Policymakers face obstacles in getting the economy back on track.
- 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 U.S.‑China relations, and defaults in the U.S. nonfinancial corporate sector.
- Other risks include fiscal consolidation in developed markets, a fiscal crisis in emerging markets, and another eurozone debt crisis.
The easing of the coronavirus lockdowns has led to a resurgence of global economic activity in recent weeks. However, many businesses will not be able to continue after suffering major revenue losses, and millions of workers have lost their jobs. Will this resurgence turn into a durable economic recovery, or will the post‑lockdown green shoots wither and die?
Historically, following a recession it takes, on average, six quarters for gross domestic product (GDP) to reach its pre‑recession level. The size of the economic shock and the unique circumstances of the current recession suggest that it will take a little longer this time. We believe that there are six key risks that present acute challenges to the economic recovery. These are:
- A second wave of the coronavirus
- Flaring up of U.S.‑China tensions
- A wave of defaults in the U.S. nonfinancial corporate sector
- Fiscal consolidation in developed markets
- A fiscal crisis in emerging markets
- A resurgence in populism that leads to another eurozone debt crisis
Below, we discuss these risks and assess the threat each poses to the global economic recovery.
A Second Wave of the Coronavirus
Most, if not all, countries in the world are far from the threshold of contagion that would ensure herd immunity, and it may take a while to produce a vaccine for COVID-19 (the disease caused by the coronavirus), despite positive developments in that area. Against this backdrop, the key question becomes whether common sense social distancing will allow us to reopen our economies without driving up the reproductive rate of the virus. The experiences of South Korea and Singapore, and early indications from Europe, provide some hope that this may be possible. If it is possible for countries to reopen most sectors of their economies without triggering a serious second wave of contagion, the global economic recovery will, most likely, continue.
Common sense social distancing will be a drag on economic growth as it prevents certain sectors, in particular the hospitality industry, from operating at pre‑crisis levels of capacity. However, this is still a much better outcome than a second lockdown, which would result in a double‑dip recession. The key question is whether it will be possible for people to function as economic agents until a vaccine is discovered.
The U.S. presidential election is looming, and China is portrayed as a villain by both the Republicans and the Democrats. The core tensions in the U.S.‑China relationship are structural: Since it was founded, the U.S. has positioned itself the defender of freedom and has fought wars with the justification that it seeks to protect democracy anywhere in the world. China is an authoritarian regime without democratic accountability that seeks to make the world safer for authoritarian regimes.
The U.S. has tried to integrate China into the global economy in the hope that, over time, growing prosperity will encourage its citizens to demand more democracy. However, it is now clear to everybody in the U.S. policy apparatus that this effort has failed. At the same time, China is getting ahead in the technology race, which means the U.S. faces a more formidable challenge from a competing governance system than it ever did from the Soviet Union.
Uncertainties over the future of U.S.‑China relations, the pressure to relocate supply chains, and restrictions on the export of technology and other trade are headwinds to growth and risks to the recovery. Friction in the relationship has clearly escalated over the past months, with a tightening of the controls on technology exports and the introduction of the National Security Law in Hong Kong. There will be plenty of noise ahead of November’s presidential election, and it remains possible that President Donald Trump could withdraw from the phase I trade deal to galvanize political support. On balance, we believe that the phase I trade deal will survive, but with diminishing conviction. Risks of other missteps are aplenty, with great sensitivity around Hong Kong- and Taiwan-related issues.
U.S. Nonfinancial Corporate Debt Has Surged in Recent Years
(Fig. 1) It is now around 75% of GDP
As of December 31, 2019.
Source: International Monetary Fund.
U.S. Nonfinancial Corporate Defaults
U.S. nonfinancial corporates (NFCs) have taken on a substantial amount of debt in recent years. According to the Federal Reserve, the debt of the NFC sector has risen from 66% of GDP in 2012 to 75% of GDP in 2019. The re‑leveraging of nonfinancial corporate balance sheets has, interestingly, not been associated with a major capex boom. As such, the increase in leverage appears to indicate financial engineering (leveraging of earnings, increased dividend payments, mergers and acquisitions) rather than the accumulation of a macro imbalance in need of a recessionary purge. The rise in leverage is partly a response to a reduction in the cost of debt and partly just a reflection of the traditional rhythm of the business cycle: As the cycle matures and profit margins come under pressure, earnings are leveraged more aggressively to generate shareholder returns.
This raises the question of whether a tsunami of corporate defaults is likely to wash over the economy, causing significant losses to the balance sheets of leveraged financial intermediaries. We are less concerned about this than the consensus view, for three reasons: First, the debt has been assumed at very low interest rates, which keeps the cost of servicing the debt at a surmountable level; second, the U.S. government has provided a lot of support for the sector through the USD 660 billion Paycheck Protection Program; and third, the balance sheets of leveraged financial intermediaries are, in part due to financial regulation, in a much better position than they were prior to the global financial crisis. Based on the low cost of servicing the debt and the absence of a capex boom, our internal models point to a default rate for the U.S. high yield sector in the 7%–9% range. Of course, should the economy be hit by another shock, such as a second lockdown, all bets are off—no company survives without revenues.
Fiscal Consolidation in Developed Economies
Governments have taken significant steps to support their economies during the crisis. The fiscal deficit of the average developed economy is projected to be around 7.2% of GDP in 2020,1 compared with a peak of 6% of GDP during the 2007–2008 global financial crisis. This potential increase in the fiscal deficit will lead to a sharp rise in the debt stock. Most developed market economies have the institutional infrastructure to monetize the deficits through quantitative easing, and in most cases the stock of debt will never be reduced—countries will simply “grow out of it.” For this reason, we are not overly concerned about the ballooning debt stocks in the developed economies.
A more pressing issue is whether economic growth will be sufficiently resilient to withstand the headwind that follows when countries inevitably embark on fiscal consolidation (polices aimed at reducing deficits and debt accumulation). We believe that fiscal consolidation will follow a similar path to that seen during the global financial crisis, when temporary measures were extended as far as possible before being phased out slowly. On the eve of the coronavirus shock there were few real economy imbalances, so it is likely that if fiscal consolidation is paced appropriately, growth can withstand the headwind from the fiscal tightening. If, however, policymakers come under pressure to reduce deficits more quickly, there is the potential for missteps.
1 Source: IMF World Economic Outlook Update, June 2020.
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