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2021: The (Most Likely) Financial Agenda
There are many things that should worry investors in 2021, but the most important are the possibility of a stock market bubble and the rise in corporate debt.
09 February, 2021

The year of 2020 will be remembered by many for the health crisis caused by the COVID-19 pandemic, the lockdowns that dismantled our very fabric of social life, or maybe the release of the much-awaited Coronavirus vaccine. But for economists and policymakers, 2020 will be remembered as the year when much of the conventional economic wisdom was turned upside down. While the new vaccine brings hope for the end of the medical crisis, economists face a harsh economic outlook for the year ahead. Below are some of the economic issues that will very likely occupy the spotlight of research papers, economic symposiums, and politicians’ agendas for 2021.

Government Debt

It comes as no surprise that the large amount of sovereign debt piled up during this year is already the subject of intense economic and political debate. According to the Institute of International Finance, global debt rose by $15tn this year alone and is likely to exceed $277tn by 2021, almost 365% of global GDP. This is up almost 50% from the level of global debt at the end of 2019. The US alone accounted for half of this; its debt is set to reach $80tn this year, from $71tn in 2019. To put this into perspective, the annual deficit and total level of nominal debt in the US has reached levels not seen since World War II. While such figures would worry any sensible observer, the particularities of this recession have changed the way economists look at debt. As recently argued in a paper by Lawrence Summers, the account of debt as a percentage of GDP is not always relevant in determining the fiscal risks. While indeed the level of debt increased unprecedentedly this year, the cost of servicing debt has decreased in most of the developed countries. If at the end of the 2008 Financial Crisis the share of government revenue spent on public debt service was 6%, today that figure is somewhere around 4%. This means that even if the level of debt is 50% higher than last year, the real impact on the governments’ budgets will be roughly 2% smaller.

But these considerations did not stop politicians from acting against large fiscal stimulus packages, potentially at the expense of a ‘V’ shaped economic recovery. As seen in the United States, arguments over the size of future government interventions and Central Banks’ lending powers will culminate the political debate of 2021. All eyes are on the newly elected US president Joe Biden and the run-off Senate races in Georgia, that could determine economic policy for the years ahead.

Inflation

There wouldn’t be much of a worry about the current levels of debt had it not been for inflation. The problem is that the reduction in the cost of servicing debt has been propelled by massive intervention from Central Banks who slashed interest rates to all-time lows and expanded their balance sheets through Quantitative Easing. According to monetarists, large fiscal spending, combined with loose monetary policy, should lead to an inevitable spike in inflation. Increases in the price level had stayed surprisingly below the 2% threshold for the past decade, for reasons not yet fully understood by economists. But the large fiscal intervention into the economy, combined with a possible boost in demand as people return to their normal lives, might lead to at least a temporary post-pandemic period of higher inflation. If this is the case, Central Banks will have no option but to raise nominal interest rates. At such high levels of debt such a move would significantly alter governments’ ability to fulfil their debt obligations.

It is true that most economists argue that demand and inflation are likely to stay below potential levels for the coming years. Furthermore, the relationship between inflation and government spending is not as strong as was once believed (a phenomena known in the literature as the flattening of the Phillips curve). Summers notices that the large government intervention in the aftermath of the 2008 Financial Crisis exhibited no noticeable inflation, albeit under different economic circumstances.

While we can sensibly expect inflation to remain within normal levels, governments should nonetheless take steps and protect their finances from such risks. One solution advocated by the Fed’s Chairman, Jerome Powell, is to increase the time span of borrowing. Much of the fiscal intervention in the US and Europe was financed with short-term bonds of 2 to 4 years. These short- term bonds are attractive because they avoid involving the government in long-term debt obligations. Nonetheless, they expose governments to possible short-run spikes in inflation. Borrowing at longer maturities would allow governments to edge against post-Covid 19 demand- driven inflation. The forward guidance from the Fed, who committed to low interest rates for the years to come, should offer enough incentives for policymakers to pursue longer term debt.

