Mather: Much like other recent Forums, the focus of our discussion was how further anticipated slowing in the U.S. economy will impact Europe. The debate was over the extent to which deterioration of the U.S. as an external source of demand will cause growth to decelerate in the euro zone and U.K. As always, this issue involves assessing the linkages between the U.S. and Europe, but it also questions whether internal domestic demand is strong enough in Europe to prevent the traditional response to a slowing U.S. economy. In the past, the lag between the U.S. and European cycles has been about six months, but this time we are seeing a bigger lag.

When looking at internal demand in the region, we questioned whether pent up demand might still be there after a long period of reduced investment spending following the stock market crash earlier this decade. We’ve seen business investment pick up, but there is still some question about whether the consumer side of the equation will also pick up in response to the improving labour market. Is there a chance that the consumer could finally start spending again and lead to a resurgence in domestic demand? We’re sceptical.

We haven’t seen a normal recovery in domestic demand in Europe’s current cycle. It’s been a bit more normal on the investment side, but it’s definitely been sub-par on the consumer side. The traditional course for the European cycle is that it starts with external demand, then exports pick up, then investment spending picks up, then the labour market improves and then the consumer finally feels wealthier and begins to spend. The ECB talks about this last step as the “third stage of the rocket.” So far, that rocket is not flying so well, and we’re less convinced that there will be a normal handoff from business to the consumer. Therefore, our focus is on the earlier stages – the external demand side – and whether the deterioration in non-domestic demand might just ground the rocket and derail the economy sooner than the ECB thinks.

Q: Does PIMCO’s view support the so-called “decoupling” between the U.S. and European economies that had been a topic of discussion late last year?
Mather: There are timing factors that seem a little different in this cycle – there is more of a lag than usual between the U.S. and European economies. But our conclusion is that there will not be the full decoupling that many people seem to be discussing. The European economy might not be getting dragged down as fast or as far as in traditional cycles, but the mechanisms that connect the European and U.S. economies are still in place.

Q: What were PIMCO’s main conclusions regarding the outlook for Europe following the Forum discussions?
Mather: Our cyclical forecast changed to reflect higher growth, but we didn’t change our inflation forecasts. The growth side of the equation continues to be driven by strength in business investment, while inflation expectations are steady due to stable energy prices, a hawkish ECB and the minor impact seen so far from fiscal reforms and union contract negotiations.

We expect real gross domestic product in Europe to range from 2.25% to 2.75% over the coming year, up from the December forecast for 1.75% to 2.25%. For the core consumer price index, we expect a range of 1.5% to 2% – the upper end of the ECB’s comfort zone – unchanged from our December forecast.

Q: Why did PIMCO raise the European growth forecast if there are concerns about resilience to the U.S. slowdown and the handoff from business to the consumer?
Mather: Our forecast takes into account the strength we’ve seen in the European economy in recent quarters, and the unusually long lag in the impact of the U.S. slowdown. The most positive factor for the European economy remains strong business investment, but there is also improvement in the labour market evidenced by the low unemployment rate. We are seeing some improvement in real wage growth though it’s still sub-standard for this part of the cycle. In general, these labour improvements paint a little better picture for the consumer in Euroland than we were seeing late last year.

There are risks associated with the headwinds facing the economy, however. There is the decrease in external demand resulting from the U.S. slowdown, and industrial sentiment seems to be peaking. If this continues, it could be a troublesome trend, since reduced business sentiment can lead to lower investment and reduced hiring, which will quickly halt the trend in jobs and wages. In this sense, the primary headwind facing the economy could essentially prevent the full handover from business-led growth to consumer-led growth.

Q: With growth forecasts up and inflation forecasts steady, what is PIMCO expecting from the ECB?
Mather: Under this base-case scenario of slightly higher growth and moderating inflation, there will be less pressure on the ECB to move rates significantly higher. Still, the ECB is a more strict inflation targeter than almost any other central bank, and as long as we see even marginally elevated core inflation, we’ll see the ECB remain quite hawkish. The ECB remains concerned that fast money growth and credit creation, coupled with further employment and capacity utilisation, will fuel an inflationary outcome. Our view is that the ECB will raise its benchmark rate to 4% from 3.75% in June, but that will likely be the last move. The ECB has basically telegraphed that they would like to see rates go to 4% before going on hold, and this is the scenario that the markets are more-or-less priced for.

