Slow path to recovery from crisis

Greek protesters hold a banner saying "We are struggling to live". Photo / AP

The chief operating officer of the world's biggest fixed-interest manager says the United States equities market is "a little out over its skis" in the way it has priced in the robust recovery from the financial crisis.

Doug Hodge, of Pacific Investment Management Company (Pimco), has briefed senior figures in New Zealand on his company's vision on "the new normal" for the world after the global financial crisis.

In Wellington last week, Hodge met fund managers, other industry figures and our Government on Pimco's vision. With a huge uncertainty over what will happen when Governments and central banks withdraw stimulus and economic support packages in coming months, and the sovereign debt fears centred on Greece, Pimco believes significant downside risk continues to haunt the developed world's economy and, as the Winter Olympics has illustrated, pushing your luck in hazardous conditions invites disaster.

Hodge, with Pimco's New Zealand boss Tony Hildyard, spoke to the Business Herald just before their meeting with Finance Minister Bill English.

Pimco's view is the global economy is not yet out of the woods. "We're not in the emergency room any more. We've come through life-saving surgery but we're still in recovery."

That, he says, is at odds with what has happened in equity markets over the past year.

"There's this view being reflected in asset prices that the global economy is going to return to full strength. We would argue that that will eventually happen but we're on a slow path to recovery and rehabilitation.

"There are still these structural challenges that have yet to be resolved and the policy tools available to many of the developed countries are limited and growing increasingly limited."

Those tools, including quantitative easing, or rapidly expanding an economy's money supply, were not meant to be permanent.

"How we exit introduces a huge degree of uncertainty yet the market has priced in this very smooth transition."

If that wasn't enough to contend with, banks and households are being urged to de-leverage their balance sheets, and the global economy is moving from a unipolar world led by the US to a multipolar world.

Even as the financial crisis unfolded many of the developing economies have reached "critical mass". Pimco has been generating headlines as it deploys more of its US$1 trillion under management into developing economies' fixed-interest securities, most notably Brazil's.

Meanwhile, the West's key institutions, including the Federal Reserve, FDIC and SEC in the US and the Bank of England and Financial Services Authority in Britain among others, "haven't adjusted to new realities and don't have the structures and policy tools to manage through the transition".

"These institutions whose functions were defined for a different world have had to adjust in a cauldron of amazing market turmoil and emergency. In the aftermath they are now part of the political debate.

"How this will be resolved creates a degree of uncertainty and that's all a part of the new normal. It does suggest we're not going back to where we were in 2006 or 2007 - there will be a new configuration and design."

Hildyard says: "A lot of the markets are pricing in a resumption to trend growth and they're almost ignoring the amount of fiscal and monetary stimulus that was required to get us to the level of growth we've got now."

He says the pullback in equity markets indicates "there's an increasing recognition that maybe the government stimulus package can't last indefinitely and this handover to the private sector will not be as smooth as originally thought".

"It's not as if the market has completely missed the situation but there's a growing recognition and it's increasingly beginning to influence investor behaviour, that we haven't received the all-clear sign just yet."

Turning to the sovereign debt problems emerging in the EU, Hodge describes the face-off between Greece and the EU as a game of chicken.

"It becomes a matter of will the Greeks take the harsh medicine that the EU is asking them to take to bring their house in order?"

Hodge is talking about austerity measures which will be politically unpalatable to the Greek government. If it doesn't the EU is threatening to withhold assistance to stave off default.

The situation is complicated because the EU doesn't have a formal model for bailing out member states in such a difficult position.

As the most powerful economy in the EU, Germany will inevitably be called on to provide most of the support should Greece be bailed out. With Pimco owned by German banking and financial services giant Allianz, Hodge is probably well placed to observe that "there's something like US$150 billion [$214 billion] to US$190 billion of Greek bonds that have been placed with European banks". If neither Greece nor the EU change their course it is this debt that means the impact will be messy.

"If the EU walk away and the Greeks default, this problem comes right back at the EU central bank.

"There will be a whole set of banks taking huge losses at a time when they're not that financially strong."

Then after Greece there is Portugal, where similar problems are looming and, even more worryingly, Spain and Britain.

"The risk is contamination turns into contagion and given the skittishness of the market as people reflect on the crisis and they see one event can trigger a whole host of events that follow and becomes worse and worse, that's a threat. Our contention is that there are greater risks to the downside in terms of economic growth [and] asset prices than what's being priced into the market today."

Pimco appears to have taken a somewhat pessimistic view. The company's colourful founder, Bill Gross, recently warned against buying UK gilts because he believed the UK's credit rating was in jeopardy.

While Pimco by itself is not the bond market, it is probably big enough to wield a significant portion of market power to intimidate.

But Hodge says his discussion with English is likely to be a lot less confrontational than his firm's recent exchange with British Prime Minister Gordon Brown's Government.

As in other countries, the New Zealand Government is increasing the amount of debt it issues to fund widening of its fiscal deficit.

Pimco is fairly positive about New Zealand's sovereign credit quality but continues to see problems with the lack of a developed secondary market for government debt.

"It's smaller, it doesn't have some of the other elements that provide liquidity like a futures market. The swaps and repo markets, which in other markets provide liquidity, are not as developed as in other countries."