In the three months since the April issue of Economic Perspective, the constellation of risks facing the global economy and markets has really not changed, but the relative risk levels have been rearranged. Thomas Dillman, President of Mutual of America Capital Management Corporation, reviews those risk factors and the changes that have occurred in each.
European Debt Crisis Rages On
The European sovereign debt crisis has clearly become the most serious near-term risk to European economies and banks; the global financial system; and by implication, world stock, bond, derivative and commodity markets. The key issue is avoiding Greek default on sovereign debt even though Standard and Poor's® announced on July 2, 2011, that it has already assigned one of the lowest non-default ratings—"CCC"—to Greek sovereign debt.
Two different plans have been promoted, one likely to avoid default, the other considered a default event. A default would likely trigger a series of events that could quickly spread to other European sovereign debt, starting with huge write-downs of Greek debt by most large European banks, some of a magnitude that could wipe out their capital, a default event in itself. It would also trigger the exercise of credit default swaps on Greek debt, requiring those investors who sold the insurance on these bonds to pay investors who purchased the insurance. If the sovereign debt of other European nations also moved into default, the crisis could result in the dissolution of the European Union and the end of the Euro, the only other viable "reserve" currency besides the dollar to facilitate global trade.
Fortunately, it appears that European Union authorities, the International Monetary Fund, and key European governments (i.e., Germany and France) have come up with an interim solution that will provide a voluntary exchange of longer-maturity loans from creditors for Greek debt maturing over the next several years. In exchange, Greece has just agreed to implement additional austerity measures to get its fiscal house in order. Despite riots in Athens by citizens who will suffer the consequences of belt-tightening, markets seem to have breathed a sigh of relief, while critics argue that this arrangement just defers a true resolution of the problem to a later date; however, time is often what is necessary to resolve financial crises. For example, U.S. banks have been able to rebuild their capital over the past two-and-a-half years because the Federal Reserve has kept rates very low and has provided tremendous amounts of liquidity. Europe is now (belatedly) implementing a similar approach in the face of a crisis in its own backyard.
U.S. Deals with Its Own Sovereign Debt Issue
Of course, Greece, Ireland, Portugal, Spain, and Italy are not the only sovereign nations that have been living beyond their means. The United States is on the verge of running up its sovereign debt to 100% of GDP. The imminent issue that Congress and the Obama Administration are dealing with is the need to raise the debt ceiling to avoid a U.S. default, basically an unthinkable event.
The rating agencies have already threatened to lower the ratings on U.S. debt while Republicans and Democrats wrangle over the composition of the spending cuts and tax increases required to raise the debt ceiling. Republicans have taken the position that they will not support an increase in the debt ceiling without a serious effort to attack rising deficits. Furthermore, they insist that deficit reduction must come exclusively from spending cuts. Democrats insist that tax increases must be part of the compromise. In addition, the pressure of next year's Presidential and Congressional elections adds incentive for both parties to raise the debt ceiling by a large enough amount ($2 trillion is the rumored target) so the issue will not come up again next year.
That's where things currently stand as President Obama and House Speaker John Boehner enter the fray to attempt to work out a compromise before the August 2 deadline, after which the United States will have to stop paying at least some of its bills. Even if the debt ceiling issue is resolved, any deal will only be a relatively small down payment on the larger need to reduce annual deficits and eventually whittle down the national debt.
Avoiding a Slowdown in Global Economic Growth
Two other risks noted in the last issue were the threat to global economic growth from a potential slowdown in the growth of the Chinese economy, and the possibility that the end of the second Federal Reserve Quantitative Easing program could result in a "double dip" into recession for the U.S. economy. Both China and the United States are crucial engines of global economic growth, and a serious slowdown in one or both would make recovery even more difficult than it has been. Europe is also an important contributor to global growth, and at least the northern nations of the European Union have continued to witness good growth. But given the sovereign debt issues there, Europe is unlikely to provide the necessary momentum to sustain global recovery by itself.
Ironically, the sources of potential slowdown in China and the United States are different. China has been raising interest rates over the past six months to arrest a steady climb in inflation as the result of an aggressive bank lending program that has resulted in a property bubble. Moreover, rising world food prices and increased demand by China's citizens have contributed significantly to the rise in the general price level. The fear has been that, if the authorities continue to tighten monetary policy and administrative restrictions to arrest inflation, Chinese growth could decelerate quickly and to a level insufficient to create enough jobs for the growing work force domestically, or enough demand for the products of other countries sufficient to sustain their growth.
The United States on the other hand has been engaged in an aggressive easing of monetary policy in order to sustain a weak recovery and to avoid deflation. In fact, one of the stated goals of QE2, as the second Quantitative Easing program is called, was to raise the rate of inflation in order to avoid what was considered a much greater problem: deflation. QE2 has achieved that goal, but there is serious concern that with the end of an increase in easing, the U.S. economy may roll over and slide into recession.
