© 2010 Towers Watson. All rights reserved.
Public Policy
Impact on the Economy, Markets, and Investors
October 21, 2010
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
towerswatson.com
© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
towerswatson.com
© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
towerswatson.com
© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
towerswatson.com
© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
towerswatson.com
© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
towerswatson.com
© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
towerswatson.com
© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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© 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Wat...
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Public Policy: Impact on the Economy, Markets, and Investors Presentation - Towers Watson

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This Towers Watson presentation explores the potential outcomes of current public policies and their impact on investment markets.

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

  1. 1. © 2010 Towers Watson. All rights reserved. Public Policy Impact on the Economy, Markets, and Investors October 21, 2010
  2. 2. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 2 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
  3. 3. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 3 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
  4. 4. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 4 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
  5. 5. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 5 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).
  6. 6. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 6 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?
  7. 7. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 7 Example of Imbalances: Fiscal Deficits in the Developed World Source: Datastream and Towers Watson Investment
  8. 8. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 8 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
  9. 9. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. Example of Imbalances: Negative Equity in U.S. Houses 9 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 10 1 2 3 4 5 6 7 S&P/Case-Shiller home-price index, Jan 2007=100 (lhs) Existing home sales mil (rhs)
  10. 10. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. U.S. Structural Growth Rate: 1969 - Present 10 Sources: Bureau of Economic Analysis, Towers Watson Investment
  11. 11. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 11 Debts and Deficits are Projected to Worsen Gov . debt (gross, % of GDP)
  12. 12. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 12 Strategies for Indebted Economies Effect 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. - 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. - 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) -
  13. 13. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 13 Policy Levers That Will Determine The Future Path Fiscal Spending, taxation and borrowing Monetary Money supply and interest rate Other legislation Policies 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
  14. 14. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 14 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 debt We 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 policy Continued de-leveraging implies a Japan-style painful work-out Resumption 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
  15. 15. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 15 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
  16. 16. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 16 Alternative Futures Decreasing likelihood
  17. 17. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 17 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
  18. 18. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 18 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
  19. 19. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 19 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
  20. 20. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 20 Contact Details Chris DeMeo 875 Third Avenue, 16th Floor, New York, NY 10022 212-309-3845 christopher.demeo@towerswatson.com Matt Stroud 875 Third Avenue, 16th Floor, New York, NY 10022 212-251-5662 matthew.stroud@towerswatson.com
  21. 21. towerswatson.com © 2010 Towers Watson. All rights reserved. Proprietary and Confidential. For Towers Watson and Towers Watson client use only. 21 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.
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