Weighing in: three global issues, three expert views

What do you think will happen in the eurozone, and what will be the impact on pension investors?

Racioppo: We believe small incremental policy steps will continue to be the approach taken by the EU in dealing with the debt problems in Greece, Portugal, Ireland and Spain, etc. The latest concessions, whereby direct lending to banks can now take place, and the creation of a bank supervisor are not enough in our view to solve the longer-term euro problems. What is really needed is a central bank agency, similar to [the one in] the U.S., with powers that would allow it to provide a guarantee to bank deposits and with the ability to regulate and create financing for the banking system. The U.S. experience in 2008/09 demonstrated that powers far beyond what the current European Central Bank has are needed.

The deleveraging required in many European economies—including Spain, Italy and even France—will result in a long period (years) of slow economic growth. This implies low returns for pension and other investors. A significant impact event, such as a breakup of the union or pullout/bankruptcy by a major member, we view as a low probability but not impossible. Such an event would cause significant volatility in global stock and bond markets. However, a portfolio can be built that is insulated from most, if any, effects that, for example, a Spanish default would cause.

Caranci: Our belief is that European leaders will continue to muddle through with the crisis, providing just enough measures at the last minute to avoid a complete collapse in market confidence. Obviously, this approach generates significant risks that, at any point in time, their actions could be ‘too little, too late.’ In other words, despite all the efforts being made, we still believe Greece will eventually have to leave the eurozone, probably as soon as next year. Unfortunately, dealing with the aftermath of such an event will prove very challenging, because all the financial infrastructure developed thus far is still inadequate to ring-fence Spain and Italy, and to prevent a dramatic escalation of the crisis.

Under these circumstances, the outlook for pension investors is not encouraging, particularly for those [with members] close to retirement, who are the ones with the largest shares of their portfolios invested in fixed income securities. Asset reallocation into relatively safer assets implies accepting both abnormally low returns and the risk of future capital losses due to the relatively high values at which ‘safe haven’ fixed income securities are currently trading.

Do you think China will have a hard or soft landing? Can investors do anything to prepare?

Caranci: Although some further moderation in China’s pace of expansion will likely take place in the coming quarters, we believe that over the next two years, the Chinese economy will be resilient to the weaker global economic environment. One of the main elements supporting this assessment is that, as recent policy actions indicate, Chinese authorities will remain very attentive to any further weakening of domestic economic activity and will provide as much stimulus as possible to avoid economic growth decelerating sharply below 8%.

Having said this, if a Chinese hard landing were to materialize, commodities—metals and the energy complex, in particular—as well as equities would suffer the largest impact. Unfortunately, avoiding those exposures would require increasing exposures to ‘safe assets’—something that has its own pitfalls.

Tal: China will have a soft landing—mainly due to the effectiveness of monetary and fiscal policies in China. Simply put, they don’t have to run anything by Congress, they just do it, and when they decide to do something, it is very effective. And the Chinese authorities have already started to stimulate the economy—very early in the game. This means that, in the short term, say, six months, I am defensive on commodities, but when we get the green light from China, I will be entering the commodity space again.

What’s the outlook for the U.S., and how will it affect Canada?

Tal: The main issue regarding the U.S. is the fiscal cliff of 2013. Regardless of who wins the elections, it will be significant—as much as 2% of GDP. I am more optimistic about the U.S. consumer than most. I think the consumer will surprise on the upside. The main reason is debt. For the first time in five years, we see consumer debt rising—reflecting mainly pent-up demand and increased willingness by banks to lend. As well, the housing market is stabilizing—a fact that will eliminate the negative wealth effect that acted as a drag on consumption. Add to it the benefit of lower oil prices and we might get a consumer who will do a bit better than expected. However, it will not be enough to take the economy to more than, say, 2% GDP growth in 2013—nothing to write home about. Overall, this is not positive for Canada, which will see export performance softening in the coming year.

Racioppo: U.S. GDP growth continues along at a very pedestrian 2% rate. The prospects for improvement are limited as economic growth in Europe is non-existent and many of the developing nations are experiencing slower growth as well. Domestically, post the year-end elections, tighter fiscal policy will result. Recall that the Republicans and Democrats could not agree on how to reduce the debt and the deficit, so mandatory across-the-board cuts were slated to be implemented. The outcome of the elections will shape the approach to fiscal tightening—cut spending or increase taxes. Regardless, it implies even slower economic growth.

Canada remains firmly attached to the hip of the U.S. as our proximity results in 75% to 80% of our exports heading to our southern neighbour. Current Canadian government policy is trying to change the dependency on the U.S., but that is a long-term objective. If U.S. economic growth is slow, then Canadian growth will also be slow.

