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This Towers Watson presentation explores the potential outcomes of current public policies and their impact on investment markets.
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© 2010 Towers Watson. All rights reserved.
Public PolicyImpact on the Economy, Markets, and Investors
October 21, 2010
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Trying to move forward
The credit crisis of 2007/08 has revealed a number of economic and market imbalances throughout the global economy and markets
Many of these imbalances are structural in nature and, if left unaddressed, can impede long term global economic growth
Public policy is an important mechanism to address these imbalances and shape economic outcomes
In our view, the implications of public policy outcomes are significant, with important consequences for the economy and markets worldwide
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Why worry about public policy now?
Policy choices will impact market conditions and investment returns, which may influence portfolio structure
Three years ago the prevailing belief was still in the superiority of “market fundamentalism”
Public policy is now a materially bigger issue, with important tensions between short-term needs and long term issues to be addressed
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Government Will Be a More Influential Economic Player
Increased spending to offset private de-leveraging
Increased taxation
More regulation
Social mandate to address inequality
Demographics and unfunded liabilities
Sources: Datastream, NIPA, Towers Watson
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Public Policy Issues and Risks
Therefore the issues are:When the pain will be incurred
Who shares in the pain and to what extent
Public policy risk acknowledges that governments could enact policies that:Make the aggregate pain large
Shift when the pain is felt (deferred or pulled closer in time)
Decide which groups suffer the most
By “pain” we mean a fall in wealth and/or a reduction in income. This can occur immediately (“short, sharp shock”) or be spread over time in the form of a reduction in the future rate of growth (of wealth and/or income).
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Why do we believe there is pain to come?
Unsustainable imbalances within the system will need to be brought back into line
Timing – the correction may start to happen now or may be deferred.
What imbalances?
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Example of Imbalances: Fiscal Deficits in the Developed World
Source: Datastream and Towers Watson Investment
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Example of Imbalances: East – West Trade and U.S. Economic Leverage
Source: Datastream and Towers Watson Investment
% of GDP Cumulative current account gap as % of GDP
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
Example of Imbalances: Negative Equity in U.S. Houses
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Sources: Standard & Poors, National Association of Realtors, and Towers Watson Investment
60
65
70
75
80
85
90
95
100
105
110
07 08 09 101
2
3
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5
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S&P/Case-Shiller home-price index, Jan 2007=100 (lhs)
Exist ing home sales mil (rhs)
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
U.S. Structural Growth Rate: 1969 - Present
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Sources: Bureau of Economic Analysis, Towers Watson Investment
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Debts and Deficits are Projected to Worsen
Gov . debt (gross, % of GDP)
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Strategies for Indebted EconomiesEffect on debt Effect on budget Effect on external balance
Growth No impact in short term. Positive in long term if fiscal surpluses used to pay down debt
In time tax revenue rises with GDP restoring fiscal balance. Assumes spending is controlled.
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Austerity No impact in short term. Positive in long term if fiscal surpluses used to pay down debt
Improves deficit by reducing spending and increasing taxes. However, likely to reduce future growth making strategy difficult to maintain
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Deflation Increases real value and worsens debt-to-GDP ratio
- Improves balance by making exports cheaper (lower labour costs)
Devaluation - - Improves balance by making exports cheaper to foreigners and imports more expensive
Inflation Reduces real value. Also helps debt-to-GDP ratio by increasing nominal GDP faster.
Improves deficit by increasing tax revenue (higher nominal incomes) provided spending increases are controlled
Worsens over time by making exports more expensive due to higher labour costs. This could be offset by a depreciating currency
Bail out Reduces debt if bail out in form of debt forgiveness, otherwise no impact
Improves deficit. If bail out in form of debt forgiveness debt servicing costs go down. If in form of transfer payments income goes up.
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Default Reduces debt Improves deficit as expenditure on interest and debt repayment is reduced (unless only a partial default, and servicing costs rise on new issuance)
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towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Policy Levers That Will Determine The Future Path
FiscalSpending, taxation and borrowing
MonetaryMoney supply and interest rate
Other legislationPolicies to stimulate or hinder growth
Regulation of financial markets
Forced transfer of value
Quantitative easing (QE) blurs the boundaries between fiscal and monetary policy. It is an activity that influences both interest rates and government borrowing.
Loose fiscal policy
Tight fiscal policy
Loose monetary policy
Tight monetary policy
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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What will happen?
Something!BIS* project that the current unfunded liabilities imply U.S.’ debt-to-GDP ratio will exceed 450% by 2040 (500% for the U.K.)This implies using approximately 100% of taxation revenue to service debtWe will not get to this point – policies are required to grow our way out or cut (and/or tax) our way out, otherwise markets will force action to be taken
The behavior of the private sector matters, as well as policyContinued de-leveraging implies a Japan-style painful work-outResumption of spending more compatible with growing our way out
* The future of public debt: prospects and implications, Bank for International Settlements working paper 300, March 2010
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Future Policy Action
Monetary policy to remain loose to stimulate the economy
Open economies will need to tighten fiscal policy sooner
But national accounting identities will bite
So fiscal policy should target economic growth (but will reflect ideology)
Defaulting on liabilities would also help, in the short run
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Alternative Futures
Decreasing likelihood
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Asset Class Implications
Growth Work-out Inflation Default
Equities Very strong Developed: weak to very weak. Emerging: stronger.
Nominal returns strong
Likely weak
Sovereign bonds
Weak Strong Nominal: very weak. Inflation-linked: strong
Very weak
Alternatives Should be strong for commodities
Strong commodities. Gold very strong
Likely weak commodities. Gold strong.
Currencies Emerging strong relative to developed
Inflating currency very weak
Defaulting currency very weak
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Portfolio Options
Maintain existing portfolio and hedge against extreme market moves
Choose which alternative is most likely and structure the portfolio accordingly
Choose the most likely alternative and hedge against the second most likely
Reduce risk – option A. Reflect the macroeconomic and financial uncertainty in a highly diversified portfolio, one that has approximately equal risk allocations to as broad a spread of instruments as possible
Reduce risk – option B. Asset owners could reduce the aggregate level of risk taken by shrinking the return-seeking part of the portfolio and increasing the liability-driven part
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Key Takeaways
Policy choices are critical in shaping the timing, severity, and sharing of economic rebalancing that needs to occur in coming years
Near term fiscal, monetary, and legislative policy choices are likely to have a significant impact on the economy, markets, and a wide variety of stakeholders
These policy choices will have a significant impact on returns and portfolio construction decisions for investors
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Contact Details
Chris DeMeo875 Third Avenue, 16th Floor, New York, NY 10022212-309-3845 [email protected]
Matt Stroud875 Third Avenue, 16th Floor, New York, NY 10022212-251-5662 [email protected]
towerswatson.com© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only.
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Disclaimer
The information included in this presentation is general information only and should not be relied upon without further review by the appropriate professional advisors. Towers Watson is not a law firm or accounting firm, and we are not providing legal, accounting or tax services or advice. Some of the information included in this presentation might involve the application of law; accordingly, we strongly recommend that audience members consult with and involve their legal counsel and other professional advisors as appropriate to ensure that they are fully advised concerning such matters. Additionally, material developments may occur subsequent to this presentation rendering it incomplete and inaccurate. Towers Watson assumes no obligation to advise you of any such developments or to update the presentation to reflect such developments.