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Derek Hamilton
Vice President,
Global Economist
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Waddell & Reed Market Perspective October - 2011
Uncertainty in economic indicators and financial markets has increased significantly in recent months, based on factors ranging from an increase in debt levels in the developed world to rapid growth in emerging market countries. But what is causing this uncertainty and how can investors respond?
Debt and the lack of political leadership
The first and arguably most important factor is the increase in debt levels in the developed world. Starting in the mid-1980s, U.S. private sector debt — namely consumer debt — relative to gross domestic product (GDP) and income increased for two decades. This primarily was an increase in mortgage debt based on continuously lower interest rates and easier lending standards. Once the 2008–09 recession hit, that debt load became unsustainable and has been declining relative to GDP and income.
This is a headwind now because many households are in a so-called balance-sheet recession. In a nutshell, a high and unsustainable level of debt absorbed an extreme shock to the system, caused by the bursting of the real estate bubble. This shock has prompted consumers to pay down debt as the value of their assets has declined relative to the amount of debt.
It is very difficult for an economy to grow without credit growth, which is why actions by the Federal Reserve have resulted in little economic growth. It does not matter how low the interest rate is on a loan if there is no demand for the loan. This is important because a lack of credit growth coupled with weak employment growth results in consumer spending that is much more susceptible to shocks.
U.S. government debt also has increased rapidly in recent years. Granted, annual federal budget deficits in excess of 10 percent of GDP were worsened by the recent recession. However, if you normalize fiscal revenues and spending for the weak economy, the structural budget deficit was more than 6 percent of GDP in 2010, according to the Congressional Budget Office. And this does not take into account the future promises to support Social Security and Medicare.
So the trend of rising spending will only accelerate from here, and policymakers face a challenge. While large fiscal deficits are unsustainable, low economic growth is much more susceptible to budget cuts via higher taxes and/or lower spending. Thus, U.S. officials must come up with a credible long-term deficit reduction plan while providing a boost to growth in the short term. Among other things, we think a simpler and more efficient tax code — including lower rates while broadening the base — would help achieve that goal. This is a very important part of achieving more sustainable growth, but it looks like these issues will not be dealt with in the near future. Politicians in both parties seem more concerned about elections in 2012 than on doing what’s best for the economy. A clear example of this attitude was seen in the protracted debt ceiling debate in August, which resulted in a further hit to consumer and business confidence. Another battle over an increase in the debt ceiling is likely to occur during the next two months, along with continued negotiations over deficit reduction.
This brings us to Europe. Many countries within the euro zone have problems with high private and government debt, but some face their most serious problems on the government side. This is the crux of recent market volatility. Governments in Europe have decided to reduce budget deficits now. In “peripheral” Europe, countries such as Greece and Portugal are struggling with this mandate because large tax increases and spending cuts are being enacted while these countries continue to experience recessions. The government debt load in Greece already is at an unsustainable level. As GDP continues to fall, tax revenues also fall and fiscal spending rises, increasing the debt load even further.
We have known about the problems in Europe for more than a year, but policymakers there apparently lack the political will to come to a resolution. We think the key problem is that it is impossible to have a monetary union without a fiscal union. There are 17 different governments in the euro zone with many different objectives. Each country approaches the problem from a different perspective and with different directives from its population. There was some indication in early October that Europe’s government leaders are finally realizing the urgency of the issue. Markets need to see that European officials are actively involved in shoring up the banking system and building the firepower to stave off future problems. After these are in place, Europe can deal with Greece in an effective way and push for an actual debt restructuring.
Impact of emerging market growth
The growth in emerging market economies may seem like an odd area to cite for economic volatility, especially given our longstanding view that these markets are the long-term growth story. But consider the situation from the perspective of developed markets.
One thing that comes with rapid growth in emerging markets is the increasing need for commodities. Whether it is energy and metals to fuel industrialization or agricultural goods for consumers who want to eat more protein, the demand for commodities is unlikely to wane soon. In the past, when the U.S. and Europe had periods of weak economic growth, there usually also would be low inflation as the demand for goods would not exceed the supply. However, as emerging markets largely are the incremental buyers of commodities, prices increasingly are determined by growth outside the U.S. and Europe. Consumers in the U.S. and peripheral Europe are experiencing weak income growth, especially when government transfers are excluded. If prices rise, income gets squeezed and the economy slows. And with high unemployment, wage gains will not offset the rise in prices.
At the same time, the rise in commodity prices coupled with strong domestic demand brings about monetary and fiscal tightening in emerging markets, which inevitably slows economic growth in those countries and acts as a further headwind for developed countries. This is especially true in China. In response to the 2008 economic crisis, policymakers around the world eased aggressively in order to combat the rapid slowdown in growth. In particular, China allowed local governments to borrow aggressively through the banking system in order to increase investment. This policy was successful in keeping the growth slowdown brief. However, inflationary pressures started to rise as growth recovered. Over about the past year, China has been steadily tightening policy in order to bring about slower growth and lower inflation, which ultimately will be another headwind for growth in developed markets.
Building confidence in economy and markets
In summary, we think all of these issues mean the cyclicality — or volatility — of the economy has increased. Uncertainty brings lower confidence, and lower confidence brings more volatility. It is unlikely that these issues will be resolved soon, as the debt burden will continue to be worked off in the developed world and the increasing need for commodities will continue in emerging markets. However, we think stronger political leadership would help to decrease this uncertainty. We believe U.S. officials must address the weakness in the economy while dealing with the long-term budget issues, and policymakers in Europe must quickly deal with the problems at hand, both in the banking system and at the sovereign debt level. We also believe effective actions by policymakers across the globe would give confidence to both consumers and businesses, and to the markets as well.
Past performance is not a guarantee of future results. The opinions expressed in this article are those of Mr. Hamilton and are not meant to predict or project the future performance of any investment product. The opinions are current through October 11, 2011. Mr. Hamilton’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
Investment return and principal value will fluctuate, and it’s possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.
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