Last year, when QE1 ended in April, U.S. economic data became much softer over the next few months. Economic estimates for the Gross Domestic Product (GDP) began to be lowered, questions about the continued sustainability of corporate profits were raised, and the S&P 500® dipped 16% through the end of August. However, at the Federal Reserve's annual outing in Wyoming, Fed chairman Ben Bernanke clearly signaled that the Federal Reserve was ready to launch another round of quantitative easing. QE2 was announced shortly thereafter, promising to add an incremental $1 trillion to the Fed's balance sheet through the purchase of that amount of U.S. Treasury securities. The S&P 500® proceeded to advance almost 30% over the ensuing eight months.
However, at the end of April, 2011, in what looked like a repeat of the previous spring, domestic economic data turned decidedly softer and below expectations. The initial explanations focused on global supply chain disruptions caused by the Japanese earthquake, tsunami and nuclear crisis in early March, as well as on various weather disturbances. Nevertheless, GDP estimates have fallen from around 3% to around 2% or less for the 2nd quarter following a below-expectations 1.9% final 1st quarter GDP growth rate. At the same time, of course, the increasing risks of a Greek default reemerged as a front burner issue as several important maturities of Greek debt approached.
If the Federal Reserve believes the economy is going into a double dip, it will probably be inclined to respond, although the type of liquidity creation used in QE1 and QE2 is probably not politically possible. It's almost a sure bet that Fed Funds rates remain near 0% through at least the middle of 2012, but what other measures the Fed can take are not clear.
U.S. Markets Generally Stable
Since the end of April of this year, the S&P® has traded off only modestly, down through the end of June by 3% from a peak on May 2, bringing its advance for the year-to-date to 5% versus the intra-year peak of 8%. Thus, the stock market has reacted less dramatically this year than last year to a similar set of risks. Whether that is a function of more time to discount those risks, or a false sense of security in the ability of central banks and governments to avoid the worst, is unknown. However, it is instructive to note that the Treasury bond market staged a significant rally during that same interval; the 1-Year Treasury yield declined from a 2011 peak of 3.74% in February to a trough of 2.86% in late June. It seems the bond market believed that the domestic economy was heading for a double dip, and/or the risks in Europe, with their global implications, encouraged a "flight to safety" in U.S. Treasury securities.
Interestingly, during the last few days of June, as a plan to avoid a Greek default was put in place, the S&P 500® rallied and the 10-Year Treasury yield hit 3.15% on June 30, up from the 2.86% low. However, as previously noted, the European sovereign debt crisis is far from over, and U.S. economic data remains anemic. The stock bulls contend that there will be a substantial rebound in U.S. GDP growth during the second half of 2011, but the jury remains out until we begin to see a more positive tone to forthcoming data items, the most important of which involve job creation.
U.S. Economy Still Sputtering
Thus, the health of the U.S. economy remains a significant element in the health of the global economy. Unfortunately, the U.S. economy faces a number of interrelated and seemingly intractable structural problems. The housing recession continues: inventory of unsold homes (whether in foreclosure or not) remains high relative to demand; new home sales remain at historically low levels; and prices have continued to decline, albeit at a decelerating rate, but nonetheless down over 30% from 2007 peaks on an aggregate national basis. The government spending component of GDP is obviously not going to be a major contributor to growth given that governments at the national, state and local levels are all grappling with staggering deficits.
In addition, consumer spending will remain lackluster as long as job growth remains anemic and increased costs of gasoline and food pinch already strained budgets. The largest source of job creation, the small business sector, has been unable to secure loans from the banking sector in order to expand, thus undermining confidence in hiring. Large corporations of course can go to public markets to raise capital at very low interest rates if needed, but they have learned that productivity improvements, or operating in low cost areas of the world, provide profit leverage without adding to payrolls. Expectations for corporate profits for the remainder of 2011 and for 2012, although reduced modestly over the past month, still anticipate robust, double-digit growth.
In the face of recent weak U.S. data, inflation and inflation expectations have begun to moderate: commodity prices have come off the boil, but remain at historically elevated levels, and the average gasoline price in the U.S. has declined from near $4.00 to closer to $3.50 per gallon, taking some pressure off consumers. Of course, if the domestic and international economies reaccelerate as the bulls suggest, inflationary pressure would be expected to rebuild.
Economic and Financial Outlook Unclear
Thus the health of the global economic and financial system remains fragile and extremely susceptible to a variety of risks. It is impossible to project with any degree of certainty, or even confidence, what course the future will take. It is possible to assert that that path will be fraught with uncertainty; the reemergence of macroeconomic and geopolitical crises from time to time; heated debate and a wide disparity of views about that course; and as a consequence, continued stock, bond and commodity volatility.
Despite these concerns, the leaders of government and business will find a way to muddle through: sustaining the recovery in progress even if at painfully slow levels, addressing the longer-term issues of deficits and debt, and maneuvering through the seismic geopolitical shifts the world will face at an increasing pace over the next few decades.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
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