May’s Market Voice focuses on the strategies pursued in the U.S., Europe, and Japan by governments and central banks to mitigate the economic impact of COVID-19. We also analyze the potential consequences asking: Is it boom or doom?
- Although U.S. Government debt has surpassed GDP and the Fed is making record expansion of its balance sheet, the fiscal picture remains benign.
- The bigger risk lies in the potential of politicization of Fed policy and that it expands into new buying. And there is also serious risk for corporate and muni markets if the economic impact of COVID-19 persists into the end of the year.
- While highly indebted euro-area governments face the same constraints as munis, the ECB will continue to provide support for as long as it is pursuing quantitative easing.
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The major stock markets have delinked from real economic activity.
Despite the lack of signs that the unprecedented shrinking of the global economy is moderating, as shown in Figure 1, major stock markets have not just stabilized but, in some cases, have sharply recovered.
Of the four major markets shown in the chart, Europe and the UK are still marginally in bear market territory. And the UK, on top of COVID-19, is also grappling with the uncertainty of Brexit.
While there is some reason for optimism from the prospect of partial reopening of markets, the outlook for economic activity remains highly uncertain and the survival prospects for many companies remain in the balance.
We suspect the firmer tone to the markets primarily reflects the unprecedented support governments — and particularly the U.S. government — are providing to the market both on the monetary and fiscal front.
But could it be that while government intervention is providing immediate support, it might well be doing so by creating the potential for long-term gloom?
Figure 1: G4 stock market indices: Three-month percentage change
Mitigating the economic impact of COVID-19
Figure 2 is taken from Refinitiv’s COVID-19 Macro Vitals app, which can be accessed if you have an Eikon subscription. This new app provides a comprehensive set of data, news, charts, and insight that records the economic impact of COVID-19.
While the U.S. and UK central banks have been the most proactive, the Bank of Japan and the ECB have also been adding to their balance sheets, with the total gain in global liquidity up roughly $2 trillion — a more than 10 percent increase — since the onset of the crisis.
In addition to the increase in balance sheets, policy rates have been cut — or kept well within negative territory — since the onset of the crisis.
And perhaps most significantly, central banks are becoming more creative in the ways they are injecting liquidity into the economy. This is particularly true for the Fed, which has set up special facilities to make direct investments in corporate and municipal securities.
Figure 2: G4 central bank balance sheets
As shown in Figure 3, there has also been action on the fiscal stimulus front to mitigate the economic impact of COVID-19. The U.S. and UK have been far more proactive than Japan or the euro-area governments.
U.S. government debt was already on an upward trajectory prior to the COVID-19 crisis, reflecting the passage of tax cuts in 2018. But this did not dissuade the Trump Administration and U.S. Congress from taking aggressive spending measures to provide support to the economy, pushing fiscal debt above 100 percent of GDP to its highest levels since World War Two.
The absence of a transnational fiscal authority in Europe has prevented a significant response (and caused some cross-border tensions about the uneven burden of dealing with the virus).
Japan has also been slow to respond because of the perception that the impact of fiscal spending is muted by the already high level of government debt — pushing towards 300 percent of GDP.
Figure 3: Government debt as percentage of GDP — 2021 projections
Does the U.S. fiscal stimulus pose any risks?
As noted above, the U.S. government has led the economic stimulus charge on both the monetary and fiscal fronts — taking government debt to levels not seen during peace time.
While the break of the 100 percent of GDP barrier may have psychological importance, it does not have any immediate macroeconomic implications.
As shown above, Japan has been operating with government debt well in excess of 200 percent of GDP for many years without creating any severe problems for the economy.
Japan does have the advantage of holding a substantial net foreign asset position — in large part the mirror image of the net foreign liability position of the U.S. — but Italy has also operated for many years with debt in excess of 100 percent of GDP.
Italy not only has a negative foreign investment position but it also cannot monetize its deficit since the authority to print euros lies with the ECB.
Italy’s relatively high debt position has created vulnerabilities, but passing the 100 percent threshold did not in itself have any immediate implications for macroeconomic performance.
Figure 4: U.S. fiscal debt and interest payments as percentage of GDP
The most important mitigating factor for the surge in U.S. debt levels is the extraordinarily low level of interest rates.
As shown in Figure 4 above, despite the surge in government debt, the projected interest burden versus GDP for this year remains close to a 30-year low. There is room for substantial additional fiscal stimulus without creating a significant servicing burden.
In the short run, the rising debt burden does not appear to pose any risk to the economy, but this is contingent on interest rates staying at historic lows.
A sharp rise in interest rates could push up the cost of servicing debt to levels where it would force the government to look for offsetting cuts in spending. Is there a risk that the Fed’s aggressive monetary expansion is going to ignite the fires of inflation?
Figure 5 suggests that there is actually very little risk of surging inflation in the next few years. While the Fed has engaged in a record expansion of its balance sheet in absolute terms, the percentage gain is still dwarfed by its activities in the wake of the 2008 Financial Crisis.
