Recovery is still a way off

Recovery is still a way off

One of the biggest economic legacies of Covid-19, and the various record fiscal support packages it demands, will be the build-up in government debt.

In the absence of a vaccine and with a second spike looming, initial hopes of a V-shaped recovery appear to be lost and the policy stance looks likely to stay abnormally loose.

In any case, governments will be left with a concerning debt pile-up, which, in the absence of effective economic levers, will likely present policymakers with issues down the line.

The strong recovery in equity markets looks driven more by record fiscal stimulus, ultra-low bond yields, the prospect of even easier money, and hopes that governments can propel future growth rather than any convincing sign of economies returning to ‘normal’.

Although the macro data appear to be improving slowly, this may be a comparatively low macro hurdle to clear, after the second quarter’s ‘eye of the storm’ wiped out years of economic growth (see chart).

How the situation plays out, of course, rests on more than finance, and analysts’ implicit assumption that Covid-19 is nearing its (only) peak probably depends still on a vaccine yet to be found.

Reflecting this, expectations of swift V-shaped macro recoveries have morphed into something closer to a U or W, which seem more likely. Central banks, long frustrated by inflation’s absence, are starting to question their traditional reaction functions, such as consumer price index targets and Phillips curves.

Mandates could change, and the latest tilts in US Federal Reserve, Bank of Japan, and Bank of England policy could all herald more widespread paradigm shifts, although such changes would not meaningfully tighten conditions.

We estimate the Fed and BoE will continue to run negative policy rates (currently -10 per cent and -6 per cent) when quantitative easing is considered.

This confirms by far the loosest overall stance we have known, highlights how little correction there will be in 2021, and questions the need for either of them to follow the BoJ and European Central Bank onto negative ‘headline’ rates.

Either way, the legacy will be debt build-up, which was amassing even before the virus. The US, Eurozone, and UK governments’ net debt as a share of GDP (about 100 per cent) is now approaching three times Japan’s when it entered a ‘lost decade’.

Thankfully, like Japan, all are in local currency, implying default risk is next to zero.

This gives their governments time to put growth and inflation generation ahead of more direct ways of addressing the debt.

Such a relaxed approach would be akin to dealing with the UK’s post-War debt that started at 250 per cent of GDP, with the advantage this time of no longer having the US dollar-denominated obligations that contributed to our having to borrow from the International Monetary Fund in 1976.