Pimco: US faces real risk of outright deflation

Pimco, the world’s biggest bond fund manager, has warned the US faces a prolonged period of stagnant growth and a real risk of outright deflation, similar to what Japan experienced in 1990s.

Echoing a warning by M&G's bond team on Monday, Pimco portfolio manager Scott Mather says if a Japan-like deflationary scenario becomes the baseline for the US, it would have "profound implications for asset prices".

Mather says there are uncomfortable similarities between the two countries.

"There are striking similarities between the US and Japan with respect to fundamental causes of the crisis. Both economies experienced rapid growth in debt, which fuelled bubbles in real estate, residential and commercial, and equity markets," he says.

"Income did not grow fast enough to service the increasing debt load, which resulted in growing delinquency and defaults. Falling asset prices exacerbated the problem.

"For both countries, the toxic mix triggered a banking crisis and ushered in an era of economic turmoil."

However, Mather says there are some important differences between the US and Japan.

"Chronologically, the US looks to be following a high-speed version of the Japanese scenario. The immediate economic crisis unfolded more quickly and was deeper in the US than Japan," he says.

"The US experienced much larger loss of employment and developed a larger output gap than Japan did.

"On the optimistic side, the policy response in the US, both fiscal and monetary, has occurred much more quickly and with greater force than it did in Japan."

Mather says preparing for the possibility of deflation is an "important step" at this moment in time.

"As was the case in Japan, if deflation materialises, it will not be kind toward real estate and equity markets that assume positive inflation to support valuations," he adds.

"With respect to nominal bonds, the case of Japan provides an interesting roadmap. A focus on the intermediate maturity of the US treasury market, five- to 10-year maturities, is warranted if the yield curve evolves as the Japanese curve did.

"In this environment it is this part of the yield curve that initially performs the best as deflation risks rise. In addition, capital gains may be harvested from rolling down the steep part of the yield curve even if the rate structure only changes slowly, as was the case in Japan.

"If more experimental monetary policy is conducted at some stage, it is likely to benefit this maturity bucket more than longer maturities."