Larry Karle, MBA - Senior Consultant, Longfellow Benefits
Larry has over 16 years of Qualified Retirement Plan Experience. His areas of expertise include defined-contribution plan design, monitoring and reviewing investment results, plan conversions, fiduciary management, and trends in participant communication and education. Larry also has worked extensively with defined-benefit plan sponsors, helping them to navigate the increasingly complex landscape of defined benefit pension plans.
As the chief economist for Payden & Rygel Investment Management, Tom is responsible for developing views on both the US and Global Economy. Tom earned his BA in economics from Drew University, and MA in Economics from Fordham University, and earned his PhD in economics in 2001. Prior to coming to Payden & Rygel, Tom was employed at The Conference Board where he served as an international economist. Tom has also been published in many publications including The Journal of Commerce, a subsidiary of The Economist.
Jeffrey Bauer, QPA,CPC – President, Angell Pension Group
Jeffrey A. Bauer graduated from the University of Rhode Island with a degree in economics. He has over 20 years of extensive experience in the fields of qualified retirement plans, nonqualified retirement programs and welfare benefit administration. He is a Qualified Pension Administrator, Certified Pension Consultant and a Member of the American Society of Pension Actuaries. Jeffrey is President and sole Principal of The ANGELL Pension Group, Inc.
Global Economic Review & Outlook January 2010 333 South Grand Avenue Los Angeles, CA 90071
What Impact Will Ballooning Government Debt Levels Have on Government Bond Yields?
The Cost of Bailing Out the Global Economy Has Caused Government Debt Levels to Rise
G-7 Governments Need to Make Progress on Reining in Deficits Over the Next Five Years
Greece Has Been In the News, But Its Situation Is Unique
Canadian Housing Market Shows Signs of Recovery
Japanese Situation Mitigated By Willingness of Japanese to Hold Debt
The People’s Bank of China Moves to Rein in Bank Lending
What Impact Will Ballooning Government Debt Levels Have on Government Bond Yields? The global economy appears to be on the road to recovery and the risk of a double dip recession is receding. Unfortunately, the cost of staving off a repeat of a 1930s-style depression was quite high. Debt-to-GDP ratios are expected to approach 100% in several G-7* industrialized countries over the next five years, including the United States and United Kingdom. Recent headlines have focused investor attention on this issue and its potential impact on government bond yields. Yet, our analysis suggests that debt levels are not closely correlated with interest rates in the short-term. Instead, inflation and central bank policy are the primary drivers of government yields over periods of less than three years. With inflation rates still very low across the G-7 and central banks likely sidelined for the first half of 2010, the risk of a sharp rise in government bond yields seems remote at this stage. Looking out further, however, there is a risk of a parallel shift higher in government bond yields if policymakers fail to take action to get their fiscal houses in order. Investors will give governments who have a proven track record of fiscal responsibility the benefit of the doubt as long as they provide credible plans for restoring fiscal balance down the road. However, governments who have periodically disappointed investors, such as Greece, have much less leeway. * The G-7 refers to the Group of Seven largest industrialized economies including Canada, France, Germany, Italy, Japan, the United Kingdom and the United States.
The Cost of Bailing Out the Global Economy Has Caused Government Debt Levels to Rise Source: The IMF Net Debt to GDP By Country Net Government Debt Levels Near 100% of GDP Are Unsustainable Net debt, defined as liabilities less assets, to GDP ratios are expected to approach 100% in several G-7 industrialized countries over the next five years, including the United States. These deficits are the byproduct of government efforts to stave off a repeat of a 1930s style depression. Although the government debt at these levels is unlikely to incite a fiscal crisis, it would limit the ability of governments to address future shocks through fiscal stimulus.
