Op-ed commentary by TCW's Komal Sri-Kumar originally published in the Financial Times.
The US economy and the eurozone debt crisis are the dominant issues causing analysts to lower earnings expectations for companies.
The US economy may have created 200,000 jobs in December and lowered the unemployment rate from 8.7% to 8.5%, but expectations for US growth are muted because the housing sector has yet to hit bottom. Meanwhile, explaining the far-flung impact of the European debt crisis, Christine Lagarde, managing director of the International Monetary Fund, said global growth in 2012 would be slower than the 4% she foresaw as recently as September.
The impact of these two problems has been overarching. Fears persist of a Lehman moment in the eurozone, pushing even the German economy into recession. At the same time, capital flows to havens – Treasuries, Bunds and gilts – have pushed yields to historically low levels.
Talks on a private sector involvement deal to impose a haircut on Greece’s creditors have stumbled. Even with a deal, Greece’s debt woes will continue. Any deal comes with the stipulation that lenders cannot be reimbursed by their credit default swap contracts since, in the event of a deal, any losses will be arrived at “voluntarily”.
As a result, disappointed sellers have attempted to get out of Greek debt, sending the implied haircut on 10-year debt to more than 70% in the secondary market.
When they undermined the sanctity of the CDS market, European authorities caused yields to rise in debt-ridden countries as investors built in an additional risk premium. In turn, higher debt yields have made it even more difficult for those countries to avoid a severe recession.
Allowing Greece and other troubled countries to take advantage of market-implied reductions in the level of debt in exchange for pro-growth economic policies would be the first step in effecting a turnround. Renewed demand for Italian paper will lower the 10-year debt yield to less than current levels of more than 6.5% during a year, in which the government has to roll over eur 300 billion of its EUR 1.9 trillion public debt.
In the US, the malaise in the housing sector will not end unless the job situation improves, raising the confidence of potential homebuyers. There are 5.8m fewer jobs available to Americans compared with December 2007.
The Obama administration has fought the jobs crisis largely by extending benefits for the unemployed. Although this has reduced suffering, the unemployment rate is over acceptable levels, house prices continue to fall and a sustainable economic recovery is in doubt.
Improvement in US labour market conditions should result in a bottom in home prices leading, finally, to sustainable growth. That is the signal for investors to boost expectations for corporate earnings and equity prices.
To achieve this, the administration needs to shift focus from compensating the unemployed to increasing the demand for labour. Authorities can do so through two targeted measures: tax credits to encourage employers to hire and, important in an election year, making companies hire domestically rather than abroad; and retraining unemployed workers, in an economy where those out of work for 27 weeks or more are more than 42% of the unemployed.
How likely are these market-friendly measures in Europe and the US? Even though the meeting between Angela Merkel and Nicolas Sarkozy this month indicated no change from their muddle-through policies, other developments could force a shift.
If the UK does not contribute to a EUR 200 billion increase in IMF resources as the EU has recommended, it would put the existing rescue mechanism in doubt and lower secondary market debt prices, even for Italy and Spain. Second, Greece lacks the funds to repay or roll over more than EUR 14 billion due March 20, and this could push Europe’s reluctant powers toward a market solution. Finally, Italian debt payments are bunched up in the first quarter, and the government will have to decide whether it wants to pay the higher rates demanded by investors and precipitate a severe recession or seek a restructuring of the country’s debt.
In the US, expect the persistence of high unemployment to be negative for the president before the elections. With monetary and fiscal easing having reached the limit of their usefulness, authorities will have to find other ways of boosting job growth. Making pro-market structural changes in the labour market may be their only option.
Investors should consider a shift to market-orientated policies as a buy signal for European debt and equities. They should buy US equities and sell Treasuries. I believe policy will change this year, not least because it would be politically attractive in both Europe and the US.
Komal Sri-Kumar is chief global strategist and chairman of the TCW Comprehensive Asset Allocation Committee at Trust Company of the West.
