The dramatic financial developments over the past week, including S&P's downgrading of the U.S. long-term credit rating, reflect an inherent fragility in the global economy that means potentially violent and difficult-to-predict market moves are likely for a number of years, according to global professional services company Towers Watson.
"The events of the past several days are consistent with the outlook we had prior to these global events — that we expect a bumpy path to recovery, including higher risk than average for all asset classes, with pressures from the debt overhang materializing in places that are hard to predict," says Carl Hess, Towers Watson's global head of investment.
Towers Watson has examined three recent events and their impact on the global markets: fear of a U.S. recession and a sharp slowdown in global growth, the U.S. sovereign debt downgrade, and the continued crisis in the euro currency zone.
Event 1: Fear of a U.S. recession and a sharp slowdown in global growth
The world economy, especially in the overindebted developed countries, remains relatively fragile. Towers Watson continues to believe that worse outcomes are more likely than very good outcomes over the medium term.
The material slowdown in U.S. economic growth has heightened fears of a recession while, on the creditor side, there are concerns that the large Asian economies may not adjust their policies to address external growth risks.
Event 2: U.S. sovereign downgrade
Over the next several days, the S&P downgrade may lead to a further sell-off in risky assets, such as equities, and it is also possible that U.S. bonds sell off. However, Towers Watson does not believe this will be the case.
"Our near-term base case is that Treasuries are unlikely to be significantly impacted, with Treasury markets largely driven by the economic outlook, as was the case in Japan following the loss of its AAA rating and demand from risk-averse investors," says Hess.
"We do not anticipate much forced selling from any significant investor base, although there is a tail risk that some unrecognized financial system linkages may cause large-scale disruption."
The company believes that, over the longer term, a modest increase in U.S. borrowing costs is possible, with the greater impact likely to be from a gradual pickup in the speed foreign investors diversify away from U.S. dollar assets. However, the absence of credible alternatives makes this a decade-long trend.
Event 3: Euro-zone crisis
A partial "contagion" is evident as solvency risks in Greece, Ireland and Portugal have spread to sovereign and bank funding fears in Spain and Italy. The spreads between Italian and Spanish bonds and German bonds hit new highs, but have since fallen, while spreads in the "core" countries, such as France, also rose.
What is imperative is that a broad and sufficient package of policy measures is put in place to address a potential contagion, although this would involve significant political costs.
While there are some details that need to be worked out, the July 21 European Union summit plan was an important step, as it provides a framework for helping the banking system, buying government bonds to contain any contagion, and facilitating orderly restructurings of debt.
Additionally, incremental policy news over the past several days, such as the European Central Bank purchasing bonds, or Italy advancing its fiscal austerity plans, are beneficial, but the major policy long-term adjustments have yet to be made.
"For long-term investors, it is important to recognize that we continue to expect these big risk-factor moves in the next few years — the debt forces behind the 2008 financial crisis have not disappeared, and the global economy still needs to be realigned, driven by significant changes in relative interest rates, inflation and exchange rates," says Hess.
"In such an environment where stress events are more common, investors should continue to focus on whether they have appropriate diversification across the main risk factors that drive market returns and should consider tail-risk hedging, when pricing is opportune, to protect against sudden large losses."
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