Government debt levels are not closely correlated with interest rates in the short-term. Instead, inflation and central bank policy are the primary drivers of government bond yields over periods of less than three years. With inflation rates still very low across the G-7 and central banks likely sidelined for the first half of 2010, the risk of a sharp rise in government bond yields seems remote at this stage. This analysis does not imply that there are no long-term consequences to increasing the supply of government debt. Countries that have a track record for running large fiscal deficits during both good and bad economic times are forced to compensate investors with higher yields. 10-Year US Treasury Yields and US Debt to GDP There Is No Correlation Between Government Bond Yields And Government Debt Issuance in the Short-Term
G-7 Governments Need to Make Progress on Reining in Deficits to Avoid Higher Interest Rates in the Long-Run Source: The IMF Budget Deficit to GDP By Country Governments are expected to make progress on reducing budget deficits over the next five years as revenues increase and spending declines as the global economy recovers. 0%
US Economic Outlook The headline consumer price index (CPI) rose 2.8% on a year-over-year basis in December, marking the second positive print since March. Core inflation, which excludes food and energy prices, increased by 1.8% over the previous year in December. Headline inflation will remain positive into the new year due to the rebound in global commodity prices. However, core inflation will likely drift lower due to the output gap, the difference between potential and actual economic growth. Economic Growth The US economy grew at an annual rate of 5.7% in Q4 2009, which was more than double the growth rate in Q3 and marked the most rapid expansion of the US economy in six years. While the US economy is moving in the right direction, it is important to point out that real GDP is still well below the peak it reached in Q2 2008. At this stage of the recovery, the US economy has climbed roughly half way out of the recession. The peak to trough decline in real GDP during the recession was around 3.8%. Forecast: Inflation Forecast: Interest Rates The Federal Reserve left its benchmark interest rate unchanged in a range between 0% and 0.25% at the conclusion of its January meeting. The central bank reiterated that economic conditions are likely to warrant an exceptionally low level of the federal funds rate for an “extended period.” We expect the Fed to leave its benchmark rate unchanged until the second half of 2010. However, the central bank will exit parts of its credit easing sooner. A key test will be whether the Fed is able to end its mortgage purchase plan in March 2010 as planned without derailing the recovery. Forecast:
A Failure to Rein in Fiscal Deficits Would Increase the Risk of Higher Rates in the Long-Term The non-partisan Congressional Budget Office expects the US debt to GDP ratio to increase from 70% in 2008 to 100% by the end of 2014. According to a study by the Federal Reserve, each percentage point increase in the debt to GDP ratio adds 4 to 5 basis points to long-term interest rates over a five year span. This suggests that long-term US Treasury yields could be 120 to 150 basis points higher than would otherwise be the case in equilibrium. Treasury Yield Curve Debt to GDP at 100% (Interest Rates in Equilibrium +150 basis points)* * Payden & Rygel estimates of where interest rates would be in three years time under the assumption of a sustained economic recovery and a normalization of monetary policy. Sources: The Federal Reserve and Payden & Rygel Estimates Debt to GDP at 70% (Interest Rates in Equilibrium)* Interest Rates Today (Below Equilibrium)
UK Economic Outlook Economic Growth Forecast: Inflation Forecast: Interest Rates Forecast: Inflation, as measured by the headline consumer price index (CPI), rose to a year-over-year rate of 2.8% in December, up from 1.9% in November. This marks the first time headline inflation has been above the Bank of England’s (BoE) 2%-target in six months. The rise in energy costs is likely to keep headline CPI back above 2% early this year. However, the strength of the British pound and spare capacity in the economy should keep this pressure subdued. The UK economy crept out of recession, with real GDP growing at 0.4% in Q4 2009. This marks the first positive print after six consecutive quarters of negative growth and the end to the longest recession since records began in the mid-1950s. The UK economy is expected to continue to recover this year. However, the deleveraging of household and bank balance sheets will act as a restraint on economic activity. The key risk is that the impact of government spending fades before there is a sustained pick-up in private demand. The BoE maintained its policy rate at 0.5% and signaled that it was in no rush to raise it from that level at its January meeting. The central bank also pledged to spend the rest of its £200 billion bond repurchase program. The BoE will likely leave its benchmark rate unchanged until late-2010. However, the central bank may move to mop up some of the liquidity it has pumped into the UK economy in the coming months if the recent improvement continues.
UK Pension Fund Demand for Long-Dated Government Bonds Have Kept a Lid on UK Government Bond Yields Source: Eurostat Debt Structure Survey 2008 UK Pension Funds Funding Status The 2004 Pensions Act in the UK requires trustees and sponsors to make “prudent” choices to meet plan funding obligations. Over the past 10-years, pension funds have shifted assets away from equities and toward gilts. The average pension fund’s holdings of bonds has almost doubled over that period from 15% in 1998 to 29% in 2008. Underfunded: Pensions Liabilities Exceed Assets Fully Funded: Pensions Assets Meet or Exceed Liabilities
Euro Zone Economic Outlook Economic Growth Forecast: Inflation Forecast: Interest Rates Forecast: Inflation, as measured by the harmonized consumer price index (CPI), rose by 0.5% in the year to December. This is well below the European Central Bank’s (ECB) 2%-inflation ceiling. The headline CPI will remain positive in the new year. However, deflation risks will persist through much of 2010 due to the output gap, which measures the difference between actual and potential economic growth. The euro zone economy grew at an annual rate of 1.7% in Q3 2009. This marked the first positive growth in five quarters, but there are still large disparities in economic performance among member countries. The euro zone economy has benefited from having had relatively less exposure to the global financial crisis. Though consumer spending and exports appear to be stabilizing, rising unemployment and a fragile banking sector remain the key risks to sustainable economic growth. The ECB left its policy rate unchanged at 1.0% following its January meeting. ECB President Jean-Claude Trichet gave no indication of a possible rate hike in the near future, stating that "the recovery process is likely to be uneven and that the outlook remains subject to uncertainty." We expect the central bank to leave its benchmark rate unchanged until mid-2010. But there is some risk that the ECB will begin exiting policies aimed at boosting economic activity.
