The past week has been a dramatic one in the financial markets, with, as of August 10, U.S. equities down more than 7% and Italian and Spanish bond yields above 6%, as well as Standard & Poor downgrading the U.S. long-term sovereign credit rating from AAA to AA+ (negative outlook). There have been many extraordinary events that have contributed to a very sharp sell-off in risky assets, which continues in global equity markets. The major macroeconomic events that have occurred are outlined below.
Event 1: Fear of a U.S. recession and a sharp slowdown in global growth
The global economy (especially over-indebted developed countries) remains relatively fragile, and worse outcomes are more likely than good ones over the medium term. The material slowdown in U.S. economic growth has increased fears of a U.S. recession, while 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 few days, the downgrade may negatively impact sentiment, causing a further sell-off in risky assets such as equities. While it is possible that U.S. bonds will also sell off (i.e., price in a higher fiscal risk premium), at Towers Watson, we don’t believe this will be the case. Our near-term base case is that the impact on treasuries will unlikely be significant, 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.
We do not anticipate much forced selling from any significant investor group, although risk exists that some unrecognized financial system linkages (e.g., what can be posted as collateral in different situations) might cause large-scale disruption. Over the longer term, a modest increase in U.S. borrowing costs is possible, with the greater impact likely to be an increase in the pace that foreign investors diversify away from U.S. dollar assets (although the absence of credible alternatives makes this a decade-long trend).
Event 3: Euro area crisis
There could be a partial “contagion” as solvency risks in Greece, Ireland and Portugal spread to sovereign and bank funding fears in Spain and Italy. Spreads between Italian and Spanish bonds and German bonds hit new highs, while spreads in the “core” countries such as France also rose. It is imperative that a sufficient package of policy measures is put in place to address contagion, albeit with significant political cost. The EU summit plan of July 21 was important because it provided a framework for one, helping the banking system; two, buying government bonds to contain contagion; and three, facilitating orderly restructurings of debt.
That said, details are missing, implementation risks are still considerable, and there are questions over the size of the support facilities. This means, there is still considerable medium-term uncertainty. Incremental policy news over the weekend, such as the European Central Bank purchasing bonds or Italy advancing its fiscal austerity plans, are beneficial, but major policy long-term adjustments have still to be made.
We should continue to expect volatility and macro risks over the next few years. The debt forces behind the 2008 financial crisis have not disappeared, and the global economy needs to be realigned (driven by large changes in relative interest rates, inflation and exchange rates). Events of the last week have not changed our views and, in fact, are consistent with the views we previously held. We anticipate a bumpy path to recovery, with higher-than-average risk for all asset classes and pressures from the debt overhang materializing in places that are hard to predict. 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.