It’s been a race to zero for central banks around the world, with interest rates of monetary authorities of the currency majors at, near, or below 0%, and where in the case of the US Federal Reserve (Fed) and European Central Bank (ECB) embarking on unlimited quantitative easing programs that have sent liquidity flooding the financial markets, and in turn creating an even larger gap between the real economy that’s suffering contraction from the lockdown, and financial assets that are being propped up by central banks more directly.
Prior to Covid-19 central bank interest rates were already low by historical standards, and a lack of liquidity had already witnessed the Fed intervene in the repo market. Elsewhere the ECB had begun its bond purchasing program, buying up bonds and forcing investors into riskier assets. Given the global manufacturing sector was in a recession and yields on bonds were low (or downright negative), taking on greater risk to secure smaller rewards in equities seemed to be one of the few choices left in a world of dwindling returns.
On the fiscal policy front, governments under pressure to deliver in the face of populist forces increased their spending, funded by issuing bonds, which in turn relied on central banks to help purchase them else risk facing a liquidity crisis on a lack of natural buyers. The recent big fiscal stimulus packages that have been passed by governments globally will be ever more reliant central bank printing and pushing both deficits and overall natural debt to fresh (and in some cases, record) highs.
The initial worry was over supply-side shocks when the virus forced a lockdown in China – a global manufacturing powerhouse – and sent suppliers scrambling for alternatives. Once it spread globally, it became a bigger demand-side worry (on certain goods and sectors) given households hunkering down would focus more on necessities. No amount of monetary or fiscal stimulus could entice one into traveling when borders are closed, or rely on the hospitality sector that in some countries had been shut down.
On the supply side, disrupted supply chains that persists translates into shortages, too much liquidity chasing fewer more-expensive-to-produce necessities on offer results in higher prices for at least non-luxury goods, and rising costs combined with weakened demand necessitates layoffs in the worst hit sectors. Prices rising on strong demand is considered a boon, but inflationary pressures due to rising costs spares none.
That triggers corporate debt repayment fears as it gets harder to service that debt with credit spreads widening, and in turn make it more difficult for corporate share buybacks, which with earnings set to get tested will translate into an earnings per share miss. The story then, had shifted from supply-side shock to demand-side worries, to outright fears of bankruptcy. Servicing the ever growing corporate and household debt in a time of starved liquidity became the next item of focus, and resulted in more direct approaches by central banks and governments to stave off a credit crunch.
This has made companies both large and small ever more reliant on direct access to more funding, and those that don’t have access to it or don’t receive enough to stay afloat will be at greater risk of bankruptcy, which in a debt-based system implies default, which in turn would shake credit markets. Extending that to household debt which will be suffering from far higher levels of unemployment and a smaller chance that SMEs will survive and that means defaults will extend to households and their respective assets, be it homes, cars, or small businesses.
Even after Covid-19, businesses that survive will be far more cautious in terms of bringing business back online, consumers far less likely to purchase non-essentials, and investors keener on wealth preservation than taking on greater risk to seek fewer rewards. Manufacturing was the sector most hurt prior to the onset of the coronavirus, but will likely outperform compared to services, with a focus on necessities and a more consolidated lineup that will take less risk in introducing product variants, opting to stick with limited size and scope instead.
Fears of a second or even third wave of cases will constantly challenge both perception and the economy, and will continue to factor into decision-making on multiple levels, and keep the hospitality sector ever reliant on government funding for survival. Share buybacks will be more heavily scrutinized in the short-term and certain companies who take US funding will be barred from doing so temporarily.
Governments will be carrying far greater obligations moving forward and will have even less financial leeway to deal with any future crisis, with more programs likelier to get axed to service a larger pile of debt. Expect a downgrading of sovereign debt to occur, which would increase the reliance on central banks to buy that debt, and hence a continuation of monetary easing and currency depreciation, which in turn would spark inflationary pressures. More desperate global circumstances could result in more desperate actions, and cause geopolitical tensions to rise.
When it comes to the stock market, while investors may fear purchasing riskier assets, pension funds whose obligations continue to rise (even after factoring in the age group most susceptible to the coronavirus) will have little choice but to seek out assets supported indirectly and directly by both governments and central banks. Should bond ratings drop and inflationary pressures persist, and the hunt for a hedge against inflation may finally commence.
The gap between financial markets and the real economy usually means one eventually has to give in to the other, be it financial markets plummeting to match that of the real economy or the latter improving to match the results of the former. Prior to the current era that gap was being held monetary easing and, in some countries, fiscal stimulus, and given both have expanded considerably, that gap could easily widen further.
* Any opinions expressed in this article are the author’s own
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© Opinion 2020