical expansion
suggests that, perhaps, developed-market
economies have entered a prolonged period
of secular stagnation. During such periods,
output and incomes barely increase,
underutilization of resources persists
and living standards sag.
Sluggish gains in labour productivity (real
output per paid hour of work) typically play
an important role in secular stagnation. In
the US, for example, labour productivity
increased at a 1.2 per cent annual rate from
the 2009 cyclical trough through 2014. By
comparison, productivity growth averaged
2.5 per cent a year from 1995-2005 and 1.7
per cent annually between 1975 and 2008.
During the second half of the 20th century,
especially, tepid productivity increases
pushed up unit labour costs (the ratio of
compensation per worker over productivity
per worker) and exacerbated inflation.
Real business profits declined, structural
unemployment increased and the
international competitiveness of
domestic companies weakened.
Yet the current weakness in labour
productivity may have significantly less
ominous implications for real economic
growth and investment opportunities,
particularly in the US and UK. Sharp increases
in employment have dramatically increased
the number of paid hours of work as
businesses became more confident in the
long-term economic outlook. Payroll
expansion also has reflected a long-term
decline in the cost of labour relative to the
cost of capital, particularly among
developed-market economies.
Profit margins remain at, or near, record-high
levels and inflation rates remain historically
low. Elevated real profits enable businesses to
buy back shares, increase dividend payouts,
make profit-accretive acquisitions, invest in
plants and equipment, and sustain large cash
holdings. None of these outcomes resemble
secular stagnation.
Standard analyses view productivity from
the supply side of the economy. As such,
productivity is measured as a function of the
quantity and quality of labour and capital, as
well as the efficiency with which these inputs
are combined to create output. However, in
this context, headline productivity figures
significantly understate improvements in
economic well-being. Output-per-hour data
fail to pick up changes in the composition
and mix of output that lead to meaningful
improvements in outcomes, rather than
outputs.
Consider each of the following examples:
◾◾ Advances in medical technology shorten
and make more comfortable the recovery
periods from surgery, returning workers to
their jobs sooner and making them more
productive.
◾◾ Satellite imaging reduces the number
of drill rigs required to discover and
extract oil.
◾◾ Solid-state electronics increase the life
expectancy and durability of household
electronics, lowering demand for
replacement and repairs.
◾◾ Advanced inventory-tracking systems
rationalize distribution channels and
eliminate intermediaries that were
previously needed to bring goods
and services to market.
◾◾ The Internet and social media expand
the reach and repetition of messages
globally at minimal cost.
◾◾ The ability of customers to complete
financial transactions, as well as book
travel and entertainment, takes off the
market many activities counted
previously in GDP.
Steve Malin, Ph.D.
Investment Strategist
◾◾ More precise tools, scanning, mechanical
drawings and sensors reduce material
consumption and waste.
◾◾ Customization of production enables
businesses to reduce planned levels
of inventories.
All of these advances reduce measured
output – the numerator of the productivity
fraction – while simultaneously improving
outcomes. Continuing advances in
technology promise to help businesses
contain costs, boost profitability and improve
standards of living around the world, even
if official productivity data do not reflect
these gains.
The investment implications look promising.
For instance, workplaces will be redesigned,
creating new opportunities for architects,
engineers and construction companies.
Improvements in robotics promise to boost
output in sectors such as national defense,
agriculture and automobile production.
Entire industries will take on a new look,
as online education, medicine and finance
become commonplace, and as
entertainment distribution broadens
to all types of mobile devices.
To be sure, the diversion of otherwise
productive investment toward cybersecurity,
environmental protection, anti-crime and
anti-terrorism measures – and compliance
with laws and regulations – will put additional
downward pressure on productivity gains.
In the end, however, productivity will
continue to be understated by official
statistics – and secular stagnation will
remain a torch song only for pessimists.
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Allianz Global Investors Insights
Soundbites from Research
Low Oil Prices Spur Energy Industry
to Action
Oil prices have shown unprecedented
volatility in recent months. In particular,
the Brent oil price peaked at USD 116 per
barrel in June 2014, but by January 2015
had collapsed by more than 60 per cent,
to USD 45 per barrel, despite a global
economy that is still in growth mode.
The initial months of this sell-off were driven
by higher than expected supply growth from
the US – a trend highlighted in previous
editions of this newsletter – higher supply
outside the US, demand concerns in
emerging markets and a stronger US dollar.
Then during its 27 November, 2014, meeting,
the Organisation of Petroleum Exporting
Countries (OPEC) did an abrupt about-face,
changing its tactics to focus more on market
share than price support. The market had
grown accustomed to OPEC support over the
past several years, and without it, the bottom
fell out of oil prices, as negative sentiment
and bearish technical charts took over.
While we believe most of the damage
to oil prices has been done, important
considerations remain, including the
additional supply risks arising from the
uncertain future of Iran’s oil exports
and the continued, relentless surge of
the US dollar.
However, despite the recent bearish trend,
the global energy industry is reacting with
tremendous urgency to reduce supply. We
have never seen the industry reduce capital
expenditure intentions and drilling activity
this fast. We expect a significant supply
response to occur in the US by mid-2015,
and believe US oil growth will flatten and
go into decline by year end. International
production will also be difficult beginning
in 2016. Meanwhile, the collapse in oil prices
is already stimulating an improvement in
demand.
Paul Strand
Sector Head, US Resources
As a result, we believe that current oil prices
are too low, and expect prices to work higher
over time as the market comes back into
balance. We view the energy sector as an
attractive investment at current levels for
investors with a 12–18 month time horizon.
Perspective on Europe
How Low Can Interest Rates Go
in the Euro Zone?
The ECB started buying up government
bonds at the beginning of March 2015, with
immediate and impressive results: a quick
drop in yields, a tumbling euro, a flattening
of yield curves and rising break-even inflation
rates.
Unsurprisingly, the arrival in the market of
a new structural buyer for substantial sums is
skewing supply and demand, thereby wiping
out term premiums and risk premiums.
But how far can yields fall? Addressing this
question requires a novel approach. In
fundamental terms, the current levels in
euro-zone bond markets are unjustifiable.
Technical flows are now, and will remain,
the determining factors that explain the
dynamics of price-setting.
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This loss of bearings goes along with an
extreme level of risk for investors, as fixedincome portfolios have never been so
vulnerable to the risk of a rise in interest
rates. This rather particular environment
looks set to persist for a long time – and
may become a new reality.
Investors should nevertheless take heed:
We are pre-empting returns, and this bow,
which is being pulled back as far as it can
go, may yet fire the arrows of tomorrow’s
crises and losses.
Franck Dixmier
CIO Fixed Income Europe
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00396 | AGI-2015-03-25-11783

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