Public Policy: Impact on the Economy, Markets, and Investors Presentation - Towers Watson

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Public PolicyImpact on the Economy, Markets, and Investors

October 21, 2010

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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


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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


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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


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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).


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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?


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Example of Imbalances: Fiscal Deficits in the Developed World

Source: Datastream and Towers Watson Investment


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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


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

4

5

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S&P/Case-Shiller home-price index, Jan 2007=100 (lhs)

Exist ing home sales mil (rhs)


U.S. Structural Growth Rate: 1969 - Present

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Sources: Bureau of Economic Analysis, Towers Watson Investment


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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

-

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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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


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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


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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


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Alternative Futures

Decreasing likelihood


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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


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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


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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


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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]


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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.

Public Policy: Impact on the Economy, Markets, and Investors Presentation - Towers Watson

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