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Keynote Address: Navigating the New Neutral Scott Mather Presenter Chief Investment Officer U.S. Core Strategies PIMCO Agenda 1.What is the New Neutral? 2.What does it mean for investors? pg 2 1. What is the New Neutral? pg 3 Ye olde normal? 16 Three centuries of long-term yields in the U.K. 14 12 Yield (%) 10 8 6 4 2 0 1713 1763 1813 1863 1913 1963 2013 2014 The high interest rates of the 70s and 80s, not today’s low yields, were the aberration As of 30 September 2014 SOURCE: Bank of England pg 4 The New Neutral in a nutshell Aging population, weak productivity growth, debt overhang and muted inflation Slow growth (real and nominal) Low interest rates Refer to Appendix for additional investment strategy, outlook, and risk information. pg 5 Building blocks of nominal growth Growth in the labor force + Increase in productivity + Inflation ≈ Potential growth in Nominal GDP Rapid GDP growth is unlikely in an environment of low inflation with an aging population Refer to Appendix for additional investment strategy, outlook, and risk information. pg 6 The developed world is getting older fast 1.4 Developed regions age group Population (Billions) 1.2 65+ 1.0 0.8 inflationary growth deflationary contraction 0.6 +14% -8% 15-64 0.4 0.2 0-14 0.0 1983 2013 2043 Dependency issues aside, the aging of the population implies slower growth As of 31 August 2014 SOURCE: UN pg 7 U.S. labor force is entering a post-baby boom bust… YoY growth (5y mov. avg.) 3% Annualized labor force growth rate 2% 1% 0% 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 Demographic and other structural factors suggest labor force growth may stagnate As of 30 September 2014 SOURCE: Bureau of Labor Statistics Refer to Appendix for additional forecast, outlook, and risk information. pg 8 …leaving productivity to do the heavy lifting YoY growth (5y mov. avg.) 4% U.S. nonfarm business sector output per hour 3% 2% 1% 0% 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009 2014 Productivity growth surged above 3% in the tech boom, but has averaged below 2% recently As of 30 June 2014 SOURCE: Bureau of Labor Statistics Refer to Appendix for additional forecast, outlook, and risk information. pg 9 Potential real growth will be limited CBO Potential Real GDP YoY growth (5-year mov. avg) 6% Actual Real GDP Forecast 5% 4% 3% 2% 1% 0% 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 The drivers of real growth indicate a relatively moderate growth trajectory going forward As of 30 June 2014 SOURCE: Bureau of Economic Analysis, CBO, PIMCO Refer to Appendix for additional forecast, outlook, and risk information. pg 10 Finally, inflation completes the picture of nominal growth 3.0 U.S. core PCE opportunistic disinflation YoY change (%) 2.5 proactive reflation 2.0 1.5 1.0 0.5 0.0 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Even if the Fed meets or exceeds its 2% inflation target, nominal GDP growth will be limited As of 31 August 2014 SOURCE: Bureau of Economic Analysis Refer to Appendix for additional forecast, outlook, and risk information. pg 11 Growth and bonds yields are closely intertwined 20 Percent 15 UST 10Y UST 10Y - Avg Nom GDP YoY 1955-1979 Averages Nom GDP: 7.9% UST 10Y: 5.6% Nom GDP YoY - Avg 1980-Current Averages Nom GDP: 5.6% UST 10Y: 6.6% 10 5 0 -5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 And the relationship has varied over time As of 30 June 2014 SOURCE: Federal Reserve, Bureau of Economic Analysis Refer to Appendix for additional investment strategy, outlook, and risk information. pg 12 The New Neutral for interest rates? Nom GDP YoY 20 FF rate UST 10Y Percent 15 10 5 Neutral? 0 -5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 If nominal GDP grows at around 4%, then Fed Funds and bond yields may not have far to rise As of 30 June 2014. SOURCE: Federal Reserve, Bureau of Economic Analysis, PIMCO Refer to Appendix for additional outlook information. pg 13 2. What does it mean for investors? pg 14 We are operating in a world of central bank policy divergence… Fed 6 ECB BoJ 90-day MM futures imp. yields 5 4 Rate (%) BoE 3 2 1 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Growth and policy divergence will lead to diverging interest rates As of 20 October 2014 SOURCE: Bloomberg Refer to Appendix for additional investment strategy, outlook, and risk information. pg 15 …so currencies should reflect rates divergence Euro (LHS) Exchange rates Yen (RHS) 100 1.37 102 1.34 104 1.31 106 1.28 108 1.25 Dec '13 110 Mar '14 Jun '14 Sep '14 The U.S. dollar should strengthen, especially against the euro and yen As of 20 October 2014 SOURCE: Bloomberg Refer to