These days, there’s lots of discussion about risks to the recovery. This is to be expected anytime the economy is moving toward the end of a recession and into a growth phase. However, more discussion is taking place this time around, simply because of this recession’s depth and the series of largely unexpected financial system shocks (most of them fortunately not in Canada) that preceded it.
So, it’s a good opportunity to remind ourselves that there are always risks to the outlook even when on the surface, things look pretty rosy. People tend to forget about risks when things are going well, and because we now all live in a global economy and a global capital market, there are more risks than before.
Of course, this doesn’t mean we should stop investing. It just means we should get sound advice and have a good understanding of what the risks are.
The risks can be divided into three categories.
1. Financial market risk
If there was a single cause of the economic downturn, it was the problems in financial markets that surfaced beginning in the summer of 2007. More specifically, it was the freezing of credit markets (i.e. the culmination of a series of issues ranging from sub-prime mortgages in the United States, to the new and (as it was discovered) untested financial instruments, to the often inappropriate assessment of financial risk that contributed to the downturn.
Many of the financial market problems have been dealt with. For instance, the TED spread — the difference between the London Interbank Offering Rate and the three-month U.S. Treasury Bill Rate — is nearly down to pre-crisis levels. Many interest rates for loans to retail and business customers have come down significantly, as have spreads between the yields on corporate and government bonds. The assessment of credit applications by lenders is easing, as illustrated by the Bank of Canada senior loan officer survey. In many markets, credit is flowing although in some, it is flowing more slowly to business than to consumers.
So, what are the risks? First, banks may be reluctant or too slow to increase their lending (or, if they do increase their lending with appropriate timing, they do so imprudently). In the United States, efforts to get toxic assets off the books of the banks have gone much more slowly than first anticipated. An announcement from the U.S. Treasury on July 8 about the ‘Legacy Asset Program’ is raising hope that progress on this front will accelerate. This is important because reducing the toxic assets on banks’ balance sheets will likely encourage banks to increase their lending.
Another risk is that banks in some countries will hoard reserves rather than increase lending. Bank reserves have been bolstered substantially by central bank actions as part of their attempts to inject liquidity into the financial system. However, in some cases, banks have preferred to keep those reserves on deposit with central banks (especially where central banks pay interest on the deposits) rather than lend them out. Finally, it is worth remembering that there will always be some underlying financial risk to the system, some of which can be mitigated, others that are unforeseen.
2. Economic risk
Recent evidence strongly suggests that the economies that have been in recession are shrinking less rapidly and will likely begin growing again either later this year or in 2010. The economies which didn’t shrink — notably India and China — give every sign that their growth will pick up.
But risks still exist here. Let’s start with the U.S. We know consumers won’t play as large a role in the coming recovery as they did in the past because they are repairing their personal balance sheets and employment continues to fall. The question is what role they will play and will it be enough?
Housing remains a risk. U.S. house prices need to stabilize both to bolster consumer confidence and provide more certainty on the part of financial institutions. While many of the right things are happening to promote stability, they haven’t all happened yet.
Another risk is examining to what extent U.S. business investment and exports will fill in the gaps left by consumers’ renewed focus on savings. We will need to see both sales and earnings pick up for business investment to recover and U.S. export markets recover in order for the latter to bloom again.
For Canada, three specific risks come to mind. First, the U.S. recovery is too weak to give Canadian exports the major boost they sorely need. The second risk is whether the stabilization of global commodity prices in general, and the increase in the price of crude oil in particular, mark the beginning of a sustained rise in global demand for these inputs. Finally, there’s currency risk. The rising Canadian dollar so beloved by tourists heading to the United States acts as a drag on Canada’s exporting industries, most especially the manufacturing industries.
3. Policy risk
Policy risk falls into two areas — monetary policy (central banks’ actions to lower interest rates and provide liquidity to the financial system) and fiscal policy (government spending increases and tax reduction programs to stimulate a return to economic growth). Before delving into the details, it is worth noting that the policy risks are the biggest simply because public policies are so crucial to the recovery. This marks a change from recent years when it was assumed that public policies could largely operate in the background while markets took care of day-to-day business.
When problems began to surface, the central banks’ initial order of business was to lower their ‘policy’ interest rates, the very short-term interest rates that signal the central banks’ policies and influence other interest rates. The next task was to inject liquidity into the financial system because credit markets were freezing up. In the case of the Bank of Canada, loans were made to a wider variety of financial institutions and a wider variety of collateral was accepted. The U.S. Federal Reserve went further and purchased securities from financial institutions, governments and non-financial institutions.
While these policies were necessary, neither the stimulative monetary nor fiscal policies can stay in place forever. If stimulative monetary policies were to remain too long, they would almost certainly fan a sharp upswing in inflation. So central banks around the world will need to reverse their stimulus policies. They all recognize this and most have begun planning and talking publicly about their exit strategies. The risk is mainly in the timing, and to a lesser extent, the mix of changes.
By and large, central banks will seek to keep policy rates low initially while backing out of their liquidity programs gradually. Problem is, central banks can’t wait for all of the evidence to confirm their stimulus had done its job, simply because the lags with which monetary policy works are too long. Change policies too soon and the recovery may be in jeopardy. Change them too late and inflation may become the next big policy problem.
Stimulative fiscal policy stepped in when it became apparent that the financial market problems were leading to an economic recession. Governments stepped up their spending and to a lesser extent increased benefits to help people weather unemployment and find new jobs. The risks are two-fold. One is to get the stimulus money out the door quickly — in this case, over a period of no more than two years, since taking longer would risk adding unnecessary stimulus to an already recovering economy. The next challenge is to move back to a balanced budget (or, in the United States, to significantly reduce the annual budget deficit).
For Canada, getting back to a balanced budget is entirely feasible, even though the process may require some hard-nosed decisions about spending and, possibly, some tax-rate adjustments. The challenge faced by the U.S. government is larger, partly because it inherited a substantial annual deficit even before it adjusted policies to deal with the downturn. Nevertheless, some good decision making can produce a credible multi-year plan for deficit reduction. Failure to make progress on the deficit front following a return to more normal economic and financial conditions would ultimately hurt economic growth prospects and might well result in higher interest rates than otherwise would be the case.
Policy risk may be the biggest risk, but provided that the policymakers use good judgment, it is also the most easily mitigated risk. Specifically, it is within the powers of both central banks and governments to stretch out their stimulus programs, if that appears necessary. It is also within their powers to shorten their stimulus programs before they expected to.
Both of these are potentially important because of timing risk, (i.e. that government stimulus runs out before growth in other sectors kicks in, or vice versa). So, good public policies can lessen financial market and economic risk, provided the former are used properly. For those of us who are observing economic and financial events around the globe and looking to provide good financial advice, we will need to keep a close eye on policy developments.
There will always be financial market, economic and policy risks. And geo-political risk overlays all of this. While this risk seems relatively benign at the moment, experience tells us that geo-political issues can arise at any time. The trick is to understand each of the risks as best we can, assess how much risk our clients are prepared to take and offer them advice accordingly. We’ve learned from the past couple of years that dealing with financial market and economic risks is a little like aging. We can’t avoid aging, but we can manage it well. Similarly, we can’t avoid many of the economic and financial risks we face, but by understanding and assessing them, we can manage them to our client’s benefit.
Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.
(08/07/09)