Pictet Asset Management
Stimulus Withdrawal Is the Next Challenge for Governments
The greatest global stimulus program ever witnessed has saved financial markets from entering the abyss, and has paved
the way for economic recovery. Relieved investors have regained their appetite for risky assets, sending equities soaring
70% since their March lows. However, the job is not yet complete—fumble the exit, and governments put at risk all they
Neither be Too Soon, nor Too Late
In the past twelve months, developed countries have resuscitated the global financial system with massive liquidity
injections and loose money. However, unprecedented levels of fiscal and monetary support cannot continue forever.
Therefore, 2010 will inevitably see some withdrawal of government stimulus from the economy, but timing this well will
not be easy, as the IMF has recently commentated:
“Great care in disengaging from public support will be necessary to avoid either sparking
a secondary crisis through premature withdrawal, or endangering monetary and fiscal
credibility through a belated exit.”
—Navigating the Financial Challenges Ahead, IMF Global Financial Stability
report, October 2009.
Historically, withdrawing stimulus too soon after a recession has had grave consequences. During the Great Depression,
the U.S. Fed itself was responsible for triggering a second, deeper recession just as recovery looked possible when it
tightened monetary policy too early. And, more recently in Japan, in 1997, the government snuffed out a barely inchoate
economic recovery by an absurd set of tax hikes in what was an astonishing policy blunder.
Exit too late and the longer-term ramifications could be even worse. Prolonging near-zero interest rates longer than
necessary may prove dangerously inflationary. Many developed governments have amassed a Brobdingnagian fiscal
deficit that they badly need to rein in. Undue delay in tackling their involuntary profligacy would risk a sovereign down
grading, which could have profound consequences for global markets.
Monetary Tightening to Come Later, Rather than Sooner
It is unlikely that governments will risk suffocating the recovery with an over-aggressive program of fiscal and monetary
contraction, not least because the growth outlook for much of the developed world remains dull. Ben Bernanke, Chairman
of the U.S. Fed, is more than anyone, aware of the dangers of doing so—he wrote his doctoral thesis on the Great
Depression. And, with U.S. unemployment at a 26-year high, a gradual tightening over the next year or two seems more
In September’s G20 meeting, world leaders reassured markets that they would not contemplate fiscal and monetary
tightening until recovery was fully assured. Less specific was what exactly would constitute recovery, but a sustained
improvement in labor markets may be the best criterion. Though the rise of jobless claims in developed economies is
slowing, there are few signs that unemployment will go down in the near future. The G20 also advised that when
governments eventually withdraw fiscal stimulus, they should offset the contractionary effect by maintaining loose
More details of the indicators the U.S. Federal Reserve may use to set interest rate policy emerged in the November
Federal Open Market Committee (FOMC) meeting. The FOMC noted that U.S. interest rates are expected to remain at
current levels for “an extended period”—generally thought to mean six months. The committee highlighted low capacity
utilization and few inflationary pressures, implying that they would only quicken monetary policy tightening when
inflation became a real threat.
Fiscal Stimulus—a Short-Lived Panacea?
Maintaining current levels of fiscal stimulus will not be easy. Taxpayers’ pockets are deep, but not infinitely so. In the
U.S., despite huge levels of debt, there are precious few signs of the badly needed spending cuts. Though in reality there is
little immediate threat to America’s ‘triple A’ rating, the sheer size of the fiscal deficit is alarming.
In the past two years, U.S. public debt as a share of GDP has mushroomed from 37% to 56% (fig.1), and the IMF expects
this figure to reach 100% over the next ten years. By the administration’s own estimates, U.S. liabilities have grown at
four times the rate of its revenues in the past six years. Debt servicing could hold down the U.S. economy for years to
come—the Congressional Budget Office (CBO) estimates that interest payments on national debt will amount to 3.8% of
GDP by 2019.
Figure 1: Federal Debt to Soar
Publically held debt % of GDP 1790–2019E
Source: Congressional Budget Office, Empirical Research Partners
Other developed economies have similarly worrying balance sheets. In Japan, a government debt crisis threatens, with
national debt approaching a shocking 200% of GDP. In the U.K., the level of indebtedness is at record levels since the
World War II.
Should the debt burden become overwhelming, this year’s panacea of fiscal and monetary stimulus will in time prove
short lived. Kenneth Rogoff, a Professor of Economics at Harvard University, recently expressed succinctly what many
now fear, that “there is every reason to worry that the banking crisis has simply morphed into a government debt crisis.”
Bond Yields Still Low Despite Recovery
Early signs of investor nerves over government debt ought to come from fixed-income markets, but bond yields have
stayed at historically low levels this year. During the height of the recent recession, ultra-low interest rates, quantitative
easing, and deflationary pressure had driven bond yields down. Although U.S. 10-year treasuries briefly touched 4%
during the middle of this year when better economic data was released, they have subsequently fallen to 3.5% (fig. 2); 2-
year treasury notes remain under 1%.
Figure 2: U.S. Bond Yields Fall Back
3 Years to 11/05/09
Source: Thomson Datastream
So why have bond yields remained unfazed by a return to growth? It is, in part, an acknowledgement that stimulus
programs such as “cash for clunkers” are merely temporary. But it is also because of still tight lending conditions. If,
however, states continue their fiscal excesses, this low-yield environment may not last. The IMF estimates that a 1%
increase in the overall fiscal deficit of a developed country results in bond yields increasing by 20 basis points. For
emerging economies, the effect is a 30 basis point increase, perhaps a symptom of their historic vulnerability to changes in
Asia Already Tightening
Led by China, Asian countries have responded vigorously to fiscal injection (fig. 3). State money has had a rapid effect in
Asian economies, where, unlike in the developed world, countries have not been handicapped by excessive consumer debt
and failing banks. China’s GDP is forecasted to grow by around 9% this year and in October its manufacturing output
expanded at the fastest rate in 18 months. This return to rapid growth is providing benign knock-on effects for China’s
neighbors and other resource-rich emerging economies, particularly in Latin America.