Emerging Markets

The burden of COVID-19 falls especially hard on emerging markets, who saw an increase of 26% in debt in 2020, reaching almost 250% of GDP by 2021, according to data from IIF. A spike in unemployment in EM led to a decrease in the ability of governments to collect tax revenues, thus increasing the cost of servicing debt. This comes in contrast with the decreasing cost of servicing debt observed in developed economies. International agencies such as the World Bank and the IMF will have to find ways in which to delay debt repayments from developing countries or otherwise face a wave of defaults and restructurings in 2021. This will require stronger collaboration with credit rating agencies and private debtors, whom so far had refused to participate in debt relief programs such as the $5bn Debt Service Suspension Initiative (DSSI) announced by the G20 in April. Failure to do so will lead to a fiscal crisis that will cripple economic growth and access to capital markets in developing countries, reversing years of economic improvements.

Another economic dilemma faced by developing countries is the devaluation of their currency by setting very low interest rates in order to attract more exports and increase output. Such a practice seems attractive to governments as it stimulates growth while at the same time reducing the cost of repaying debt. But this is not a risk-free policy. Out of the $17bn of debt in EM that will need to be paid in 2021, 15% is denominated in US dollars. This will mean that a currency devaluation against the dollar will significantly reduce the EM’s capacity to repay its debt in foreign currency. This will also mean that these countries will see a reduction in their credit rating, limiting their access to international capital markets and potentially leading to a sell-off in EM bonds by foreign investors.

The Financial Markets

There are many things that should worry investors in 2021, but the most important are the possibility of a stock market bubble and the rise in corporate debt.

Empirically, the first seems easy to imagine given the historical rally the financial markets have had since the drops in April. Theoretically, it partially depends on whether prospects for corporate earnings are strong and interest rates will remain at low levels. Using Robert Shiller’s famous inverted cyclically adjusted price/earnings ratio we observe a yield on the S&P 500 of just 3% today. The only years it has been lower than this were 1929 and 1999-2000. Something hardly desirable by any investor.

The real difference this time is the ultra low interest rates. Expected returns on equities should be considered together with the returns on such supposedly safe assets, something known as the equities risk premium. The lower the interest on bonds, the higher the return investors expect from equities. Furthermore, low interest rates also acted as an incentive for investors to seek higher returns on riskier assets. The case for the 60/40 portfolio might be long gone.

These two effects together explain the momentum in the markets, despite a much more pessimistic outlook for the real economy. But the contrast between the markets’ rally and the slumping economy might prompt political action against Wall Street.

Investors should also look out for ‘zombie’ companies whose survival depends on the cheap credit made available by low interest rates and Central Banks’ corporate debt purchase programmes. Data suggests that companies rated triple C minus have almost doubled compared to last year. The economic implications of this phenomenon are likely to be seen in less productivity and a less efficient allocation of capital in the coming years. Creative destruction often lays at the core of a post-recession economic recovery. Policymakers will clearly want to consider this as we find our way out of the pandemic.

Government Debt

It comes as no surprise that the large amount of sovereign debt piled up during this year is already the subject of intense economic and political debate. According to the Institute of International Finance, global debt rose by $15tn this year alone and is likely to exceed $277tn by 2021, almost 365% of global GDP. This is up almost 50% from the level of global debt at the end of 2019. The US alone accounted for half of this; its debt is set to reach $80tn this year, from $71tn in 2019. To put this into perspective, the annual deficit and total level of nominal debt in the US has reached levels not seen since World War II. While such figures would worry any sensible observer, the particularities of this recession have changed the way economists look at debt. As recently argued in a paper by Lawrence Summers, the account of debt as a percentage of GDP is not always relevant in determining the fiscal risks. While indeed the level of debt increased unprecedentedly this year, the cost of servicing debt has decreased in most of the developed countries. If at the end of the 2008 Financial Crisis the share of government revenue spent on public debt service was 6%, today that figure is somewhere around 4%. This means that even if the level of debt is 50% higher than last year, the real impact on the governments’ budgets will be roughly 2% smaller.

But these considerations did not stop politicians from acting against large fiscal stimulus packages, potentially at the expense of a ‘V’ shaped economic recovery. As seen in the United States, arguments over the size of future government interventions and Central Banks’ lending powers will culminate the political debate of 2021. All eyes are on the newly elected US president Joe Biden and the run-off Senate races in Georgia, that could determine economic policy for the years ahead.

Inflation

There wouldn’t be much of a worry about the current levels of debt had it not been for inflation. The problem is that the reduction in the cost of servicing debt has been propelled by massive intervention from Central Banks who slashed interest rates to all-time lows and expanded their balance sheets through Quantitative Easing. According to monetarists, large fiscal spending, combined with loose monetary policy, should lead to an inevitable spike in inflation. Increases in the price level had stayed surprisingly below the 2% threshold for the past decade, for reasons not yet fully understood by economists. But the large fiscal intervention into the economy, combined with a possible boost in demand as people return to their normal lives, might lead to at least a temporary post-pandemic period of higher inflation. If this is the case, Central Banks will have no option but to raise nominal interest rates. At such high levels of debt such a move would significantly alter governments’ ability to fulfil their debt obligations.