Greece Has Been In the News, But Its Situation Is Unique *Gross debt Sources: The European Commission and Thompson Reuters Greek Debt as a Percentage of GDP Euro Zone Stability Pact Mandate Government 10-Year Benchmark Yields Fitch Ratings lowered Greece’s sovereign credit rating from A- to BBB+, the lowest rating of any euro zone member. The move, which caused interest rates on Greek government bonds to rise, was prompted by Greece’s refusal to take credible actions to reduce its government debt.
Australia Economic Outlook Headline inflation, as measured by the consumer price index (CPI), rose to 2.1% year-over-year in December, following a 1.3% rise in November. This was the highest level in over a year and marks the first time since 2008 that inflation has been within the Reserve Bank’s 2% to 3% target range. Inflation will be of greater concern once the effects of previous rate cuts and the government’s fiscal stimulus measures have fed through into domestic demand. But this seems unlikely before the middle of 2010. Economic Growth The Australian economy grew at an annual rate 0.8% in Q3 2009 –below its 2.5% Q2 performance. Government stimulus fueled strong gains in consumer spending and a bounce back in business investment. The rebound in commodity prices and healthy export growth to China have helped Australia to skirt the global recession. However, the negative wealth effect from declines in home values and equity prices suggests growth will be more subdued than it has been in the recent past. Forecast: Inflation Forecast: Interest Rates The Reserve Bank of Australia (RBA) left its benchmark rate at 3.75% at its January meeting, following three consecutive months of 25 basis point hikes. The RBA remains the first major central bank to increase the cost of borrowing. The improving economic outlook reinforces our view that the RBA will continue hiking rates. However, the central bank is mindful that consumer demand remains weak and has therefore paused its hiking cycle to assess its impact. The central bank is likely to move again in small 25 basis point increments over the coming months. Forecast:
Australia is the First Major Economy to Hike Rates Central Bank Policy Rate and Unemployment Rate The Reserve Bank of Australia raised its benchmark interest rate by 25 basis points for three consecutive months at the end of 2009, making it the first major economy to increase the cost of borrowing. Though the central bank left rates unchanged at its January policy meeting, recent data indicating that the country’s unemployment rate fell in December has raised speculation of another rate hike in February.
Canada Economic Outlook Forecast: Forecast: Forecast: Economic Growth Inflation Interest Rates The Canadian economy emerged from recession in Q3 2009 with real GDP growth of 0.4%. The improvement was broad based with consumer spending, business investment, and government spending all contributing. Canadian economic growth should continue to strengthen in the coming quarters as low interest rates and a well functioning financial system fuel new lending. Higher commodity prices and stronger global demand should also boost activity. Headline inflation, as measured by the consumer price index (CPI), rose by 1.2% year-over-year in December. This is the second straight month that inflation has fallen within the Bank of Canada’s (BoC) 1% to 3% target. Despite a pick up in Canadian economic growth, the output gap and a strong Canadian dollar should keep inflation under control. The BoC maintained its benchmark interest rate at 0.25% in January – the lowest level in the central bank’s history. The BoC has conditionally committed to keep this rate until at least the end of Q2 2010. The BoC decided against implementing quantitative easing (QE), stating that Canada has a stable banking system and is in better condition than many other industrial economies. The central bank suggested that it would intervene if the value of the high Canadian dollar threatened to impede economic recovery. However, no such action seems necessary at the present time.
Canadian Housing Market Shows Signs of Recovery Canadian House Prices and Housing Starts The Canadian housing sector appears to be recovering after coming to a virtual standstill at the end of 2008. Though still down 1.4% on a year-over-year basis, new home prices increased 0.4% in November from October, the fifth consecutive monthly gain. Housing starts also rose to a seasonally adjusted annual pace of 174,500 in December, the highest level in 14 months.
