You’ve entitled your presentation “There’s Really No Such Thing as a Free Lunch”
We are seeing changes in market sentiment every time there is a policy measure on the monetary side and on the fiscal side. But in the case of Europe, clearly fiscal policy is not an option. Austerity is the word of the day. If only we could solve the structural issues and imbalances by expanding the balance sheets of the central banks without costs attached, well, life would be too easy
Balance sheet expansion of the central bank while the balance sheet of the public sector is contracting, it seems to me, is one of the ways to frame what is going on in the economy. Central bank liquidity does have an impact in the short term. Then of course we all go back to the reality check that is the fact that we still have to deal with solvency issues.
How do Europe and the U.S. compare?
I think that the euro crisis remains at the centre; it remains the biggest upside and downside risk to global economic performance. Clearly, everybody is asking what’s going to be the end-game. Are we going to see a default in 2012? Will the Eurozone exist at the end of this year or the next five years, in the current form?
Balance sheets have to be repaired at the level of the private sector, especially the financial sector, while deleveraging has to take place as well in the public sector where, as we know in the periphery especially, the overextension of national sovereign governments has led to the sovereign debt crisis that we are seeing.
Balance sheet repair in the United States has to happen still in the private sector. We have decided here to postpone the repair of the balance sheet of the public sector. That, I think, so far, has been the right decision — and probably an important support for growth in the US economy, together with monetary policy. We are not yet in what one would call a self-sustaining recovery.
Clearly, we cannot yet pull back on policy. Think just about the fact that, according to our forecasts, we are looking at the U.S. growing at 1.8% in 2012. The recent stimulus package has to be extended, and we do think it will happen — I’m referring to federal tax cuts and unemployment benefits — just that alone would shave 1.5% from GDP growth if those benefits were not extended. So it’s still important that fiscal policy remains supportive and that we don’t start creating a fiscal drag on the economy quite yet.
The big question will be 2013, when this process of balance sheet repair on the public sector side might start happening. At that point whoever will be president will face a choice: basically unemployment benefits, federal tax cuts, Bush tax cuts and the fiscal stimulus of 2009 — all these measures will come due and expire. If you add them all together, having them suddenly out of the picture would probably make the fiscal drag closer to 3% or 3.5% of GDP. How are we going to deal with that and what does that mean for growth?
Are there other risks that need to taken into account?
Besides the geopolitical risk in the Middle East, where oil prices would skyrocket again, I think a self-imposed drag on the fiscal side could easily tip this economy into a recession. More of a problem for 2013, but definitely in this case political risk would play a role. Let’s remember that last July the U.S. was downgraded not so much because of the debt ceiling discussion or because of the size of the debt or because of the creditworthiness of the U.S., but mostly because there was a gridlock that we can’t get out of and won’t get out of even after the election.
Are there risks in emerging markets?
The emerging world is also slowing down, from the 7% growth in 2010 to 6%, or probably closer to 5%. Emerging markets are not in a condition to decouple from the advanced world, even if the situation is very different from what it was 10 years ago with the Asian crisis. Emerging economies could not even think of enacting a counter-cyclical policy.
Of course, now emerging market are in much better shape and counter-cyclical policies have already started with 30 rate cuts across the emerging (and developed) world; in the next few months we will see more of that and also some fiscal stimulus. Nevertheless, it’s clear that demand in consumption coming from the advanced world still affects the speed limits for growth in the emerging world.
The big question is China. China is one of the most imbalanced, overleveraged economies in the world. We’re looking at China to slow down a bit but not crash between now and 2013, while a political transition takes place. But we think China will eventually have to deal with its own imbalances and its own process of balance sheet repair and with a financial sector that will see a mounting amount of non-performing loans and a public sector that is going to have to stop investing in (infrastructure) projects that don’t have the returns needed to finance them.
What does this mean for investors?
For investors I think that, in the short term the risk is on. I think we have to ask ourselves what can be the turning point for risk sentiment. Clearly the policy measures that have been put in place have affected risk sentiment and prompted the strongest beginning of the year rally that we have seen in a long, long time. I would say that this rally can continue for a little bit longer. What’s going on in Greece could become the first milestone in this disruption of sentiment. I would say that once we get over this hump, that will be something that will relieve investors and will probably put us onto a “risk on” mode for a little while.
Then the reality checks will come. I think unfortunately that we are in for some negative macro surprises even if we’ve seen some strong economic data recently. Investors are looking at the short term and are very concerned with a lot of volatility; swings in the mood of investors happen very, very fast. Negative surprises will continue to bring volatility and alternate periods of “risk-off” with policy driven “risk on” times.
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