COVID-19 scars will linger on society and our economy in many ways, but for now, most are simply relieved that there is light at the end of what has been a long and dark tunnel. 2021 brings a brighter outlook for the economy and an optimism that is shining through in buoyant capital markets.
In the near-term, the differing paths and pace of fiscal stimulus will dictate the relative economic performance of countries. Clear contrasts are emerging – the US is still ramping up stimulus measures while China is focused on normalisation and Australia’s own measures are drawing to a close.
In the longer term, while many health-related questions remain unanswered, the big one that matters to investors and market watchers is: what is the consequence of all this debt sloshing around in the world’s financial markets?
Policy makers’ aggressive use of government spending to tackle the COVID-19 pandemic was necessary and helped prevent the crisis from being even worse, but it set a strong precedent for the new economic cycle and perhaps the one beyond that as well.
HOW DID WE GET HERE?
The pandemic meant re-writing the policy playbook. The old routes to engineering a recovery had become potholed and bumpy – policy makers were forced to find a new path. This led to a momentous shift towards governments as the spenders of last resort and increasing political pressure to shift away from any notion of austere fiscal tightening.
The drawn-out recovery following the Global Financial Crisis (GFC) emphasised the inability of loose monetary policy to stimulate either growth or inflation, despite generating ample amounts of liquidity. A few countries managed to start down the path of policy normalisation – the US and Australia – but it was short-lived.
Government spending also became a more attractive option in light of a prolonged period of stubbornly low inflation before the pandemic, as various structural factors had kept a lid on prices. As a result, when COVID-19 hit, the rescue from monetary and fiscal policy was tightly coordinated.
As policy rates were effectively slashed to zero, and negative in real terms, it gave policymakers greater latitude to spend and run up large fiscal deficits and higher and higher levels of government debt.
The unique nature of the COVID-19 recession was another factor. It was not caused by an economic imbalance or financial instability, as in the past, but by policy decisions to close off large parts of the global economy to protect public health. This created an obligation on many governments to offset, or at least attempt to repair, the economic damage created and rebuild economic confidence.
THE TRANSITION FROM DEBT-TO-GDP TO INTEREST-TO-GDP
The new reality is that most economies will now operate with persistently higher levels of debt. The recent surge in fiscal largesse means debt-to-gross domestic product (GDP) ratios globally are at levels not seen since war time. Some believe that this is not sustainable.
A decade ago, economists Rogoff and Reinhart argued that debt-to-GDP ratios of more than 90% would weigh on economic activity and slow the rate of growth. They argued that high levels of debt would negatively impact the outlook for interest rates, increasing the cost of debt, draining business confidence and creating a drag on economic activity.
What we’ve learnt is that debt levels can actually rise well above this with limited side effects. This is not to say that there are no negative consequences, but simply that it’s unlikely there is a magic number at which a heavy debt burden suddenly becomes unsustainable.
The absolute level of debt still matters, but what is of growing scrutiny is the cost in servicing that debt. It’s not just ‘debt-to-GDP’ but also ‘interest-to-GDP’ that needs watching. Enter central banks.
When real rates are so low, levering up to invest back into the economy makes sense, especially given the size of the economic shock from the pandemic. The risk is that the assumption of “lower for longer” turns out to be wrong. But given the hand-holding between central banks and governments since the onset of the pandemic, monetary and fiscal policy are more intertwined than ever before.
There is also a greater tolerance for all this debt by markets. Low rates and free spending were welcomed by financial markets in the wake of the COVID-19 crisis. Concerns over rising debt, excess liquidity and asset bubbles were pushed aside as investors optimistically looked across the bridge to the other side. The rising levels of debt-to-GDP were rewarded by equity investors and shrugged off by bond markets.
In the past, free-spending governments faced the risk of being punished by the bond markets. Finding the balance between needing to repair fiscal positions without removing fiscal support too soon is a challenging task. This lesson was learnt the hard way in the austerity imposed in Europe around the time of the Eurozone debt crisis, which unfortunately only compounded the region’s economic woes.
HOW TO GET RID OF ALL THAT DEBT?
There are three realistic means to lower government debt levels:
- Pay it back through higher taxes and reduced spending;
- Outgrow the debt by increasing productivity, raising incomes and generating a higher tax take without raising taxes; and
- Erode nominal debt levels through a higher rate of inflation.
Not all of these options will suit everyone. Economies with poor demographics or aging populations will find it difficult to reduce spending, given the need to support a social safety net. Raising taxes on individuals is politically challenging and increases in corporate taxes, while very topical, are hardly guaranteed.
Inflating away debt may be appealing, as long as wages are rising and the standard of living is not being squeezed, but persistent high levels of inflation have been notoriously difficult to create.
The inflation outlook is also highly uncertain. The very large stimulus packages in places like the US come at a time when private sector activity is increasing, raising the chance of inflation overshoots, but the forces that restricted prices from rising in the past will reassert themselves in the long run.
Reducing the debt load is not likely to be high on the list of political priorities until there is a shift in the rate outlook, making debt sustainability a more urgent issue. Until then, the risk of removing stimulus in the early stages of the recovery, the lingering risks around vaccines and virus mutations, and the tolerance for rising debt implies policies will be focused on supporting the economy.
This is not true everywhere and the Australian government is looking to get the budget back on track given the faster recovery, low case count and ongoing vaccine roll-out.
Similarly in China, where they have been a step ahead in the economic recovery, the focus has shifted not to debt sustainability, but financial stability and the risk of bubbles being created from leaving the taps open for too long.
The dialling back of stimulus measures in Australia – in sharp contrast to the US – will create disparities. This fiscal divergence will show through in the form of economic divergence in the coming quarters.
WHAT DOES ALL THIS DEBT MEAN?
Persistently higher debt may create a more volatile economic and market outlook. More debt heading into the next recession, which is hopefully still some years in the future, could amplify the volatility.
The implications for inflation are the current focus for markets given the uncertainly around the inflation outlook, although this differs by country. For example, it’s more likely that US policy makers may have greater success in pushing inflation above the central bank target than European policy makers.
Eventually, market attention will turn towards the sustainability of fiscal support and investors will focus on differentiating economies based on their fiscal capacity to continue spending and their ability to direct stimulus to opportunities with the greatest economic impact. Those countries with room to spend more are likely to be viewed favourably when the time comes to increase spending to offset the next economic shock.
The implications of debt sustainability are more obvious for bond markets given the scope for bond yields to be kept low, contrasting the risk of higher than expected inflation.
Low rates will also translate to higher valuations in equity markets over time, as a lower discount rate is applied to future earnings. As equity investors become more accustomed to debt, developed equities markets are likely to become a portfolio tool used for income rather than capital appreciation. Higher debt loads should enable higher shareholder payouts either though dividends or buybacks.
The upshot of all this debt is that the role of government bonds as an income generator is severely curtailed and poses a greater risk than reward in portfolios today, and equities may take up the mantel of income provider. The result will likely be an increasing allocation to alternative assets within portfolios where the characteristics of the underlying investments fulfil the role that traditional asset classes did in years gone past.
Kerry Craig is a global market strategist at J.P. Morgan Asset Management.