Japan Economic Outlook Forecast: Forecast: Forecast: Economic Growth Inflation Interest Rates Japanese real GDP grew at an annual rate of 1.3% in Q3 2009, down from a revised Q2 2.7% increase. The continued positive growth was spurred by a rise in exports as well as an increase in household spending associated with recent tax cuts and subsidies. Japan’s record ¥15.4 trillion fiscal package has provided a temporary boost to private-sector demand, but the recovery is fragile. The biggest risk is that the new government led by the Democratic Party of Japan (DPJ) begins unwinding stimulus measures, worsening the effects of a weakening job market. The headline consumer price index (CPI) fell 1.9% in the year to November 2009. Japan’s deflation has been much more broad based than other countries. Core inflation, excluding food and energy, was down 1.7% over the same time period. Continued deflation is the primary threat to economic stability in Japan as the output gap, the difference between potential and current economic growth, widens. Wages will also continue to drop as companies attempt to offset shrinking profit margins. The Bank of Japan (BoJ) voted in January to leave its policy rate unchanged at 0.1% due to low inflation and economic growth potential. The central bank announced a new program to provide 3-month loans to financial institutions at 0.1% in December. The BoJ has little choice but to keep interest rates near zero and may even expand its bond repurchasing program. The bank currently purchases ¥1.8 trillion of bonds a month.
Japanese Situation Mitigated By Willingness of Japanese to Hold Debt Breakdown of Foreign and Domestic Holdings of Debt Demand from Japanese investors for government bonds has mitigated the impact of rising debt levels on interest rates. However, the ballooning government debt burden remains cause for concern. On January 26 th , ratings agency Standard & Poor’s lowered its outlook on Japan’s sovereign debt to negative from stable and threatened to downgrade the nation’s AA rating unless policy makers find a way to curb public spending. Source: Eurostat Debt Structure Survey 2008 94% Domestic Holdings
China Economic Outlook Forecast: Forecast: Forecast: Economic Growth Inflation Interest Rates The Chinese economy grew at a year-over-year rate of 10.7% in Q4 2009, which followed revised growth of 9.1% in Q3. Massive fiscal stimulus and support for lending have been the key drivers of economic activity. A revival in private demand appears to be underway, suggesting less need for government intervention in the Chinese economy going forward. The primary risk is the development of an asset bubble if monetary policy is left too loose for too long. China has recovered from a temporary deflation due to the decline in international commodity prices with the headline consumer price index (CPI) rising 1.9% year-over-year in December . Stronger-than-expected credit growth and the likely deregulation of fuel and utility prices should keep the headline CPI back in positive territory through the first months of 2010. The People’s Bank of China (PBoC) moved to tighten credit by raising its bank reserve requirement by 50 basis points to 16.0% in January. The increase is primarily targeted at managing liquidity by curbing bank lending The central bank may continue efforts to absorb liquidity, with analysts predicting that there could be two or three more required reserve increases before June.
The People’s Bank of China Moves to Rein in Bank Lending The People’s Bank of China took its strongest step towards tightening monetary policy on January 12 by increasing its commercial lenders' reserve requirement ratio by 50 basis points. The move is aimed at stopping the possible creation of an asset bubble and makes China one of the largest economies to begin retracting policies used to combat the global financial crisis. Commercial Bank Lending and the People’s Bank of China (PBoC) Reserve Requirement Rate Sources: The People’s Bank of China and Bloomberg Reserve Requirement Ratio Hiked to 16.0%
Plan Sponsor realization (due to volatility frozen funding changes) that liability management should be the driver in asset allocation.
Downside risk of harsh funding requirements outweighing potential upside equity gains due to 7 year amortization on gains.
Assumed actuarial rate of return now the Corporate Bond Yield Curve.
Asset/liability modeling and interest rate sensitivity needed.
- Active Plan Sponsors dialing down equity component to typically 50/50 asset allocation.
Frozen plans looking to terminate forecasting savings due to a change in the lump sum interest calculation to higher corporate bond rate dialing down equity position typically to below 50%.
Actuarial Plan Design / M&A Legislative Changes Funding Policies & Goals Investment Strategy Employee Education Plan Cost At Longfellow, we understand the ever-changing complexities, goals, and concerns that you and your participants face. No two Defined Benefit Plans are alike. Longfellow takes your concerns and works with the best industry minds to create custom, cost effective, long term, solutions. Retirement Solutions Model – Defined Benefit Flexibility and Focus…Solutions that work for you The Consultant’s Role
Jeffrey Bauer, QPA,CPC – President, Angell Pension Group
Longfellow Benefits 116 Huntington Ave, 10 th FL Boston, MA 02116 T. 617.351.6000 F. 617.351.6001 Securities and advisory services offered through NRP Financial, Inc. Member FINRA / SIPC. Longfellow Benefits and NRP Financial, Inc. are not affiliated entities. www.longfellowbenefits.com