Published: September 30, 2011
We’ve seen ebbs and flows in economic growth since the financial crisis in 2008, but we have yet to see any sustainable run of growth that would set us up for what we could call a typical recovery. In a typical recovery, the economy is going to grow above trend for a period of time and start to reduce the output gap.
In this recovery, every time the economy has started to turn higher, we’ve hit setbacks. In 2010, the first round of the European sovereign crisis contributed to a slowdown that wasn’t technically a double dip, but certainly looked like one in terms of the shape. Growth picked up pace again with the Fed’s second round of quantitative easing, but has slowed once again and markets have been extremely volatile. Events have also contributed to investor concerns about growth. These include the recent debt ceiling debate and rating downgrade in the US, and the spread of volatility in European sovereign debt to countries like Italy and France. Considering this backdrop, we don’t think it’s clear yet what would be the impetus for a reacceleration in growth, and so we think the risk of recession in the US may have increased significantly. In our view, modest economic growth is now probably the best-case scenario.
The European story is also concerning but somewhat different because of the different levels of economic growth among the countries in the Eurozone. Germany has clearly generated some very strong growth and unemployment has fallen to record levels. However, the economic situation in some of the so-called ’peripheral’ countries like Greece, Ireland, Spain, Italy and Portugal has deteriorated over the last two years, raising global concerns about the European banking system. The situation in many of the peripherals and the broader global slowdown appear to be weighing on growth in Germany; the economy grew just 0.1% in the second quarter versus 1.3% in the first quarter. We don’t expect a recession in Germany but we do think growth will be slower and the risks are probably to the downside. The UK is somewhere in the middle between the US and Europe. Europe has a significant influence on UK growth, and so does the US.
We think it’s interesting the way each central bank has handled its own situation. European Central Bank (ECB) policymaking seems to have evolved very differently compared to the policies in the US and UK, and part of the reason is that the ECB’s task has been greatly complicated by the economic disparities across the Eurozone. Because of these disparities, the ECB seems to have chosen to target its interest rate policy towards countries with stronger economic growth while taking other measures to support countries with weaker growth. For example, the ECB is offering European banks unlimited funding on a secured basis. Providing unlimited liquidity is an unconventional policy, and the ECB has made this policy even more unconventional by pairing this liquidity provision with interest rate hikes. Their approach contrasts with the US, where the Federal Reserve (Fed) has provided liquidity through quantitative easing measures as part of an overall easing programme.
We have always believed in a tiered approach to liquidity.
Throughout this cycle, the Fed has handled monetary policy by the so called ’crisis playbook’, which says that you should lower interest rates until you can’t ease any more and then you should do quantitative easing and anything else you can do to make financial conditions easier in a crisis.
The Bank of England (BoE) seems to have handled their policy by a similar playbook. But like the ECB, the BoE has a single mandate to target inflation, so it’s striking that the BOE has decided not to raise rates even though inflation has been persistently above target. Traditionally inflation has been seen as an all-encompassing indicator for monetary policy, based on the idea that inflation is a representation of all broad macroeconomic conditions. But, in our view, the world has changed and just because inflation is elevated that doesn’t mean that macroeconomic conditions warrant a tightening of monetary policy. We think the BoE recognises this and has been able to effectively decouple the relationship between inflation and monetary policy, whereas the ECB has been less willing to adjust its approach. The Fed reached the same conclusion as the BoE, but its stance was easier to defend, because it has a dual mandate covering inflation and employment. [[[PAGE]]]
We think investors are going to have to manage their liquidity a bit more efficiently and look for strategies that offer an attractive yield premium relative to the risk. If you accept that daily liquidity is going to be very expensive, having too much liquidity is going to be expensive in terms of low yields, while having too little could be expensive as well in terms of business risk. But we don’t think liquidity management is an all-or-nothing proposition.
We have always believed in a tiered approach to liquidity, where some portion of the assets is held in strategies offering daily liquidity and another portion is invested in strategies that take a little bit more risk in an effort to capture risk premiums for liquidity, credit risk or duration risk. Today, we believe a tiered approach is even more important, and that the main opportunity is in capturing liquidity risk premiums.
In fact, one of our key priorities today is strategies that focus specifically on trying to capture liquidity risk premiums, with very little exposure to credit or duration risk, which we think can fit very well with other strategies to form an overall liquidity management strategy.
An example of an investment strategy that focuses on liquidity risk premiums rather than duration or credit risk premiums is term non-traditional repurchase (’repo’) agreements, where a financial institution will sell securities such as investment-grade corporate bonds to an investor in exchange for cash, with the obligation to repurchase those securities from the investor after a specified term.
By combining strategies that offer daily liquidity and strategies that focus on trying to capture liquidity premiums, investors should be able to create a cash management programme that allows for a significant amount of uncertainty regarding the economic environment but also offers higher return potential. The mix of strategies will vary according to the investor, but we think that many investors are probably too focused on daily liquidity and could take some additional liquidity risk.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by GSAM to buy, sell, or hold any security. Views and opinions are current as of the date of this article and may be subject to change, they should not be construed as investment advice. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. The economic and market forecasts presented herein have been generated by GSAM for informational purposes as of the date of this article. There can be no assurance that the forecasts will be achieved. This material has been approved in the United Kingdom solely for the purposes of Section 21 of the Financial Services and Markets Act 2000 by Goldman Sachs Asset Management International, which is authorised and regulated by the Financial Services Authority (FSA).
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