It is true that most economists argue that demand and inflation are likely to stay below potential levels for the coming years. Furthermore, the relationship between inflation and government spending is not as strong as was once believed (a phenomena known in the literature as the flattening of the Phillips curve). Summers notices that the large government intervention in the aftermath of the 2008 Financial Crisis exhibited no noticeable inflation, albeit under different economic circumstances.

While we can sensibly expect inflation to remain within normal levels, governments should nonetheless take steps and protect their finances from such risks. One solution advocated by the Fed’s Chairman, Jerome Powell, is to increase the time span of borrowing. Much of the fiscal intervention in the US and Europe was financed with short-term bonds of 2 to 4 years. These short- term bonds are attractive because they avoid involving the government in long-term debt obligations. Nonetheless, they expose governments to possible short-run spikes in inflation. Borrowing at longer maturities would allow governments to edge against post-Covid 19 demand- driven inflation. The forward guidance from the Fed, who committed to low interest rates for the years to come, should offer enough incentives for policymakers to pursue longer term debt.

Emerging Markets

The burden of COVID-19 falls especially hard on emerging markets, who saw an increase of 26% in debt in 2020, reaching almost 250% of GDP by 2021, according to data from IIF. A spike in unemployment in EM led to a decrease in the ability of governments to collect tax revenues, thus increasing the cost of servicing debt. This comes in contrast with the decreasing cost of servicing debt observed in developed economies. International agencies such as the World Bank and the IMF will have to find ways in which to delay debt repayments from developing countries or otherwise face a wave of defaults and restructurings in 2021. This will require stronger collaboration with credit rating agencies and private debtors, whom so far had refused to participate in debt relief programs such as the $5bn Debt Service Suspension Initiative (DSSI) announced by the G20 in April. Failure to do so will lead to a fiscal crisis that will cripple economic growth and access to capital markets in developing countries, reversing years of economic improvements.

Another economic dilemma faced by developing countries is the devaluation of their currency by setting very low interest rates in order to attract more exports and increase output. Such a practice seems attractive to governments as it stimulates growth while at the same time reducing the cost of repaying debt. But this is not a risk-free policy. Out of the $17bn of debt in EM that will need to be paid in 2021, 15% is denominated in US dollars. This will mean that a currency devaluation against the dollar will significantly reduce the EM’s capacity to repay its debt in foreign currency. This will also mean that these countries will see a reduction in their credit rating, limiting their access to international capital markets and potentially leading to a sell-off in EM bonds by foreign investors.

The Financial Markets

There are many things that should worry investors in 2021, but the most important are the possibility of a stock market bubble and the rise in corporate debt.

Empirically, the first seems easy to imagine given the historical rally the financial markets have had since the drops in April. Theoretically, it partially depends on whether prospects for corporate earnings are strong and interest rates will remain at low levels. Using Robert Shiller’s famous inverted cyclically adjusted price/earnings ratio we observe a yield on the S&P 500 of just 3% today. The only years it has been lower than this were 1929 and 1999-2000. Something hardly desirable by any investor.

The real difference this time is the ultra low interest rates. Expected returns on equities should be considered together with the returns on such supposedly safe assets, something known as the equities risk premium. The lower the interest on bonds, the higher the return investors expect from equities. Furthermore, low interest rates also acted as an incentive for investors to seek higher returns on riskier assets. The case for the 60/40 portfolio might be long gone.

These two effects together explain the momentum in the markets, despite a much more pessimistic outlook for the real economy. But the contrast between the markets’ rally and the slumping economy might prompt political action against Wall Street.

Investors should also look out for ‘zombie’ companies whose survival depends on the cheap credit made available by low interest rates and Central Banks’ corporate debt purchase programmes. Data suggests that companies rated triple C minus have almost doubled compared to last year. The economic implications of this phenomenon are likely to be seen in less productivity and a less efficient allocation of capital in the coming years. Creative destruction often lays at the core of a post-recession economic recovery. Policymakers will clearly want to consider this as we find our way out of the pandemic.

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