We believe that the ECB’s tightening of policy to date, along with global headwinds, are going to remove the inflation threat and lower inflation expectations. In addition, we should not forget that there are internally generated headwinds that will begin to slow growth and reduce inflation pressure. The ECB will likely consider that the full effects of accumulated rate hikes and recent strength in the euro have yet to work their way into the economy. We also think that the ECB is finding some comfort in the fact that fiscal reforms are so far proving less inflationary than some had thought, that oil prices have come down and that union-related wage pressures are proving to be benign. Once the ECB pauses, however, we believe they will be very reluctant and slow to cut rates, even in the face of weakening demand.

Q: Around the time of PIMCO’s last Forum in December 2006, there were significant fiscal reforms about to move forward. How have these factors played out so far?
Mather: One of the most prominent fiscal reforms was the large 3% hike in the German Value Added Tax (VAT) starting this year. Because Germany makes up a large portion of the euro zone, there had been a lot of speculation about the sort of inflationary impulse this would produce. So far, the pass-through that we’re seeing after the tax increase is turning out to be much smaller than we or others had anticipated. This could change as time goes by, but for now it appears that the increase in prices has been absorbed by retailers and producers and not fully passed on to the consumer. Corporations, with record levels of profitability and strong balance sheets, certainly have the capacity to absorb the tax increase. So while the inflationary impact of this remains muted, it is still the case that fiscal tightening will be a drag on growth, which has not existed in the last several years.

Q: Union labour negotiations were also a concern late last year. Has the outcome influenced the outlook?
Mather: Union wage talks are one thing that the ECB talked a lot about last year and that had inflation hawks worried. But by now the bulk of the negotiations are behind us and indications are that there will be higher wages but not so much that it is worrisome on the inflation front. There had been pretty high demands from the major unions, but the final settlements have not been anywhere close to those demands. This should ease some of the ECB’s worries – labour is not fully able to re-price itself and so the ECB doesn’t have to fret about a wage price spiral.

In general, the labour market in Europe doesn’t have the pricing power that it had in decades past. Although we’ve seen some improvement – falling unemployment and a bump up in wage growth compared to recent years – labour in the euro zone still seems a bit exposed. We believe that is at least partly because there is more labour mobility than there has historically been. Increased movement of workers and trade between Western and Eastern Europe has helped keep a lid on wage pressures and prices.

Q: Is Europe seeing any tightening of credit analogous to the subprime mortgage crisis in the U.S.?
Mather: There are signs that credit growth has peaked in Europe, which provides further evidence of a turning point in the European cycle. Late last year, there was some worry about the growth in non-financial private sector credit, which was running close to a double-digit pace. Now it looks like we’ve seen the top and it's falling back into the single-digit range.

Higher interest rates have reduced demand for mortgage credit. We basically saw the peaks in the euro zone’s hot property markets around 2005 and housing activity and appreciation has continued to slow since the ECB started hiking rates. We’re not seeing anything on the order of what we’re seeing with U.S. home prices or the destruction of U.S. mortgage credit demand, but the areas that were worrying the ECB looked much better in the first quarter than they did six or nine months ago.

This slowing in credit growth is likely comforting for the ECB. It is still not entirely in their comfort zone and they would like to see it fall further, but at least it’s heading in the right direction from the ECB’s perspective.

Q: How are intra-European dynamics affecting PIMCO’s outlook?
Mather: There is still a dichotomy within Europe. Some countries are experiencing U.S.-like growth dominated by consumption, while growth in others has been driven by trade and exports. These differences are creating a big divide in how economies are performing. Germany’s export-led growth, for example, is underpinning a strong industrial sector, even as the industrial sectors in France and Italy are sluggish. On the other side of the coin, the consumer is not really adding much in Germany, but spending is supporting growth in France. In many ways this will be a longer-term secular issue for Europe, but in the near term it makes it tough to generalise euro zone economic cycles because there are many moving parts.