What role is government intervention playing in world markets today?

Tal: In recent years, governments and central banks have played significant roles in global economic activity, with the amount of fiscal stimulus unprecedented in the post-war era. However, after years of low interest rates, the effectiveness of monetary policy is diminishing. Now we are at a time when the private sector is trying to take over, which is a tall order. This is the main reason for my assessment that overall growth in North America will be relatively subdued in the coming year or so.

Racioppo: It is not apparent that there is any more or less government intervention in terms of day-to-day business. However, governments or their agencies (central banks) are stepping in during times of failure or loss. The 2008/09 crisis and current EU problems are examples. Losses or financings that should have been absorbed by the private sector are being undertaken or underwritten by governments. The loss or financial burden is then left with the government, which, of course, can affect overall economic growth as government and its agency balance sheets are weakened.

There is a push-pull relationship occurring between governments and central banks in world markets.

Caranci: We have gone from an environment in which governments jumped into world markets with stimulus to prop up economies amidst the financial contagion crisis in 2008, to one where governments must now restore balance sheets and, thus, are the thorn in the side of economic growth.

As such, there is a push-pull relationship occurring between governments and central banks in world markets, in attempts to keep economies afloat and simultaneously address large deficit positions. In Europe, deep and front-loaded government austerity measures in many economies have been met with a number of easing tactics by the European Central Bank to reduce the strain in financial markets and the private sector. The fate of the euro ultimately rests in the hands of politicians of the 17 member countries. The only way to maintain a common currency among those countries is to have a fiscal union. However, as we’ve repeatedly witnessed, there has been considerable resistance in doing so, as individual nations would be forfeiting part of their sovereignty to effectively enter into a federation. So, as economists and financial market participants, we are waiting on political outcomes in order to have greater clarity of the economic consequence.

In the U.S., the government is also front-and-centre in world markets. It is steering considerable change in the financial industry through regulation. In addition, firm ideological battle lines in Congress are stoking economic uncertainty. Large debt and deficit positions mean that the U.S. government is no longer in a position to offer economic stimulus. This makes it crucially important that any policy initiatives that are undertaken are credible and do not severely undermine economic growth and market confidence in an already fragile global environment.

How is Canada faring in all of this?

Caranci: Canada has been remarkably resilient in a global economy that continues to thrust up roadblocks to growth. Canada’s economic success, in large part, has been attributed to robust housing demand in an environment of extremely low rates and a well-functioning banking sector. However, analysts and the central bank have sounded the warning bell that the housing market looks to be overheated. In response, the federal government tightened lending rules four times in four years.

With less support expected from the housing sector, the other important pillars of economic activity are pushed into the spotlight—business investment and government outlays. Canada is in an enviable position relative to other advanced economies. At the federal level, debt levels are relatively low. This means that Canada is not being forced into a position of taking harsh measures such as those seen in Europe or those measures feared in the U.S. Many of the provinces, however, face a tighter fiscal environment, particularly Ontario. So the net effect will be an economic drag stemming from the public sector.

This means that businesses must pick up the baton in 2013 to help heal ailing Canadian competitiveness in global markets. However, the economic environment is not conducive to making large outlays, so, at best, we can expect modest acceleration under the expectation that recent global financial market fears ease and export conditions improve. If so, business investment should re-emerge as a leading growth area of the economy.

In retrospect, it’s fair to say that the performance of the Canadian domestic economy as it rebounded from the Great Recession was nothing short of remarkable.

Tal: In retrospect, it’s fair to say that the performance of the Canadian domestic economy as it rebounded from the Great Recession was nothing short of remarkable. A generous government and resilient consumers softened the blow of a U.S. and global downturn and provided a healthy lift during the early stages of the recovery. Strong export growth and a surge in capital spending followed, further spurring activity during the second leg of the economic revival But does the economy have any more tricks up its sleeve to outperform yet again? We doubt it. While growth should do well enough to avoid a new round of monetary policy easing, tapped-out consumers and cost-cutting governments could see the Bank of Canada wait for a U.S. growth-induced pickup in 2014 before raising rates.

Racioppo: Canada remains greatly reliant on the U.S. In recent years, the boom in commodity prices has helped provide a boost to economic growth. The slowdown now being experienced in the developed and developing worlds will reduce some of those benefits related to commodity exports. Pockets of our economy remain strong, such as the oil industry, and, of course, our banks are better capitalized than most in the world. A corporate analogy for the Canadian economy might be as follows: We have a strong balance sheet, but our income statement is being affected by the slow-growth environment experienced by our customers.

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