2012 Global Outlook: De-synchronizing the Global Economy December 2011 Neal M. Soss, Managing DirectorChief Economist 212-325-3335 [email protected]ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO https://firesearchdisclosure.credit-suisse.com.
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Monetary policy responseThe financial system is in a fragile state. Some institution, market, or
instrument seems always at the edge of breaking down – or just over that
edge. Very low interest rates throughout the developed world pose a
significant challenge to the profitability of traditional financial business models
by reducing the rewards of maturity transformation. New regulatory initiatives,
including especially higher capital-to-asset ratio requirements on ever more
strictly construed asset classifications, inhibit the volume and profitability of credit transformation. (No surprise there – that’s what deleveraging the
Ultra-low interest rates tend to be more persistent than ultra-high ones.
This partly reflects the asymmetry in the efficiency of monetary policy in
stimulating versus restraining economic activity. It also partly reflects the
arithmetic of fiscal sustainability: low interest rates suppress the debt service
cost entry for debtor governments, while high interest rates contribute to
explosive debt-to-GDP dynamics. Finally, the exit from ultra-low interest ratesis higher interest rates – that is, a bear market in bonds. Bear markets tend to
expose and magnify financial fragilities; therefore, human nature tends to
incline the monetary authorities to a more cautious pace of raising interest
rates.
While ultra-low interest rates are still performing their corrosive role on
the profitability of the financial sector business model, the sector is also
trying to accommodate an emergent regulatory environment.
The Bank of Japan has been at this longest and has gone furthest – to the
point of buying ETFs on its own stock market. The Bank of England and the
US Fed have undertaken significant QE, arguably with more of a focus on aportfolio balance effect to encourage holding of riskier assets. The ECB has so
far dipped its toe tentatively into these waters, but we expect considerable
expansion of its efforts, at least selectively, toward Europe’s troubled
sovereigns.
The bottom line is that QE is probably a necessary component of
managing the ongoing restructuring of the global financial system.
That’s the First World central bank response. For the rest of the world, more
conventional monetary policy responses are still available (because policy
rates are still well above zero). Central banks in Australia and Brazil havealready begun to cut rates to counter the risks to global economic growth and
financial stability. We expect more of the same from them and expect others,
such as India and Thailand, to join the easing policy posture soon enough.
At the same time, the ECB under President Draghi has proved to be more
active than expected, already cutting rates by 50 bps to 1.00%. We expect
more. In our view, this greater activism may augur well for more forcefulinterventions from the ECB in government bond markets. The ECB must be
viewed as being in an asymmetrical posture whereby the cash rate for euros
could come down but cannot be expected to rise while the public finances of
much of the Continent are in tatters and the growth outlook ranges fromanemic to something worse.
The familiar workings of the Capital Asset Pricing Model imply that the
variance (or volatility) of capital asset prices includes the expected variance of the rate of interest on cash over the expected holding period of the asset plus
twice the covariance of that cash rate with the remaining market risks.
When the central bank effectively puts the variance and the covariance
to zero, the volatility of all capital asset prices should be suppressed,putting a bullish underpinning to risk asset markets of all kinds –
whether longer-dated bonds or credit instruments or equities. That's the
That implies less consumption-smoothing by households or investment-
smoothing by businesses or even counter-cyclical fiscal operations by (many)
governments than was possible during the Great Moderation. And that, in turn,
implies a more volatile fundamental economic backdrop for risk assets. That
volatility has perhaps already begun to manifest itself in the inadequate
recovery from the last recession experienced by nearly all First World
countries and by the repeated pattern of alternating speed-up and slowdown
scares in the last few years. This is a force for increasing the volatility –
and correlation – of capital asset prices, whether manifested in yield curveshapes, credit spreads, or equities prices. In the context of an efficient-frontier
tradeoff between risk and return, this should be a force suppressing risk asset
2012 financing needs for various euro area sovereigns €bn
Net Financing2012
BondRedemptions
Total FinancingNeed
Austria 8 14 22Belgium 13 28 41Finland 7 6 13France 83 99 182Germany 25 157 182Italy 32 193 225Netherlands 12 34 46Spain 40 50 90Total 220 581 801NOTE: These funding needs exclude those of Ireland, Portugal, and Greece, for which some financing will come fromEFSF issuance. Source: Credit Suisse
Results of a regression of the log of CDS spreads in
November 2011 on the ratio of gross government debt
to GDP (as forecast by the IMF for the end of 2011)
for a sample including 41 countries drawn both from
the emerging markets and from the developed markets
Source: Credit Suisse, Haver Analytics®, and the IMF’s WorldEconomic Outlook
Source: Credit Suisse, Haver Analytics®, and the IMF’s WorldEconomic Outlook
R2
= 0.0281
3
4
5
6
7
8
9
0 50 100 150 200 250
Gross Govt debt (% of GDP)
L o g C D S
s p r
e a d v s
R2 = 0.0104
3
4
5
6
7
8
9
-15 -10 -5 0 5
Govt deficit as % of GDP
L o g C D S
s p
r e a d v s
… and neither do the cross-country
differences in the ratio of government fiscal
deficits to GDP
Results of a regression of the log of CDS spreads inNovember 2011 on the ratio of general governmentbalances to GDP (as forecast by the IMF for 2011) for asample including 41 countries drawn both from theemerging markets and from the developed markets
Results of a regression of the log of CDS spreads (in
November 2011) on the ratio of gross government debt
to GDP (as forecast by the IMF for the end of 2011) for
a country sample including 17 EU countries
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™service, Haver Analytics®, and the IMF’s World Economic Outlook
Source: Credit Suisse, the BLOOMBERG PROFESSIONAL™service, Haver Analytics®, and the IMF’s World Economic Outlook
… but even within the EU, there is a poor
correlation between the ratio of the fiscal
deficits to GDP and the sovereign spreadsResults of a regression of the log of CDS spreads (inNovember 2011) on the ratio of the generalgovernment balances to GDP (as forecast by the IMFfor the full year 2011) for a country sample thatincludes 17 EU countries
Correlation between core inflation and commodity pricesCorrelation of yearly changes since January 2001; note that India uses WPI, and China uses non-food CPI
Source: the BLOOMBERG PROFESSIONAL™ service, Thomson Reuters DataStream, Credit Suisse