Figure 3: Chinese Domestic Stimulus Results in Growth
China Loan Growth and Export Growth
Source: CEIC, Morgan Stanley
Consequently, policy tightening in China is already underway. The government has begun constricting Bank of China
liquidity and has increased the minimum reserve requirements for banks. However, given its obsession with growth, it
seems inevitable that China will exhibit sharp economic swings, with the risk of asset price bubbles ever present.
It is therefore likely that Asia will lead the global rate hiking cycle. South Korea’s economy grew by 2.9% in the third
quarter (quarter over quarter), the fastest in seven years, while growth in Singapore also surged. In both of these countries,
as well as in Hong Kong, rising house prices are accompanying a return to growth. Australia recently increased rates, and
speculation has emerged that South Korea will soon follow suit.
A Matter of When, Not If
Had states not intervened with such force, the world’s economy would be in far worse shape. As the IMF remarks,
complacency is now the danger. For the time being, most developed governments seem determined to maintain a loose
fiscal and monetary environment as long as any doubt over sustained recovery lingers. But withdrawal is a matter of
when, not if. And no matter how well timed, when governments begin their exit, markets are likely to react poorly in the
Fears of a New Bubble Brewing
The global economy lies in a “sweet spot” of recovery, low bond yields, and a benign inflation outlook. Besides potential
policy misfire, where else may trouble lie?
The bears insist that we are already in the midst of a dangerous asset bubble fueled by excess liquidity, near zero interest
rates and a falling dollar. According to these doomsayers, a self-sustaining pro-cyclical triple momentum play of long
commodities and emerging markets, and short U.S. dollars, has left markets wildly over inflated. The impact of this
bubble collapsing will be horrific, so they prophesy. These fears seem somewhat overblown, at least for now. Bond
markets present a more realistic near-term threat, and there is a clear risk of an upward shift across the yield curve once
monetary policy starts to tighten.
Bond Yield Rise Could Trigger Dangerous Relapse…
Some say investors are now too complacent about the inflation outlook. Even with severely depressed levels of
employment, the gargantuan scale of fiscal stimulus is a real medium-term inflationary risk. In October, the Institute of
Supply Manufacturers (ISM) Index recorded its fastest monthly expansion in three years, the latest in a surfeit of better
economic data, but bond yields hardly budged (fig. 4).
Figure 4: Unprecedented Divergence
Change in Bond Yields versus Global Industrial Activity
Source: Thomson Datastream/Pictet
If bond yields rise, stocks would suffer, and the nascent recovery in the housing market would falter. The dollar would
also find support, which would hardly be good news for risky assets. And, if this year’s commodity price rally continues
unchecked, rising oil prices could threaten the recovery and cause problems for financial markets (fig. 5).
Figure 5: Commodities Close to Breaking Upwards
As of 10/13/09
Source: ISI Group, De Graaf
How would governments respond to a relapse into recession? Their options would be limited. It is unlikely that bond
markets will digest a further round of fiscal stimulus without forcing yields higher. Renewed economic weakness,
accompanied by rising longer-term interest rates, would present a policy conundrum.
…but a Sharp Correction in U.S. Treasuries Unlikely
Bond yields now look low given the inflationary implications of a colossal global fiscal injection, particularly as recovery,
albeit a slow one, now looks certain. A sharp correction however, as far as 10-year U.S. treasury yields are concerned, is
unlikely. We think the relatively steep slope of the yield curve should limit any rise to 20 to 30 basis points, at least until
monetary policy tightening is imminent.
A “Good” Financial Crisis for Emerging Markets
Free of the burden of failing financial sectors, most emerging economies have had a relatively “good” financial crisis.
Improved internal finances had facilitated a rapid fiscal response, which in turn has enabled a swift return to growth.
Emerging countries face a different set of challenges than do developed countries in sustaining long term growth; namely,
they must rebalance growth and become less reliant on a neo-mercantilist model.
Recovery to Slow Next Year
Global recovery in 2010 is likely to slow as government-induced liquidity dries up. Equity markets will likely face a
tougher environment next year, particularly if bond yields rise. Recent weeks have seen greater uncertainty in stock
markets; investors, still shaken by events last year, are naturally prone to some degree of pessimism.
Drivers of Global Equity Advance Remain
Nonetheless, the foundations of this year’s equity market advance—positive economic momentum, excess liquidity and
attractive valuations—remain broadly in place. High levels of institutional cash have been steadily reduced with
improving risk sentiment, and this should continue. Retail investors are yet to return to the equity market in full strength,
and strong corporate cash positions could trigger further M&A activity next year.
Optimistic, if cautious
Given that financial markets seemed on the verge of meltdown less than a year ago, the extent of economic stabilization
and the speed of recovery in asset prices is remarkable. As we near 2010, we have a pro-equity stance, one increasingly
tempered by short-term caution. However, though the worst of the crisis may be over, many imbalances that triggered it
remain, and the cost of policy-induced recovery has badly dented government balance sheets.
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