So we have these gaps opening up in the regional economic dynamics because different countries might be exposed to different things. German growth is much more exposed to the external environment than France is, but French growth might be more exposed to ECB monetary policy than Germany is. The temptation is to look at the euro zone as one big happy family. Sometimes the ECB, for example, tries to compare the euro zone to the United States where country comparisons are analogous to state comparisons, but that’s not a fair comparison in our minds simply because Europe still doesn’t have the same labour mobility as the U.S. There is also not the same level playing field in terms of federal policies and taxation and redistribution, so these countries seem to be on different paths even though they share a common currency and interest rate policy. All of this prevents the economic harmonisation that would be necessary to really be one big happy family.

Q: Are there differences between the euro zone economy and the U.K. economy?
Mather: The U.K. continues to surprise us with its ability to handle higher interest rates. In particular, U.K. consumers are highly indebted and more exposed to interest rates than their neighbours in the euro zone. So the U.K. economy is sort of defying gravity at this point – growth still hasn’t reacted significantly to higher interest rates but we are confident it will soon. Interest rate hikes will slow the consumer by way of the housing market, and interest rates will slow the industrial sector through strength in the pound and increased capital expenditure costs.

Q: In early January, the Bank of England’s Monetary Policy Committee surprised markets with an interest rate hike. Can we expect further hikes?
Mather: Immediately after the surprise hike, the market priced in another interest rate increase. Since then, the market has moved between pricing in one and two more 25 basis point rises by the MPC. The need for further hikes is finely balanced between the short- and medium-term inflation dynamic. Short-term, inflation remains uncomfortably around 3%, while medium-term the MPC, by its own projections, forecasts inflation to fall below target by mid year and return to target next year. It seems most likely that the MPC will deliver at least one of the hikes, which the market is priced for, since the MPC has incorporated this path of short-term rates into their forecasts. Beyond that, we find it difficult to see additional hikes. Inflation will be falling below trend, other inflation risks will likely not have materialised and growth should begin to slow under the weight of past interest rate hikes and the strength in the pound sterling. If the MPC were to hike two additional times, it would slow growth more sharply and bring forward potential rate cuts in 2008.

Q: Given the euro zone and U.K. outlooks, what is PIMCO’s investment strategy?
Mather: One of our key strategies is to exploit yield curve movements as both the ECB and MPC near the end of their tightening cycle and markets begin to speculate on the next easing cycle. In the U.K., there is a relatively rapid transmission of monetary policy to the economy, mainly through the mortgage market. The overly indebted consumer will begin to slow the economy relatively quickly in the face of higher debt servicing costs and the stronger headwinds of slower external growth and a stronger pound. Therefore, we expect to find value at the front end of the U.K. yield curve, which is already priced for a worst case of two additional hikes.

Even if those expectations were fulfilled, we think it would hasten the need for a cut cycle relatively soon. This presents an asymmetric payoff outcome from positions designed to benefit from the MPC either stopping early or needing to reverse course relatively quickly. Similarly, we think there is another asymmetric payoff opportunity from underweighting the long end of the U.K. where years of an unnatural demand/supply dynamic have resulted in a near-record level of inversion. Gradually, demand is waning while supply is predictably increasing. We therefore expect a return to a more normally shaped, upward sloping yield curve over the next few years. In the meantime, positioning for this event should add extra yield to the portfolio.

For the euro zone, the curve is currently quite flat and we think it’s very possible it will invert because the ECB is fairly stubborn on inflation and is likely to maintain a hawkish bias into a slowdown. Our view differs from the market in that we believe Europe, as in past cycles, will not be immune from a U.S.-led global slowdown. We think it is likely the market will therefore romance more ECB tightening than will actually be delivered as it begins to worry about future growth. Over the short-term, this will exert a flattening bias, but ultimately we believe that there will be a time in our cyclical horizon when it will become appropriate to position for a normally shaped curve.

Q: Thank you, Scott.