- Once the initial post-lockdown economic surge has abated, the global economy faces six key risks to its long-term recovery.
- These include a second wave of the coronavirus, deteriorating US-China relations and defaults in the US no-financial corporate sector.
- Other risks include fiscal consolidation in developed markets, a fiscal crisis in emerging markets and another eurozone debt crisis.
Economic activity is surging on the back of the easing of the coronavirus lockdown measures.
The big question for us is whether the economic recovery will be sustainable once we get to the other side of this initial surge.
We see six key risks to the economic recovery. These risks are:
1. A second wave of the coronavirus
2. A flare up of the tensions between US and China
3. A wave of default across the U.S. non-financial corporate sector
4. The looming fiscal consolidation across the developed economies
5. The scope for fiscal crisis in the emerging markets
6. The scope for another Eurozone crisis, which would be triggered by a surge in populism.
Let’s examine each of these six points.
1. A Second Wave of the Coronavirus
It is pretty clear that the coronavirus is not going to away, so until we have a vaccine, we are going to have live with it. We are probably going to be living in a world with sporadic outbreaks. And The political response to these outbreaks becomes key.
The key question for us is to what extent will we be able to go back to operating like economic agents and reopening our economies without triggering a wide-range, broad-based second lockdown.
How far can we get with common sense social distancing?
If we look across the world, there is some scope for optimism.
We look to Korea, and we look to Germany, and we look to China. We have seen second-wave outbreaks, but we have been able to manage these second wave outbreaks without triggering severe lockdowns.
Of course, we will not be able to open every sector of the economy. In particular, services is going to be a drag and will not go back to operating at full capacity.
Think about restaurants, hotels, etc. We think that if we can reopen our economies and we can avoid a second lockdown, we will be able to keep this recovery online.
2. A Flare Up In US‑China Geopolitical Tensions
The U.S. presidential elections are looming, and it is pretty clear that both Democrats and Republicans are going to paint China as the ultimate villain.
For years, the US has had the strategy of integrating China into the global economy in the hope that rising household incomes will put pressure on the Chinese political system to change into a democracy. Clearly, this is not happening.
In addition, China is getting ahead in the tech race. And therefore, China is a much formidable challenge to the US than the Soviet Union ever was.
Now, it’s pretty clear to all of us that over the last couple of years, US-China uncertainty has been a headwind to growth. And as long as these geopolitical tensions remain, that will continue to be the case.
It is our view, though, that the phase one trade deal will remain on track and that the tensions between the US and China will take much more of the nature of a fight over values and of tech.
With that, we believe, that the US-China geopolitical relationship will not derail the economic recovery.
3. A Wave of Defaults Across the U.S. Non-financial Corporate Sector
The debt of the U.S. non-financial corporate sector has surged over the last decade or so. In part, this has been in response to cheap credit, low interest rates, tight credit spreads. And in part, this has been about companies wanting to deliver on shareholder expectations of earnings.
We think that the concerns about a big wave of defaults across the US non-financial corporate sector is somewhat overblown. Our internal models put the default rate for the U.S. high yield sector in the 7 to 9 percent range. We should be able to cope with that without derailing the recovery.
Of course, if we go through a second lockdown, all bets are off. No company can survive for a long period of time without any revenues.
4. The Fiscal Consolidation in The Developed Market Economies
To support economic activity as we’ve gone through the lockdowns, governments have allowed fiscal deficits to surge.
We are not too concerned about the stock of that, which has obviously grown to quite significant levels. We are much more focused on the flow of the fiscal deficit and on the fiscal consolidation.
We believe that developed market economies will be given the time to undertake the fiscal consolidation and rein in fiscal deficits in tandem with a pick-up in private demand. As such, the fiscal consolidation of the developed market economies should not impose a problem to the recovery. It will be a headwind, but it will not derail the recovery.
5. A Fiscal Crisis in Emerging Market Economies
While we are not too concerned about the fiscal situation in the developed economies, we are much more concerned about the fiscal developments in the emerging markets.
Emerging market economies generally have a weaker institutional infrastructure than developed economies. As a consequence, they are less able to shoulder large fiscal deficits. When fiscal deficits become too large, they tend to lead to a run on the currency and in extreme scenarios to an inability of a government to refinance its debts.
When we look across the universe of emerging markets, two countries in particular stick out – South Africa and Brazil. So when we look at South Africa, we see an external deficit. We see a very large fiscal deficit. And we see a very large stock of debt.
All of this is combined with a political fragility in that South Africa has a distinct key-man risk. Altogether, this leaves South Africa fragile and vulnerable to a fiscal crisis.
The situation in Brazil is somewhat different. But Brazil also has a very large fiscal deficit and a large stock of debt. In addition, Brazil has a history of high inflation, which leaves the economy vulnerable to runs on the currency.
Altogether, the non-China emerging markets account for a little less than 20% of global GDP. As such, a fiscal crisis in some of these economies is going to be a headwind to the global recovery, but it is probably not going to derail the global recovery.
6. A Eurozone Crisis Triggered by a Surge in Populism
Many of the economies in the Euro area, in particular the southern part of the Euro area, have been living through a decade of very weak growth. This has left big portions of the population feeling angry and feeling like they live in a world without any opportunities.
Now they’ve been hit by the coronavirus shock. They may have another decade ahead of them that will not be good in terms of employment and will increase the resentment of the population against the Euro area.
This is a fertile ground for populist policymakers. Whilst, the coronavirus shock is not the fault of any economy and in particular it is not the fault of the southern European economies, the lack of fiscal space is their own doing, and this is a problem. If we get the combination of a populist policymaker and we have countries without fiscal space, it becomes very difficult for the wealthier economies in the Euro area to explain to their populations why they need to make fiscal transfers to another economy when there are not even enough jobs at home.
The Franco-German Recovery Fund is an attempt to preempt a surge in populism. Whilst the economic amounts in the Franco-German recovery fund are indeed meaningful, we see the much bigger value of this fund as political. The fund signals solidarity across the Eurozone. Wealthier countries are willing to help less fortunate countries in the Euro area.
Whether the recovery fund will turn out to be successful remains to be seen. And a lot depends on the terms and conditions that will be attached to the loans and grants distributed from the fund.
Whilst, no risk individually may derail the recovery, the combination of these six key risks will be a powerful headwind to the economic recovery. The defining question over the coming couple of years is how policymakers respond to these risks.
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