Appendix for additional investment strategy, outlook, and risk information. pg 16 Yen/$ (axis inverted) $/Euro 1.40 YTD moves should be put in historical context U.S. TW major currency dollar (Mar '73=100) 115 Trade-weighted U.S. dollar 105 95 85 75 65 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 While the dollar has rallied recently, there is room for further appreciation As of 17 October 2014 (weekly close) SOURCE: Bloomberg Refer to Appendix for additional investment strategy, outlook, and risk information. pg 17 The Fed has been focused on reflating the economy… October 9th: "I have been concerned that the market path of interest rates is lagging behind what the committee is thinking." October 16th (after sell-off): “Inflation expectations are declining in the US…for that reason I think that a logical policy response at this juncture may be to delay the end of the QE.” James Bullard, St. Louis Fed President October 11th: “if foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to remove accommodation more slowly than otherwise.” Stanley Fischer, Vice Chair of the Federal Reserve September 22nd: “Right now with inflation running below 2% we really need the economy to run a little hot for at least some period of time to actually push inflation back up to our objective.” William Dudley, NY Fed President Past is prologue? 1995: “[W]hen the goals [of price stability and output stability] conflict and it comes to calling for tough trade-offs, to me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target.” Janet Yellen, Chair of the Federal Reserve pg 18 …but inflation expectations are low and falling 2.75 U.S. 10-year breakeven inflation Rate (%) 2.50 2.25 2.00 1.75 Oct '11 Apr '12 Oct '12 Apr '13 Oct '13 Apr '14 Oct '14 TIPS appear attractive, especially as a means to protect against future surprises in inflation As of 20 October 2014 SOURCE: Bloomberg Refer to Appendix for additional investment strategy, outlook, and risk information. pg 19 Growth and inflation trends in the eurozone are worrying… Germany expectations of economic growth (LHS) Eurozone inflation YoY (RHS) 3.5 60 3.0 40 2.5 20 2.0 0 1.5 -20 1.0 -40 0.5 -60 Oct '10 Apr '11 Oct '11 Apr '12 Oct '12 Apr '13 Oct '13 Apr '14 0.0 Oct '14 Growth sentiment and inflation are falling As of 20 October 2014 SOURCE: Eurostat, ZEW Refer to Appendix for additional investment strategy, outlook, and risk information. pg 20 Eurozone MUICP YoY (%) ZEW survey (% balance) 80 10-year nominal rate - inflation (%) …so the ECB should remain accommodative 5 U.S. Real yields Germany Italy Spain 4 3 2 1 0 -1 -2 Sep '09 Sep '10 Sep '11 Sep '12 Sep '13 Sep '14 The ECB wants negative real rates across the eurozone As of 30 September 2014 SOURCE: Bloomberg, PIMCO. Refer to Appendix for additional investment strategy, outlook, and risk information. pg 21 Mexico’s improving fundamentals present an opportunity… Gross govt debt/GDP (%) 120 Comparing Mexico and the U.S. Mexico debt/GDP Moody's rating (Mexico) U.S. debt/GDP A3 100 Baa1 80 Baa2 60 Baa3 Ba1 40 Ba2 20 0 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Improving credit characteristics could separate Mexico from the rest of EM As of 20 October 2014 SOURCE: PIMCO, Moody’s, IMF Refer to Appendix for additional investment strategy, outlook, and risk information. pg 22 …and could lead to yield curve convergence MXN swaps 8 USD swaps 7 Rate (%) 6 5 4 3 2 1 0 3M 1YR 2YR 3YR 5YR 7YR 10YR 12YR 15YR 20YR 30YR A steep curve and structural reforms make Mexican rates attractive As of 20 October 2014 SOURCE: Bloomberg, PIMCO Refer to Appendix for additional investment strategy, outlook, and risk information. pg 23 Investing in a New Neutral world Returns from beta may be lower Active management will be a larger component of returns Alpha opportunity set remains robust Flexibility is required to exploit Secular and Cyclical trends What we like TIPS Short-dated corporates U.S. dollar Select global sovereigns (Italy, Spain, Mexico) Non-Agency mortgages Refer to Appendix for additional investment strategy, outlook, and risk information. pg 24 Appendix Past performance is not a guarantee or a reliable indicator of future results. FORECAST Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. INVESTMENT STRATEGY There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. OUTLOOK Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. RISK All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world. ©2014 PIMCO PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY 10019 is a company of PIMCO. pg 25 Keynote Address: Navigating the New Neutral Scott Mather Presenter Chief Investment Officer U.S. Core Strategies PIMCO