We are fully aware that it is not easy to make short-term macroeconomic forecasts, especially after a financial crisis with the potential to bring long-term headwinds to the economy. The Great Financial Crisis left many legacies. There was the deleveraging phase (as investors paid off debt) that typically follows credit/real estate bubbles. And, there were many dislocations in the job market and in the investment cycle, as well as distortions created by an excess of regulation.
As long-term investors, rather than engaging in short-term macro forecasting, we are more interested in the big picture and in understanding the long-term macro environment in which we are going to invest for the next three to five years. At the same time, we believe in the existence of short-term economic cycles and the reversion to mean of financial markets. Regarding the long-term macro picture, the total level of government debt worldwide, has increased, not decreased, since the financial crisis and is now up more than 30% since 2007. We believe this may prevent central banks from managing an aggressive tightening, but in our opinion, it will not change the link between growth and rates that underpins any economic cycle. Were central banks to lose that link, (starting with the Federal Reserve), it could be disruptive for their credibility.
U.S. Economic Trends
In our opinion, short-term economic indicators are pretty clear. In the U.S., the deleveraging phase of the private sector is at the point of maturity. The household debt/service ratio (measures debt payments as a percentage of disposable income) and the debt/disposable income ratio are both far below the pre-crisis level, and we are seeing evidence of credit growth in the banking sector. One could argue that the recovery of the labor market is abnormally low, but we believe that this trend can only partially be attributed to the recent crisis.
If we look at long-term trends, we can see that the transformation of the U.S. labor market was already in place well before the crisis. Wages, are starting to grow again in the private sector, although slowly. Signs of normalization are also coming from the housing market, with business activity and prices slowly recovering. For this reason, we tend to believe that the next step in U.S monetary policy will set the stage for a normalization of interest rates and that long-term government yields are directionally headed up.
European Economic Trends
In Europe, the growth trajectory remains muted, although we are finally seeing positive signals from cyclical indicators. These signals are coming not only from the business side but also from consumer indicators, thanks in part to the easing of fiscal austerity that was mostly responsible for the extended recession. Here, the legacy of the crisis is more profound, especially in terms of unemployment. The outcome of recent European elections, with some anti-euro forces gaining ground, could be a trigger for finally implementing more convincing pro-growth fiscal measures. For its part, the ECB (European Central Bank) is reacting by acting more forcefully to revive the bank loans market in an effort to fight deflation fears and to indirectly weaken a strong euro.
In addition, the robustness of credit markets both in the U.S. and Europe (in some cases even too strong and bordering on overheating) seems to point toward a sound corporate sector and suggest that an impending recession is not in the cards.
In the wake of normalizing economic conditions, we believe that the most likely trend for long-term government bond yields is up, although slow to unfold. Inflation, the biggest enemy of bonds, is still the “great absent” in this post-crisis recovery. Regulations support the demand for safe assets. And the economy is still far away from overheating on a global basis.
Finally, I believe that the most appropriate investment strategy going forward is a balanced and diversified approach. This calls for retaining a preference for risky assets, but on an increasingly more cautious and selective basis. In addition, volatility priced at reasonable levels may provide the opportunity to buy protection on any equity downside.
 Elaboration Pioneer Investments, on BIS Quarterly Review of March 2014 for Total General Government Debt in Advanced Economies.
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