Also, as shown in the chart, the earlier balance sheet expansion had only a modest and delayed impact on total credit creation, suggesting there was only a marginal impact on aggregate demand, and by inference inflation.
Indeed, as is also shown, there was little feed through to inflation, and the Fed failed to achieve its target of a sustained two percent rate.
Figure 5: Fed balance sheet expansion impact on credit creation and inflation (percentage Y/Y change)
Inflation not the only risk
As was the case following the Financial Crisis, the uncertain economic outlook is likely to deter companies from taking on large amounts of additional debt to expand operations.
The expansion of the Fed’s balance sheet is likely to have a modest and delayed impact on credit growth and inflation. For at least the next two to three years, there seems little risk that higher interest rates are going to turn the growing debt levels into a significant financing burden.
The expansion of the Fed’s activities, however, may potentially cause more immediate challenges. The extension of its asset purchases into lower quality corporate and municipal securities could create policy conflicts.
There is a clear risk that the Fed could become increasingly politicized in its decisions of which companies to support. There is also the possibility that the Fed’s insistence on repayment could force municipalities into painful politically unpopular cuts in wages and services.
It is generally recognized that the Bank of Japan’s rapid credit creation and adoption of zero rates in the wake of the late 1980s stock crash allowed insolvent companies to rely on near free financing to continue operations.
But tying up capital in walking-dead or “zombie” companies resulted in many years of stagnant productivity and slow growth.
Hopefully, an immunization for COVID-19 will be forthcoming by the end of the year, allowing a quick move back to the normal.
But there is certainly risk that it will be years rather than months before reliable treatment emerges, forcing society and the economy to restructure activity to moderate contagion.
Under this circumstance, there is risk that monetary and fiscal support for existing companies (especially large employers) will stall the process of restructuring.
The risk is that like Japan, zombie companies will eat up our capital, creating many years of painfully slow growth.
Figure 6: Selected credit spreads
Not all borrowers can print currency
The economic impact of COVID-19 is creating funding stresses for borrowers in virtually every market.
The U.S. government has the advantage that control of the dollar printing press means there is little risk of default — although there is the long-term threat of inflation — but corporate and municipal borrowers do not have this luxury.
The difficulty that these borrowers face as their sources of revenue collapse was the reason why the government has been so aggressive in providing support through grants and loans.
Figure 6, however, suggests the support has not been adequate to dispel concerns about credit risk as COVID-19 takes its toll on the economy.
While spreads on both corporate and muni bonds have moderated since the government measures were announced, they remain wide by historic standards, and are comparable to spread levels during the Financial Crisis.
The government support, to date, is giving these borrowers a lifeline into the third quarter. However, the future remains dim if there is not a significant pickup in economic activity before the end of the year.
The curse of the euro
Although Italy is a sovereign state, its adoption of the euro as its currency means that like a municipal borrower it does not have the ability to print money to cover its debts.
Not surprisingly, the spread of Italian rates versus German bonds (the risk-free euro proxy) is closely tracking the U.S. muni spread.
However, the U.S. government is considering providing fiscal support for the muni market while the structure of the euro precludes any such support for Italy (or other stressed borrowers, such as. Spain, Portugal, and Greece).
Indeed, the Maastricht Treaty, the legal basis for the euro, precludes any cross-border fiscal transfers.
Pressure on Italian bonds was more severe in 2015 when Greece was on the verge of default and possibly leaving the euro.
However, the spread collapsed when then ECB President Mario Draghi said he would do “whatever it takes” to maintain the euro.
As shown in Figure 7, the ECB has since gone on a buying spree of resident-issued bonds, which includes general government bonds.
In essence, the ECB is funding the heavily indebted euro-area governments, and this has been facilitated by the asset accumulation required by its policy of quantitative easing.
Like the U.S. fiscal situation, the primary risk for Italy is a pickup in inflation limiting the ability of the ECB to continue expanding its balance sheet.
Figure 7: 1Y USD vs EUR LIBOR spread and EURUSD 1Y forward premium
The bottom line
Although U.S. government debt is now greater than GDP, the servicing burden remains low due to the historic low levels of interest rates.
Indeed, there appears to be room for substantially more fiscal expansion as long as interest rates stay low.
The experience of the 2008 Financial Crisis suggests that there is little risk that the Fed’s current exercise in balance sheet expansion will lead to a quick rise of inflation.
But if the contraction caused by the economic impact of COVID-19 extends into 2021, the Fed may face an uncomfortable trade-off of providing support to contracting sectors when disrupted supply chains and firming demand create pockets of inflationary price increases.
There is also serious risk that both Federal and Fed support for key sectors could become politicized and impede the economy’s transition to an extended adjustment to COVID-19.
The outlook for muni and corporate debt looks dire if the economic contraction extends into the fourth quarter because it is not clear how long the government is prepared to provide support.
In principal, this is also true for heavily indebted European sovereign borrowers, but they should continue to get a lifeline from the ECB, as long as interest rates remain in negative territory and they are pursuing quantitative easing.
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The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Refinitiv, or any of its respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.